Like every country, India has its own central bank – RBI, which performs the following roles:
1. Conduct monetary policy
2. Monitor and regulate banks and financial institutions
3. Act as government’s bank
I will focus primarily on the first role in this article. Conducting monetary policy means that the central bank is in charge of making sure the country has the right amount of money by taking decision on how much money gets printed and how much get circulated into the economy.
What do we mean by money?
By money we mean currency, coins, deposits, saving accounts, travelers’ checks and short term deposits (less than 90 days). Credit cards are NOT considered as money because money is an asset while transaction on credit card is a liability i.e. credit.
Right amount of money
So how much is the right amount of money in an economy? Economists say that the right amount is just “enough money” that allows aggregate demand (AD) to grow at a rate that will let the economy expand at an acceptable rate without inflation. In layman’s language, right amount of money is just enough money to enable growth of GDP at a healthy rate without inflation. It is for the central bank (RBI) and/or the government to decide how much is a healthy GDP growth rate and how much inflation is acceptable.
Goals of RBI
The following quote comes from the RBI website and explains its goals:
\"...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.\"
Tools and Policy
It is clear from RBI’s goal that its main role is to maintain low and stable inflation by regulating credit system of the country. To understand this we need to know what causes inflation in the economy. Inflation is an increase in the prices of goods and services in the economy. It is caused by excess demand of products and services by the population due to increased growth or income. Hence, an increase in aggregate demand (AD) causes inflation. To check inflation, RBI has to control growth in AD. The best way to influence AD is to influence interest rate because AD is interest rates sensitive.
Interest rates on home loans influence housing demand. Auto loan rates affect the plan of individuals to purchase automobiles such as cars, bikes and trucks. Banks loan affects the ability of corporate to borrow and hence, influence economic growth. Hence, if RBI or any other central bank has to control AD, it has to influence interest rates.
However, RBI does not decide interest rates directly i.e. it cannot decide the interest rates on home loans or auto loans or corporate borrowing. RBI simply does not have any direct control over them. It can only use its tools to influence key rates. Whatever these tools may be, always remember the common thing – Controlling the amount of money that flows into the economy.
1. By reducing the availability of money in the economy, RBI can reduce AD because lesser money will be there to buy things – decreasing demand
2. By increasing the availability of money in the economy, RBI can increase AD because individuals as well as corporate have more money to spend – increasing demand
3. To reduce AD, raise interest rates because people and corporate will borrow less money and hence spending will go down. This would in turn reduce the demand for goods and services.
4. To increase AD, just do the reverse i.e. lower the interest rates. Individuals and corporate would borrow more money at lower rates and consume more goods and services, increasing AD in the economy.
Changing the Cash Reserve Ratio (CRR)
Banks cannot loan out all their deposits because they may fail soon. RBI or central banks require banks to keep a small portion of their deposits as “banks reserves”, which the banks cannot lend out. The current value of CRR is ….
When RBI increases CRR, banks are required to keep a higher amount of money in their banks reserves. Hence, less money is available for individuals and corporate in the market. This causes AD to decrease (see point no 1 above) and thus reducing inflation. On the other hand when RBI decreases CRR, Banks have more funds to lend to people. To loan out these extra money, banks will reduce the interest rates and increase AD.
Changing the Bank Rate
This is the rate at which RBI lends money to other banks (or financial institutions). These loans are usually very short-term loans. The main idea is that if the central bank, RBI, has reduced this rate, it is a signal to banks that it is appropriate to borrow money from it in larger quantities. These banks then lend out this extra money to their customers. To loan out these money banks have to lower interest rates which in turn increase AD.
Changing the Reverse Repo Rate
The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the reverse repo rate. The RBI uses this tool when it feels there is too much money floating in the banking system.
If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk). Consequently, banks would have lesser funds to lend to their customers. This helps reduce the flow of excess money into the economy.
Open market operations
This is the primary and most frequent way by which RBI control monetary policy. Open market operations involve buying and selling of short term government securities. This method may be different from others but the end result is the same – controlling money supply in the economy.
When RBI buys government securities from commercial banks, it gives them money and keeps those securities with itself. Thus, banks have now more money to lend out (see point 2). To loan out this extra money, banks lower interest rates on their products. We know how lower interest rates influence AD.
Current Rates Figures (as of Jan 6, 2009)
CRR = 5.0%
Repo Rate = 5.5%
Reverse Repo Rate = 4.0%
Final Few Words
Nobel Laureates Finn Kydland and Edward Prescott once wrote that policy makers should be time consistent i.e. stick to their good long-run policies and not have their attention diverted to short-term emergencies. Had our RBI and central government listened to his wise comments, they would not have made hasty short-term decisions to control liquidity to tame inflation even. They were aware of the fact that inflation was caused by supply side constraints and NOT demand side. Yet, short term decisions, which are more often politically motivated, affect long term growth of the country. The aggressive approach of RBI has now led to a severe credit crunch in our economy. Some may argue that it is caused by sub-prime crisis and not RBI’s policies. I partially agree to that. However, majority of liquidity issues were caused by increased CRR.
Source: http://www.indianmoney.com/article-display.php?cat_id=2&sub_id=21&aid=102&ahead=Monetary%2520Policy%2520of%2520Reserve%2520Bank%2520of%2520India
Saturday, June 26, 2010
Fixed Income Securities - Bonds Basics
A bond is a debt security, similar to an I.O.U (I Owe yoU) .When you purchase a bond; you are lending money to the issuer which may be a government, municipality, corporation, federal agency, corporate or other entity. In return for the loan, the issuer promises to pay you a specified rate of interest during the life of the bond and to pay back the face value of the bond or the principal when it “matures,” or comes due.
Among the types of bonds you can choose from are: government securities, municipal bonds, corporate bonds, mortgage and asset—backed securities and foreign government bonds.
Types of Bonds
Zero coupon bonds do not pay any interest. They are issued at a substantial discount to par value. The bond holder receives the full principal amount on the redemption date. Zero coupon bonds may be created from fixed rate bonds by a financial institutions separating "stripping off" the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond are allowed to trade independently.
Government Securities is a bond where government is the issuer or borrower. It is the safest form of bond as it is extremely unlikely that the government defaults (unless the economy is as bad as that of Pakistan). Government issues bonds to raise money for funding infrastructure development, support subsidies or several other initiatives. For example government of India has recently started issuing fertilizer and oil bonds to Public Sector companies to fund subsidies on fertilizers and oils.
Municipal Bond is a bond issued by a state, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.
Corporate Bond is a bond issued by corporate i.e. public or private companies to the investors. The company borrows money from investors and promise to pay interest at regular interval. The interest rates on such bonds are high compared to government bonds because the probability of government defaulting on interest payments is low compared to that of corporate. Hence, corporate bonds have high risk and hence require higher return.
High Yield Bonds are those bonds that are rated below investment grade (lower than BBB-) by the credit rating agencies. I will talk in details about rating agencies and bond rating. As these bonds are more risky than investment grade bonds, investors usually expect to earn a higher yield. These bonds are also known as Junk Bonds.
Inflation linked bonds are bonds where the principal amount and interest payments are indexed to inflation. The interest rate is usually lower than that of fixed rate bonds with a comparable maturity. Though, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation linked bonds in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.
Other indexed bonds, for example equity-linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP.
Asset-backed Securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and also collateralized debt obligations (CDOs).
Subordinated Bonds are those that have a lower priority than other bonds of the issuer in case of liquidation/winding up. In case of bankruptcy, there is a hierarchy of creditors. First and foremost the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After these senior bonds have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Thus, subordinated bonds generally have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first; the subordinated tranches are paid later.
Perpetual Bonds are generally called perpetuities. They have no maturity date.
Bearer Bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate that is the bearer can claim the value of the bond. Usually they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risk prone because they can be lost or stolen.
Registered Bond is a bond whose ownership and any subsequent purchaser are recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner only.
Fixed Rate Bonds have a coupon (interest) that remains constant throughout the life of the bond.
Floating rate notes (FRNs) have a coupon which is linked to an index. Common indices include: money market indices, such as LIBOR or Euribor, and CPI (the Consumer Price Index). Coupon examples: 3 month USD LIBOR + 0.20%, or twelve month CPI + 1.50%. FRN coupons reset periodically, usually every one or three months. In assumption, any Index could be used as the basis for the coupon of an FRN, so long as the issuer and the buyer can agree to terms.
Features of Bonds
The most important features of a bond are:
Principal or face amount -It is the amount on which the issuer pays interest, and which has to be repaid at the end.
Issue price - It is the price at which investors buy the bonds when they are first issued, which will normally be approximately equal to the principal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees.
Maturity date -It is the date on which the issuer has to repay the principal amount. As long as all payments have been made, the issuer has no more compulsions to the bond holders after the maturity date. The length of time until the maturity date is called as the term or tenure or maturity of a bond. The maturity can be any length of time, though debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to 30 years. Few bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. In early 2005, a market developed in Euros for bonds with a maturity of fifty years.
In the market for government securities, there are three groups of bond maturities:
• Short term (bills): maturities up to 1 year;
• Medium term (notes): maturities between 1 and 10 years;
• Long term (bonds): maturities greater than 10 years.
Coupon -Coupon is the interest payment that the issuer pays to the bond holders. Generally coupon rate is fixed throughout the life of the bond. It can also vary with a money market index, like LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.
Indentures and Covenants - An indenture is a formal debt agreement that creates the terms of a bond issue, while covenants are the clauses of such an agreement. Covenants state the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the central and state securities and commercial laws apply to the enforcement of these agreements, which are interpreted by courts as contracts between issuers and bondholders. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document usually requiring approval by a majority (or super-majority) vote of the bondholders.
Coupon date- These are the dates on which the issuer pays the coupon to the bond holders. In the India most bonds are semi-annual, which means that they pay a coupon every six months.
We will now discuss Government bonds in great detail in rest of the article.
Government Bond
A Government security is a tradable security issued by the Central Government or the State Governments, acknowledging the Government’s debt obligation. Such securities can be short term (usually called Treasury Bills, with original maturities of less than 1 year) or long term (usually called Government bonds or dated securities with original maturity of one year or more). In India, the Central Government issues both Treasury Bills and bonds or dated securities while the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs). Government securities carry practically no risk of default and, hence, are called risk-free instruments. Government of India also issue savings instruments (Savings Bonds, National Saving Certificates (NSCs), etc.) or special securities (Oil bonds, FCI bonds, fertilizer bonds, power bonds, etc.) but they are usually not fully tradable and are not eligible for meeting the SLR requirement.
One of the world’s largest and most liquid bond markets is comprised of debt securities issued by the U.S. Treasury, by U.S. government agencies and by U.S government-sponsored enterprises.
Treasury Bills (T-Bills)
Treasury Bills, which are money market instruments, are short term debt instruments issued by the Government of India and are presently issued in three tenors, viz., 91 day, 182 day and 364 day. Treasury Bills are zero coupon securities and pay no coupon. They are issued at a discount and redeemed at the face value at maturity. The return to the investors is, therefore, the difference between the maturity value or face value (i.e., Rs.100) and the issue price.
For example, a 91 day Treasury Bill of Rs.100/- (face value) may be issued at a discount of say, Rs.1.80, that is Rs.98.20 and redeemed at the face value of Rs.100. Thus, the buyer will pay Rs. 98.2 today for 1 unit of Treasury Bill worth Rs. 100. After 91 days he will get Rs. 100. Hence, his return would be:
(100-98.2)/98.2 = 1.83% for 91 days period
= 1.83*4 for 1 year (Simple Interest payment i.e. 365/91 ~ 4 periods)
= 7.32% per annum simple interest rate.
Treasury Bills are issued through auctions conducted by the Reserve Bank of India usually every Wednesday and payments for the Treasury Bills purchased have to be made on the following Friday. The Treasury Bills of 182 days and 364 days' tenure are issued on alternate Wednesdays, that is, Treasury Bills of 364 day tenure are issued on the Wednesday preceding the reporting Friday while Treasury Bills of 182 days tenure are issued on the Wednesday prior to a non-reporting Friday. Currently, the notified amount for issuance of 91 day and 182 day Treasury Bills is Rs.500 crore each whereas the notified amount for issuance of 364 day Bill is higher at Rs.1000 crore.
An annual calendar of T-Bill issuances for the following financial year is released by the Reserve Bank of India in the last week of March. The Reserve Bank of India also announces the issue details of Treasury bills by way of press release every week.
Dated Government Securities
Dated Government securities are longer term securities and carry a fixed or floating coupon (interest rate) paid on the face value, payable at fixed time periods (usually half-yearly). The tenor of dated securities can be up to 30 years. The Public Debt Office (PDO) of the RBI acts as the registry / depository of
Government securities and deals with the issue, interest payment and repayment of principal at maturity. Most of the dated securities are fixed coupon securities. The nomenclature of a typical dated fixed coupon Government security has the following features - coupon, name of the issuer, maturity and face value. For example, 7.49% GOI 2017 would have the following features:
Date of Issue : April 16, 2007
Date of Maturity : April 16, 2017
Coupon : 7.49% paid on face value
Coupon Payment Dates : Half-yearly (October16 and April 16) every year
Minimum Amount of issue/ sale : Rs.10,000
Dated securities may be of the following types:
1. Fixed Rate Bonds
2. Floating Rate Bonds
3. Zero Coupon Bonds
4. Capital Indexed Bond
5. Bonds with Call/Put Options
State Development Loans (SDLs)
State Governments also raise loans from the market. SDLs are dated securities issued through an auction similar to the auctions conducted for dated securities issued by the Central Government. Interest is serviced at half-yearly intervals and the principal is repaid on the maturity date. Like dated securities issued by the Central Government, SDLs issued by the State Governments qualify for SLR. They are also eligible as collaterals for borrowing through market repo as well as borrowing by eligible entities from the RBI under the Liquidity Adjustment Facility (LAF).
How are the Government Securities issued?
Government securities are issued through auctions conducted by the RBI. Auctions are conducted on the electronic platform called the Public Debt Office – Negotiated Dealing System (PDO-NDS). Commercial banks, scheduled urban cooperative banks, Primary Dealers, insurance companies and provident funds, who maintain funds account (current account) and securities accounts (SGL account) with RBI, are members of this electronic platform. All members of PDO-NDS can place their bids in the auction through this electronic platform. All non-NDS members including non-scheduled urban co-operative banks can participate in the primary auction through scheduled commercial banks or Primary Dealers. For this purpose, the urban co-operative banks need to open a securities account with a bank / Primary Dealer – such an account is called a Gilt Account. A Gilt Account is a dematerialized account maintained by a scheduled commercial bank or Primary Dealer for its constituent (e.g., a non-scheduled urban co-operative bank).
The RBI, in consultation with the Government of India, issues an indicative half-yearly auction calendar which contains information about the amount of borrowing, the tenor of security and the likely period during which auctions will be held. A Notification and a Press Communiqué giving exact particulars of the securities, viz., name, amount, type of issue and procedure of auction are issued by the Government of India about a week prior to the actual date of auction.
Types of Auction
With the introduction of auctions, the rate of interest (coupon rate) gets fixed through a market based price discovery process. An auction may either be yield based or price based.
Yield Based Auction
A yield based auction is generally conducted when a new Government security is issued. Investors bid in yield terms up to two decimal places (for example, 7.85 per cent, 7.87 per cent, etc.). Bids are arranged in ascending order and the cut-off yield is arrived at the yield corresponding to the notified amount of the auction. The cut-off yield is taken as the coupon rate for the security. Successful bidders are those who have bid at or below the cut-off yield. Bids which are higher than the cut-off yield are rejected. An illustrative example of the yield based auction is given below:
Yield based auction of a new security
• Maturity Date: September 8, 2018
• Coupon: It is determined in the auction (8.22% as shown in the illustration below)
• Auction date: September 5, 2008
• Auction settlement date: September 8, 2008
• Notified Amount: Rs.1000 crore
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=114&aid=147&acat=&ahead=Fixed%2520Income%2520Securities%2520-%2520Bonds%2520Basics
Among the types of bonds you can choose from are: government securities, municipal bonds, corporate bonds, mortgage and asset—backed securities and foreign government bonds.
Types of Bonds
Zero coupon bonds do not pay any interest. They are issued at a substantial discount to par value. The bond holder receives the full principal amount on the redemption date. Zero coupon bonds may be created from fixed rate bonds by a financial institutions separating "stripping off" the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond are allowed to trade independently.
Government Securities is a bond where government is the issuer or borrower. It is the safest form of bond as it is extremely unlikely that the government defaults (unless the economy is as bad as that of Pakistan). Government issues bonds to raise money for funding infrastructure development, support subsidies or several other initiatives. For example government of India has recently started issuing fertilizer and oil bonds to Public Sector companies to fund subsidies on fertilizers and oils.
Municipal Bond is a bond issued by a state, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.
Corporate Bond is a bond issued by corporate i.e. public or private companies to the investors. The company borrows money from investors and promise to pay interest at regular interval. The interest rates on such bonds are high compared to government bonds because the probability of government defaulting on interest payments is low compared to that of corporate. Hence, corporate bonds have high risk and hence require higher return.
High Yield Bonds are those bonds that are rated below investment grade (lower than BBB-) by the credit rating agencies. I will talk in details about rating agencies and bond rating. As these bonds are more risky than investment grade bonds, investors usually expect to earn a higher yield. These bonds are also known as Junk Bonds.
Inflation linked bonds are bonds where the principal amount and interest payments are indexed to inflation. The interest rate is usually lower than that of fixed rate bonds with a comparable maturity. Though, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation linked bonds in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.
Other indexed bonds, for example equity-linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP.
Asset-backed Securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and also collateralized debt obligations (CDOs).
Subordinated Bonds are those that have a lower priority than other bonds of the issuer in case of liquidation/winding up. In case of bankruptcy, there is a hierarchy of creditors. First and foremost the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After these senior bonds have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Thus, subordinated bonds generally have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first; the subordinated tranches are paid later.
Perpetual Bonds are generally called perpetuities. They have no maturity date.
Bearer Bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate that is the bearer can claim the value of the bond. Usually they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risk prone because they can be lost or stolen.
Registered Bond is a bond whose ownership and any subsequent purchaser are recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner only.
Fixed Rate Bonds have a coupon (interest) that remains constant throughout the life of the bond.
Floating rate notes (FRNs) have a coupon which is linked to an index. Common indices include: money market indices, such as LIBOR or Euribor, and CPI (the Consumer Price Index). Coupon examples: 3 month USD LIBOR + 0.20%, or twelve month CPI + 1.50%. FRN coupons reset periodically, usually every one or three months. In assumption, any Index could be used as the basis for the coupon of an FRN, so long as the issuer and the buyer can agree to terms.
Features of Bonds
The most important features of a bond are:
Principal or face amount -It is the amount on which the issuer pays interest, and which has to be repaid at the end.
Issue price - It is the price at which investors buy the bonds when they are first issued, which will normally be approximately equal to the principal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees.
Maturity date -It is the date on which the issuer has to repay the principal amount. As long as all payments have been made, the issuer has no more compulsions to the bond holders after the maturity date. The length of time until the maturity date is called as the term or tenure or maturity of a bond. The maturity can be any length of time, though debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to 30 years. Few bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. In early 2005, a market developed in Euros for bonds with a maturity of fifty years.
In the market for government securities, there are three groups of bond maturities:
• Short term (bills): maturities up to 1 year;
• Medium term (notes): maturities between 1 and 10 years;
• Long term (bonds): maturities greater than 10 years.
Coupon -Coupon is the interest payment that the issuer pays to the bond holders. Generally coupon rate is fixed throughout the life of the bond. It can also vary with a money market index, like LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.
Indentures and Covenants - An indenture is a formal debt agreement that creates the terms of a bond issue, while covenants are the clauses of such an agreement. Covenants state the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the central and state securities and commercial laws apply to the enforcement of these agreements, which are interpreted by courts as contracts between issuers and bondholders. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document usually requiring approval by a majority (or super-majority) vote of the bondholders.
Coupon date- These are the dates on which the issuer pays the coupon to the bond holders. In the India most bonds are semi-annual, which means that they pay a coupon every six months.
We will now discuss Government bonds in great detail in rest of the article.
Government Bond
A Government security is a tradable security issued by the Central Government or the State Governments, acknowledging the Government’s debt obligation. Such securities can be short term (usually called Treasury Bills, with original maturities of less than 1 year) or long term (usually called Government bonds or dated securities with original maturity of one year or more). In India, the Central Government issues both Treasury Bills and bonds or dated securities while the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs). Government securities carry practically no risk of default and, hence, are called risk-free instruments. Government of India also issue savings instruments (Savings Bonds, National Saving Certificates (NSCs), etc.) or special securities (Oil bonds, FCI bonds, fertilizer bonds, power bonds, etc.) but they are usually not fully tradable and are not eligible for meeting the SLR requirement.
One of the world’s largest and most liquid bond markets is comprised of debt securities issued by the U.S. Treasury, by U.S. government agencies and by U.S government-sponsored enterprises.
Treasury Bills (T-Bills)
Treasury Bills, which are money market instruments, are short term debt instruments issued by the Government of India and are presently issued in three tenors, viz., 91 day, 182 day and 364 day. Treasury Bills are zero coupon securities and pay no coupon. They are issued at a discount and redeemed at the face value at maturity. The return to the investors is, therefore, the difference between the maturity value or face value (i.e., Rs.100) and the issue price.
For example, a 91 day Treasury Bill of Rs.100/- (face value) may be issued at a discount of say, Rs.1.80, that is Rs.98.20 and redeemed at the face value of Rs.100. Thus, the buyer will pay Rs. 98.2 today for 1 unit of Treasury Bill worth Rs. 100. After 91 days he will get Rs. 100. Hence, his return would be:
(100-98.2)/98.2 = 1.83% for 91 days period
= 1.83*4 for 1 year (Simple Interest payment i.e. 365/91 ~ 4 periods)
= 7.32% per annum simple interest rate.
Treasury Bills are issued through auctions conducted by the Reserve Bank of India usually every Wednesday and payments for the Treasury Bills purchased have to be made on the following Friday. The Treasury Bills of 182 days and 364 days' tenure are issued on alternate Wednesdays, that is, Treasury Bills of 364 day tenure are issued on the Wednesday preceding the reporting Friday while Treasury Bills of 182 days tenure are issued on the Wednesday prior to a non-reporting Friday. Currently, the notified amount for issuance of 91 day and 182 day Treasury Bills is Rs.500 crore each whereas the notified amount for issuance of 364 day Bill is higher at Rs.1000 crore.
An annual calendar of T-Bill issuances for the following financial year is released by the Reserve Bank of India in the last week of March. The Reserve Bank of India also announces the issue details of Treasury bills by way of press release every week.
Dated Government Securities
Dated Government securities are longer term securities and carry a fixed or floating coupon (interest rate) paid on the face value, payable at fixed time periods (usually half-yearly). The tenor of dated securities can be up to 30 years. The Public Debt Office (PDO) of the RBI acts as the registry / depository of
Government securities and deals with the issue, interest payment and repayment of principal at maturity. Most of the dated securities are fixed coupon securities. The nomenclature of a typical dated fixed coupon Government security has the following features - coupon, name of the issuer, maturity and face value. For example, 7.49% GOI 2017 would have the following features:
Date of Issue : April 16, 2007
Date of Maturity : April 16, 2017
Coupon : 7.49% paid on face value
Coupon Payment Dates : Half-yearly (October16 and April 16) every year
Minimum Amount of issue/ sale : Rs.10,000
Dated securities may be of the following types:
1. Fixed Rate Bonds
2. Floating Rate Bonds
3. Zero Coupon Bonds
4. Capital Indexed Bond
5. Bonds with Call/Put Options
State Development Loans (SDLs)
State Governments also raise loans from the market. SDLs are dated securities issued through an auction similar to the auctions conducted for dated securities issued by the Central Government. Interest is serviced at half-yearly intervals and the principal is repaid on the maturity date. Like dated securities issued by the Central Government, SDLs issued by the State Governments qualify for SLR. They are also eligible as collaterals for borrowing through market repo as well as borrowing by eligible entities from the RBI under the Liquidity Adjustment Facility (LAF).
How are the Government Securities issued?
Government securities are issued through auctions conducted by the RBI. Auctions are conducted on the electronic platform called the Public Debt Office – Negotiated Dealing System (PDO-NDS). Commercial banks, scheduled urban cooperative banks, Primary Dealers, insurance companies and provident funds, who maintain funds account (current account) and securities accounts (SGL account) with RBI, are members of this electronic platform. All members of PDO-NDS can place their bids in the auction through this electronic platform. All non-NDS members including non-scheduled urban co-operative banks can participate in the primary auction through scheduled commercial banks or Primary Dealers. For this purpose, the urban co-operative banks need to open a securities account with a bank / Primary Dealer – such an account is called a Gilt Account. A Gilt Account is a dematerialized account maintained by a scheduled commercial bank or Primary Dealer for its constituent (e.g., a non-scheduled urban co-operative bank).
The RBI, in consultation with the Government of India, issues an indicative half-yearly auction calendar which contains information about the amount of borrowing, the tenor of security and the likely period during which auctions will be held. A Notification and a Press Communiqué giving exact particulars of the securities, viz., name, amount, type of issue and procedure of auction are issued by the Government of India about a week prior to the actual date of auction.
Types of Auction
With the introduction of auctions, the rate of interest (coupon rate) gets fixed through a market based price discovery process. An auction may either be yield based or price based.
Yield Based Auction
A yield based auction is generally conducted when a new Government security is issued. Investors bid in yield terms up to two decimal places (for example, 7.85 per cent, 7.87 per cent, etc.). Bids are arranged in ascending order and the cut-off yield is arrived at the yield corresponding to the notified amount of the auction. The cut-off yield is taken as the coupon rate for the security. Successful bidders are those who have bid at or below the cut-off yield. Bids which are higher than the cut-off yield are rejected. An illustrative example of the yield based auction is given below:
Yield based auction of a new security
• Maturity Date: September 8, 2018
• Coupon: It is determined in the auction (8.22% as shown in the illustration below)
• Auction date: September 5, 2008
• Auction settlement date: September 8, 2008
• Notified Amount: Rs.1000 crore
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=114&aid=147&acat=&ahead=Fixed%2520Income%2520Securities%2520-%2520Bonds%2520Basics
Gold - Investment Strategies
In my previous article, I discussed about the history of Gold, Gold-standards and its place in Indian culture. In this article I will cover a very interesting and important relationship between Gold and Oil prices. It is worth noting that rise and fall in the price of oil affects the price of Gold! I will also cover several investment strategies for Gold and discuss whether investing in gold is better than investing in stocks.
Many of our readers asked me why Gold is so important than the local currency. I will explain this by giving example of Zimbabwe, where inflation is over 1,000,000%. Such a high inflation has led to the devaluation of its currency to such an extent that its value is nothing. You can not even buy a loaf of bread for 500 Million Zimbabwe dollars. Yeah they recently issued a 500 Million dollar note!! So if a person has to buy something in global market he or she will get nothing because the value of his or her country’s currency is almost zero! Hence, no sane person will accept his currency which is getting depleted with every passing second. But if the same person buys anything in global market by selling his or her gold deposits, he or she will get the equivalent price of gold in US dollars or for that matter equivalent amount in any other good currency (Rs, ₤, €, ¥). Thus, gold is a universal currency traded and accepted everywhere irrespective of local or national economy. Also, the value of gold is preserved even in Zimbabwe.
Relationship between Gold and Oil
Oil and gold are arguably the most important commodities on the planet today and the ratio of their nominal prices is far from a trivial issue. The gold/oil ratio expresses the interrelationship between the commodity that forms the foundation of our entire global economy and the commodity that has been the ultimate form of money for six millennia of human history. Gold and oil prices tend to rise and fall in sympathy with one another. There are two reasons for this:
1. Historically, oil purchases were paid for in gold. Even today, a sizable percentage of oil revenue ends up invested in gold. As oil prices rise, much of the increased revenue is invested as it is surplus to current needs and much of this surplus is invested in gold or other hard assets.
2. Rising oil prices place upward pressure on inflation. This enhances the appeal of gold because it acts as an inflation hedge. With the rising interest rates the real return on bank deposits or saving becomes negligible. Hence, most of the central banks across the world put their money in gold to stop the devaluation of their reserves.
In the above figure, we can see that when the red line representing oil crosses the yellow line representing gold, the ratio is approximately 10:1. Historically, it has been between 10 and 12 in a short term period while it touches 14 in long term. Both these prices generally move in tandem reflecting the complex nature of their relationship.
Gold-to-Oil Ratio
This ratio measures “how many barrels of oil one can buy with an ounce of gold” and is calculated as:
Gold-Oil Ratio = Price of Gold (per oz.) / Price of Crude Oil (per barrel)
The gold-oil ratio helps us to identify overbought and oversold opportunities for gold. The gold oil ratio expresses the interrelationship between the commodity that forms the foundation of our entire global economy and the commodity that has been the ultimate form of money for six thousand years of human history.
Table below shows the average Gold-to-Oil ratio for the last year (monthly breakup data). We can see that the fall in oil price was much steeper than that of gold. Hence, the ratio actually increased after July 2008 and surpassed historical average of 14 in November. The last three year average for this ratio was about 17. Does this mean gold is trading at its highest price level? Analysts disagree to it simply because the ratio is more of a long-term gauge and not on a month to month, year to year trend. Near-term price direction is difficult to predict trading the ratio.
Source : http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=18&aid=144&ahead=Gold%2520-%2520Investment%2520Strategies
Many of our readers asked me why Gold is so important than the local currency. I will explain this by giving example of Zimbabwe, where inflation is over 1,000,000%. Such a high inflation has led to the devaluation of its currency to such an extent that its value is nothing. You can not even buy a loaf of bread for 500 Million Zimbabwe dollars. Yeah they recently issued a 500 Million dollar note!! So if a person has to buy something in global market he or she will get nothing because the value of his or her country’s currency is almost zero! Hence, no sane person will accept his currency which is getting depleted with every passing second. But if the same person buys anything in global market by selling his or her gold deposits, he or she will get the equivalent price of gold in US dollars or for that matter equivalent amount in any other good currency (Rs, ₤, €, ¥). Thus, gold is a universal currency traded and accepted everywhere irrespective of local or national economy. Also, the value of gold is preserved even in Zimbabwe.
Relationship between Gold and Oil
Oil and gold are arguably the most important commodities on the planet today and the ratio of their nominal prices is far from a trivial issue. The gold/oil ratio expresses the interrelationship between the commodity that forms the foundation of our entire global economy and the commodity that has been the ultimate form of money for six millennia of human history. Gold and oil prices tend to rise and fall in sympathy with one another. There are two reasons for this:
1. Historically, oil purchases were paid for in gold. Even today, a sizable percentage of oil revenue ends up invested in gold. As oil prices rise, much of the increased revenue is invested as it is surplus to current needs and much of this surplus is invested in gold or other hard assets.
2. Rising oil prices place upward pressure on inflation. This enhances the appeal of gold because it acts as an inflation hedge. With the rising interest rates the real return on bank deposits or saving becomes negligible. Hence, most of the central banks across the world put their money in gold to stop the devaluation of their reserves.
In the above figure, we can see that when the red line representing oil crosses the yellow line representing gold, the ratio is approximately 10:1. Historically, it has been between 10 and 12 in a short term period while it touches 14 in long term. Both these prices generally move in tandem reflecting the complex nature of their relationship.
Gold-to-Oil Ratio
This ratio measures “how many barrels of oil one can buy with an ounce of gold” and is calculated as:
Gold-Oil Ratio = Price of Gold (per oz.) / Price of Crude Oil (per barrel)
The gold-oil ratio helps us to identify overbought and oversold opportunities for gold. The gold oil ratio expresses the interrelationship between the commodity that forms the foundation of our entire global economy and the commodity that has been the ultimate form of money for six thousand years of human history.
Table below shows the average Gold-to-Oil ratio for the last year (monthly breakup data). We can see that the fall in oil price was much steeper than that of gold. Hence, the ratio actually increased after July 2008 and surpassed historical average of 14 in November. The last three year average for this ratio was about 17. Does this mean gold is trading at its highest price level? Analysts disagree to it simply because the ratio is more of a long-term gauge and not on a month to month, year to year trend. Near-term price direction is difficult to predict trading the ratio.
Source : http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=18&aid=144&ahead=Gold%2520-%2520Investment%2520Strategies
Futures and Options (F&O) – Part 1
There is a whole world of financial securities other than stocks and bonds. One of such securities is Derivatives, which are financial instruments whose “value” are derived from the value of the underlying. Hence, they are called “derivative” i.e. derive from something else. The underlying on which derivative is based could be:
Asset: e.g. stocks, bonds, mortgages, real estate, commodities, real estate properties.
Index: e.g. stock market indices, Consumer Price Index, Foreign Currencies and interest rates
Other items: e.g. Weather (yes- you will derivatives written on rain!!)
For example – a derivative on a stock derive its value from the value of underlying stock! There are three main types of derivatives: Forwards (similar to Futures), Options and Swaps. Futures are very similar to Forwards except for the fact that Futures are traded on exchange while Forwards are traded over the counter (OTC). In this article I am going to concentrate only on Futures (F) and Options (O). So whenever you come across any article on F&O or any reference to it, remember it means Futures & Options.
Why do we need derivatives?
Derivatives are used to either
1. Hedge the risk i.e. lessen the risk which may arise due to changes in the value of underlying – This is known as “hedging”.
2. Increase the profit arising from the changes in the value of underlying in the direction they expect or guess – This is known as “speculation”.
Hence, there should not be any misconception that derivatives or F&O are used only by speculators to make money. These are extremely useful financial instruments which are used by corporate or individuals to mitigate their risk. But unfortunately same instruments can be used by speculators to make money. One simple example is nuclear energy. People can use it to generate 1000s of MW of energy for peaceful purpose whereas others can use the same nuclear energy to make nuclear bombs for mass destruction. Is it fair to blame nuclear energy for this? We cannot. So if you want to blame someone, blame speculators and not derivatives.
How hedging works?
Assuming that our readers are not speculators, I will focus on how futures or future contracts are used for hedging. Suppose I am a petroleum distributor whose job is to sell petroleum products such as Petrol and Diesel in the market while you are an airline owner, say Mr. Vijay Mallya I am in the business of selling petroleum while you are a net buyer of petroleum products. I will be concerned with drop in prices of petroleum because that would hurt my revenues and profit margin. This is because I am selling petrol, right? While you, an airline owner, would be concerned with any increase in prices of petroleum because it would increase your costs. Thus we two have a common concern – uncertainty in the price of petroleum products.
To reduce our risk and buy a peace of mind, we will sit together and fix a price of petroleum to be sold in the future. Thus, I have reduced the risk of prices going down while you have reduced the risk of prices going up. This is called hedging.
F&O Market in the US and India
You would be surprised to know that the volume of F&O trade is much more than volume of stocks trade in the world. This shows the sheer popularity of F&O instruments among investors. In the US futures are traded primarily on CME (Chicago Mercantile Exchange), which is the largest financial derivatives exchange in the United States and most diversified in the world. CME’s currency market is the world’s largest regulated marketplace for foreign exchange (FX) trading. In the US Options are traded on CBOE (Chicago Board Options Exchange).
In India Futures and Options are traded on both BSE and NSE. The market hasn’t developed to its potential yet due to lot of political and regulatory issues. Hence, the size of derivatives market is much smaller in India as compared to those in developed worlds.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=12&aid=97&ahead=Futures%2520and%2520Options%2520(F&O)%2520%e2%80%93%2520Part%25201
Asset: e.g. stocks, bonds, mortgages, real estate, commodities, real estate properties.
Index: e.g. stock market indices, Consumer Price Index, Foreign Currencies and interest rates
Other items: e.g. Weather (yes- you will derivatives written on rain!!)
For example – a derivative on a stock derive its value from the value of underlying stock! There are three main types of derivatives: Forwards (similar to Futures), Options and Swaps. Futures are very similar to Forwards except for the fact that Futures are traded on exchange while Forwards are traded over the counter (OTC). In this article I am going to concentrate only on Futures (F) and Options (O). So whenever you come across any article on F&O or any reference to it, remember it means Futures & Options.
Why do we need derivatives?
Derivatives are used to either
1. Hedge the risk i.e. lessen the risk which may arise due to changes in the value of underlying – This is known as “hedging”.
2. Increase the profit arising from the changes in the value of underlying in the direction they expect or guess – This is known as “speculation”.
Hence, there should not be any misconception that derivatives or F&O are used only by speculators to make money. These are extremely useful financial instruments which are used by corporate or individuals to mitigate their risk. But unfortunately same instruments can be used by speculators to make money. One simple example is nuclear energy. People can use it to generate 1000s of MW of energy for peaceful purpose whereas others can use the same nuclear energy to make nuclear bombs for mass destruction. Is it fair to blame nuclear energy for this? We cannot. So if you want to blame someone, blame speculators and not derivatives.
How hedging works?
Assuming that our readers are not speculators, I will focus on how futures or future contracts are used for hedging. Suppose I am a petroleum distributor whose job is to sell petroleum products such as Petrol and Diesel in the market while you are an airline owner, say Mr. Vijay Mallya I am in the business of selling petroleum while you are a net buyer of petroleum products. I will be concerned with drop in prices of petroleum because that would hurt my revenues and profit margin. This is because I am selling petrol, right? While you, an airline owner, would be concerned with any increase in prices of petroleum because it would increase your costs. Thus we two have a common concern – uncertainty in the price of petroleum products.
To reduce our risk and buy a peace of mind, we will sit together and fix a price of petroleum to be sold in the future. Thus, I have reduced the risk of prices going down while you have reduced the risk of prices going up. This is called hedging.
F&O Market in the US and India
You would be surprised to know that the volume of F&O trade is much more than volume of stocks trade in the world. This shows the sheer popularity of F&O instruments among investors. In the US futures are traded primarily on CME (Chicago Mercantile Exchange), which is the largest financial derivatives exchange in the United States and most diversified in the world. CME’s currency market is the world’s largest regulated marketplace for foreign exchange (FX) trading. In the US Options are traded on CBOE (Chicago Board Options Exchange).
In India Futures and Options are traded on both BSE and NSE. The market hasn’t developed to its potential yet due to lot of political and regulatory issues. Hence, the size of derivatives market is much smaller in India as compared to those in developed worlds.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=12&aid=97&ahead=Futures%2520and%2520Options%2520(F&O)%2520%e2%80%93%2520Part%25201
Futures and Options (F&O) – Part 2
As you may know, I covered derivatives, types of derivatives, hedging and futures concepts in the previous article. I also explained the concept of Future Contracts and its uses. Many of our readers had some questions regarding my first article. I have tried to answer those questions with best of my abilities. You can find those questions at the bottom of this article. Here in Part 2, I am going to discuss another very important derivative called Options. The trading market for Option is so huge and exciting that it commands a dedicated article on itself.
Options
An option is a contract where the buyer has the “right” (depends on buyer to execute it), but not the “obligation” (legally bonded) to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date. An option is a security, just like a stock or bond, and constitutes a binding legal contract with strictly defined terms and conditions.
Futures Vs Options
Remember from the previous article, Futures are contracts where both the buyer and the seller have the obligation to honor the contract whereas option does not involve any obligation for both the parties. A contract is a zero sum game i.e. one party will book loss while the other take home the profit. If the contract is futures, the losing party will pay the winning party. However, in options, the buyer will decide whether to execute the contract. You will understand this by the following example.
Let say there is a contract between you and me which says that I will buy one kg of gold at Rs. 1,000 per gm from you on March 1st, 2009. I am the buyer of this contract and you are the seller. So we will either go for cash settlement or you have to deliver the gold to me. Now suppose on the date of settlement i.e. March 1st, 2009, price of gold is Rs. 500 per gram. Thus, the market price of gold on March 1st, 2009 is lower than the contract price.
If the contract were Futures, I would have to buy the gold from you because I have the “obligation” to do so. Hence, I will pay you Rs. 1,000 per gm and you will deliver me the gold. Hence, you make profit while I book loss. Good for you, Bad for me!!
However, if the contract were an Option, I would not have executed it i.e. would not have bought the gold from you. I would have let the contract expire (i.e. do nothing and wait till March 1st, 2009 passes by). How can I do so? I can do it because Options gives me (the buyer) the “right” and not the “obligation” to buy it. Thus, an option would protect me from any adverse movement in the price of underlying asset. In an option, seller has no right because he is compensated by the buyer by paying option premium. Thus, the buyer of an option contract has the “right” but the seller of option contract has the “obligation” to honor the option.
So you may now be wondering that why on earth somebody will ever buy a futures contract when options contract are better. We must know that option has a “premium” attached to it which is called “Options Premium”. This is the amount that a buyer of option contract has to pay the seller of the option contract in exchange for higher flexibility and protection against adverse price movement in the value of underlying. Thus, if I have to buy an option contract from you, I will pay a premium to the seller i.e. You.
Options Vs Stocks
In order for you to better understand the benefits of trading options you must first understand some of the similarities and differences between options and stocks.
Similarities:
• Listed Options are securities, just like stocks.
• Options trade like stocks, with buyers making bids and sellers making offers.
• Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.
Differences:
• Options are derivatives, unlike stocks (i.e, options derive their value from something else, the underlying security).
• Options have expiration dates, while stocks do not.
• There is not a fixed number of options, as there are with stocks available e.g. there could tens or even hundreds of options written on the same stock
• Stockowners have a share of the company, with voting and dividend rights. Options convey no such rights.
Remember these options are not issued or written by companies who stocks act as underlying asset. These options are generally written by brokers or traders for investors.
Options Terminology
Options Premium
An option Premium is the price of the option that a buyer pays to purchase the contract from the seller.
Strike Price
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract from the seller. The strike price also helps to identify whether an option is In-the-Money, At-the-Money, or Out-of-the-Money when compared to the price of the underlying security.
Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist.
Classes of Options
There are two classes of options – American Option and European Option. The key differences are:
1. American option can be exercised before the expiration while an European option is exercised only on the expiration date.
2. Dividends can be issued by the underlying stock in an American option while it is not the case in European option
Types of Options
There are only two types of options: Call option and Put option. In this article we will discuss only European options i.e. options which can not be executed before the agreed upon date.
Call Options
A Call Option is an option to “buy” a stock (underlying) at a specific price on a certain date. The buyer of call option holds the rights while the seller has the obligation to honor the contract. The buyer of a call option enters the contract assuming that the value of underlying will increase in future and benefit him. The seller thinks otherwise i.e. the stock price will not go up and hence the buyer will not execute the contract. So he (seller) will keep the option premium to himself – that would be his profit. Hence, the buyer will execute the contract only when the market price of underlying stock is higher than the strike price.
Example 1 – I bought a call option from you with the following feature: Underlying is an Infosys Stock, Exercise price is Rs. 1100 and expiration period is Jan 24, 2009. Option premium is Rs. 100 per underlying stock and the option is written on only 1 stock.
How call option helps me (the buyer) in realizing profits. Let us assume that the stock price on Jan 24, 2009 is Rs. 1250. Thus, I will execute the call option and you will sell the stock to me for Rs. 1100 and NOT at the current price. I will take that stock from you and sell it for Rs. 1250 in the open market and book a profit of Rs. 1250 – Rs. 1100 – Rs. 100 (Option premium) = Rs. 50. Now look at my return on investment and NOT on amount of investment. My return on investment (ROI) is = (Profit * 100 / Total Cost or investment) %
= 50*100/100 = 50%
Compare this to someone who invested in Infosys stock and NOT in the option. If he bought the stock at Rs. 1000 and sold for Rs. 1250 in the market, his profit would be
= (Profit * 100 / Total Cost or investment) %
= (250* 100 /1000) = 25%
Isn’t it great? One golden rule of investment – Don’t measure your profit or loss based on “absolute value of profit or loss” but on return on investment (ROI).
Remember this – The buyer of a call option will execute the contract only when the market price of the underlying stock will be higher than the strike price of the stock. This is because the buyer will buy the stock from the seller at a lower cost and sell in the open market to book the difference as profit. However, if the market price of underlying stock is less than that of the exercise price, the buyer will let the option expire. In the above example, if the stock price of Infosys on Jan 24, 2009 were Rs. 1090, I will not exercise the contract! Thus, my only loss would be Rs. 100, the option premium that I paid to the seller (you).
Put Options
Put options are options to sell a stock at a specific price on a certain date. Put options mean “right to sell”. It is just the opposite of a call option. The buyer of a put option holds the right to sell while the seller has the obligation to buy. Here, the buyer assumes that the price of underlying asset will go down in future and he will benefit from the put option. Hence, the buyer of a put option will execute the contract only when the market price of underlying stock is lower than the strike price.
Profit realization for the buyer - When do you make profit by selling something? Only when you buy something for X amount and sell it for Y amount where Y>X. Or, you sell someone a product at a price higher than the market price. Why will someone buy a product at a price higher than the market price? He will do it only when he has signed a contract to do so. This is put option which protects and benefits its buyer from any downward movement in the stock price.
State of an option
In-the-Money option – This is when strike price is less than the market price for a call option or the strike price is more than the market price for a put option.
At-the-money – This is when strike price is equal to the market price.
Out-of-the-money – This is when the strike price is more than the market price for the call option while the strike price is less than the market price for the put option.
How to read an option traded listed on an exchange
If you read any business newspaper you may find quotations like this:
INFOSYSTCH Jan 29 CA 1,020.00 51.00 51.00 50.00 51.00
What does this mean? It simply means it is an option with
1. Underlying as Infosys stock
2. Jan 29 is the expiry date
3. to BUY (because it is a “call”) Infosys stock - CA is Call Option
4. 1020.00 is the Strike Price
5. The numbers (51.00, 51.00, 50.00, 51.00) shown after the strike are high price, low price, previous close and Last price respectively.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=12&aid=100&ahead=Futures%2520and%2520Options%2520(F&O)%2520%e2%80%93%2520Part%25202
Options
An option is a contract where the buyer has the “right” (depends on buyer to execute it), but not the “obligation” (legally bonded) to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date. An option is a security, just like a stock or bond, and constitutes a binding legal contract with strictly defined terms and conditions.
Futures Vs Options
Remember from the previous article, Futures are contracts where both the buyer and the seller have the obligation to honor the contract whereas option does not involve any obligation for both the parties. A contract is a zero sum game i.e. one party will book loss while the other take home the profit. If the contract is futures, the losing party will pay the winning party. However, in options, the buyer will decide whether to execute the contract. You will understand this by the following example.
Let say there is a contract between you and me which says that I will buy one kg of gold at Rs. 1,000 per gm from you on March 1st, 2009. I am the buyer of this contract and you are the seller. So we will either go for cash settlement or you have to deliver the gold to me. Now suppose on the date of settlement i.e. March 1st, 2009, price of gold is Rs. 500 per gram. Thus, the market price of gold on March 1st, 2009 is lower than the contract price.
If the contract were Futures, I would have to buy the gold from you because I have the “obligation” to do so. Hence, I will pay you Rs. 1,000 per gm and you will deliver me the gold. Hence, you make profit while I book loss. Good for you, Bad for me!!
However, if the contract were an Option, I would not have executed it i.e. would not have bought the gold from you. I would have let the contract expire (i.e. do nothing and wait till March 1st, 2009 passes by). How can I do so? I can do it because Options gives me (the buyer) the “right” and not the “obligation” to buy it. Thus, an option would protect me from any adverse movement in the price of underlying asset. In an option, seller has no right because he is compensated by the buyer by paying option premium. Thus, the buyer of an option contract has the “right” but the seller of option contract has the “obligation” to honor the option.
So you may now be wondering that why on earth somebody will ever buy a futures contract when options contract are better. We must know that option has a “premium” attached to it which is called “Options Premium”. This is the amount that a buyer of option contract has to pay the seller of the option contract in exchange for higher flexibility and protection against adverse price movement in the value of underlying. Thus, if I have to buy an option contract from you, I will pay a premium to the seller i.e. You.
Options Vs Stocks
In order for you to better understand the benefits of trading options you must first understand some of the similarities and differences between options and stocks.
Similarities:
• Listed Options are securities, just like stocks.
• Options trade like stocks, with buyers making bids and sellers making offers.
• Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.
Differences:
• Options are derivatives, unlike stocks (i.e, options derive their value from something else, the underlying security).
• Options have expiration dates, while stocks do not.
• There is not a fixed number of options, as there are with stocks available e.g. there could tens or even hundreds of options written on the same stock
• Stockowners have a share of the company, with voting and dividend rights. Options convey no such rights.
Remember these options are not issued or written by companies who stocks act as underlying asset. These options are generally written by brokers or traders for investors.
Options Terminology
Options Premium
An option Premium is the price of the option that a buyer pays to purchase the contract from the seller.
Strike Price
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract from the seller. The strike price also helps to identify whether an option is In-the-Money, At-the-Money, or Out-of-the-Money when compared to the price of the underlying security.
Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist.
Classes of Options
There are two classes of options – American Option and European Option. The key differences are:
1. American option can be exercised before the expiration while an European option is exercised only on the expiration date.
2. Dividends can be issued by the underlying stock in an American option while it is not the case in European option
Types of Options
There are only two types of options: Call option and Put option. In this article we will discuss only European options i.e. options which can not be executed before the agreed upon date.
Call Options
A Call Option is an option to “buy” a stock (underlying) at a specific price on a certain date. The buyer of call option holds the rights while the seller has the obligation to honor the contract. The buyer of a call option enters the contract assuming that the value of underlying will increase in future and benefit him. The seller thinks otherwise i.e. the stock price will not go up and hence the buyer will not execute the contract. So he (seller) will keep the option premium to himself – that would be his profit. Hence, the buyer will execute the contract only when the market price of underlying stock is higher than the strike price.
Example 1 – I bought a call option from you with the following feature: Underlying is an Infosys Stock, Exercise price is Rs. 1100 and expiration period is Jan 24, 2009. Option premium is Rs. 100 per underlying stock and the option is written on only 1 stock.
How call option helps me (the buyer) in realizing profits. Let us assume that the stock price on Jan 24, 2009 is Rs. 1250. Thus, I will execute the call option and you will sell the stock to me for Rs. 1100 and NOT at the current price. I will take that stock from you and sell it for Rs. 1250 in the open market and book a profit of Rs. 1250 – Rs. 1100 – Rs. 100 (Option premium) = Rs. 50. Now look at my return on investment and NOT on amount of investment. My return on investment (ROI) is = (Profit * 100 / Total Cost or investment) %
= 50*100/100 = 50%
Compare this to someone who invested in Infosys stock and NOT in the option. If he bought the stock at Rs. 1000 and sold for Rs. 1250 in the market, his profit would be
= (Profit * 100 / Total Cost or investment) %
= (250* 100 /1000) = 25%
Isn’t it great? One golden rule of investment – Don’t measure your profit or loss based on “absolute value of profit or loss” but on return on investment (ROI).
Remember this – The buyer of a call option will execute the contract only when the market price of the underlying stock will be higher than the strike price of the stock. This is because the buyer will buy the stock from the seller at a lower cost and sell in the open market to book the difference as profit. However, if the market price of underlying stock is less than that of the exercise price, the buyer will let the option expire. In the above example, if the stock price of Infosys on Jan 24, 2009 were Rs. 1090, I will not exercise the contract! Thus, my only loss would be Rs. 100, the option premium that I paid to the seller (you).
Put Options
Put options are options to sell a stock at a specific price on a certain date. Put options mean “right to sell”. It is just the opposite of a call option. The buyer of a put option holds the right to sell while the seller has the obligation to buy. Here, the buyer assumes that the price of underlying asset will go down in future and he will benefit from the put option. Hence, the buyer of a put option will execute the contract only when the market price of underlying stock is lower than the strike price.
Profit realization for the buyer - When do you make profit by selling something? Only when you buy something for X amount and sell it for Y amount where Y>X. Or, you sell someone a product at a price higher than the market price. Why will someone buy a product at a price higher than the market price? He will do it only when he has signed a contract to do so. This is put option which protects and benefits its buyer from any downward movement in the stock price.
State of an option
In-the-Money option – This is when strike price is less than the market price for a call option or the strike price is more than the market price for a put option.
At-the-money – This is when strike price is equal to the market price.
Out-of-the-money – This is when the strike price is more than the market price for the call option while the strike price is less than the market price for the put option.
How to read an option traded listed on an exchange
If you read any business newspaper you may find quotations like this:
INFOSYSTCH Jan 29 CA 1,020.00 51.00 51.00 50.00 51.00
What does this mean? It simply means it is an option with
1. Underlying as Infosys stock
2. Jan 29 is the expiry date
3. to BUY (because it is a “call”) Infosys stock - CA is Call Option
4. 1020.00 is the Strike Price
5. The numbers (51.00, 51.00, 50.00, 51.00) shown after the strike are high price, low price, previous close and Last price respectively.
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=12&aid=100&ahead=Futures%2520and%2520Options%2520(F&O)%2520%e2%80%93%2520Part%25202
Mutual Fund - A complete Analysis
Definition:
A mutual fund is a professionally-managed firm of collective investments that pools money from many investors and invests it in stocks, bonds, short-term money market instruments, and/or other securities. In a mutual fund, the fund manager, who is also known as the portfolio manager, trades the fund's underlying securities, realizing capital gains or losses, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. The value of a share of the mutual fund, known as the net asset value per share (NAV), is calculated daily based on the total value of the fund divided by the number of shares currently issued and outstanding.
Concept:
A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. The money thus collected is then invested in capital market instruments such as shares, debentures and other securities. The income earned through these investments and the capital appreciation realised are shared by its unit holders in proportion to the number of units owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.
History:
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 Reserve Bank the. 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 banks and Life Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC). SBI Mutual Fund was the first non- UTI Mutual Fund 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 crores.
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 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 UTI 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 assets of Rs.153108 crores under 421 schemes.
Types of Mutual Funds:
On the basis of their structure and objective, mutual funds can be classified into following major types:
Closed-end funds
Open-end funds
Large cap funds
Mid-cap funds
Equity funds
Balanced funds
Growth funds
No load funds
Exchange traded funds
Value funds
Money market funds
International mutual funds
Regional mutual funds
Sector funds
Index funds
Fund of funds
Closed-end Mutual Fund
A closed-end mutual fund has a set number of shares issued to the public through an initial public offering. These funds have a stipulated maturity period generally ranging from 3 to 15 years. The fund is open for subscription only during a specified period. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where they are listed.Once underwritten, closed-end funds trade on stock exchanges like stocks or bonds. The market price of closed-end funds is determined by supply and demand and not by net-asset value (NAV), as is the case in open-end funds. Usually closed mutual funds trade at discounts to their underlying asset value.
Open-end mutual fund
An open-end mutual fund is a fund that does not have a set number of shares. It continues to sell shares to investors and will buy back shares when investors wish to sell. Units are bought and sold at their current net asset value.Open-end funds keep some portion of their assets in short-term and money market securities to provide available funds for redemptions. A large portion of most open mutual funds is invested in highly liquid securities, which enables the fund to raise money by selling securities at prices very close to those used for valuations.
Large Cap Funds
Large cap funds are those mutual funds, which seek capital appreciation by investing primarily in stocks of large blue chip companies with above-average prospects for earnings growth. Different mutual funds have different criteria for classifying companies as large cap. Generally, companies with a market capitalisation in excess of Rs 1000 crore are known large cap companies. Investing in large caps is a lower risk-lower return proposition (vis-à-vis mid cap stocks), because such companies are usually widely researched and information is widely available.
Mid cap funds
Mid cap funds are those mutual funds, which invest in small / medium sized companies. As there is no standard definition classifying companies as small or medium, each mutual fund has its own classification for small and medium sized companies. Generally, companies with a market capitalization of up to Rs 500 crore are classified as small. Those companies that have a market capitalization between Rs 500 crore and Rs 1,000 crore are classified as medium sized. Big investors like mutual funds and Foreign Institutional Investors are increasingly investing in mid caps nowadays because the price of large caps has increased substantially. Small / mid sized companies tend to be under researched thus they present an opportunity to invest in a company that is yet to be identified by the market. Such companies offer higher growth potential going forward and therefore an opportunity to benefit from higher than average valuations.But mid cap funds are very volatile and tend to fall like a pack of cards in bad times. So, caution should be exercised while investing in mid cap mutual funds.
Equity Mutual Funds
Equity mutual funds are also known as stock mutual funds. Equity mutual funds invest pooled amounts of money in the stocks of public companies. Stocks represent part ownership, or equity, in companies, and the aim of stock ownership is to see the value of the companies increase over time. Stocks are often categorized by their market capitalization (or caps), and can be classified in three basic sizes: small, medium, and large. Many mutual funds invest primarily in companies of one of these sizes and are thus classified as large-cap, mid-cap or small-cap funds.Equity fund managers employ different styles of stock picking when they make investment decisions for their portfolios. Some fund managers use a value approach to stocks, searching for stocks that are undervalued when compared to other, similar companies. Another approach to picking is to look primarily at growth, trying to find stocks that are growing faster than their competitors, or the market as a whole. Some managers buy both kinds of stocks, building a portfolio of both growth and value stocks.
Balanced Fund
Balanced fund is also known as hybrid fund. It is a type of mutual fund that buys a combination of common stock, preferred stock, bonds, and short-term bonds, to provide both income and capital appreciation while avoiding excessive risk. Balanced funds provide investor with an option of single mutual fund that combines both growth and income objectives, by investing in both stocks (for growth) and bonds (for income). Such diversified holdings ensure that these funds will manage downturns in the stock market without too much of a loss. But on the flip side, balanced funds will usually increase less than an all-stock fund during a bull market.
Growth Funds
Growth funds are those mutual funds that aim to achieve capital appreciation by investing in growth stocks. They focus on those companies, which are experiencing significant earnings or revenue growth, rather than companies that pay out dividends. Growth funds tend to look for the fastest-growing companies in the market. Growth managers are willing to take more risk and pay a premium for their stocks in an effort to build a portfolio of companies with above-average earnings momentum or price appreciation.In general, growth funds are more volatile than other types of funds, rising more than other funds in bull markets and falling more in bear markets. Only aggressive investors, or those with enough time to make up for short-term market losses, should buy these funds.
No-Load Mutual Funds
Mutual funds can be classified into two types - Load mutual funds and No-Load mutual funds. Load funds are those funds that charge commission at the time of purchase or redemption. They can be further subdivided into (1) Front-end load funds and (2) Back-end load funds. Front-end load funds charge commission at the time of purchase and back-end load funds charge commission at the time of redemption.
On the other hand, no-load funds are those funds that can be purchased without commission. No load funds have several advantages over load funds. Firstly, funds with loads, on average, consistently underperform no-load funds when the load is taken into consideration in performance calculations. Secondly, loads understate the real commission charged because they reduce the total amount being invested. Finally, when a load fund is held over a long time period, the effect of the load, if paid up front, is not diminished because if the money paid for the load had invested, as in a no-load fund, it would have been compounding over the whole time period.
Exchange Traded Funds
Exchange Traded Funds (ETFs) represent a basket of securities that are traded on an exchange. An exchange traded fund is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index. An ETF will invest in either all of the securities or a representative sample of the securities included in the index. The investment objective of an ETF is to achieve the same return as a particular market index. Exchange traded funds rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios.
Value Funds
Value funds are those mutual funds that tend to focus on safety rather than growth, and often choose investments providing dividends as well as capital appreciation. They invest in companies that the market has overlooked, and stocks that have fallen out of favour with mainstream investors, either due to changing investor preferences, a poor quarterly earnings report, or hard times in a particular industry.Value stocks are often mature companies that have stopped growing and that use their earnings to pay dividends. Thus value funds produce current income (from the dividends) as well as long-term growth (from capital appreciation once the stocks become popular again). They tend to have more conservative and less volatile returns than growth funds.
Money Market Mutual Funds
A money market fund is a mutual fund that invests solely in money market instruments. Money market instruments are forms of debt that mature in less than one year and are very liquid. Treasury bills make up the bulk of the money market instruments. Securities in the money market are relatively risk-free. Money market funds are generally the safest and most secure of mutual fund investments. The goal of a money-market fund is to preserve principal while yielding a modest return. Money-market mutual fund is akin to a high-yield bank account but is not entirely risk free. When investing in a money-market fund, attention should be paid to the interest rate that is being offered.
International Mutual Funds
International mutual funds are those funds that invest in non-domestic securities markets throughout the world. Investing in international markets provides greater portfolio diversification and let you capitalize on some of the world's best opportunities. If investments are chosen carefully, international mutual fund may be profitable when some markets are rising and others are declining.
However, fund managers need to keep close watch on foreign currencies and world markets as profitable investments in a rising market can lose money if the foreign currency rises against the dollar.
Regional Mutual Fund
Regional mutual fund is a mutual fund that confines itself to investments in securities from a specified geographical area, usually, the fund's local region. A regional mutual fund generally looks to own a diversified portfolio of companies based in and operating out of its specified geographical area. The objective is to take advantage of regional growth potential before the national investment community does. Regional funds select securities that pass geographical criteria. For the investor, the primary benefit of a regional fund is that he/she increases his/her diversification by being exposed to a specific foreign geographical area.
Sector Mutual Funds
Sector mutual funds are those mutual funds that restrict their investments to a particular segment or sector of the economy. These funds concentrate on one industry such as infrastructure, heath care, utilities, pharmaceuticals etc. The idea is to allow investors to place bets on specific industries or sectors, which have strong growth potential. These funds tend to be more volatile than funds holding a diversified portfolio of securities in many industries. Such concentrated portfolios can produce tremendous gains or losses, depending on whether the chosen sector is in or out of favour.
Index Funds
An index fund is a type of mutual fund that builds its portfolio by buying stock in all the companies of a particular index and thereby reproducing the performance of an entire section of the market. The most popular index of stock index funds is the Standard & Poor's 500. An S&P 500 stock index fund owns 500 stocks-all the companies that are included in the index. Investing in an index fund is a form of passive investing. Passive investing has two big advantages over active investing. First, a passive stock market mutual fund is much cheaper to run than an active fund. Second, a majority of mutual funds fail to beat broad indexes such as the S&P 500.
Fund of Funds
A fund of funds is a type of mutual fund that invests in other mutual funds. Just as a mutual fund invests in a number of different securities, a fund of funds holds shares of many different mutual funds.Fund of funds are designed to achieve greater diversification than traditional mutual funds. But on the flipside, expense fees on fund of funds are typically higher than those on regular funds because they include part of the expense fees charged by the underlying funds. Also, since a fund of funds buys many different funds which themselves invest in many different stocks, it is possible for the fund of funds to own the same stock through several different funds and it can be difficult to keep track of the overall holdings.
Advantages of Mutual Funds
The advantages of investing in a Mutual Fund are:
Diversification:
The best mutual funds design their portfolios so individual investments will react differently to the same economic conditions. For example, economic conditions like a rise in interest rates may cause certain securities in a diversified portfolio to decrease in value. Other securities in the portfolio will respond to the same economic conditions by increasing in value. When a portfolio is balanced in this way, the value of the overall portfolio should gradually increase over time, even if some securities lose value.
Professional Management:
Most mutual funds pay topflight professionals to manage their investments. These managers decide what securities the fund will buy and sell.
Regulatory oversight:
Mutual funds are subject to many government regulations that protect investors from fraud.
Liquidity:
It's easy to get your money out of a mutual fund. Write a check, make a call, and you've got the cash.
Convenience:
You can usually buy mutual fund shares by mail, phone, or over the Internet. Low cost: Mutual fund expenses are often no more than 1.5 percent of your investment. Expenses for Index Funds are less than that, because index funds are not actively managed. Instead, they automatically buy stock in companies that are listed on a specific index.
Transparency
Flexibility
Choice of schemes
Tax benefits
Well regulated
Drawbacks of Mutual Funds
Mutual Funds have their own drawbacks and it may not suit the investment needs of all kinds of investors because of its limitations and the drawbacks. Following are the few drawbacks of Mutual Funds:
No Guarantees:
No investment is risk free. If the entire stock market declines in value, the value of mutual fund shares will go down as well, no matter how balanced the portfolio. Investors encounter fewer risks when they invest in mutual funds than when they buy and sell stocks on their own. However, anyone who invests through a mutual fund runs the risk of losing money.
Fees and commissions:
All funds charge administrative fees to cover their day-to-day expenses. Some funds also charge sales commissions or "loads" to compensate brokers, financial consultants, or financial planners. Even if you don't use a broker or other financial adviser, you will pay a sales commission if you buy shares in a Load Fund.
Taxes:
During a typical year, most actively managed mutual funds sell anywhere from 20 to 70 percent of the securities in their portfolios. If your fund makes a profit on its sales, you will pay taxes on the income you receive, even if you reinvest the money you made.
Management risk:
When you invest in a mutual fund, you depend on the fund's manager to make the right decisions regarding the fund's portfolio. If the manager does not perform as well as you had hoped, you might not make as much money on your investment as you expected. Of course, if you invest in Index Funds, you forego management risk, because these funds do not employ managers.
The Future
By December 2004, Indian mutual fund industry reached Rs 1,50,537 crore. It is estimated that by 2010 March-end, the total assets of all scheduled commercial banks should be Rs 40,90,000 crore.The annual composite rate of growth is expected 13.4% during the rest of the decade. In the last 5 years we have seen annual growth rate of 9%. According to the current growth rate, by year 2010, mutual fund assets will be double.
Some facts for the growth of mutual funds in India
1 . 100% growth in the last 6 years.
2. Number of foreign AMC's are in the que to enter the Indian markets like Fidelity Investments, US based, with over US$1trillion assets under management worldwide.
3. Our saving rate is over 23%, highest in the world. Only channelizing these savings in mutual funds sector is required.
4. We have approximately 29 mutual funds which is much less than US having more than 800. There is a big scope for expansion.
5. 'B' and 'C' class cities are growing rapidly. Today most of the mutual funds are concentrating on the 'A' class cities. Soon they will find scope in the growing cities.
6. Mutual fund can penetrate rurals like the Indian insurance industry with simple and limited products.
7. SEBI allowing the MF's to launch commodity mutual funds.
8. Emphasis on better corporate governance.
9. Trying to curb the late trading practices.
10. Introduction of Financial Planners who can provide need based advice
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=11&aid=56&acat=&ahead=Mutual%2520Fund%2520-%2520A%2520complete%2520Analysis
A mutual fund is a professionally-managed firm of collective investments that pools money from many investors and invests it in stocks, bonds, short-term money market instruments, and/or other securities. In a mutual fund, the fund manager, who is also known as the portfolio manager, trades the fund's underlying securities, realizing capital gains or losses, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. The value of a share of the mutual fund, known as the net asset value per share (NAV), is calculated daily based on the total value of the fund divided by the number of shares currently issued and outstanding.
Concept:
A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. The money thus collected is then invested in capital market instruments such as shares, debentures and other securities. The income earned through these investments and the capital appreciation realised are shared by its unit holders in proportion to the number of units owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.
History:
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 Reserve Bank the. 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 banks and Life Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC). SBI Mutual Fund was the first non- UTI Mutual Fund 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 crores.
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 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 UTI 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 assets of Rs.153108 crores under 421 schemes.
Types of Mutual Funds:
On the basis of their structure and objective, mutual funds can be classified into following major types:
Closed-end funds
Open-end funds
Large cap funds
Mid-cap funds
Equity funds
Balanced funds
Growth funds
No load funds
Exchange traded funds
Value funds
Money market funds
International mutual funds
Regional mutual funds
Sector funds
Index funds
Fund of funds
Closed-end Mutual Fund
A closed-end mutual fund has a set number of shares issued to the public through an initial public offering. These funds have a stipulated maturity period generally ranging from 3 to 15 years. The fund is open for subscription only during a specified period. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where they are listed.Once underwritten, closed-end funds trade on stock exchanges like stocks or bonds. The market price of closed-end funds is determined by supply and demand and not by net-asset value (NAV), as is the case in open-end funds. Usually closed mutual funds trade at discounts to their underlying asset value.
Open-end mutual fund
An open-end mutual fund is a fund that does not have a set number of shares. It continues to sell shares to investors and will buy back shares when investors wish to sell. Units are bought and sold at their current net asset value.Open-end funds keep some portion of their assets in short-term and money market securities to provide available funds for redemptions. A large portion of most open mutual funds is invested in highly liquid securities, which enables the fund to raise money by selling securities at prices very close to those used for valuations.
Large Cap Funds
Large cap funds are those mutual funds, which seek capital appreciation by investing primarily in stocks of large blue chip companies with above-average prospects for earnings growth. Different mutual funds have different criteria for classifying companies as large cap. Generally, companies with a market capitalisation in excess of Rs 1000 crore are known large cap companies. Investing in large caps is a lower risk-lower return proposition (vis-à-vis mid cap stocks), because such companies are usually widely researched and information is widely available.
Mid cap funds
Mid cap funds are those mutual funds, which invest in small / medium sized companies. As there is no standard definition classifying companies as small or medium, each mutual fund has its own classification for small and medium sized companies. Generally, companies with a market capitalization of up to Rs 500 crore are classified as small. Those companies that have a market capitalization between Rs 500 crore and Rs 1,000 crore are classified as medium sized. Big investors like mutual funds and Foreign Institutional Investors are increasingly investing in mid caps nowadays because the price of large caps has increased substantially. Small / mid sized companies tend to be under researched thus they present an opportunity to invest in a company that is yet to be identified by the market. Such companies offer higher growth potential going forward and therefore an opportunity to benefit from higher than average valuations.But mid cap funds are very volatile and tend to fall like a pack of cards in bad times. So, caution should be exercised while investing in mid cap mutual funds.
Equity Mutual Funds
Equity mutual funds are also known as stock mutual funds. Equity mutual funds invest pooled amounts of money in the stocks of public companies. Stocks represent part ownership, or equity, in companies, and the aim of stock ownership is to see the value of the companies increase over time. Stocks are often categorized by their market capitalization (or caps), and can be classified in three basic sizes: small, medium, and large. Many mutual funds invest primarily in companies of one of these sizes and are thus classified as large-cap, mid-cap or small-cap funds.Equity fund managers employ different styles of stock picking when they make investment decisions for their portfolios. Some fund managers use a value approach to stocks, searching for stocks that are undervalued when compared to other, similar companies. Another approach to picking is to look primarily at growth, trying to find stocks that are growing faster than their competitors, or the market as a whole. Some managers buy both kinds of stocks, building a portfolio of both growth and value stocks.
Balanced Fund
Balanced fund is also known as hybrid fund. It is a type of mutual fund that buys a combination of common stock, preferred stock, bonds, and short-term bonds, to provide both income and capital appreciation while avoiding excessive risk. Balanced funds provide investor with an option of single mutual fund that combines both growth and income objectives, by investing in both stocks (for growth) and bonds (for income). Such diversified holdings ensure that these funds will manage downturns in the stock market without too much of a loss. But on the flip side, balanced funds will usually increase less than an all-stock fund during a bull market.
Growth Funds
Growth funds are those mutual funds that aim to achieve capital appreciation by investing in growth stocks. They focus on those companies, which are experiencing significant earnings or revenue growth, rather than companies that pay out dividends. Growth funds tend to look for the fastest-growing companies in the market. Growth managers are willing to take more risk and pay a premium for their stocks in an effort to build a portfolio of companies with above-average earnings momentum or price appreciation.In general, growth funds are more volatile than other types of funds, rising more than other funds in bull markets and falling more in bear markets. Only aggressive investors, or those with enough time to make up for short-term market losses, should buy these funds.
No-Load Mutual Funds
Mutual funds can be classified into two types - Load mutual funds and No-Load mutual funds. Load funds are those funds that charge commission at the time of purchase or redemption. They can be further subdivided into (1) Front-end load funds and (2) Back-end load funds. Front-end load funds charge commission at the time of purchase and back-end load funds charge commission at the time of redemption.
On the other hand, no-load funds are those funds that can be purchased without commission. No load funds have several advantages over load funds. Firstly, funds with loads, on average, consistently underperform no-load funds when the load is taken into consideration in performance calculations. Secondly, loads understate the real commission charged because they reduce the total amount being invested. Finally, when a load fund is held over a long time period, the effect of the load, if paid up front, is not diminished because if the money paid for the load had invested, as in a no-load fund, it would have been compounding over the whole time period.
Exchange Traded Funds
Exchange Traded Funds (ETFs) represent a basket of securities that are traded on an exchange. An exchange traded fund is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index. An ETF will invest in either all of the securities or a representative sample of the securities included in the index. The investment objective of an ETF is to achieve the same return as a particular market index. Exchange traded funds rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios.
Value Funds
Value funds are those mutual funds that tend to focus on safety rather than growth, and often choose investments providing dividends as well as capital appreciation. They invest in companies that the market has overlooked, and stocks that have fallen out of favour with mainstream investors, either due to changing investor preferences, a poor quarterly earnings report, or hard times in a particular industry.Value stocks are often mature companies that have stopped growing and that use their earnings to pay dividends. Thus value funds produce current income (from the dividends) as well as long-term growth (from capital appreciation once the stocks become popular again). They tend to have more conservative and less volatile returns than growth funds.
Money Market Mutual Funds
A money market fund is a mutual fund that invests solely in money market instruments. Money market instruments are forms of debt that mature in less than one year and are very liquid. Treasury bills make up the bulk of the money market instruments. Securities in the money market are relatively risk-free. Money market funds are generally the safest and most secure of mutual fund investments. The goal of a money-market fund is to preserve principal while yielding a modest return. Money-market mutual fund is akin to a high-yield bank account but is not entirely risk free. When investing in a money-market fund, attention should be paid to the interest rate that is being offered.
International Mutual Funds
International mutual funds are those funds that invest in non-domestic securities markets throughout the world. Investing in international markets provides greater portfolio diversification and let you capitalize on some of the world's best opportunities. If investments are chosen carefully, international mutual fund may be profitable when some markets are rising and others are declining.
However, fund managers need to keep close watch on foreign currencies and world markets as profitable investments in a rising market can lose money if the foreign currency rises against the dollar.
Regional Mutual Fund
Regional mutual fund is a mutual fund that confines itself to investments in securities from a specified geographical area, usually, the fund's local region. A regional mutual fund generally looks to own a diversified portfolio of companies based in and operating out of its specified geographical area. The objective is to take advantage of regional growth potential before the national investment community does. Regional funds select securities that pass geographical criteria. For the investor, the primary benefit of a regional fund is that he/she increases his/her diversification by being exposed to a specific foreign geographical area.
Sector Mutual Funds
Sector mutual funds are those mutual funds that restrict their investments to a particular segment or sector of the economy. These funds concentrate on one industry such as infrastructure, heath care, utilities, pharmaceuticals etc. The idea is to allow investors to place bets on specific industries or sectors, which have strong growth potential. These funds tend to be more volatile than funds holding a diversified portfolio of securities in many industries. Such concentrated portfolios can produce tremendous gains or losses, depending on whether the chosen sector is in or out of favour.
Index Funds
An index fund is a type of mutual fund that builds its portfolio by buying stock in all the companies of a particular index and thereby reproducing the performance of an entire section of the market. The most popular index of stock index funds is the Standard & Poor's 500. An S&P 500 stock index fund owns 500 stocks-all the companies that are included in the index. Investing in an index fund is a form of passive investing. Passive investing has two big advantages over active investing. First, a passive stock market mutual fund is much cheaper to run than an active fund. Second, a majority of mutual funds fail to beat broad indexes such as the S&P 500.
Fund of Funds
A fund of funds is a type of mutual fund that invests in other mutual funds. Just as a mutual fund invests in a number of different securities, a fund of funds holds shares of many different mutual funds.Fund of funds are designed to achieve greater diversification than traditional mutual funds. But on the flipside, expense fees on fund of funds are typically higher than those on regular funds because they include part of the expense fees charged by the underlying funds. Also, since a fund of funds buys many different funds which themselves invest in many different stocks, it is possible for the fund of funds to own the same stock through several different funds and it can be difficult to keep track of the overall holdings.
Advantages of Mutual Funds
The advantages of investing in a Mutual Fund are:
Diversification:
The best mutual funds design their portfolios so individual investments will react differently to the same economic conditions. For example, economic conditions like a rise in interest rates may cause certain securities in a diversified portfolio to decrease in value. Other securities in the portfolio will respond to the same economic conditions by increasing in value. When a portfolio is balanced in this way, the value of the overall portfolio should gradually increase over time, even if some securities lose value.
Professional Management:
Most mutual funds pay topflight professionals to manage their investments. These managers decide what securities the fund will buy and sell.
Regulatory oversight:
Mutual funds are subject to many government regulations that protect investors from fraud.
Liquidity:
It's easy to get your money out of a mutual fund. Write a check, make a call, and you've got the cash.
Convenience:
You can usually buy mutual fund shares by mail, phone, or over the Internet. Low cost: Mutual fund expenses are often no more than 1.5 percent of your investment. Expenses for Index Funds are less than that, because index funds are not actively managed. Instead, they automatically buy stock in companies that are listed on a specific index.
Transparency
Flexibility
Choice of schemes
Tax benefits
Well regulated
Drawbacks of Mutual Funds
Mutual Funds have their own drawbacks and it may not suit the investment needs of all kinds of investors because of its limitations and the drawbacks. Following are the few drawbacks of Mutual Funds:
No Guarantees:
No investment is risk free. If the entire stock market declines in value, the value of mutual fund shares will go down as well, no matter how balanced the portfolio. Investors encounter fewer risks when they invest in mutual funds than when they buy and sell stocks on their own. However, anyone who invests through a mutual fund runs the risk of losing money.
Fees and commissions:
All funds charge administrative fees to cover their day-to-day expenses. Some funds also charge sales commissions or "loads" to compensate brokers, financial consultants, or financial planners. Even if you don't use a broker or other financial adviser, you will pay a sales commission if you buy shares in a Load Fund.
Taxes:
During a typical year, most actively managed mutual funds sell anywhere from 20 to 70 percent of the securities in their portfolios. If your fund makes a profit on its sales, you will pay taxes on the income you receive, even if you reinvest the money you made.
Management risk:
When you invest in a mutual fund, you depend on the fund's manager to make the right decisions regarding the fund's portfolio. If the manager does not perform as well as you had hoped, you might not make as much money on your investment as you expected. Of course, if you invest in Index Funds, you forego management risk, because these funds do not employ managers.
The Future
By December 2004, Indian mutual fund industry reached Rs 1,50,537 crore. It is estimated that by 2010 March-end, the total assets of all scheduled commercial banks should be Rs 40,90,000 crore.The annual composite rate of growth is expected 13.4% during the rest of the decade. In the last 5 years we have seen annual growth rate of 9%. According to the current growth rate, by year 2010, mutual fund assets will be double.
Some facts for the growth of mutual funds in India
1 . 100% growth in the last 6 years.
2. Number of foreign AMC's are in the que to enter the Indian markets like Fidelity Investments, US based, with over US$1trillion assets under management worldwide.
3. Our saving rate is over 23%, highest in the world. Only channelizing these savings in mutual funds sector is required.
4. We have approximately 29 mutual funds which is much less than US having more than 800. There is a big scope for expansion.
5. 'B' and 'C' class cities are growing rapidly. Today most of the mutual funds are concentrating on the 'A' class cities. Soon they will find scope in the growing cities.
6. Mutual fund can penetrate rurals like the Indian insurance industry with simple and limited products.
7. SEBI allowing the MF's to launch commodity mutual funds.
8. Emphasis on better corporate governance.
9. Trying to curb the late trading practices.
10. Introduction of Financial Planners who can provide need based advice
Source: http://www.indianmoney.com/article-display.php?cat_id=1&sub_id=11&aid=56&acat=&ahead=Mutual%2520Fund%2520-%2520A%2520complete%2520Analysis
Investing in Gold
Investment in gold can be done openly through bullion or coin ownership or indirectly through gold exchange-traded funds, certificates, accounts, spread betting, derivatives or shares.
Why investors buy gold
Investors usually buy gold for two main reasons:
· To financially gain from increasing gold prices,
· As a hedge or safe haven against any economic, political, social or currency- based crises.
Investment strategies
Fundamental analysis
Investors using fundamental analysis to analyze the macroeconomic situation which includes international economic indicators, such as GDP growth rates, inflation, interest rates, productivity and energy prices. They would also analyze the annual global gold supply versus demand. While gold production is unlikely to change in the near future, supply and demand due to private ownership is highly liquid and subject to rapid changes. This makes gold very special from almost every other commodity.
Technical analysis
As with stocks, the gold investors may base their investment decision partly or solely on technical analysis. Normally this involves analyzing chart patterns, moving averages, market trends and the economic cycle in order to speculate on the future price.
Using leverage
Investors may choose to leverage their position by borrowing money against their on hand gold assets and then purchasing more gold on account with the loaned funds. This method is referred as a carry trade. Leverage is also an essential part of buying gold derivatives and unhedged gold mining company shares. Leverage via carry trades or derivatives may increase investment gains but also increases risk as if the gold price decreases the investor may be subject to a margin call.
Source: http://indianmoney.com/article-display.php?cat_id=1&sub_id=18&aid=627&acat=&ahead=Investing%20in%20Gold
Why investors buy gold
Investors usually buy gold for two main reasons:
· To financially gain from increasing gold prices,
· As a hedge or safe haven against any economic, political, social or currency- based crises.
Investment strategies
Fundamental analysis
Investors using fundamental analysis to analyze the macroeconomic situation which includes international economic indicators, such as GDP growth rates, inflation, interest rates, productivity and energy prices. They would also analyze the annual global gold supply versus demand. While gold production is unlikely to change in the near future, supply and demand due to private ownership is highly liquid and subject to rapid changes. This makes gold very special from almost every other commodity.
Technical analysis
As with stocks, the gold investors may base their investment decision partly or solely on technical analysis. Normally this involves analyzing chart patterns, moving averages, market trends and the economic cycle in order to speculate on the future price.
Using leverage
Investors may choose to leverage their position by borrowing money against their on hand gold assets and then purchasing more gold on account with the loaned funds. This method is referred as a carry trade. Leverage is also an essential part of buying gold derivatives and unhedged gold mining company shares. Leverage via carry trades or derivatives may increase investment gains but also increases risk as if the gold price decreases the investor may be subject to a margin call.
Source: http://indianmoney.com/article-display.php?cat_id=1&sub_id=18&aid=627&acat=&ahead=Investing%20in%20Gold
Subscribe to:
Posts (Atom)