Investment Planning PDF

Module 4
Investment Planning
Certified Financial Planner Module 4: Investment Planning
This session will help you understand
• The importance of investment planning in the financial
planning process.
• The types of investment products and their risk return

characteristics.
• How to evaluate investment choices in the light of the

client’s financial needs.
• Understand what client portfolios- how they are created,

monitored and rebalanced based on needs.
• How to recommend a investment portfolio.

Purpose of Investments
• Investment is nothing but using money to make more
money.
• It involves sacrifice of something now for the prospects of

getting something in future.
• To part with money, investors need compensation for:

– Time period for which the money Is parted with.
– The expected rate of price rise- Inflation
– The uncertainty of payments in future.
• Investment planning is an important part of overall

financial planning.

The Financial Planning process involves 6 steps
Establishing and
Defining the client-
Planner relationship
Monitoring the Gathering Client Data &
recommendations Goals
Implementing the Analysing and

Financial plan Evaluating Financial
recommendations Status
Developing and
Presenting Financial
Planning
Recommendations/
Alternatives
Financial Planning Steps
• Establishing the relationship:
– The Financial Planner will describe the services that he is
offering. The client and planner to mutually decide on their
respective responsibilities.The remuneration is also to be
decided upon.
• Gathering the data and goals of the client:
– The financial planner is to gather information on the client’s
financial situation.Both mutually define personal and
financial goals, set time frames for results with the planner
evaluating the clients appetite for risks.
• Analysis and evaluation of clients financial status:
– The financial planner will then evaluate the clients financial
status, assess the current situation and then decide on what
needs to be done to achieve the set goals.This could include
analysis of assets, liabilities and cash flows, insurance
coverage, investment or tax strategies.

Financial Planning Steps
• Developing plan and making recommendations:
– The financial planner will then make recommendation to the client
based on the goals and objectives of the client. The financial
planner should go over the plans with you to help the client
understand the risks involved.
– The financial planner should revise the recommendations when
possible, based on your concerns.
• Implementation:
– The Financial Planner will then implement the plan on the basis
of the consensus arrived at with the client.In some cases, the
planner may act as a coach, co-ordinating the whole process with
you and other professionals.
• Monitoring the financial recommendations:
– The Financial planner and the client should agree on who will
actually monitor the progress that is being made towards the
goal. In case the Financial planner is in charge, he/ she should
periodically report to you and make recommendations.

RISK AND RETURN

Introduction to Risk & Return
• Return and risk are two important characteristics of any

investment product.
• Generally return and risk go hand in hand.
• A rational investor likes return and dislike risk, so most of
the investment is a tradeoff between risk and return.
To part with money, investors require compensation for

• The time period for which the resources are committed
• The expected rate of price-rise
• The uncertainty of the payments in future

Type of returns
• Total return or Holding period return: The period during
which the investment is held by the investor is known as
holding period and the return generated on that
investment is called as holding period return during that
period.
• Annualized return (CAGR): It is also known as
compounded annual growth rate. The year-over-year
growth rate of an investment over a specified period of
time. The compound annual growth rate is calculated by
taking the nth root of the total percentage growth rate,
where n is the number of years in the period being
considered.

Measurement of return
• Return is reward for undertaking investment.
Historical return
A) Total return: The total amount of earnings on an investment is
"total return". And this is generally broken down into two main
components.
Current Income – Income received regularly over the course of the
investment (dividends, interest or rent)
Capital Gains – the increase in the market value of the specific
investment vehicle. This return is generally not received or
recognized until the asset is sold.
• B) Average return: It is a measure of return that gives summary of a
series of return .It represents the series with one number. The sum of
annual return is divided by the number of years it shows now much
on an average investment has grown over a period of time. It is also
called as arithmetic mean.

Expected return
The expected rate of return is the weighed average of all possible returns multiplied
by their respective probabilities.
n
E(R) = ∑Ri Pi
i=1
Where, E(R) = Expected return from the stock
Ri = Return form the stock under state i
Pi = Probability that the state i occurs
n = Number of possible states of the world
Portfolio return
The expected return on a portfolio of securities weighted average of expected

return for the individual investment in a portfolio.

How much risk can an investor take?
This would depend on the following factors:
Risk Tolerance Age Goals Time horizon
How much are Younger If you are saving The longer you
you prepared to investors can to buy a house or can afford to
lose over one year usually afford starting to invest wait, the less risk
without giving up to be more for retirement, is involved. Do
you will need to not invest in
on investment? aggressive
invest in growth risky assets if
stocks. This you may need
means taking on funds in the short
more risk term.

Types of Investment Risks
Non Systematic/ Interest Rate
Systematic/ Market Re-investment
Non Market Risks
Risks Risks
Risks
The element of The variability The risk that The possibility

return variability in a security's interest income of a reduction in
from an asset total returns or principal the value of a
which results not related to repayments will security,
from overall market have to be especially a
fluctuations in variability reinvested at bond, resulting
the aggregate lower rates in a from a rise in
market declining rate interest rates.
environment.
Such changes
generally affect
security prices
inversely
Types of Investment Risks
Exchange
Purchasing Re-investment Interest Rate Political Rate
Power Risks Risks Risks Risks Risks
The risk of The risk that The possibility The risk of The risk that
loss in the interest of a reduction loss when a business'
value of income or in the value of investing in a operations
cash due to principal a security, given country or an
inflation. repayments especially a caused by investment's
This is also will have to bond, changes in a value will be
known as be resulting from country's affected by
inflation risk reinvested at a rise in political changes in
lower rates interest rates. structure or exchange
in a policies rates
declining
rate
environment
Managing risk
• Avoiding Risks: Simply avoid the risk altogether. Don’t invest in the financial
market to avoid financial loss. However, some risks are unavoidable.
• Controlling Risks: Put in place some control measures for the risks. For
example, you can install sprinkler systems in your office to control the risk of
loss due to a fire.
• Accepting risk: Assume all financial responsibility of a risk. Self Insurance

falls under this. For example, An employer can self insure a medical expense
benefits plan for his employees by setting aside a sum of money for this.
• Transferring Risks: Shifting the financial responsibility for that risk to the other
party, generally in exchange for a fee. Purchasing Insurance is the most
common method of transferring risk from the individual to the insurance
company

Measurement of risk
• Being able to measure and determine the past volatility of a security
is important in that it provides some insight into the riskiness of that
security as an investment.
Historical risk:
Variance: Variance is the standard measure of total risk. It measures
the dispersion of returns around the expected return. The larger the
dispersion, the more risk involved with an individual security.
Variance is an absolute number and can be difficult to interpret. The
square root of variance is standard deviation.
Standard Deviation: Standard Deviation is a measure of variability of
returns of an asset as compared with its mean or expected value. It
measures total risk. There is a direct relationship between standard
deviation and risk. The larger the dispersion around a mean value,
the greater the risk and larger the standard deviation for a security.
The standard deviation of a portfolio is the not the average of the
standard deviations of individual assets. The standard deviation of a
portfolio is usually less than the average standard deviation of the
stock in the portfolio.

Steps to calculate historical standard
deviation
• For each observation, take the difference between
the individual observation and the average return.
• Square the difference.
• Sum the squared differences.
• For sample SD, divide this sum by one less than the
number of observations. For population SD, divide
this sum by the total number of observations
• Take the square root.

Beta: Beta is a measure of the systematic risk of a security that
cannot be avoided through diversification. Beta is a relative
measure of risk-the risk of an individual stock relative to the
market portfolio of all stocks. If the stock has a beta of 1, the
implication is that the stock moves exactly with the market. A
beta of 1.2 is 20 percent riskier than the market and 0.8 is 20
percent less risky than the market.
Expected Risk:
The variance of a probability distribution is the sum of the squares
of the deviation .the variance of a probability distribution is the
sum of the squares of the deviations of actual returns from the
expected return, weighted by the associated probabilities.
• σ 2 = ∑ Pi Ri –E (r) 2
Where,
E(r) = expected return from the stock
Ri = return from stock under state
Pi = probability that the event i occurs
n = number of possible events
Portfolio risk
• Portfolio risk is computed by risk attached with each of the securities
in the portfolio i.e. standard deviation or variance as well as the
interactive risk between the securities i.e. covariance.
• Covariance is a measure of the degree to which two variables move
together over time. A positive covariance indicates that variables move
in the same direction, and a negative covariance indicates that they
move in opposite directions.
• Covariance is an absolute number and can be difficult to interpret.
• Correlation coefficient (r) is a measure of the relationship of returns
between two stocks. Correlation coefficient of (+1) means that returns
always move together in the same direction. They are perfectly
positively correlated. Correlation coefficient of (-1) means that returns
always move in exactly the opposite directions. They are perfectly
negatively correlated. A correlation coefficient of zero means that
there is no relationship between two stocks' returns. They are
uncorrelated.

Measuring Risks
• Coefficient of determination (R2) gives the variation in
one variable explained by another and is an important
statistic in investments.
• R2 is calculated by squaring the correlation coefficient (r).
It is a measure of systematic risk;
• I - R2 is defined as unsystematic risk. The beta coefficient
reports the volatility of some return relative to the market.
• The strength of the relationship is indicated by R2. If R2
equals 0.15, an investor can assume that beta has little
meaning because the variation in the return is caused by
something other than the movement in the market
(unsystematic risk). If R2 equals 0.95, the variation in the
market explains 95 percent of the variation in the return
(systematic risk-where beta is a good measure of risk).

Managing Risks
• Diversification
• Diversification means spreading your money over a

number of investments in order to reduce unique risks
associated with individual investments
• When you invest in the stock market you face both market
risk and unique risk. You can mitigate unique risk by
taking a diversified approach to investing.
• The more stocks you add to your portfolio (your collection
of individual investments) the more unique risk you
eliminate and the smoother your overall returns become.

Diversification
• There are three main practices that can help you ensure
the best diversification:
– Spread your portfolio among multiple investment

vehicles such as cash, stocks, bonds, mutual funds,
and perhaps even some real estate.
– Vary the risk in your securities. You're not restricted to

choosing only blue chip stocks. In fact, it would be wise
to pick investments with varied risk levels; this will
ensure that large losses are offset by other areas.
– Vary your securities by industry. This will minimize the

impact of specific risks of certain industries.

Types of Diversification
Company Balancing potential risk of negative returns from one
Diversification country by investing in other countries that don’t
face the same risk.
Geographical Spreading your risks by investing in different

Diversification countries or in different regions in a particular
country.
Manager Using different fund managers with different

Diversification investment styles and philosophies to reduce risks.
Asset Putting some of your money in more risky funds and

Allocation putting some in less risky, fixed income yielding
instruments is called asset allocation.

Managing Risks
• Hedging:
• Hedging is a strategy to protect oneself from losing by a
counterbalancing transaction. It can be used to protect
one financially--to buy or sell commodity futures as a
protection against loss due to price fluctuation or to
minimize the risk of a bet.
• Hedging against investment risk means strategically using
instruments in the market to offset the risk of any adverse
price movements. In other words, investors hedge one
investment by making another. Technically, to hedge you
would invest in two securities with negative correlations

How do investors hedge?
• Hedging techniques involve using complicated financial
instruments known as derivatives, the two most common
of which are options and futures.
• Keep in mind that because there are so many different
types of options and futures contracts an investor can
hedge against nearly anything, whether a stock,
commodity price, interest rate, or currency.
• Every hedge has a cost, so before you decide to use
hedging, you must ask yourself if the benefits received
from it justify the expense. Remember, the goal of
hedging isn't to make money but to protect from losses.

Relationship between risk and return
RISK/RETURN TRADEOFF
R
E Higher Risk, higher potential return
T
U
R
N
Low return high risk
Risk (Standard Deviation)
Low levels of uncertainty (low risk) are associated with low potential returns.
High levels of uncertainty (high risk) are associated with high potential returns.
The risk/return tradeoff is the balance between the desire for the lowest possible
risk and the highest possible return. Other factors you will need to consider for
investments are; how long you want to invest the money for and whether you
need quick access to it at any time during the investment period.
Compounding
+ =
Compounding is the money that money makes, added to

the money that money has already made.
And each time money makes money, it becomes capable
of making even more money than it could before!

Compounded Annual Growth Rate (CAGR)
• CAGR measures a market's annual growth over a period of time (usually
several years). This measure is a constant percentage rate at which a
market would grow or contract year on year to reach its current value.
• CAGR is a formula used to express the rate of growth in sales, earnings,
units or some other measure over a number of years.
• The CAGR is a more representative measure of annual growth over a
number of years.
• CAGR = ((Y / X) ^ (1 / N)) - 1
– Where: (“^ " ) denotes "to the power of”
– Where: Y is the value in the final year
– Where: X is the value in the first year
– Where: N is the number of years included in the calculation
• CAGR-based forecasts do not show the effects of inflation that would

impact the overall dollar value in the future
Real Returns
• The earnings from an investment above the prevailing
inflation rate is called the real return on that investment.
• The real returns are determined with the help of the

following formula:
– [{(1 + nominal rate)/ (1+ inflation rate)}-1]*100
• Where the nominal rate is the absolute return and the

inflation rate is the rate of inflation for the period.

Risk Adjusted Returns
• In determining the various returns earned by a portfolio, a higher return
by itself is not necessarily indicative of superior performance.
Alternately, a lower return is not indicative of inferior performance.
• In order to determine the risk-adjusted returns of investment portfolios,

several eminent authors have worked since 1960s to develop
composite performance indices to evaluate a portfolio by comparing
alternative portfolios within a particular risk class. The most important
and widely used measures of performance are:
– The Treynor Measure

– The Sharpe Measure
– Jenson Model
– Fama Model

Measures of Performance
• Treynor Measure: Developed by Jack Treynor, this performance
measure evaluates funds on the basis of Treynor's Index. This Index is
a ratio of return generated by the fund over and above risk free rate of
return during a given period and systematic risk associated with it
(beta).
• Symbolically, it can be represented as:
– Treynor's Index (Ti) = (Ri - Rf)/Bi.
• Where, Ri represents return on fund, Rf is risk free rate of return and
Bi is beta of the fund.
• Sharpe Measure: According to Sharpe, it is the total risk of the fund

that the investors are concerned about. So, the model evaluates funds
on the basis of reward per unit of total risk.
• Symbolically, it can be written as:
– Sharpe Index (Si) = (Ri - Rf)/Si
• Where, Si is standard deviation of the fund.

• Jenson Model: developed by Michael Jenson (sometimes referred to
as the Differential Return Method) involves evaluation of the returns
that the fund has generated vs. the returns actually expected out of
the fund given the level of its systematic risk. The surplus between the
two returns is called Alpha, which measures the performance of a fund
compared with the actual returns over the period.
• Required return of a fund at a given level of risk (Bi) can be calculated
as:
– Ri = Rf + Bi (Rm - Rf)
• Where, Rm is average market return during the given period. After
calculating it, alpha can be obtained by subtracting required return
from the actual return of the fund. Higher alpha represents superior
performance of the fund and vice versa.

• The Fama Model: The Eugene Fama model is an extension of
Jenson mode and compares the performance, measured in terms of
returns, of a fund with the required return commensurate with the total
risk associated with it.
• The difference between these two is taken as a measure of the
performance of the fund and is called net selectivity.
• The net selectivity represents the stock selection skill of the fund
manager, as it is the excess return over and above the return required
to compensate for the total risk taken by the fund manager. Higher
value of which indicates that fund manager has earned returns well
above the return commensurate with the level of risk taken by him.
– Required return can be calculated as: Ri = Rf + Si/Sm*(Rm - Rf)
• Where, Sm is standard deviation of market returns. The net selectivity
is then calculated by subtracting this required return from the actual
return of the fund.

Post- Tax Returns
• The amount of taxes paid will affect an investor's total
return. Therefore it is important for an investor to
understand the impact of taxes on the performance of
investment.
• There are many different assumptions to use in

calculating the impact of taxes on investment returns. The
post-tax return is calculated by multiplying the pretax rate
by the quantity one minus the marginal tax bracket of the
investor.

Holding Period Returns
• The amount of taxes paid will affect an investor's total return.
Therefore it is important for an investor to understand the impact
of taxes on the performance of investment.
• There are many different assumptions to use in calculating the

impact of taxes on investment returns. The post-tax return is
calculated by multiplying the pretax rate by the quantity one
minus the marginal tax bracket of the investor.
• The holding period return (HPR) is the total return and is

determined by taking the total return divided by the initial cost of
the investment:
– HPR= (PI - Po + D)/ Po
• Where, PI is the sale price, Po is the purchase price, and D is
the dividend paid.
• There is a major weakness in using the holding period. It does
not consider how long it took to earn the return.

Yield to Maturity (YTM)
• The yield to maturity is the internal rate of return of a bond if
held to maturity
• Internal rate of return is the discounted rate that makes the

present value of the cash outflows equal to initial cash inflows
such that the net present value is equal to zero.
• YTM considers the current interest return and all price

appreciation or depreciation. It is also a measure of risk and is
the discount rate that equals the present value of all cash flows.
From a firm perspective, it is the cost of borrowing by issuing
new bonds. From an investor perspective, it is the internal rate
of return that is received if the bond is held to maturity.
• The yield to maturity can easily be solved using a financial

calculator, in the same way as finding the internal rate of return.

Investment Portfolio
• A portfolio is a combination of different investment assets
mixed and matched for the purpose of achieving an
investor's goal(s).
• Items that are considered a part of your portfolio can
include any asset you own--from real items such as art and
real estate, to equities, fixed-income instruments, and cash
and equivalents.
• The Following are the various types of portfolio strategies:
– Aggressive Investment Strategy: Search for maximum
returns from an investment. Suitable for risk takers and
for a longer time horizon. Higher investment in Equities.
– Conservative Investment Strategy: Safety of investment
is a high priority. Suitable for those who have a low risk
appetite and a shorter time horizon. High investments in
cash and cash equivalents, and high quality fixed
income yielding assets.

Investment Portfolios
• Moderately Aggressive investment strategies: These are
suitable for people who have a large an average appetite
for risk and a longer time horizon. The objective is to
balance the amount of risk and return contained within the
fund. The portfolio would consist of approximately 50-55%
equities, 35-40% bonds, 5-10% cash and equivalents.
• You can further break down the above asset classes into
subclasses, which also have different risks and potential
returns. More advanced investors might also have some
of the alternative assets such as options and futures in the
mix. As you can see, the number of possible asset
allocations is practically unlimited.

Why is important to maintain a
portfolio?
• Diversification which works on the principle of “Not putting
all your eggs in one basket”.
• Different securities perform differently at any point in time,
so with a mix of asset types, your entire portfolio does not
suffer the impact of a decline of any one security.
• When your stocks go down, you may still have the stability
of the bonds in your portfolio.
• If you spread your investments across various types of
assets and markets, you'll reduce the risk of catastrophic
financial losses.

Investment Vehicles
Small Savings
• Small savings continue to be a favorite investment
alternative for a large section of investing population
despite the emergence of a number of alternative avenues
such as mutual funds and unit-linked insurance plans
(ULIPs).
• Small savings scheme in India generally include National
Savings Scheme (NSC), Public Provident Fund (PPF) and
Kisan Vikas Patra (KVP).
• All small savings schemes tend to be characterized as the
same despite the fact that they vary on parameters
including tenure, returns and liquidity. There is much more
to these schemes than just the safety and returns.

Small Savings
• Public Provident Fund:
• It presently offers a return of 8% per annum and has a
maturity period of 15 years. Contributions can vary from Rs
500 to Rs 70,000 per annum.
• Investment under PPF is not very liquid. Withdrawals are
permitted only after the expiry of 5 years from the end of the
financial year of the first deposit. Also only a small portion
can be withdrawn
• Investors are entitled to claim tax-benefits under Section 80
C for deposits made up to Rs 70,000 pa in the PPF account
and interest exemptions under Section 10 of the Income Tax
Act.
• Suitable investment option for investors who have age on
their side and for whom liquidity is not a concern.

Small Savings
• National Savings Certificate:
• NSC is another attractive instrument offering a return of 8% pa.
Investors are required to make a single deposit and the interest
component is returned along with the principal amount on maturity.
NSC has an edge over its peers on account of a relatively lower
tenure i.e. 6 years.
• Premature encashment of certificate is allowed under specific
circumstances only, such as death of the holder(s), forfeiture by the
pledgee or under court's order.
• Investments in NSC enjoy tax-benefits under Section 80 C of the
Income Tax Act. The interest is entitled for exemption under section
80L of the Income Tax Act. An added incentive is that the accrued
interest is automatically reinvested, and qualifies for benefit under
Section 80 C.
• Investors who offer more weightage to tax benefits vis-à-vis other
factors like liquidity should consider investing in the NSC

Small Savings
• Kisan Vikas Patra
• KVP falls under the category of small saving schemes which
don't offer any benefits under the Income Tax Act. The
scheme runs over a tenure of 8 years and 7 months (which is
a fairly longish horizon) and doubles the amount invested.
This makes the return one of the most attractive one amongst
its peers.
• Investors are permitted to liquidate their investments in KVP
any time after 2.5 years from the investment date. However a
loss of interest has to be borne. In terms of tenure for
withdrawal (2.5 years) it scores far better than the NSC and
PPF on this parameter.
• Investors whose priority is earning attractive returns while
maintaining a reasonable degree of liquidity should consider
investing in the KVP. Also KVP will hold appeal for investors
in cases where tax benefits are not a priority.

Small Savings
• Post office monthly income scheme:
• This scheme provides monthly income (at 8% pa) to investors. On
competition of 6 years, a 10% bonus on the principal sum is
provided.
• POMIS offers investors an exit option after 1 year from the
investment date.
• An exit after 1 year would also entail a loss of 5% of the amount
invested. As a result, while the investor would not suffer any loss in
interest earnings, but the loss of principal can be a significant one
(especially for investors with high investments). Investors have to
wait for a 3 year period if they wish to liquidate their holdings
without any loss of principal.
• The interest on investments as well as bonus received on maturity
qualifies for tax benefits under Section 80L of the Income Tax Act.
• POMIS is best suited for investors like retirees who are looking for
regular returns. The combination of assured returns with tax
benefits makes POMIS an attractive proposition.

Small Savings
• Post office Time Deposits:
• Fixed deposits of varying tenures offered under the domain of
small saving schemes. These deposits are available for
periods ranging from 1 year to 5 years with the interest rates
varying correspondingly. Interest payments are made
annually. POTD have emerged as one of the most favoured
instruments in recent times.
• Investors can exercise the exit option within 6 months without
receiving any interest (1-Yr lock-in for exit with interest
receipt). However the penalty clause is applicable depending
on the interest rates offered by the time deposit. A flat penalty
of 2% is deducted from the relevant rate in case of premature
withdrawals.
• Interest on POTD is eligible for tax benefits under Section
80L of the Income Tax Act.
• POTD fit into most portfolios across investor classes.

Small Savings
• Senior Citizens Savings Schemes:
• The scheme has been reserved for citizens above 60 years
of age, albeit citizens above 55 years can invest in the same
subject to certain conditions being fulfilled. SCSS offers a
return of 9% pa, making it a must have proposition for the
target audience. The SCSS in tandem with the POMIS can
prove to be a very lucrative option for senior citizens who
need regular income without taking on any risk.

Fixed Income Instruments
• Securities:
– Government Securities (G-Secs):
– Government Securities (G-Secs) market comprises almost 95% of
the debt market.
– Government Security is a sovereign debt issued by the Reserve
Bank of India (RBI) on behalf of Government of India. These
securities are issued to cover the Central Government's annual
market borrowing programme to fund the fiscal deficit. The term
"Government Security" includes: * Central Government Dated
Securities * State Government Securities * Treasury Bills (TBs).
– The market borrowing of the Central Government is raised through
the issue of dated securities and 364 days TBs either by auction or
by floatation of fixed coupon loans. In addition, TBs of 91 days are
issued for managing the temporary cash mismatches of the
Government. These do not form part of the borrowing programme of
the Central Government.
• Government securities are of 2 types:
(a) Dated Securities are generally of fixed maturity
and fixed coupon securities usually carrying semi-
annual coupon. These are called dated securities
because these are identified by their date of
maturity and the coupon
* They are issued at face value. * Coupon or interest rate
is fixed at the time of issuance and remains constant till
redemption of the security. * The tenor of the security
is also fixed. * Interest /Coupon payment is made on a
half yearly basis on its face value. * The security is
redeemed at par on its maturity date.

(b) Zero Coupon Bonds are bonds issued at discount to
face value and redeemed at par. The key features of
these bonds are:
• They are issued at a discount to the face value. * The
tenor of the security is fixed. * The securities do no
carry any coupon or interest rate. The difference
between the issue price and face value is the return on
this security. * The security is redeemed at par on its
maturity date.
– Though the benchmark does not change, the rate of
interest may vary according to the change in the
benchmark rate till redemption of the security. The
tenor of the security is also fixed. * Interest /Coupon
payment is made on a half yearly basis on its face
value. * The security is redeemed at par on its maturity
date.

(c) Floating Rate Bonds are bonds with variable interest
rate with a fixed percentage over a benchmark rate.
There may be a cap and a floor rate attached, thereby
fixing a maximum and minimum interest rate payable
on it. The key features of these securities are:
• They are issued at face value. * Coupon or interest
rate is fixed as a percentage over a predefined
benchmark rate at the time of issuance. The
benchmark rate may be TB rate, Bank rate, etc
(d) Treasury Bills: There are different types of TBs based
on the maturity period and utility of the issuance like,
ad-hoc TBs, 3 months, 12 months TBs etc. At present,
the TBs in vogue are the 91-days and 364-days TBs.

• State Government Securities:
• State Government Securities are securities/loans issued
by the RBI on behalf of various State Governments for
financing their developmental needs.
• The RBI auctions these securities from time to time.
These auctions are of fixed coupon, with pre-announced
notified amounts for different States.
• The coupon rate and year of maturity identifies the
government security.
• For Central Government securities and State Government
securities the day count is taken as 360 days for a year
and 30 days for every completed month. However, for TBs
it is 365 days for a year.

• Yield to maturity (YTM) is the discount rate that equates
present value of all the future cash inflows to the cost
price of the security and is also called the Internal Rate of
Return (IRR). The concept of Yield to Maturity assumes
that the future cash flows are reinvested at the same rate
at which the original investment was made. The price of a
security/bond is inversely related to its yield. As the yield
increases, the price decreases and if the yield falls there is
an increase in the price.
• All entities registered in India like Banks, Financial
Institutions, Primary Dealers, Companies, Corporate
Bodies, Partnership Firms, Institutions, Mutual Funds,
Foreign Institutional Investors, State Governments,
Provident Funds, Trusts, Nepal Rashtra Bank and even
individuals are eligible to purchase Government
Securities.

• Advantages of State Government Securities:
• No TDS - Interest income up to Rs.12000/- is exempt
under section 80L of Income Tax Act. The additional
benefit of Rs.3000/- is also available for interest earned on
Government securities
• Zero default risk, being a sovereign paper
• Regular income in the form of half yearly interest
payments
• Highly liquid due to active secondary market
• Simplified and transparent transactions
• Hassle free settlement through Demat / SGL accounts
• Easy loans available from Banks
• Holding possible in dematerialized form

• How to invest in Government Securities:
• Investment in Government Securities can either be made
in the primary market by participating in the RBI auctions
or by purchasing from the secondary market.
• RBI has recently introduced the scheme of Non-
Competitive Bidding for the benefit of retail investors.
Under this scheme non- institutional participants will be
allotted securities at the weighted average cutoff rate.
• Up to 5% of the issue size is reserved for investors under
this scheme.
• Investors can invest in a hassle free manner by opening a
Demat account.
• Investors can contact any Primary Dealer to make an
investment in Government Securities.

• Corporate Bonds:
• Corporate bonds are debt obligations, issued by private and
public corporations.
• They are typically issued in multiples of Rs 1,000. Companies
use the funds they raise from selling bonds for a variety of
purposes, from building facilities to purchasing equipment to
expanding the business.
• When you buy a bond, you are lending money to the corporation
that issued it.
• The corporation promises to return your money, or principal, on
a specified maturity date. Until that time, it also pays you a
stated rate of interest, usually semiannually.
• The interest payments you receive from corporate bonds are
taxable. Unlike stocks, bonds do not give you an ownership
interest in the issuing corporation. Benefits of Investing in
Corporate Bonds
• Why Corporate Bonds?
• Attractive yields: Corporates usually offer higher yields than
comparable-maturity government bonds or CDs. This high-yield
potential is generally accompanied by higher risks.
• Dependable income: People who want steady income from
their investments, while preserving their principal, include
corporates in their portfolios.
• Safety: Corporate bonds are evaluated and assigned a rating
based on credit history and ability to repay obligations. The
higher the rating, the safer the investment. (See Understanding
Credit Risk)
• Diversity: Corporate bonds provide the opportunity to choose
from a variety of sectors, structures and credit-quality
characteristics to meet your investment objectives.
• Marketability: If you must sell a bond before maturity, in most
instances you can do so easily and quickly because of the size
and liquidity of the market.

• Types of Corporate Bonds:
– Short-term notes
– Maturities of up to 5 years
– Medium-term notes/bonds
– Maturities of 5-12 years
– Long-term bonds
– Maturities greater than 12 years

• Structure of Corporate Bonds: Another important fact to
know about a bond before you buy is its structure.
• With traditional debt securities, the investor lends the

issuer a specified amount of money for a specified time. In
exchange, the investor receives fixed payments of interest
on a regular schedule for the life of the bonds, with the full
principal returned at maturity.
• In recent years, however, the standard, fixed interest rate

has been joined by other varieties.

• Structure of Corporate Bonds:
– Fixed-rate Most bonds are still the traditional fixed-rate
securities
– Floating-rate These are bonds that have variable
interest rates that are adjusted periodically according
to an index tied to short-term Treasury bills or money
markets. While such bonds offer protection against
increases in interest rates, their yields are typically
lower than those of fixed-rate securities with the same
maturity.
– Zero-coupon These are bonds that have no periodic
interest payments. Instead, they are sold at a deep
discount to face value and redeemed for the full face
value at maturity.

• Benefits to a developing economy- In any developing
economy, it is imperative that a well developed bond
market with a sizable corporate bond segment exists,
alongside the banking system, as :
– A developed and freely operating corporate bond
market may judge the intrinsic worth of investment
demands better in view of the disciplinary role of free
market forces;
– The corporate bond market could exert a competitive
pressure on commercial banks in the matter of
lending to private business and thus help improve the
efficiency of the capital market as a whole; and
– The debt market must emerge as a stable source of
finance to business when equity markets are volatile.

Deposits
1. Bank Deposits:
• Bank Savings Accounts: The simplest kind of short
term (or cash) investment is a savings account. Returns
are low compared to other investments, but returns are
guaranteed by the supplier - so your investment won't
drop in value in the short term like others might. You can
withdraw part or all of your money whenever you want
(total liquidity).
• Bank fixed term investment : You keep a fixed
lumpsum amount of money for a fixed period of time with
the bank for a higher rate of interest. Good for short to
medium term investment. Returns are high but is not very
liquid.

Deposits
2. Company Fixed Deposits:
• Fixed deposits in companies that earn a fixed rate of return
over a period of time are called Company Fixed Deposits.
Financial institutions and Non-Banking Finance Companies
(NBFCs) also accept such deposits. Deposits thus mobilised
are governed by the Companies Act under Section 58A. These
deposits are unsecured, i.e., if the company defaults, the
investor cannot sell the company to recover his capital, thus
making them a risky investment option.
– NBFCs are small organisations, and have modest fixed and
manpower costs. Therefore, they can pass on the benefits to
the investor in the form of a higher rate of interest.
– NBFCs suffer from a credibility crisis. So be absolutely sure to
check the credit rating. AAA rating is the safest.According to
latest RBI guidelines, NBFCs and comapnies cannot offer more
than 14 per cent interest on public deposits.

Deposits
• Investment Objectives:
– A Company/NBFC Fixed Deposit provides for faster
appreciation in the principal amount than bank fixed deposits
and post-office schemes. However, the increase in the interest
rate is essentially due to the fact that it entails more risk as
compared to banks and post-office schemes.
– Company/NBFC Fixed Deposits are suitable for regular income
with the option to receive monthly, quarterly, half-yearly, and
annual interest income. Moreover, the interest rates offered are
higher than banks.
– A Company/NBFC Fixed Deposit provides you with limited
protection against inflation, with comparatively higher returns
than other assured return options.
– You can borrow against a Company/NBFC Fixed Deposit from
banks, but it depends on the credit rating of the company you
have invested in. Moreover, some NBFCs also offer a loan
facility on the deposits you maintain with them.

Deposits
– Company Fixed Deposits are unsecured instruments, i.e.,
there are no assets backing them up. Therefore, in case
the company/NBFC goes under, chances are that you
may not get your principal sum back. It depends on the
strength of the company and its ability to pay back your
deposit at the time of its maturity. While investing in an
NBFC, always remember to first check out its credit
rating. Also, beware of NBFCs offering ridiculously high
rates of interest.
– Income is not at all secured. Some NBFCs have known to
default on their interest and principal payments. You must
check out the liquidity position and its revenue plan
before investing in an NBFC.

Deposits
– If the Company/NBFC goes under, there is no assurance
of your principal amount. Moreover, there is no guarantee
of your receiving the regular-interval income from the
company. Inflation and interest rate movements are one
of the major factors affecting the decision to invest in a
Company/NBFC Fixed Deposit. Also, you must keep the
safety considerations and the company/NBFC's credit
rating and credibility in mind before investing in one.
– Company/NBFC Fixed Deposits are rated by credit rating
agencies like CARE, CRISIL and ICRA. A company rated
lower by credit rating agency is likely to offer a higher rate
of interest and vice-versa. An AAA rating signifies highest
safety, and D or FD means the company is in default.

Deposits
• Some of the options available are:
– Monthly income deposits, where interest is paid every
month.
– Quarterly income deposits, where interest is paid once
every quarter.
– Cumulative deposits, where interest is accumulated and
paid along with the principal at the time of maturity.
– Recurring deposits, similar to the recurring deposits of
banks.

Insurance based investments
• Three main characteristics of insurance based
investments are Income Protection Capital Appreciation
and Tax-deferred Savings.
• There are two very common kinds of life insurance, these
are "Term Life" and "Permanent Life". Term life insurance
is usually for a relatively short period of time, whereas a
permanent life policy is one that you pay into throughout
your entire life.
• Most life insurance policies carry relatively small risk
because insurance companies are usually stable and are
heavily regulated by government
• The advantage is Insurance coverage and low risks.
• The disadvantage is that your family will not get the full
value of the funds in case you live long. Also Cash Value
funds can fluctuate, based on market conditions.

• Annuity: These offer- Capital Appreciation, Tax-Deferred
Benefits and a safe investment options.
• A series of fixed-amount payments paid at regular intervals
over the specified period of the annuity. Most annuities are
purchased through an insurance company.
• Two types:
– Fixed Annuity: the insurance company makes fixed rupee
payments to the annuity holder for the term of the contract.
This is usually until the annuitant dies. The insurance
company guarantees both earnings and principal.
– Variable Annuity: at the end of the accumulation stage the
insurance company guarantees a minimum payment and
the remaining income payments can vary depending on the
performance of your annuity investment portfolio.

• Annuities are advantageous because deferred annuities
allow all interest, dividends, and capital gains to
appreciate tax free until you decide to annuitize (start
receiving payments) and the risk of losing your principal is
very low, annuities are considered to be very safe.
• However, fixed annuities are susceptible to inflation risk
because there is no adjustment for runaway inflation.
Variable annuities that invest in stocks or bonds provide
some inflation protection and if you pass away early then
you will not get back the full value of your investment

• ULIP’s:
• Combines insurance protection and a lucrative
investment tool.
• By selecting from amongst our financial funds, you
choose your own investment strategy, which you can
change during the course of the policy period depending
on the status of the individual financial markets.
• You have the option of drawing on some of your savings
and the possibility of depositing additional money in the
form of extraordinary premiums.
• You can choose from our total of six financial funds. In
this way you determine the level of risk and potential
yields which are most acceptable for you.

• ULIP’s:
• Some of the Advantages are as follows:
– You decide whether you are willing to take risks for
the possibility of higher returns or if you want secure
returns.
– There is unparalleled flexibility with ULIPS.
– Transparency in the product.
– You are allowed to make partial withdrawals- better
liquidity.
– The sum assured can be altered as per your needs
and requirements.

Mutual Funds
• A mutual fund is nothing but money pooled in by a large
group of people that is professionally managed.
• A mutual fund manager proceeds to buy a number of
stocks from various markets and industries. Depending on
the amount you invest, you own a part of the overall fund.
The advantages of mutual funds are as follows:
– Professional Management & Convenient
Administration. Also well regulated.
– Diversification and good return potential.
– Low costs and liquidity.
– Transparency and flexibility.
– Tax Benefits.
– Wide choice of schemes.

History of Indian Mutual Fund
Industry
• First Phase- 1964 to 1987
– UTI was setup by the RBI in 1963.
– In 1978 UTI was delinked from RBI
– First scheme launched by UTI was Unit Scheme 1964.
– By the end of 1988, UTI had Rs. 6700 crores of assets
under management.
• Second Phase- 1987 to 1993
– Market the entry of public sector in the mutual fund
market with LIC, GIC and some Public Sector banks
setting up mutual funds.
– At the end of 1993, the mutual fund industry had
assets under management of Rs.47,004 crores.

Industry
• Third Phase- 1993 to 2003
– Marked the entry of Private sector in the mutual fund
market.
– 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.
– Kothari Pioneer 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.

Industry
• Fourth Phase – Since February 2003
– 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 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.
– As at the end of September, 2004, there were 29
funds, which manage assets of Rs.153108 crores
under 421 schemes.

Growth in assets under management

Advantages and Disadvantages of
Mutual Funds
• Advantages • Disadvantages
– Diversification, – Make tax planning
professional management difficult.
and convenience. – May be somewhat
– Funds offer lower costs by difficult to track in terms
virtue of their size of what they actually are
– Spread many internal investing in.
costs over a large – So called non-substantial
shareholder base, allowing changes in the way the
for economies of scale. funds are managed (such
as manager switches)
may not be disclosed to
investors by fund
companies in a timely
manner.

Equity Shares
• Common stock- these share in the ownership of the
company. The share holders are entitled to a share in the
profits of the company and voting rights.
• Profits are paid in the form of dividends.
• History has dictated that common stocks average 11-12%
per year and outperform just about every other type of
security including bonds and preferred shares. Stocks
provide potential for capital appreciation, income, and
protection again moderate inflation.
• Risks associated with stocks can vary widely, and usually
depends on the company. Purchasing stock in a well
established and profitable company means there is much
less risk you'll lose your investment whereas by
purchasing a penny stock your risks increase
substantially.

Equity Shares
• Advantages-
– Easy to buy and sell
– Very easy to locate reliable information on public
companies.
– There a thousands of companies to choose from.
• Disadvantages-
– Your original investment is not guaranteed.
– Your stock is only as good as the company you invest
in, if you invest in a poor company, you will suffer from
poor stock performance.

Equity Shares
• Shares- By investing in shares in a public company listed
on a stock exchange you get the right to share in the
future income and value of that company.
• Your return can come in two ways:
– Dividends paid out of the profits made by the company.
– Capital gains made because you're able at some time
to sell your shares for more than you paid. Gains may
reflect the fact that the company has grown or
improved its performance or that the investment
community see that it has improved future prospects.

Direct Investment
• You can invest directly in term deposits, bonds, shares
and property or you can place your money in a
superannuation scheme or managed fund and have full
time specialists look after the investment decisions for
you.
• Direct investment in shares in specific companies or
selected rental properties should only be undertaken if
you have detailed knowledge or are prepared to pay for
specialist advice.
• If you want to invest directly in shares or property
remember the importance of duration, risk, diversification,
returns and liquidity.

Managed Funds
• In a managed fund your money is pooled with other
investors, and a professional fund manager invests it in a
variety of investments
• Managed funds come in many forms - different funds
invest in different types of assets for different objectives.
Some funds target all-out growth and invest more in high
risk shares than others - they could rise dramatically or
just as easily drop dramatically.
• Other funds look for solid long term growth from a range
of deposits, bonds, and shares - a better place for a lump
sum intended for your retirement. Financial advisors,
banks and insurance companies can all advise you on
managed funds that match your investment needs.
• Managed funds usually involve paying management and
administration fees. These can vary a lot, so check to see
what you'd have to pay.

American Depository Receipt
• Introduced to the financial markets in 1927, an American
Depository Receipt (ADR) is a stock which trades in the
United States but represents a specified number of shares
in a foreign corporation.
• ADRs are bought and sold on American stock markets just
like regular stocks, and are issued/sponsored in the U.S.
by a bank or brokerage.
• The majority of ADRs range in price between $10 and
$100 per share
• The main objective of ADRs is to save individual investors
money by reducing administration costs and avoiding duty
on each transaction.

American Depository Receipt
• Analyzing foreign companies involves more than just
looking at the fundamentals as there are some
different risks to consider such as:
– Political Risk - Is the government in the home country
of the ADR stable?
– Exchange Rate Risk - Is the currency of the home
country stable? ADRs track the shares in the home
country, therefore if their currency is devalued it trickles
down to your ADR and can result be a loss.
– Inflationary Risk - This is an extension of the
exchange rate risk. Inflation is a big blow to business,
the currency of a country with high inflation becomes
less and less valuable each day.

Closed End Investment Fund
• An investment fund that issues a fixed number of shares
in an actively managed portfolio of securities.
• The shares are traded in the market just like a stock, but
because closed-end funds represent a portfolio of
securities they are very similar to a mutual fund.
• Unlike a mutual fund, the market price of the shares are
determined by supply and demand and not by net asset
value.
• Closed end funds are usually specialized in their
investment focus
• There are also "dual purpose" closed-end funds which
simply mean that there are two classes of shareholders:
preferred shareholders who receive mainly dividends as
income, and common shareholders who profit from the
capital appreciation of the funds share price.

Closed End Investment Fund
• Advantages are:
– funds are easy to buy and sell on financial markets,
furthermore they are regulated by the Securities and
Exchange Commission.
– the funds usually invest in hundreds of companies so offer
good diversification in certain areas.
– if bought in a tax deferred account closed-end funds are a
great investment for long term capital appreciation.
• Weaknesses are:
– fixed interest payments are taxed at the same rate as
income.
– the price of the closed-end fund is not exclusively linked to
the performance of the securities held by the fund. The funds
share price depends on supply and demand in the open
market.

Zero Coupon Securities
• A zero coupon security, or a "stripped bond" is basically a
regular coupon paying bond without the coupons.
• The process of "stripping" or "zeroing" a bond is usually
done by a brokerage or bank. The bank or broker stripping
the bonds then registers and trades these zeros as
individual securities.
• After the bonds are stripped there are two parts, the
principal and the coupons.
• The interest payments are known as "coupons", and the
final payment at maturity is known as the "residual" since
it is what is left over after the coupons are stripped off.
• Both coupons and residuals are bundled and referred to
as zero coupon bonds or "zeros".

Zero Coupon Securities
• Advantages are:
– zero's can be bought at huge discounts
– once you buy a zero coupon security you essentially
lock-in the yield to maturity.
• Weaknesses are:
– if the company issuing the zero goes bankrupt or
defaults then you have everything to lose. Whereas
with a regular coupon bond you may have at least
gotten some interest payments out of the investment.
– interest earned on the zero coupon bond is taxed as
income (a higher rate) rather than a capital gain.

Convertible Securities
• Convertibles, sometimes called CVs, are referring to either
a convertible bond or a preferred stock convertible. A
convertible bond is a bond which can be converted into
the company's common stock.
• Convertibles typically offer a lower yield than a regular
bond because there is the option to convert the shares
into stock and collect the capital gain.
• But, should the company go bankrupt, convertibles are
ranked the same as regular bonds so you have a better
chance of getting some of your money back.

Convertible Securities
• Advantages are:
– Your original investment cannot go lower than the market
value of the bond, it doesn't matter what the stock price does
until you convert into stock.
– Convertibles can be purchased through tax-deferred
retirement accounts.
– CVs gain popularity in times of uncertainty when interest
rates are high and stock prices are low. This is the best time
to buy a convertible.
• Disadvantages are:
– the return on the bond or preferred stock is usually quite low.
– "forced conversion" means that the company can make you
convert your bond into stock at virtually anytime, pay very
close attention to the price at which the bonds are callable.

Futures Contract
• Futures are contracts on commodities, currencies, and
stock market indexes that attempt to predict the value of
these securities at some date in the future.
• They are a form of very high risk speculation.
• A futures contract on a commodity is a commitment to
deliver or receive a specific quantity and quality of a
commodity during a designated month at a price
determined by the futures market.
• It is important to know that a very high portion of futures
contracts trades never lead to delivery of the underlying
asset, most contracts are "closed out" before the delivery
date.

Futures Contract
• Strengths:
– Futures are extremely useful in reducing unwanted
risk.
– Futures markets are very active, so liquidating your
contracts is usually easy.
• Weaknesses:
– Futures are considered to be one of the most risky
investments in the financial markets, this is for
professionals only.
– Losing your original investment is very easy in volatile
markets.
– The extremely high amount of leverage can create
enormous capital gains and losses, you must be fully
aware of any tax consequences.

Treasuries
• Also known as a Government Security, treasuries are a debt
obligation of a local national government.
• Because they are backed by the credit and taxing power of a
country they are regarded as having little or no risk of default.
• This includes short-term treasury bills, medium-term treasury
notes and long-term treasury bonds.
• One major advantage of treasuries is that they are exempt from
state and municipal taxes, this is especially lucrative in states
with high income tax rates.
• Strengths:
– Treasuries are considered to have almost no risk.
– This low risk makes it fairly easy to borrow against the
bonds.
• Weaknesses:
– Rates of return are not that great compared to other debt
instruments.

The Money Market
• The money market is a fixed income market, similar to the
bond market.
• The major difference is the money market is a securities
market dealing in short-term debt and monetary
instruments.
• Money market instruments are forms of debt that mature
in less than one year and are very liquid.
• Money market securities trade in very high denominations,
giving the individual investor limited access.
• The easiest way for retail investors to gain access is
through money market mutual funds or a money market
bank account.
• These accounts and funds pool together the assets of
thousands of investors and buy money market securities.

The Money Market
• Money market funds are low risk investments because
they invest in short term government treasuries like T-bills
and highly regarded corporations.
• The one downside with money market funds is that they
are not covered by the same federal securities insurance
that bank accounts are, although some funds pursue
insurance through private companies.
• Advantages- gains on money market funds are usually tax
exempt as they invest in G- Secs ,any dividends are
taxable. Good Low risks investments used as defensive
investments when the stock markets are declining.
• Disadvantages- offer lower returns than equities/ bonds.
Some securities can be very expensive and difficult to
purchase.

Options
• Options are a privilege sold by one party to another that offers
the buyer the right to buy (call) or sell (put) a security at an
agreed-upon price during a certain period of time or on a
specific date.
• A call gives the holder the right to buy an asset (usually stocks)
at a certain price within a specific period of time. Buyers of calls
hope that the stock will increase substantially before the option
expires, so that they can then buy and quickly resell the amount
of stock specified in the contract, or merely be paid the
difference in the stock price, when they go to exercise the
option.
• A put gives the holder the right to sell an asset (usually stocks)
at a certain price within a specific period of time
• Buyers of puts are betting that the price of the stock will fall
before the option expires, thus enabling them to sell it at a price
higher than its current market value and reap an instant profit.

Options
• Speculators simply buy an option because they think the
stock will either go up or down over the next little while.
Hedgers use options strategies such as a "covered call"
that allows them to reduce their risk and essentially lock-in
the current market price of a security. Using options (and
futures) is popular with institutional investors because it
allows them to control the amount of risk they are exposed
to.
• Advantages- Allows you to drastically increase your
leverage in stock. Options in shares will actually cost you
lesser than purchasing shares. Can be used as a useful
hedging tool.
• Disadvantages- Highly complex, requires a close watch,
high risk tolerance and in- depth information of the stock
market. You may lose a lot of money

Preferred Stock
• Represents ownership in a company but usually don’t
have voting rights.
• Usually get a fixed dividend, throughout and enjoy better
position in case of liquidation of the company.
• Preferred stock may also be callable, meaning that the
company has the option to purchase the shares from
shareholders at anytime, and usually for a premium.
• The major objective of a preferred stock is to provide a
much higher dividend. These are not as volatile or risky as
common stock.
• Advantages- Higher dividend, lesser risk, better benefits in
case of liquidation.
• Disadvantages- Higher dividend means higher taxes. Also
the returns offered are the same as corporate bonds,
which are less risky.

Derivatives
• These are financial instruments that “derive” their value
from the underlying, which can be a commodity, a stock or
stock index or even a complex parameter like the interest
rate.
• It has no independent value.
• Include forwards, futures or option contract of
predetermined fixed duration, linked for the purpose of
contract fulfillment to the value of specified contracts
underlying.
• Derivative markets can be classified into commodity and
financial derivative markets, which each have various sub-
branches.

Derivatives
Futures-
• “Forwards” trading in commodities emerged the commodity
“Futures”.
• The development of futures trading is an advancement over
forward trading
• Futures trading represent a more efficient way of hedging risk.
• A Futures contract just like a forward agreement to buy or sell an
asset at a certain future time for a certain price. However,
unlike a Forward, Futures are traded on the exchange.

Forwards V/S Futures
Feature Forward contracts Futures contracts
Operational Traded directly between two parties

Traded on the exchange
mechanism and not the exchanges
Contract
Differ from trade to trade. Standardised
specifications
Flexibility to structure the contract
price, quantity, quality (in case of
Flexibility
commodities), delivery time and
place of delivery
Assumed by the clearing house,
which becomes the counter-party to
Counter-party risk Exists
all the trades or unconditionally
guarantees their settlement.
Low, as contracts are tailor made High, as contracts are standardized

Liquidity
contracts. exchange traded contracts.
Low liquidity hampers price High liquidity enables price

Price discovery
discovery discovery
Index, Stock and Commodity
Examples Currency market in India
Futures

Terminologies
• Spot price: The price at which an asset • Forwards: A forward contract is a
trades in the cash market. customized contract between two entities,
• Futures price: The price at which the futures where settlement takes place on a specific
contract trades in the futures market. date in the future at today’s pre-agreed price.
• Contract maturity: The period over which a • Futures: A futures contract is an agreement
contract trades. The maturity is 1, 2, 3 months between two parties to buy or sell an asset at
in India. a certain time in the future at a certain price.
• Expiry date: The last trading day of the Futures contracts are special types of
contract. forward contracts which are standardized
exchange-traded contracts.
• Contract size: The notional value of the • Options: Options are of two types - calls and
contract worked out as Futures Price puts. Calls give the buyer the right but not the
multiplied by the volume of units. obligation to buy a given quantity of the
• Basis: Spot Price - Futures Price. Basis underlying asset, at a given price on or
should theoretically be negative. before a given future date. Puts give the
• Cost of carry: Though the term originated buyer the right, but not the obligation to sell a
from Commodity Futures for financial futures it given quantity of the underlying asset at a
reflects the relationship between futures and given price on or before a given date.
spot. It can be summarized in terms of an • Warrants: Options generally have life of upto
interest cost the futures buyer is paying over one year, the majority of options traded on
the spot price today. options exchanges having a maximum
• Initial margin: Upfront amount that must be maturity of nine months. Longer-dated
deposited in the margin account prior to options are called warrants and are generally
trading. traded over-the-counter.
• Marking-to-market: The process of • LEAPS: The acronym LEAPS means Long -
Revaluing each investor's positions generally Term Equity Anticipation Securities. These
at the end of each trading day and computing are options having a maturity of upto three
the profit or loss on the positions accordingly. years. LEAPS are not currently available in
India.
Terminologies
• Baskets: Basket options are options on portfolios of underlying assets. The
underlying asset is usually a moving average or a basket of assets. Equity index
options are a form of basket options.
• Swaps: Swaps are private agreements between two parties to exchange cash
flows in the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. The two commonly used swaps are interest rate
swaps: These entail swapping only the interest related cash flows between the
parties in the same currency. Currency swaps: These entail swapping both
principal and interest between the parties with the cashflows in one direction being
in a different currency than those in the opposite direction.
• Swaption: Swaption are options to buy or sell a swap that will become operative
at the expiry of the options. Thus a Swaption is an option on a forward swap.
Rather than have calls and puts, the Swaption market has receiver Swaption and
payer Swaption. A receiver Swaption is an option to receive fixed and pay floating
interest. A payer Swaption is an option to pay fixed and receives floating interest..

Option
• Option is a security that represents the right, but not the
obligation, to buy or sell a specified amount of an
underlying security (stock, bond, futures contract, etc.) at
a specified price within a specified time.
• Option Holder is the buyer of either a call or put option.
Option Writer is the seller of either a call or put option.
• Options unlike futures are also concerned with speed of
the trend and not just the underlying trend. They are more
complex.
• Directional strategies can be implemented using Options
• Options can be categorized as call and put options. The
option, which gives the buyer a right to buy the underlying
asset, is called Call option and the option, which gives the
buyer a right to sell the underlying asset, is called Put
option.

Four Basic Positions
• Calls: A call represents the right, but not the obligation, to buy an
underlying instrument at a fixed price (E), within a fixed period of time
(T). A simple way to understand options is to observe the cash flows
for the option considered i.e. what is an inflow and what's an outflow.
Now in the following case, a long call option, strike and premium is
what goes out (a cash outflow) and spot price i.e. the price of the
underlying comes in (a cash inflow).
For the Buyer (Long)
Risk Limited to premium (P) paid
Reward Unlimited
Breakeven Price Exercise price (E) + Premium (P)
Profit or Loss (P/L)

Intrinsic Value (I) - Premium (P)
at expiration
Intrinsic Value Spot price (S) - Exercise price (E) Long Call

For the Seller (Short)
Limited by zero to Ex. price

Risk
(E) - Premium (P)
Limited to the premium (P)

Reward
received
Exercise price (E) - Premium

Breakeven Price
(P)
Short Call
Profit or Loss (P/L0 at Premium (P) - Intrinsic Value
expiration (I)

For the Buyer (Long)
Limited to premium (P)

Risk
Paid
Limited by zero to Ex.
Reward price (E) - Premium
(P)
Exercise price (E) -
Breakeven Price
Premium (P)
Long Put
Profit or Loss (P/L0 at Intrinsic Value (I) -
expiration Premium (P)

For the Seller (Short)
Limited by zero to Ex.

Risk
price (E) - Premium (P)
Limited to premium (P)

Reward
received
Exercise price (E) - Short Call

Breakeven Price
Premium (P)
Profit or Loss (P/L0 Premium (P) - Intrinsic

at expiration Value (I)

Options
Options
Options are deferred settlement contracts

Settlement i.e. delivery and payment takes place in the future
Give the buyer the right and no obligation
Give the seller the obligation and no right
To buy or sell (call or put options).
A specific asset (called underlying and outrightly defined).
At a specific price (strike or exercise price).
On/on or before a specific date (European/American options).

Components of Option Value
Options Premium = Intrinsic value + Time Value
• Intrinsic value is the value which you can get back if you exercise the
option..
– For calls, it is stock price – exercise price.
– For puts, it is exercise price – stock price.
• Time Value = The price (premium) of an option less its intrinsic value.
Time value is made up of two components: insurance value and interest
value.
• Insurance value is the premium component of time value based on the

probability of the underlying reaching the exercise price.
Interest value is the interest component of time value based on the
carrying cost of the underlying. Interest value can be positive (calls) or
negative (puts).
Option premium (price) = Intrinsic value + Time value = Intrinsic value +
(Insurance value + Interest Value)

Intrinsic value versus time value for
a call option

Key Features
• Call option Key features: A call option has intrinsic value when its
exercise price is below the underlying security price. In other words, a
call option with intrinsic value gives the holder the right to buy the
underlying security at a price below the current market level.
Call intrinsic value = Underlying security price – Exercise price
The higher the price of the underlying security in relation to the
exercise price, the greater the option’s intrinsic value and therefore
the value of the option.
• Put option Key features: A put option will have intrinsic value when
its exercise price is above the current market price of the underlying
security. This gives the holder the right to sell the underlying security
above the current market level.
Put intrinsic value = Exercise price – Underlying security price
Intrinsic value is also the amount that an option is in-the-money. An
option with no intrinsic value is out-of-the-money. The intrinsic value
of an option is always a positive figure.

Market Scenario Call Option Put Option
Market price > Strike price in-the-money out-of-the-money
out-of-the-
Market price < Strike price in-the-money
money
Market price = Strike price at-the-money at-the-money
Market price ~ Strike price near-the-money near-the-money

Real Estate
• Real estate investing doesn't just mean purchasing a house, it
can include vacation homes, commercial properties, land
(both developed and undeveloped), condominiums, along with
many other possibilities.
• The value of the real estate is arrived at by considering a
number of factors, such as the location, the age and condition
of the home, improvements that have been made, recent
sales in the neighbourhood, if there are any zoning plans and
so on.
• Holding real estate involves significant risks- property taxes,
maintenance, repairs among other costs of holding the asset.
• These are usually purchased via brokers, who get a
percentage of the amount. It can also be purchased directly.

Other Investments
• Collectibles: is a general name for any physical asset that
appreciates in value over time because it is rare or is desirability by
many. Some examples are things like stamps, coins, art, or sports
cards but there are no strict boundaries as to what a collectible is.
• Investment in collectibles provides capital appreciation to investors with
medium to long term investment horizon. It can also be an efficient
hedge against inflation and also gives a sense of self fulfillment.
Investment objectives can vary depending on the person and the
collectible.
• Major Weaknesses:
– Not very liquid, they can often be hard to sell at a desirable price.
– They do not provide any tax protection.
– Collectibles do not offer any income to the investor.
– The true value can often be difficult to determine.
– Because there are so many uncertainties don't count on any
collectible for your retirement.

Other Investments
• Bullion & Precious Metals: Bullion is a coin or other object
composed primarily of a precious metal (such as gold, silver or
platinum) with little to no numismatic value over and beyond that
of the metal itself. Gold, silver and the platinum group metals are
known as the precious metals.
• The volatility of equity markets and the arrival of low interest
rates have increased the investor presence in alternative
investments such as gold and other precious metals.
• The reasons for investing in bullion and precious metals have
remained much the same over its long history.
– Gold is a safe haven in times of economic and financial
instability
– An excellent hedge against inflation over the long term.
– They have solid value
– Excellent investments to diversify your investment portfolio
– They are recognized in every country.
– It is easily and discreetly bought and sold. It can be easily
converted to cash at any time.

Investment Strategies
• Active Investment:
– An investment strategy involving ongoing buying and
selling actions of the investor. Active investors will
purchase investments and continuously monitor their
activity in order to exploit profitable conditions.
– Active investing is highly involved.
• Passive Investment:
– An investment strategy involving limited ongoing
buying and selling actions.
– Passive investors will purchase investments with the
intention of long-term appreciation and limited
maintenance.
– Also known as a buy-and-hold or couch potato
strategy, passive investing requires good initial
research, patience, and a well diversified portfolio.

Advantages and disadvantages
Active Management
• Advantages • Disadvantages
• Expert analysis — seasoned • Higher fees and operating
money managers make informed expenses.
decisions based on experience, • Mistakes may happen — there
judgment, and prevailing market is always the risk that
trends. managers may make unwise
• Possibility of higher-than-index choices on behalf of investors,
returns — Managers aim to beat which could reduce returns.
the performance of the index. • Style issues may interfere with
• Defensive measures — Managers performance — at any given
can make changes if they believe time, a manager's style may be
the market may take a downturn. in or out of favor with the
market, which could reduce
returns.

Advantages and disadvantages
Passive Management
• Low operating expenses: The • Performance dictated by index
costs are greatly lesser in this form — Investors must be satisfied
of management. with market returns because
• No action required — There is no that is the best any index fund
decision-making required by the can do.
manager or the investor. • Lack of control — Managers
cannot take action. Index fund
managers are usually
prohibited from using defensive
measures, such as moving out
of stocks, if the manager thinks
stock prices are going to
decline.

Tactical Allocation
• Tactical allocation among specific types of stocks (such as small
or large, value or growth, foreign or domestic) and bonds (such as
long or short, high-quality or low-quality) can be handled in one of
two ways:
– Investors retain the tactical asset allocation decision and actively
manage the exposure to various categories. Most investors fall in
this category whether they manage allocations in a disciplined, pre-
determined fashion or simply let it fall where it may, as a residual of
other decisions.
– The investor ignores tactical allocation by selecting a neutrally
weighted portfolio that reflects the entire available investment
universe. Few investors select this truly passive asset allocation
strategy. Given factors such as homeland bias, investors tend to
over-emphasize areas closer to home, consistently under-weighting
foreign securities.
• Only after both the strategic stock/bond allocation and the handling of
the tactical allocation are decided upon, can we begin examining the
merits and pitfalls of passive versus active investment selection
strategies.

Tactical Allocation
• With the context of comprehensive planning, understanding the
main drivers of portfolio returns is a major step in properly
implementing an investment strategy.
• In order of their influence on results, these drivers are:
– Strategic asset allocation investment policy between growth and
fixed-income investments. This allocation should be based on
each client’s unique objectives and risk tolerance. The policy
allocation should be the foundation block of any long-term
investment strategy.
– Actively managed tactical allocation versus a market neutral,
static allocation. Significant value can be added (or detracted)
by concentrating the portfolio in certain asset categories.
– Selection of investments for each asset category may add (or
detract) an additional layer of value.

Advantages and Disadvantages
• Investment selection—passive strategies. Passive investing presents
some obvious advantages that are often publicized by indexing
supporters.
• Low cost—offers an incremental advantage that is both meaningful and
certain. An active manager has to add enough value to overcome the
cost disadvantage.
• Reduced uncertainty of decision errors—investors are exposed to
market risk simply by being invested. Reaching for returns in excess of
those provided by the market brings about the additional risk of selecting
the wrong investments.
• Style consistency—if the appropriate indexes are selected, indexing, at
least in theory, allows investors to control their overall allocation.
Investors could only do this effectively through successful tactical
allocation. There are no guarantees they will succeed.
• Tax efficiency—indexing is generally regarded as more tax efficient,
though it is mostly the case for larger-cap indexes that are fairly stable
and involve less trading. In smaller-cap indexes, where successful stocks
grow in size and leave the index, tax liabilities resulting from more
frequent rebalancings quickly accumulate.

• Investment selection—active strategies. The efficient market theory in
its purest form strongly supports passive investing, as it dismisses the
possibility for superior returns through investment selection. In reality,
there are multiple market “anomalies” that do not support the efficient
market theory, at least not in its purest form.
• Deeply rooted psychological biases negate the assumptions that all
investors will act rationally. Passive strategies are also subject to certain
natural biases, which may open the door to superior returns by active
strategies.
• Natural biases: Large cap bias—Most indexes are market capitalization
weighted. The largest holdings account for most of the return, causing
indexes to out-perform active managers when large stocks do well, but
under-perform when smaller companies are in favor. Historically, small
companies have produced better returns than large ones.
• Large market bias—The weighted nature of indexes also causes passive
investors to maintain most investments in the largest markets. The
largest markets are not necessarily the best performing. The over-
emphasis on Japan in the EAFE index, for example, allowed most active
international managers to out-perform that index for years.

• Investment restrictions bias—many large institutions are restricted by
charter as to the types of securities they are allowed to purchase. Banks
and insurance companies, for example, have many investment
restrictions in building their bond portfolios. Such restrictions decrease
market efficiency and leave openings to be exploited by opportunistic,
skillful bond managers.
• Psychological biases: Cause and effect mismatches—Mistaking cause
for effect could explain why investors tend to overbuy stocks with
impressive earnings history, or with high past returns. Many investors
assume that past results are representative of future results. In reality,
past results are representative of past events and will not necessarily
repeat in the future. Excessive buying of stocks with high past returns
leads to over-valuation. Active managers that are aware of this bias
could benefit by avoiding many over-valued situations.
• Conservatism bias—Once people have formed an opinion, it is difficult
to change it. The stocks of companies posting either positive or negative
earning surprises tend to slowly reflect new information. Investors are
initially unwilling to accept the new evidence of improved or diminished
prospects. Active managers that recognize this fact could obtain superior
returns by more quickly recognizing the new economic realities of the
companies they research.

• Ironically, the very success of indexing is based on the research
work performed by active managers. The information disseminated
through research by active managers leads to market efficiency. In
a sense, passive investors are “free riders,” benefiting at no cost
from the work of all active managers. But the more investors select
indexing, the less efficient the markets become due to decreased
research coverage.
• Opportunistic, active managers could exploit increased
inefficiencies and deliver market-beating returns. As a result, more
investors would migrate to active styles in search of better returns.
Research coverage, in turn, would increase, also increasing the
efficiency of markets, therefore the relative attractiveness of
passive management.
• Passive management could not exist without active managers
keeping the markets efficient. This apparent paradox serves as a
natural “checks and balances” system in the markets.
• Unbiased investment advisors who correctly identify the
advantages and disadvantages of both passive and active
strategies can help their clients create investment portfolios that
allow for the benefits of both worlds.

What makes a good index?
• An index should accurately represent the universe of

investment choices as well as the performance of the
asset category it represents
• An index should be investable
• An index should be truly passive and objective

How to select an active investment
manager?
• One can expect consistently poor-performing managers to continue to
perform poorly. The same cannot be said about managers who have
demonstrated superior returns. These managers may not necessarily
continue to do well, no matter how much most investors want to believe
it.
• Let’s examine some of the reasons why previously successful managers
may not repeat their index-topping performance in the future:
– Success leads to asset growth, lower flexibility, and reduced
investment alternatives.
– Success may lead to lack of focus (marketable star managers may be
used to launch new products or simply in other non-investing
capacities).
– Star managers may be lured away with higher pay by other firms.
– Star managers may quit to start their own firms, or simply lose interest
and motivation.
– Success could lead to overconfidence, sloppiness, and downplaying
risks.
– Buyout of successful firms could lead to a multitude of integration
problems.

Attributes of Successful managers
• Disciplined and research-oriented, providing a clearly articulated
process
• Low expenses—show commitment to higher returns to investors
• A true passion for investing rather than a passion for empire
building—shareholder interests should come ahead of the
management company’s interest
• Close-knit investment teams—people who like each other tend
to achieve better results as a team and are less likely to split
• Consistency between the advertised investment process and
the reality of operations
• Interests of the managers are aligned with the interests of the
shareholders through incentive systems
• Unique investment edge: a successful proprietary valuation
model, specific knowledge in any one area, quicker access to
information, and so on

Asset Allocation
• Apportioning of investment funds among a broad array of asset
classes such as stocks and bonds. Its objective is to determine
an asset mix which is most likely to meet the investment goals
of a client with the acceptable risk appetite of the client.
• The asset allocation process may comprise following
steps:
– Analysis of the client’s investment objective & risk tolerance
– Analysis of expected returns from various asset classes and
risk-return trade-off
– Determination of the asset classes to be included in the
portfolio
– Determination of proportionate weighting of each asset class
• Asset categories typically include: equity, fixed income
securities, money market instruments, real estate, precious
metals and other assets

Factors to be considered for asset
allocation
• The economic environment, market valuations and
sentiment indicators:
– A study of the economic environment helps to find out
which stage we are in the business cycle.
– Managers need to examine recent returns versus
historical experience, price-to earnings ratios,
dividend yields, price cash flow ratios, real interest
rates and so on, to determine if an asset category is
over- or undervalued.
– Next, “sentiment” indicators are used to identify the
consensus view and provide useful insight into the
psychology of the markets.
– The goal here is to determine where capital flows
might head next.

Factors to be considered for asset
allocation
• Expectations and client objectives:
– Income needs.
– Growth requirements
– Inflation and purchasing power
– Risk tolerance.
– Investment time horizon
– Liquidity requirement
– Tax situation
– Legal issues, unique needs and preferences

Steps in construction of preliminary
portfolio mix
1. Deciding which asset classes to include and which to
exclude from the portfolio.
2. Deciding on the normal (long-term) percentages of
commitment to be represented by each asset class
allowed in the portfolio. This is based on the investor’s
objectives, constraints and risk tolerance.
3. Altering the asset mix weightings away from the initial
parameters in an attempt to capture excess returns
caused by short-term fluctuations in asset prices (known
as market timing).
4. Selecting individual securities within an asset class to
achieve superior returns relative to that class (security
selection).

Portfolio Rebalancing
• Portfolio rebalancing involves periodically readjusting the

portfolio (mix of assets) to match the original allocation of
different assets or asset classes following a significant change in
one or more.
• More simply stated, it is returning your portfolio to the proper mix
of stocks, bonds and cash when they no longer conform to your
original or target plan.

Say you have determined that given your risk tolerance, time horizon
and financial goals that your portfolio should look like this:
Stocks 60% Rs60,000

Bonds 35% Rs35,000
Cash 5% Rs5,000
Total 100% Rs100,000
A couple of your stocks have done well in the market and your
portfolio looks like this:
Stocks 66% Rs 80,000

Bonds 29% Rs 35,000
Cash 4% Rs 5,000
Total 100% Rs120,000
Your portfolio is up by Rs20, 000

This is where the conservative investor will step in and bring the portfolio
back to the original allocation. This can be done in a number of ways.

How to bring the portfolio back to the
original allocations
• First, you could sell off some of the stock that had the
recent run up and invest the profits in bonds and cash
until the original percentages are achieved.
• Another alternative would be to look at your other stock
holdings and sell any underperformers to generate the
cash to invest in the other two asset classes.
• The third alternative would be to invest new money into
your portfolio in the bonds and cash portion to bring those
percentages up to proper levels.
• As a rule of thumb, when your assets drift 5% or more
away from your allocation, you should re-balance. This
can occur naturally over time or following an abrupt rise or
decline in one or more asset classes.

What happens if you do nothing?
• If you are risk adverse, a portfolio that becomes more
heavily weighted in volatile stocks will keep you up at
night.
• Consider what happened to many investors during the
tech stock boom of the late 1990s. Not only did they let
the technology stocks grow out of any reasonable
allocation, many also sold off other stock to buy more
technology companies.
• When the market crashed, the investors who had let
technology balloon to a hugely disproportionate
percentage of their portfolio had nothing to fall back on.
• Portfolio rebalancing is an important part of sticking to
your game plan. You should look at your portfolio at least
quarterly in terms of rebalancing and more frequently if
you have had a significant gain or loss in any asset class.
Thank you!

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Module 4

• The types of investment products and their risk return

• How to evaluate investment choices in the light of the

• Understand what client portfolios- how they are created,

• How to recommend a investment portfolio.

Certified Financial Planner Module 4: Investment Planning

• It involves sacrifice of something now for the prospects of

• To part with money, investors need compensation for:

• Investment planning is an important part of overall

Certified Financial Planner Module 4: Investment Planning

Implementing the Analysing and

Certified Financial Planner Module 4: Investment Planning

Certified Financial Planner Module 4: Investment Planning

Certified Financial Planner Module 4: Investment Planning

• Return and risk are two important characteristics of any

To part with money, investors require compensation for

Certified Financial Planner Module 4: Investment Planning

Certified Financial Planner Module 4: Investment Planning

Certified Financial Planner Module 4: Investment Planning

The expected return on a portfolio of securities weighted average of expected

Certified Financial Planner Module 4: Investment Planning

Risk Tolerance Age Goals Time horizon

Certified Financial Planner Module 4: Investment Planning

The element of The variability The risk that The possibility

• Accepting risk: Assume all financial responsibility of a risk. Self Insurance

Certified Financial Planner Module 4: Investment Planning

Certified Financial Planner Module 4: Investment Planning

Certified Financial Planner Module 4: Investment Planning

Certified Financial Planner Module 4: Investment Planning

Certified Financial Planner Module 4: Investment Planning

• Diversification means spreading your money over a

Certified Financial Planner Module 4: Investment Planning

– Spread your portfolio among multiple investment

– Vary the risk in your securities. You're not restricted to

– Vary your securities by industry. This will minimize the

Certified Financial Planner Module 4: Investment Planning

Geographical Spreading your risks by investing in different

Manager Using different fund managers with different

Asset Putting some of your money in more risky funds and

Certified Financial Planner Module 4: Investment Planning

Certified Financial Planner Module 4: Investment Planning

Certified Financial Planner Module 4: Investment Planning

Low return high risk

Risk (Standard Deviation)

Compounding is the money that money makes, added to

Certified Financial Planner Module 4: Investment Planning

• CAGR-based forecasts do not show the effects of inflation that would

• The real returns are determined with the help of the

– [{(1 + nominal rate)/ (1+ inflation rate)}-1]*100

• Where the nominal rate is the absolute return and the

Certified Financial Planner Module 4: Investment Planning

• In order to determine the risk-adjusted returns of investment portfolios,

– The Treynor Measure

Certified Financial Planner Module 4: Investment Planning

• Sharpe Measure: According to Sharpe, it is the total risk of the fund

Certified Financial Planner Module 4: Investment Planning

Certified Financial Planner Module 4: Investment Planning

Certified Financial Planner Module 4: Investment Planning

• There are many different assumptions to use in

Certified Financial Planner Module 4: Investment Planning

• There are many different assumptions to use in calculating the

• The holding period return (HPR) is the total return and is

Certified Financial Planner Module 4: Investment Planning