A.D.M.College for Women(Autonomous) Nagapattinam.

B.Com V Semester-Major Based Elective 3

Dr.P.Rajeswari ( Assistant Professor of Commerce)

Investment Management

UNIT - I Investment

The income that a person receives may be used for purchasing goods and services that he currently requires or it may be saved for purchasing goods and services that he may require in the future .In other words, income can be what is spent for current consumption. savings are generated when a person or organization abstain from present consumption for a future use .The person saving a part of his income tries to find a temporary repository for his savings until they are required to finance his future expenditure .this result in investment.

Meaning of investment:

Investment is an activity that is engaged in by people who have savings, i.e. investments are made from savings, or in other words, people invest their savings. But all savers are not investor’s. Investment is an activity which is different from saving. Let us see what is meant by investment.

It may mean many things to many persons. If one person has advanced some money to another, he may consider his loan as an investment. He expect to get back the money along with interest at a future date .another person may have purchased on kilogram of gold for the purpose of price appreciation and may consider it as an investment.

Thus investment may be defined as “a commitment of funds made in the expectation of some positive rate of return “since the return is expected to realize in future, there is a possibility that the return actually realized is lower than the return expected to be realized. This possibility of variation in the actual return is known as investment risk. Thus every investment involves return and risk.

Definition:

F. Amling defines investment as “purchase of financial assets that produces a yield that is proportionate to the risk assumed over some future investment period.” According to Sharpe, ”investment is sacrifice of certain present value for some uncertain future values”.

NATURE AND SCOPE OF INVESTMENT MANAGEMENT : Nature and scope of investment can be determined from the meaning of financial investments and how it is different from economic investment. It is also determined from the time period and the risk and its differences with speculation, gambling and arbitrage. The nature of scope of investment management is

● To understand the exact meaning of investment ● To find out different avenues of investment ● To maximize return and minimize risk ● To make a programme for investment through evaluating securities, constructing a portfolio and reviewing a portfolio ● To find out a time period for investments to take place ● To evaluate through various techniques to get the best return for the investor

Importance of Investments:

Investments are important due to increase in life expectancy of a person, planning for retirement income, high planning for additional income due to high rates of taxation and inflationary pressure in an economy, the expectation of continuous stable income in the form of regular dividends, interests and other receipts. The following discussion provides an explanation of these issues.

Longer Life Expectancy:

Investment decisions have become significant because statistics show that life expectancy has increased with good medical care. People usually retire between the ages of 60 and 65. The income shrinks at the time of retirement because the annual inflow of earnings from employment stops. If savings are invested at the right age and time, wealth increases if the principal sum is invested adequately in different saving schemes. The importance of investment decisions is enhanced by the fact that there is an increasing number of women working in the organizations. Men and women are responsible for planning their own investments during their working life so that after retirement they are able to have a stable income through balanced investments.

Taxation:

Taxation introduces an element of compulsion in a person’s savings. Every country has different tax saving schemes for bringing down taxation levels of a person. Since investments provide regular and stable income and also give relief in taxation, they are considered to be very important and useful if investments are made by proper planning.

Interest Rates:

Interest rates vary according to the choice of investment outlet. Investors prefer safe investments with a good return. A risk-less security will bring low rates of return. Government securities are risk- free. However, market risk is high with high rates of return. Before allocations of any amount, the different types of securities must be analyzed to calculate their benefits and their disadvantages. The investor should make his portfolio with several kinds of investments. Stability of interest is as important as receiving a high rate of interest. This book is concerned with determining that the investor is getting an acceptable return commensurate with the risks that are taken.

Inflation:

In a developing economy, there are rising prices and inflationary trends. A rise in prices has several problems coupled with a falling standard of living. Before funds are invested, they must be evaluated to find the right choice of investments to tide over inflationary situations. The investor will look at different investment outlets and compare the rate of return/interest to cover the risk of inflation. Security and safety of capital is important. Therefore, he/she should invest in those securities that have an assured and regular return. An investor has to consider, the taxation benefit decides the safety of capital and its continuous return.

Income:

Investment decisions are important due the general increase in employment opportunities and an understanding of investment channels for saving in India. New and well paying job opportunities are in sectors like software technology; business processing offices, call centres, exports, media, tourism, hospitality, manufacturing sector, banks, insurance and financial services. The employment opportunities gave rise to increasing incomes. Higher income has increased a demand for investments and earnings above the regular income of people. Investment outlets can be selected to make investments for supporting the regular income. Awareness of financial assets and real assets has led to the ability and willingness of working people to save and invest their funds for return in their lean period leading to the importance of investments.

Investment Outlets:

The availability of a large number of investment outlets has made investments useful and important. Apart from putting aside savings in savings banks where interest is low, investors have the choice of a variety of instruments. The question to reason out is which is the most suitable channel? Which investment will give a balanced growth and stability of return? The investor in his choice of investment has the objective of a proper mix between high rate of return and stability of return to get the benefits of both types of investments.

Thus, the objectives of investment are to achieve a good rate of return in the future, reducing risk to get a good return, liquidity in time of emergencies, safety of funds by selecting the right avenues of investments and a hedge against inflation.

Concepts of Investment:

There are two concepts of Investment:

Economic Investment:

The concept of economic investment means addition to the capital stock of the society. The capital stock of the society is the goods which are used in the production of other goods. The term investment implies the formation of new and productive capital in the form of new construction and producers durable instrument such as plant and machinery. Inventories and human capital are also included in this concept. Thus, an investment, in economic terms, means an increase in building, equipment, and inventory.

Financial Investment:

This is an allocation of monetary resources to assets that are expected to yield some gain or return over a given period of time. It means an exchange of financial claims such as shares and bonds, real estate, etc. Financial investment involves contracts written on pieces of paper such as shares and debentures. People invest their funds in shares, debentures, fixed deposits, national saving certificates, life insurance policies, provident fund etc. in their view investment is a commitment of funds to derive future income in the form of interest, dividends, rent, premiums, pension benefits and the appreciation of the value of their principal capital. In primitive economies most investments are of the real variety whereas in a modern economy much investment is of the financial variety.

Elements of Investment:

The Elements of Investments are as follows:

● Return: Investors buy or sell financial instruments in order to earn return on them. The return on investment is the reward to the investors. The return includes both current income and capital gain or losses, which arises by the increase or decrease of the security price.

● Risk: Risk is the chance of loss due to variability of returns on an investment. In case of every investment, there is a chance of loss. It may be loss of interest, dividend or principal amount of investment. However, risk and return are inseparable. Return is a precise statistical term and it is measurable. But the risk is not precise statistical term. However, the risk can be quantified. The investment process should be considered in terms of both risk and return.

● Time: Time is an important factor in investment. It offers several different courses of action. Time period depends on the attitude of the investor who follows a ‘buy and hold’ policy. As time moves on, analysis believes that conditions may change and investors may revaluate expected returns and risk for each investment.

● Liquidity: Liquidity is also important factor to be considered while making an investment. Liquidity refers to the ability of an investment to be converted into cash as and when required. The investor wants his money back any time. Therefore, the investment should provide liquidity to the investor.

● Tax Saving: The investors should get the benefit of tax exemption from the investments. There are certain investments which provide tax exemption to the investor. The tax saving investments increases the return on investment. Therefore, the investors should also think of saving income tax and invest money in order to maximize the return on investment. Objectives of Investment Management:

Investing is a wide spread practice and many have made their fortunes in the process. The starting point in this process is to determine the characteristics of the various investments and then matching them with the individuals need and preferences. All personal investing is designed in order to achieve certain objectives. These objectives may be tangible such as buying a car, house etc. and intangible objectives such as social status, security etc. similarly; these objectives may be classified as financial or personal objectives. Financial objectives are safety, profitability, and liquidity. Personal or individual objectives may be related to personal characteristics of individuals such as family commitments, status, dependents, educational requirements, income, consumption and provision for retirement etc.

The objectives can be classified on the basis of the investors approach as follows:

● Short term high priority objectives: Investors have a high priority towards achieving certain objectives in a short time. For example, a young couple will give high priority to buy a house. Thus, investors will go for high priority objectives and invest their money accordingly.

● Long term high priority objectives: Some investors look forward and invest on the basis of objectives of long term needs. They want to achieve financial independence in long period. For example, investing for post retirement period or education of a child etc. investors, usually prefer a diversified approach while selecting different types of investments. Low priority objectives: These objectives have low priority in investing. These objectives are not painful. After investing in high priority assets, investors can invest in these low priority assets. For example, provision for tour, domestic appliances etc.

● Money making objectives: Investors put their surplus money in these kinds of investment. Their objective is to maximize wealth. Usually, the investors invest in shares of companies which provide capital appreciation apart from regular income from dividend. Every investor has common objectives with regard to the investment of their capital.

The importance of each objective varies from investor to investor and depends upon the age and the amount of capital they have. These objectives are broadly defined as follows.

● Lifestyle — Investors want to ensure that their assets can meet their financial needs over their lifetimes. ● Financial security — Investors want to protect their financial needs against financial risks at all times.

● Return — Investors want a balance of risk and return that is suitable to their personal risk preferences. ● Value for money — Investors want to minimize the costs of managing their assets and their financial needs.

● Peace of mind — Investors do not want to worry about the day to day movements of markets and their present and future financial security.

Achieving the sum of these objectives depends very much on the investor having all their assets and needs managed centrally, with portfolios planned to meet lifetime needs, with one overall investment strategy ensuring that the disposition of assets will match individual needs and risk preferences.

Speculation:

Speculation is the practice of engaging in risky financial transactions in an attempt to profit from short or medium term fluctuations in the market value of a tradable good such as a financial instrument, rather than attempting to profit from the underlying financial attributes embodied in the instrument such as capital gains, interest, or dividends. Many speculators pay little attention to the fundamental value of a security and instead focus purely on price movements. Speculation can in principle involve any tradable good or financial instrument. Speculators are particularly common in the markets for stocks, bonds, commodity futures, currencies, fine art, collectibles, real estate, and derivatives.

Difference between Investment and Speculation:

Investment is all about value creation (e.g. manufacturing products and providing services) while speculation is concerned about price movement. In the latter, you profit purely from price differences. The price movement is mostly influenced by the psychology of the market.

Investment is has lower risk but need more capital to generate more value while speculation is challenging, has higher risk but requires less capital. This explains why most people are speculating because its entry requirement (capital) is lower. Investment is about getting what market offers you while speculation is about trying to get more by doing more in believing that you can beat the market.

Investment is about doing least since you let the companies or industries work for you by owning a piece of their businesses while speculation is about doing the most (unconsciously) and it is more involving because you keep chasing the price movement. You need to keep buying and selling to generate profit.

Investment is over long term while speculation is of shorter term. For the former, the success rate is highest by maximizing the holding period of a position while for the latter; the success rate will peak if the position is kept open for the shortest time possible. This also explains why people like to speculate because it provides “shortcuts” to wealth. Investment is about simplicity while speculation is about complexity (timing market, predicting market direction, stock picking…). That’s why most people fail when speculating. It gives a false sense of simplicity. Investment = growing system (like a living organic creature) while speculation = zero- sum game (one person’s gain is another person’s loss). The former will grow over time while the latter remains constant or shrinking over time.

Advantages and Disadvantages of Speculation:

Advantages of Speculating:

Sustainable consumption level: Let’s consider some of the principles that explain the causes of shortages and surpluses and the role of speculators. When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying.

● Their purchases raise the price, thereby checking consumption so that the smaller supply will last longer. Producers encouraged by the high price further lessen the shortage by growing or importing to reduce the shortage. ● On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus. ● Another service provided by speculators to a market is that by risking their own capital in the hope of profit, they add liquidity to the market and make it easier or even possible for others to offset risk, including those who may be classified as hedgers and arbitrageurs.

Market liquidity and efficiency:

Without speculators, only producers and consumers would participate in that market. With fewer players in the market, there would be a larger spread between the current bid and ask price of commodities. Any new entrant in the market who wanted to trade in commodities would be forced to accept an illiquid market, would enter the market with large difference in the bid price and ask price or may not find any counterparties at all.

● A commodity speculator may exploit the difference and reduce the spread through competition with other speculators. Some argue that speculators increase the liquidity in a market, and therefore promote an efficient market, while others say that, as more and more speculators participate in a market, underlying real demand and supply can become diminishingly small compared to trading volume, and prices can become distorted.

Bearing risks:

For instance, a farmer might be considering planting cotton on some unused farmland. But he might not want to do so because he is concerned that the price might fall too far by harvest time. By selling his crop in advance at a fixed price to a speculator, the farmer can hedge the price risk and is now willing to plant the corn. Thus, speculators can actually increase production through their willingness to take on risk.

Finding environmental and other risks: Hedge funds that do “fundamental analysis “are far more likely than other investors to try to identify a firm’s “off-balance-sheet exposures”, including “environmental or social liabilities present in a market or company but not explicitly accounted for in traditional numeric valuation or mainstream investor analysis”, and hence make the prices better reflect the true quality of operation of the firms.

Shorting

Shorting may act as a means to stop unsustainable practices earlier and thus reduce damages and forming market bubbles.

Disadvantages of Speculation:

Winner’s Curse:

Auctions are a method of squeezing out speculators from a transaction, but they may have their own perverse effects. The winner’s curse says that in an auction, the winner will tend to overpay in one of two ways:

The winning bid exceeds the value of the auctioned asset such that the winner is worse off in absolute terms; or The value of the asset is less than the bidder anticipated, so the bidder may still have a net gain but will be worse off than anticipated.

The winner’s curse is not very significant to markets with high liquidity for both buyers and sellers, as the auction for selling the product and the auction for buying the product occur simultaneously, and the two prices are separated only by a relatively small spread. This mechanism prevents the winner’s curse phenomenon from causing mispricing to any degree greater than the spread.

Economic Bubbles:

Speculation is often associated with economic bubbles. A bubble occurs when the price for an asset exceeds its intrinsic value by a significant margin. Speculative bubbles are characterized by rapid market expansion driven by word-of-mouth as initial rises in commodity price attract new buyers and generate further inflation. Speculative bubbles are essentially social epidemics whose contagion is mediated by the structure of the market.

Volatility

For a speculator, a good performance would occur when there is a very high level of volatility. It is a controversial point whether the presence of speculators increases or decreases the short-term volatility in a market. Their provision of capital and information may help stabilize prices closer to their true values. On the other hand, crowd behaviour and positive feedback loops in market participants may also increase volatility at times.

Functions of Speculation: Speculators perform many important func­tions:

● First, speculators promote stability of prices by reducing the gap between demand and supply. If at a particular point of time, there is an excess supply of a commodity and the price becomes low, the speculator buys it and holds it for sale in the future when the commodity will be in short sup­ply.

● Such action reduces the present supply and prevents prices from falling as much as they would have and increases the future supply thus prevent­ing prices from rising then as high as they would otherwise have. Thus, as a result of the functions of the speculators, the range of price fluctuations becomes less.

● Secondly, speculators reduce the risks of pro­duction by enabling manufacturers to buy raw materials in the future at current prices. Modern production organisation involves risks. In primi­tive communities, there were practically no risks because each man produced for himself and con­sumed what he produced.

● But in a modern society production is carried on in anticipation of future demand. All types of productive activity involve risks and uncertainty. It is the special functions of the speculators to assume these risks and help to increase production.

● Thirdly, stock exchange speculation performs another social objective. Investment in capital mar­ket is guided by speculation. Since shares can be easily bought and sold, the cause of long-term in­vestment is promoted by the existence of stock markets. Again, if speculators are well informed, the prospects of different classes of industrial es­tablishments will be reflected in the present quota­tions of stock prices.

● The ordinary lay investor will thus get a reliable guide in stock market quotations for the proper disposal of his savings. The entre­preneur may also raise fresh capital funds by issu­ing fresh shares through the stock market. Thus stock exchange speculator helps the investor, the manufacturer as well as speculator himself.

Investment objectives:

Investment is made because it serves some objective for an investor. Depending on the life stage and risk appetite of the investor, there are three main objectives of investment: safety, growth and income. Every investor invests with a specific objective in mind, and each investment has its own unique set of benefits and risks. Let us understand these objectives in detail. Safety

While no investment option is completely safe, there are products that are preferred by investors who are risk averse. Some individuals invest with an objective of keeping their money safe, irrespective of the rate of return they receive on their capital. Such near-safe products include fixed deposits, savings accounts, government bonds, etc.

Growth: While safety is an important objective for many investors, a majority of them invest to receive capital gains, which means that they want the invested amount to grow.There are several options in the market that offer this benefit. These include stocks, mutual funds, gold, property, commodities, etc. It is important to note that capital gains attract taxes, the percentage of which varies according to the number of years of investment.

Income:

Some individuals invest with the objective of generating a second source of income. Consequently, they invest in products that offer returns regularly like bank fixed deposits, corporate and government bonds, etc.

Other objectives:

While the aforementioned objectives are the most common ones among investors today, some other objectives include:

Tax exemptions: some people invest their money in various financial products solely for reducing their tax liability. Some products offer tax exemptions while many offer tax benefits on long-term profits.

Liquidity:

Many investment options are not liquid. This means they cannot be sold and converted into cash instantly. However, some people prefer investing in options that can be used during emergencies. Such liquid instruments include stock, money market instruments and exchange-traded funds, to name a few.

INVESTMENT AVENUES

Many types of investment avenues or channels for making investments are available. A sound investment programme can be constructed if the investor familiarizes himself with the various alternative investments available. Investment media are of several kinds – some are simple and direct, others present complex problems of analysis and investigations. Some investments are appropriate for one type of investor and another may be suitable to another person.

The ultimate objective of the investor is to derive a variety of investments that meet this preference for risk and expected return. The investor will select the portfolio, which will maximize his utility. Securities present a wide range of risk-free instruments to highly speculative shares and debentures. From this broad spectrum, the investor will have to select those securities that maximize his utility. The investor, in other words, has an optimization problem. He has to choose the security, which will maximize his expected returns subject to certain considerations. The investment decision is an optimization problem but the objective function varies from investor to investor. It is not only the construction of a portfolio that will promise the highest expected return but it is the satisfaction of the need of the investor. For instance, one investor may face a situation when he requires extreme liquidity. He may also want safety of securities. Therefore, he will have to choose a security with low returns.

Another investor would not mind high risk because he does not have financial problems but he would like a high return. Such an investor can put his savings in growth shares, as he is willing to accept the risk. Another important consideration is the temperament and psychology of the investor. Some investors are temperamentally suited to take risks; there are others who are not willing to invest in risky securities even if the return is high. One investor may prefer safe government bonds whereas another may be willing to invest in blue chip equity shares of the company.

Many alternative investments exist. These can be categorized in many ways. The investment alternatives/avenues are given below :

Direct Investment Avenues:

● Fixed Principal Investments ● Cash ● Savings Account Savings,Certificate Government Bonds ● Corporate Bonds and Debentures

Indirect Investment Avenues:

● Pension Fund Provident Fund Insurance ● Investment Companies and ● Mutual Funds and Unit Trust of India

● Variable Principal Securities ● Equity Shares ● Convertible Debentures or Preference Securities.

Non-security Investments:

Real Estate Mortgages Commodities Art, Antiques and Other Valuables.

The investment avenues have been categorized as direct and indirect investment alternatives/avenues. Direct investments are those where the individual makes his own choice and investment decision. Indirect investments are those in which the individual has no direct hold on the amount he invests. He contributes his savings to certain organizations like Life Insurance Corporation (LIC) or Unit Trust of India (UTI) and depends upon them to make investments on his and other people’s behalf. So, there is no direct responsibility or hold on the securities. An individual also makes indirect investment for retirement benefits, in the form of provident funds and pension, life insurance policy, investment company securities and securities of mutual funds. Individuals have no control over these investments.

They are entrusted to take care of the particular organization. In the organizations like Life Insurance Corporation or Unit Trust of India, provident funds are managed according to their investment policy by a group of trustees on behalf of the investor. The examples of indirect investment alternatives are an important and rapidly growing segment of our economy. In choosing specific investments, investors will need definite ideas regarding a number of features that their portfolio should have.

To summarize:

Direct investments are those where the individual has a direct hold on his investment decision. Indirect investments are those where the investor is dependent on another organization.

Risk-less vs. Risky Investments

Most investors are risk averse but they expect maximum return from their investments. Every investment must be analyzed because there is some risk in it. Only government securities are risk-less. The Indian investment scene has many schemes to offer to an individual. On an analysis of these schemes, it appears that the investor has a wide choice. A vast range of investments is in the government sector. These are mostly risk-free but low return yielding. Several incentives are attached to it. The private sector investments consist of equity and preference shares, debentures and financial engineering securities. These have the features of high risk. Ultimately, the investor must make his investment decisions.

The dilemma faced by the Indian investor is the reconciliation of profitability, liquidity and risk of investments. Government securities are risk-free and the investor is secured. However, to him, the return or yield is very important as he has limited resources and would like to plan an appreciation of the investments for his future requirements. Government securities give low returns and do not fulfil his objective of money appreciation. Private sector securities are attractive, though risky. Reliance, Infosys, Wipro and Tatas give to the investor the expectation of future appreciation of investment by several times. The multinational and blue chip companies offer very high rates of return and also give bonus shares to their shareholders.

Real Estate and Gold have the advantage of eliminating the impact of inflation, since the price rises experienced by them have been very high. The Indian investor in this context cannot choose his investments very easily.

An investor can maximize returns with minimum risk involved if he carefully analyzes the information published in the prospectuses of private companies. Contents as the past performance, name of promoters and board of directors, the main activities, its business prospects and selling arrangements should be assessed before the investor decides to invest in the company. From the point of view of an investor, convertible bonds may under proper conditions, prove an ideal combination of high yield, low risk and potential of capital appreciation.

Fixed and Variable Principal Securities:

Fixed principal investments are classified as those whose principal amount and the terminal value are known with certainty. Cash has a definite and constant rupee value, whether it is deposited in a bank or kept in a cash box. It does not earn any return. Savings accounts have a fixed return; they differ only in terms of time period. The principal amount is fixed plus interest is earned on the deposit. Savings certificates are classified as national savings certificates, bank savings certificates and postal savings certificates. Government bonds, corporate bonds and debentures are sold having a fixed maturity value and a fixed rate of income overtime.

The variable principal securities differ from the fixed principal securities because their terminal values are not known with certainty. The price of preference shares is determined by demand and supply forces even though preference shareholders have a fixed return. Equity shares also have no fixed return or maturity date. Convertible securities such as convertible debentures or preference shares can convert themselves into equity shares according to certain prescribed conditions and thus have features of fixed principal securities supplemented by the possibility of a variable terminal value. Debentures, preference shares and equity shares are examples of securities sold by companies to investors to raise necessary funds. To summarize:

Fixed securities terminal values are certain with fixed return and maturity dates. Variable principal securities terminal values are uncertain. Their price is determined by demand and supply mechanism.

Non-security Investments:

‘Non-security Investments’ differ from securities in other categories. Real estate may be the ownership of a single home or include residential and commercial properties. The terminal value of real estate is uncertain but generally there is a price appreciation, whereas depreciation can be claimed in tax. Real estate is less liquid than corporate securities. Mortgages represent the financing of real estate. It has a periodic fixed income and the principal is recovered at a stated maturity date. Commodities are bought and sold in spot markets; contracts to buy and sell commodities at a future date are traded in future markets. Business ventures refer to direct ownership investments in new or growing business before firms sell securities on a public basis. Art, antiques and other valuables such as silver, fine China and jewels are also another type of specialized investments which offer aesthetic qualities also.

These features should be consistent with the investors’ objectives and in addition should have additional conveniences and advantages. The following features are suggested for a successful selection of investments.

Features of Investment Avenues: The features of an investment programme consists of safety of principal, liquidity, income stability, adequate income, purchasing power, stability, appreciation, freedom from management of investments, legality and transferability.

Safety of Principal

The investor, to be certain of the safety of principal, should carefully review the economic and industry trends before choosing the types of investment. To ensure safety of principal, the investor should consider diversification of assets. Adequate diversification involves mixing investment commitments by industry, geographically, by management, by financial type and by maturities. A proper combination of these factors would reduce the risk of loss. Diversification in proper investment programmes must be reasonably accomplished.

Liquidity

An investor requires a minimum amount of liquidity in his investments to meet emergencies. Liquidity will be ensured if the investor buys a proportion of readily saleable securities out of his total portfolio. He may, therefore, keep a small proportion of cash, fixed deposits and units which can be immediately made liquid. Investments like stocks and property or real estate cannot ensure immediate liquidity.

Income Stability

Regularity of income at a consistent rate is necessary in any investment pattern. Not only stability, it is also important to see that income is adequate after taxes. It is possible to find out some good securities which pay practically all their earnings in dividends.

Appreciation and Purchasing Power Stability

Investors should balance their portfolios to fight against any purchasing power instability. Investors should judge price level inflation, explore the possibility of gain and loss in the investments available to them, limitations of personal and family considerations. The investors should also try and forecast which securities will appreciate. A purchase of property at the right time will lead to appreciation in time. Growth stock will also appreciate over time. These, however, should be done through analysis and not as speculation or gamble.

Legality and Freedom from Care

All investments should be approved by law. Law relating to minors, estates, trusts, shares and insurance be studied. Illegal securities will bring out many problems for the investors. One way of being free from care is to invest in securities like Unit Trust of India, Life Insurance Corporation, mutual funds or savings certificates. The management of securities is then left to the care of the Trust who diversifies the investments according to safety, stability and liquidity withtheir investment policy. The identity of legal securities and investments in such securities will also help the investor in avoiding many problems.

Tangibility Intangible securities have many times lost their value due to price level inflation, confiscatory laws or social collapse. Some investors prefer to keep a part of their wealth invested in tangible properties like building, machinery and land. It may, however, be considered that tangible property does not yield an income apart from the direct satisfaction of possession or property.

Unit 2- New Issue Market

New Issue Market:

Meaning:

A new issue is a stock or bond that is being sold to investors for the first time. ... The market that deals with these new issues is called the new issue market, as opposed to the secondary market that deals with existing shares and bonds.

Definition:

The market in which a new issue of securities is first sold to investors. This is not a separate market but refers to a niche of the overall market.

Functions of New issue Market:

The main function of the New Issue Market, i.e. channelling of investible funds, can be divided, from the operational stand-point, into a triple-service function:

(a) Origination

(b) Underwriting

(c) Distribution

The institutional setup dealing with these can be said to constitute the New Issue Market organisation. Let us elucidate a little on all of these.

(a) Origination :

Origination refers to the work of investigation and analysis and processing of new proposals. This in turn may be:

(i) A preliminary investigation undertaken by the sponsors (specialised agencies) of the issue. This involves a/careful study of the technical, economic, financial and/legal aspects of the issuing companies to ensure that/it warrants the backing of the issue house.

(ii) Services of an advisory nature which go to improve the quality of capital issues. These services include/advice on such aspects of capital issues as: determination of the class of security to be/issued and price of the issue in terms of market conditions; the timing and magnitude of issues; method of flotation; and technique of selling and so on.

The importance of the specialised services provided by the New Issue Market organisation in this respect can hardly be over- emphasized. On the thoroughness of investigation and soundness of judgement of the sponsoring institution depends, to a large extent, the allocative efficiency of the market. The origination, however, thoroughly done, will not by itself guarantee success of an issue. A second specialised service i.e. “Underwriting” is often required.

(b) Underwriting:

The idea of underwriting originated on account of uncertainties prevailing in the capital market as a result of which the success of the issue becomes unpredictable. If the issue remains undersubscribed, the directors cannot proceed to allot the shares, and have to return money to the applicants if the subscription is below a minimum amount fixed under the Companies Act. Consequently, the issue and hence the project will fail.

Underwriting entails an agreement whereby a person/organisation agrees to take a specified number of shares or debentures or a specified amount of stock offered to the public in the event of the public not subscribing to it, in consideration of a commission the underwriting commission.

If the issue is fully subscribed by the public, there is no liability attaching to the underwriters; else they have to come forth to meet the shortfall to the extent of the under- subscription. The underwriters in India may broadly be classified into the following two types:

(i) Institutional Underwriters;

(ii) Non-Institutional Underwriting.

The public financial institutions namely IDBI, IFCI, ICICI, LIC and UTI, underwrite a portion of the issued capital. Usually, the underwriting is done in addition to granting term finance by way of loans on debentures. These institutions are usually approached when one or more of the following situations prevail:

(i) The issue is so large that broker-underwriting may not be able to cover the entire issue.

(ii) The gestation period is long enough to act as distinctive

(iii) The project is weak, inasmuch as it is being located in a backward area.

(iv) The project is in the priority sector which may not be able to provide an attractive return on investment.

(v) The project is promoted by technicians.

(vi) The project is new to the market. The quantum of underwriting assistance varies from institution to institution according to the commitments of each of them for a particular industry.

However, institutional underwriting suffers from the following two drawbacks:

1. The institutional handling involves procedural delays which sometimes dampen the initiative of the corporate managers or promoters.

2. The other disadvantage is that the institutions prefer to wait and watch the results to fulfill their obligations only where they are called upon to meet the deficit caused by under subscription.

(c) Distribution :

The sale of securities to the ultimate investors is referred to as distribution; it is another specialised job, which can be performed by brokers and dealers in securities who maintain regular and direct contact with the ultimate investors. The ability of the New Issue Market to cope with the growing requirements of the expanding corporate sector would depend on this triple-service function.

Corporate Securities:

Corporate securities or company securities are known to be the documentary media for mobilising funds by the joint stock companies. The need for the issue of corporate securities arises in the following two situations: (i) For the initial successful establishment of business activities; and (ii) For the financing of major expansion programmes requiring immediate funds. These are of two classes:

(a) Ownership securities, and (b) Creditorship securities.

(1) Ownership Securities-Shares:

Issue of share is the best method for the procurement of fixed capital requirements because it has not to be paid back to shareholder within the life time of the company. Funds raised through the issue of shares provide a financial floor to the capital structure of a company.

A share may be defined as a unit of measure of a shareholder’s interest in the company. “A share is a right to participate in the profits made by a company while it is a going concern and in the assets of the company when it is wound up.” (Bachan Cozdar Vs. Commissioner of Income tax).

The share capital of company is divided into a large number of equal parts and each part is individually called a share. Under the provisions of Section 86 of the Indian Companies Act, 1956, a public company or a private company which is subsidiary of a public company can issue only two types of shares i.e. equity shares and preference-shares. However, an independent private company can issue deferred shares as well.

Preference Shares:

Preference Shares are those shares which carry priority rights with regard to payment of dividend and return of capital. According to Sec. 85 of the Indian Companies Act, preference share is that part of the share capital of the company which is endowed with the following preferential rights:

(1) Preference with regard to the payment of dividend at fixed rate; and

2) Preference as to repayment of capital in the event of company being wound up.

Thus, Preference shareholders enjoy two preferential rights over the equity shares. Firstly, they are entitled to receive a fixed rate of dividend out of the net profits of the company prior to the declaration of dividend on equity shares. Secondly, the assets remaining after the payment of debts of the company under liquidation are first distributed for returning preferential capital (contributed by the preference shareholders).

Features of Preference Shares:

1. Dividends:

Preference shares have dividend provisions which are cumulative or non- cumulative. Most shares have the cumulative provisions, which mean that any dividend not paid by the company accumulates. Normally, the firm must pay these unpaid dividends prior to the payment of dividends on the common stock.

2. Participating Preference Shares:

Most preference shares are non-participating, meaning that the preference shareholder receives only his stated dividend and no more. The theory is that the preference shareholder has surrendered claim to the residual earnings of his company in return for the right to receive his dividend before dividends are paid to common shareholders.

3. Voting Rights:

Preference shares do not normally confer voting rights. The basis for not allowing the preference shareholder to vote is that the preference shareholder is in a relatively secure position and, therefore, should have no right to vote except in the special circumstances.

4. Par Value:

Most preference shares have a par value. When it does, the dividend rights and call price are usually stated in terms of the par value. However, those rights would be specified even if there were no par value. It seems, therefore, as with equity shares, the preference share that has a par value has no real advantage over preference share that has no par value. 5. Redeemable or Callable Preference Shares:

Typically, preference shares have no maturity date. In this respect it is similar to equity shares. Redeemable or callable preference shares may be retired by the issuing company upon the payment of a definite price stated in the investment. Although the “call price” provides for the payment of a premium, the provision is more advantageous to the corporation than to the investor.

6. Sinking Fund Retirement:

Preference share issue is often retired through sinking funds. In these cases, a certain percentage of earnings (above minimum amounts) are allocated for redemption each year. The shares required for sinking fund purposes can be called by lot or purchased in the open market.

7. Preemptive Right:

Common law statute gives shareholders, equity or preference, the right to subscribe to additional issues to maintain their proportionate share of ownership. However, the existence of the preemptive right depends on the law and the provisions of the company’s articles of incorporation. The right is a bit more likely to be waived for preference shares than for equity, particularly if preference shares are non-voting.

Advantages and Disadvantages of Preference Shares:

Advantages of Preference shares:

No Legal Obligation for Dividend Payment:

There is no compulsion of payment of preference dividend because nonpayment of dividend does not amount to bankruptcy. This dividend is not a fixed liability like the interest on the debt which has to be paid in all circumstances.

Improves Borrowing Capacity:

Preference shares become a part of net worth and therefore reduces debt to equity ratio. This is how the overall borrowing capacity of the company increases.

No dilution in control:

Issue of preference share does not lead to dilution in control of existing equity shareholders because the voting rights are not attached to the issue of preference share capital. The preference shareholders invest their capital with fixed dividend percentage but they do not get control rights with them.

No Charge on Assets: While taking a term loan security needs to be given to the financial institution in the form of primary security and collateral security. There are no such requirements and therefore, the company gets the required money and the assets also remain free of any kind of charge on them.

Disadvantages of Preference Shares:

Costly Source of Finance:

Preference shares are considered a very costly source of finance which is apparently seen when they are compared with debt as a source of finance. The interest on the debt is a tax-deductible expense whereas the dividend of preference shares is paid out of the divisible profits of the company i.e. profit after taxes and all other expenses. For example, the dividend on preference share is 9% and an interest rate on debt is 10% with a prevailing tax rate of 50%.

The effective cost of preference is same i.e. 9% but that of the debt is 5% {10% * (1-50%)}. The tax shield is the main element which makes all the difference. In no tax regime, the preference share would be comparable to debt but such a scenario is just an imagination.

Skipping Dividend Disregard Market Image:

Skipping of dividend payment may not harm the company legally but it would always create a dent on the image of the company. While applying for some kind of debt or any other kind of finance, the lender would have this as a major concern. Under such a situation, counting skipping of dividend as an advantage is just a fancy. Practically, a company cannot afford to take such a risk.

Preference in Claims:

Preference shareholders enjoy a similar situation like that of an equity shareholder but still gets a preference in both payment of their fixed dividend and claim on assets at the time of liquidation.

Equity Shares:

Equity shares or ordinary shares are those ownership securities which do not carry any special right in respect of annual dividend or the return of capital in the event of winding up of the company. According to Sec. 85(2) of the Indian Companies Act. “Equity shares (with reference to any company limited by shares) are those which are not preference shares”. A substantial part of risk capital of a company is raised from this source, which is of permanent nature. Equity shareholders are the real owners of the company. They get dividend only after the dividend on preference shares is paid out of the profits of the company. They may not receive any return, if there are no profits. At the time of winding up of the company equity capital can be paid back after every claim including that of preference shareholders has been settled. As the equity shareholders have higher risk, they also have a chance of getting higher dividend if the company earns higher profits. Equity shareholders control the affairs of the company because by possessing the voting rights they elect the directors of the company.

Features of Equity Shares:

● Equity shareholders have the right to vote on various matters of the company.

● The management of the company is elected by equity shareholders.

● The equity share capital is held permanently by the company and returned only upon winding up.

● Equity shares give the right to the holders to claim dividend on the surplus profits of the company. The rate of dividend on the equity capital is determined by the management of the company.

● Equity shares are transferable in nature. They can be transferred from one person to another with or without consideration. The above mentioned are few of the features of equity shares.

Classification Of Equity Shares On The Basis Of Share Capital

Equity financing or share capital is the amount raised by a particular company by issuing shares. A company can increase its share capital by additional Initial Public Offerings (IPOs). Here is a look at the classification of equity shares on the basis of share capital:

Authorised Share Capital:

Every company, in its Memorandum of Associations, requires to prescribe the maximum amount of capital that can be raised by issuing equity shares. The limit, however, can be increased by paying additional fees and after completion of certain legal procedures.

Issued Share Capital:

This implies the specified portion of the company’s capital, which has been offered to investors through issuance of equity shares. For example, if the nominal value of one stock is Rs 200 and the company issues 20,000 equity shares, the issued share capital will be Rs 40 lakh.

Subscribed Share Capital:

The portion of the issued capital, which has been subscribed by investors is known as subscribed share capital.

Paid-Up Capital: The amount of money paid by investors for holding the company’s stocks is known as paid-up capital. As investors pay the entire amount at once, subscribed and paid-up capital refer to the same amount.

Advantages of Equity Shares: ● No Charge on Assets:The company can raise the fixed capital without creating any charge over the assets.

● No-Recurring Fixed Payments: Equity shares do not create any obligation on the part of company to pay fixed rate of dividend.

● Long term Funds:Equity capital constitutes the permanent source of finance and there is no obligation for the company to return the capital except when the company is liquidated.

● Right to Participate in Affairs:Equity shareholders, being the real owners of the company, have the right to participate in the affairs of the company.

● Appreciation in the value of Assets:Investors in equity shares are rewarded by handsome dividends and appreciation in the value of their shareholdings under boom conditions.

● Ownership:Equity shareholders are the real owners of the company. They alone have voting rights. They elect the directors to manage the company.

Disadvantages of Equity Shares:

● Difficulty in Trading on Equity:The company will not be in a position to adopt the policy of trading on equity if all or most of the capital is raised in the form of equity shares.

● Speculation:During the period of boom, higher dividends on equity shares results in the appreciation of the value of shares which in turn leads to speculation.

● Manipulation:As the affairs of the company are controlled by equity shareholders on the basis of voting rights, there are chances of manipulation by a powerful group.

● Concentration of Control:Whenever the company intends to raise capital by new issues, priority is to be given to existing shareholders. This may lead to concentration of power in few hands.

● Less Liquid:Since equity shares are not refundable they are treated as illiquid.

● Not always Acceptable:Because of the uncertainty of the return on the equity shares, conservative investors will hesitate to purchase them. For companies, equity shares are the biggest source of finance which helps them expand and grow. The concept of equity shares is wide and there are many types of it. To begin with, let us understand the meaning of equity shares.

Equity Shares Meaning

Equity shares are the shares that the companies issue to the public for long term financing. Legally the equity shares are not redeemable in nature and that is why they are referred to as long term source of finance for a company. The investors of the equity shares have the right to vote, share the profits and claim the assets of the company. The value of equity shares is expressed in the various term like par value or face value, book value, issue price, market price, intrinsic value and so on.

Let us now learn about the features of equity shares.

Features of Equity Shares:

• Equity shareholders have the right to vote on various matters of the company. • The management of the company is elected by equity shareholders. • The equity share capital is held permanently by the company and returned only upon winding up. • Equity shares give the right to the holders to claim dividend on the surplus profits of the company. The rate of dividend on the equity capital is determined by the management of the company. • Equity shares are transferable in nature. They can be transferred from one person to another with or without consideration.

The above mentioned are few of the features of equity shares. Let us now learn about the advantages of equity shares.

Advantages of Equity Shares

From the Shareholder’s Point of View: • Equity shares are liquid in nature and can be sold easily in the capital market. • The dividend rate is higher for the equity shareholders when the company earns high profits. • The equity shareholders have the right to control the company’s management. • The equity shareholders not only get the benefit of dividend but they also get the benefit of price appreciation in the value of their investment.

From the Company’s Point of View:

• Equity shares are the permanent source of capital for a company. • There is no requirement of creating a charge over the assets of the company when equity shares are issued. • The liability of the equity shares is not required to be paid. • The company does not have any obligation to pay dividend to the shareholders. • The credit worthiness of the company increases among the investors and creditors when the company has a larger equity capital base. The above mentioned are the advantages of equity shares to both the shareholders and the company. Let us now learn about the types of equity shares.

Types of Equity Shares:

Anyone who makes an investment in equity shares or monitors the functioning of the company must know about the various types of equity shares. The equity shares are presented in the liability side of the balance sheet and they are classified in the following types.

• Authorised Share Capital

As the name suggests, authorised capital is the maximum amount of capital that a company can issue. The authorised limit can be increased after seeking permission from the respective authorities and paying fees.

• Issued Share Capital

Out of the authorised share capital, the capital which the company offers to the investors is termed as issued share capital.

• Subscribed Share Capital

Subscribed capital is a part of the issued share capital that investors agree and accept.

• Paid Up Capital

Paid up capital is a part of the subscribed capital for which the investors pay. In general, the companies issue the shares to the investors after collecting all the money in one go. Therefore, it is not wrong to say that subscribed and paid-up capital is the same thing where the company collects all the money and issues shares. However, conceptually the paid-up capital is the amount of capital that the company invests in the business.

• Right Shares

When you make an investment in equity shares and the company issues further shares to you, it is termed as the right shares. The right shares are issued to protect the ownership of the existing investors.

• Bonus Shares Bonus shares are issued by the company to its investors in the form of a dividend.

• Sweat Equity Shares

When the employees or directors perform their job well in terms of providing know-how or intellectual property rights to the company, the company issues sweat equity shares to them as a reward.

The above mentioned are the different classes of equity shares. Now let us learn about the various types of equity share prices.

Various Prices of Equity Shares

• Par or Face Value:

Par or face value represents the value of shares recorded in the books of accounts.

• Issue Price:

The price at which the shares of the company are offered to the investors is called the issue price. In most of the new companies, the face value and the issue price of a share is the same.

• Share at Discount and Share Security Premium:

When the company issues its shares at a price which is lower than its face value, the deficit amount is termed as a discount. On the other hand, when the company issues its shares at a price which is higher than its face value, the excess amount is termed as premium.

• Book Value:

Book value is the balance sheet value of shares. The formula to calculate the book value is as follows;

Paid Up Capital + Reserves and Surplus – Any Loss / Total Number of Equity Shares of the Company

• Market Value:

When the company is listed on the stock exchange, the price at which the shares of the company are traded is termed as the market value of the shares. The stock market value would differ with the fundamental value of shares because in both the cases different sentiments affect the stock value.

• Fundamental Value: Fundamental value or intrinsic value of the shares is determined on the basis of the fundamentals of the company. This value is mostly required during mergers and acquisitions.

The above mentioned are the different types of prices of equity shares. When you make an investment in equity shares, you purchase the shares from the stock market at market value. If you are looking to make an investment in equity shares, you may seek help from a well-established broker like IndiaNivesh Ltd. who can help you make an investment in shares at the right valuations.

Deferred Shares:

The shares which are issued to the founders or promoters are called deferred shares or founders shares. The promoters take these shares for enabling them to control the company. These shares have extra ordinary rights though their face value is very low.The holders of deferred shares can get dividend only after preference and equity shareholders shall have received their dividend.Now-a-days, these shares have lost their popularity. At present in India public companies cannot issue deferred shares.

(2) Creditorship Securities or Debentures:

A company can raise finances by issuing debentures. A debenture may be defined as the acknowledgement of debt by a company. Debentures constitute the borrowed capital of the company and they are known as creditorship securities because debenture holders are regarded as the creditors of the company. The debenture holders are entitled to periodical payment of interest at a fixed rate and are also entitled to redemption of their debentures as per the terms and conditions of the issue.

A debenture may be defined broadly, as “an instrument in writing, issued by a company under its seal and acknowledging a debt for a certain sum of money and giving an undertaking to repay that sum on or after a fixed future date and mean while to pay interest thereon at a certain rate per annum of stated Intervals.”As per Sec. 2 (12) “debenture includes debenture stock, bonds and other securities of a company whether constituting a charge on the assets of the company or not.”

A company may have a debenture stock which is nothing but borrowed money consolidated into one mass for the sake of convenience. Instead of each lender having a separate bond or mortgage, he has a certificate entitling him to a certain sum, being a portion of one large loan.

Allotment of Shares:

Procedures for Issue and Allotment of Shares :

A private company can start business as soon as it gets the certificate of incorporation. It is prohibited by law to issue any prospectus, inviting the general public to subscribe towards its share capital. The shares are taken up privately by the promoters and their relatives and friends. But in case of public company, a proper procedure has been laid down in the Companies Act for the issue and allotment of shares. The following are the main provisions of the Companies Act relating to the issue and allotment of shares.

Provisions of companies act relating to issue and allotment of shares

1. A public company must file a prospectus or statement in lieu of prospectus, inviting offers from the public for the purchase of shares in the company.

2. After studying the prospectus, the public applies for shares of the company in the printed prescribed forms. The company can ask for the issue price of the share to be paid in full along with the application or it can be payable in installments as share application money, share allotment money, share first call, share second call and so on. The amount payable as application money must be at least 5 percent of the nominal amount of the share.

3. No allotment of shares can be made unless the ‘Minimum Subscription‘ as given in the prospectus had been subscribed or applied for. Minimum Subscription is the minimum amount which, in the estimate of the directors, is required to run the business. It has to be stated in the prospectus.

4. The amount of share application money must be deposited in a bank. It can be operated by the company only after getting the certificate of commencement.

5. If the minimum subscription amount of 90% of the issue was not achieved by the company within 60 days from the date of closure of the issue, the company has to refund the entire subscription amount immediately. For any delay beyond 78 days, the company has to pay an interest of 6% per annum.

After allotment, the directors can call upon the shareholders to pay the full amount due on shares in one or more installments as mentioned in the prospectus. The articles of a company usually contain provisions regarding calls. If there is no such provision in the Articles, the following provisions shall apply: No call shall be for more than 25% of the nominal value of each share. Interval between any two calls should not be less than one month. At least 14 days’ notice must be given to each member for a call specifying the amount, date and place of payment. Call should be made on a uniform basis on the entire body of shareholders falling under the same class.

Bonus shares:

Bonus shares are the additional shares that a company gives to its existing shareholders on the basis of shares owned by them. Bonus shares are issued to the shareholders without any additional cost. Bonus Shares definition implies those additional stocks which are issued to existing shareholders free-of-cost, or as a bonus. why the companies issue bonus shares. Bonus shares are issued by a company when it is not able to pay a dividend to its shareholders due to shortage of funds in spite of earning good profits for that quarter. In such a situation, the company issues bonus shares to its existing shareholders instead of paying dividend. These shares are given to the current shareholders on the basis of their existing holding in the company. Issuing bonus shares to the existing shareholders is also called capitalization of profits because it is given out of the profits or reserves of the company.

How the bonus shares calculation is done.

The bonus shares are given to the existing shareholders according to their existing stake in the company. Like for example, a company declaring one for two bonus shares would mean that an existing shareholder would get one bonus share of the company for every two shares held. Suppose a shareholder holds 1,000 shares of the company. Now when the company issues bonus shares, he will receive 500 bonus shares (1,000 *1/2 = 500). When the company issues bonus shares, the term “record date” is used along with it.

Record date:

Record date is a cut-off date set by the company. If you are the owner of the shares of the company on this cut-off date then you are eligible to receive the bonus shares. The record date is set by the company so that they can find the eligible shareholders and distribute bonus shares to them.

Advantages of bonus shares:

● There is no need for investors to pay any tax on receiving bonus shares. ● It is beneficial for the long-term shareholders of the company who want to increase their investment. ● Bonus shares enhance the faith of the investors in the operations of the company because the cash is used by the company for business growth. ● When the company declares a dividend in the future, the investor will receive higher dividend because now he holds larger number of shares in the company due to bonus shares. ● Bonus shares give positive sign to the market that the company is committed towards long term growth story. ● Bonus shares increase the outstanding shares which in turn enhances the liquidity of the stock. ● The perception of the company's size increases with the increase in the issued share capital. ● Since there are many advantages of bonus shares, let us now learn the conditions for the issue of bonus shares. ● The issue of bonus shares must be authorized by the Articles of the company. ● The issue of bonus shares must be recommended by the resolution of the Board of Directors. Also this recommendation must be later approved by the shareholders of the company in the general meeting. ● The Controller of Capital Issues must give permission to the issue.

The above mentioned are the conditions that a company must fulfil to issue bonus shares. To be eligible for the different types of bonus shares you must hold the shares of the company in the demat account. If you want to open a demat account, you can consider Kotak Securities. We are the leading broking firm of India that provides premium services to the clients at the most affordable rates.

Rights Shares:

Right shares meaning is that a company can provide new shares to its existing shareholders - at a particular price and within a specific time-period - before being offered for trading in stock markets.

The right issue of shares is an extravagant method to raise capital of the listed companies. When a company undergoes liquidity crises, it summons the existing shareholders for additional money in exchange for an issue of shares at discounted prices. Thus, such an issue is referred to as right issue.

During the process of right issue, a company provides shares at a minimal price than its market value. Like a blessing comes along a disguised curse, there are certain advantages and disadvantages of right issue, so this blog will cover them all.

Features of a Right Issue:

It enables the existing shareholders to trade with the other interested participants until a specified date on which the new shares are purchasable. The right issue of trade is similar to equity shares trade. A company during the right issue of shares gives preferential treatment to its existing shareholders. Thereby the shareholders avail the right to buy additional shares at affordable prices before a specified date. In the right issue, the number of additional shares purchased by an existing shareholder is always in proportion to his existing shareholding.

Moreover, the existing shareholders get leverage to dismiss the right issue. Besides, if a shareholder chooses not to purchase the additional shares, then his existing shareholding shall get diluted after the issuance of additional shares. A company can initiate the right issues only at indigent times without incurring underwriting fees.

Advantages of Right Issue of Shares :

The right issue creates a win-win situation for both the company and its shareholders. As the company get access to the required funds and the shareholders have the power to purchase shares at lower prices corresponding to their percentage holding in the company. Have a look at the perks of using the right issue over other modes of fund-raising:

Fastest Method of Raising Capital-

Unlike public offerings, the right issue involves less rigorous rules and regulation as it is more of an internal matter. The only protocol that persists in the right issue is that the listed companies file a letter of offer with SEBI[1] and stock exchanges for public comments to obtain approval before they issue new shares.

Inflation of Promoter Shareholding-

The factor which turns out to be an enormous benefit of the right issue is that it helps promoters to increase their shareholding. The shareholders can subscribe to an ‘unsubscribed portion’ of the issue, which elevates their shareholding.

Record Date and Pricing-

In order to reckon the eligible shareholders who can participate in the rights issue, companies announce a record date. It helps the companies to issue rights and reward their shareholders with low-priced shares. Moreover, it further avails them to raise the required capital with maximum subscriptions.

No Scope of Debt–

It goes without saying that the right issue is the most secure fundraising method. It acts as a favourable gateway to raise capital wherein the company can expand its business without any simultaneous increase in debt. Through the right issue, a company raises the desired money from its existing shareholders without modifying any terms of percentage holdings of members. Thus, it eliminates any scope for debt.

Drawbacks of Right Issue for a Company:

Although the right issue is undeniably the cheapest source which helps a company to attain the required funds, yet sometimes the companies have to snag the downside of it. Here are the most common limitations of right issue:

Raise capital up to a confined limit-

An apparent drawback of such an issue is that a company cannot raise an amount in case of (IPOs) Initial Public Offering. Mostly, stock exchanges put a restriction on the amount on which a company can raise via the right issue. Also, the limit is usually proportional to the existing equity value of the company. Thereby in case, a company has undervalued stocks, then raising funds through the right issue might create pressure on the company.

Value of each share may get diluted-

At the time of issue of equity shares to raise money; there are chances of stake dilution of the existing shareholders. As the percentage shareholdings get reduced with the initiation of new shareholders, it turns out to be a troublesome situation for the existing shareholders.

Diminish the company’s public image- Generally, the issue of right shares in an indication of liquidity crises that a company suffers. If a reputed firm issue right shares, then it creates a negative market sentiment. Thus, shareholders assume that the company is struggling to run its business operations smoothly.

Book Building:

Meaning

Book building is a process of price discovery. Book building is a process by which the issuer company before filing of the prospectus, builds-up and ascertains the demand for the securities being issued and assesses the price at which such securities may be issued and ultimately determines the quantum of securities to be issued.

Under book building process, the issuing company is required to tie up the issue amount by way of private placement. The issue price is not priced in advance. It is determined by offer of potential investors about price which they may be willing to pay for the issue. To tie-up the issue amount, the company organizes road shows and various advertisement campaigns.

Benefits of Book Building:

Book building helps in evaluating the intrinsic worth of the instrument being offered and the company’s credibility in the eyes of public. The entire exercise is done on a wholesale basis.

(a) Price of instrument is determined in a more realistic way on the commitments made by the prospective investors to the issue.

(b) The prime objective of book building process is to determine the highest market price for shares and securities and demand level from highest quality investors in order to adjust pricing and allocation decision.

(c) Book building is a process of fixing price for an issue on feedback from potential investors on how they are willing to bid to pick up issues and instruments.

(d) The process of book building is advantageous to the issuer company as the pricing of issue would be more realistic as the final price is decided about 11 to 12 days before the opening of the issue. Book building also offers access to capital more quickly than the public issue.

(e) As the issue is pre-sold, there would be no uncertainties relating to the fate of the issue involved.

(f) The Issuer company saves advertising and brokerage commissions.

(g) Issuers can choose investors by quality.

(h) Investors have a voice in the pricing of issues. They have a greater certainty of being allotted what they demand. Investors need not lockup huge amounts of capital with the Issuer as they pay at the end of the process. (i) The issue price is market-determined. As it is a distant possibility that the market price of the shares would fall lower than the issue price. Hence, the investor is less likely to suffer from erosion of his investment on listing.

(j) Optimal demand based pricing is possible.

(k) Efficient capital raising with improved issue procedures, leading to a reduction in issue costs, paper work and lead times.

(l) Flexibility to increase/decrease price and/or size of offering the issues is possible. m) Transparency of allocations is made.

(n) Upgraded information flow of issues, lead managers, syndicate members and investors is made possible.

(o) Book-building process inspires investors confidence leading to a larger investor universe.

(p) Book-building process creates a liquid and buoyant after market.

(q) As the syndicate members will get firm allocation, the investors to that extent are assured of allotment.

(r) Immediate allotment and listing of placement portion of securities.

Limitations of Book Building:

1. Book building is appropriate for mega issues only. In the case of small issues, the companies can adjust the attributes of the offer according to the preferences of the potential investors. It may not be possible in big issues, since the risk-return preference of the investors cannot be estimated easily.

2. The issuer company should be fundamentally strong and well known to the investors.

3. The book building system works very efficiently in matured market conditions. In such circumstances, the investors are aware of various parameters affecting the market price of the securities. But, such conditions are not commonly found in practice.

4. There is a possibility of price rigging on listing as promoters may try to bailout syndicate members.

Bonds:

It describes the key stages involved in a bond issue, gives practical tips specific to each stage and contains links to detailed materials relevant to the transaction. It also discusses matters to be considered after closing. The issuance of a corporate bond is a common way for corporations to raise money for its business operations. The idea behind corporate bond issuance is to secure a business loan that is favorable for both the issuer (borrower) and the bondholder (investor). The issuance process involves multiple parties and must comply with government regulations throughout the entire process.

Underwriting

The issuing corporation must first acquire the services of an underwriter, which will usually be an investment bank. The underwriter seeks to buy the bonds from the issuer and sell the bonds to investors. Because of the risk involved in buying these bonds, underwriters will seek out partnerships with other investment banks to share the underwriting responsibilities and risk. This partnership is referred to as a syndicate. The underwriter and issuer will have the aid of legal counsel throughout the process.

Regulatory Compliance:

An issuer must file a registration statement and preliminary prospectus with the Securities and Exchange Commission 20 days prior to a corporate bond’s public offering. The issuer may have the option of “on the shelf” registration, meaning the issuer can register the bond without having to sell the entire issue all at once -- this allows the issuer to time the issue’s entry into the bond market according to market conditions.

Bond Structuring

The largest purchasers of corporate bonds are institutional investors, and underwriters often will poll these investors to help determine appropriate coupon rates and maturities. It is important for the underwriter to structure these corporate bonds according to the investment objectives of both the issuer and investor. Once the initial pricing of a bond issue is established, the underwriter will submit the pricing to the Trade Report and Compliance Engine.

Bringing Bond to Market:

The underwriter is responsible for filing certain paperwork with the Depository Trust and Clearing Corporation. Once this paperwork has been filed, the underwriter will commence with the public sale of the corporate bond issue. The fee that the underwriter earns will be the initial price paid to the issuer for taking on the corporate bond, minus the price at which the corporate bond is offered to the public.

UNIT -3 Security Analysis

Security analysis is the analysis of tradable financial instruments called securities. These are usually classified into debt securities, equities, or some hybrid of the two. Tradable credit derivatives are also securities. Commodities or futures contracts are not securities. They are distinguished from securities by the fact that their performance is not dependent on the management or activities of an outside or third party. Options on these contracts are however considered securities, since performance is now dependent on the activities of a third party.

The definition of what is and what is not a security comes directly from the language of a United States Supreme Court decision in the case of SEC v. W. J. Howey Co.. Security analysis is typically divided into fundamental analysis, which relies upon the examination of fundamental business factors such as financial statements, and technical analysis, which focuses upon price trends and momentum. Quantitative analysis may use indicators from both areas.

Types of securities :

1. Shares A share is an equity security. Its owner owns one part of the capital of the company which has issued the shares in question. The shares enable the shareholder the right to take part in the decision-making in the company. If the latter operates with profit, the owners of shares may receive dividends. The amount of the dividend is decided upon by the shareholders at a General Meeting of the Shareholders.

2. Bonds A bond is a debt security.

When purchasing a bond, you have no right to participate in the company's decision making but are entitled to the reimbursement of the principal and the interest. There are several ways of repayment as the companies may decide that the principal be paid in regular annual installments or on the maturity of bonds. The interest may be refunded in a fixed amount or may be variable (inflation rate or foreign currency). The issuers pay the interest once every year or once every half-year (on the coupon maturity date).

Open-end funds :

An open-end fund stands for a diversified portfolio of securities and similar investments, chosen and professionally managed by a fund management company. Since the fund does not have fixed capital but is rather 'open ended', it grows together with new investors joining and thus funding it. Open-end funds can invest in domestic and international securities, in either shares, bonds or other investment vehicles. Depending on the portfolio, the fund's risk and returns vary accordingly.

4. Index open-end funds :

With an index open-end fund, fund management companies allot investors’ assets to a basket of securities making up a chosen index that thus tracks the yield of the mentioned index. While the big investors may invest directly into a fund, minor investors can only trade in fund shares on stock exchanges. Due to the possibility of arbitrage, the market price of index open-end fund shares does usually not stray from its NAV for more than 1%. Close-end funds (ID).

ID is a close-end investment fund investing its capital into securities by other issuers. Investment company is managed by a management company (DZU) which decides which securities to include in the fund's portfolio. The DZU is paid a management fee by the investment company; it usually amounts to 1-2% per year in Slovenia. The value of shares of the close-end funds is closely correlated to the value of the company's Investment certificates.

Investment certificates are debt securities issued by a bank, and are designed to offer the investor an agreed yield under pre-defined conditions stipulated in the prospectus. Issuers are mainly large banks, and an important criterion in selecting the bank in whose investment certificates you would like to invest is its credit rating. Investment certificates represent an investment directly linked to an index, share price, raw material price, exchange rate, interest, industry, and other publicly available values.

Warrants:

Warrants are options issued by a joint-stock company, which give holders the right to purchase a certain quantity of the respective company’s shares at a pre-determined price. After a certain period, the right to purchase shares terminates.

Meaning

SEBI stands for Securities and Exchange Board of India. This is the authority that is appointed for regulating the financial securities in India. SEBI plays an important role in regulating the security market in India. At the initial time, SEBI was not allowed to watch the stock market. Let us see the journey of the SEBI as the regulator in the financial market. So, in this article on “SEBI Meaning, Role, Objective, Structure and Functions”.

In this, we will get to know about the brief regarding the SEBI role in India, the objective for its establishment, structure and the functions of SEBI. We will take one by one topic to understand it easily. Let’s continue with the topic ahead, capital markets were at the emerging stage during the 1970’s and the start of 1980’s as the new individuals are getting inspired in India. At the start this started with some of the malpractices that took place like as the unofficial self-styled bankers, unofficial private placements, many Act, violation of rules and regulations of the stock exchange, delay in the delivery of the shares etc. Due to this wrong malpractices took place, people started to lose their confident in the stock market.

Then government thought that there is a need to establish the authority in the regulation of the working and to reduce this malpractices. As a result, the Government started the establishment of Securities and Exchange Board of India. The above was the reason why the government established the body to look after the financial market in hope that the people will not lose their confident in the market. Now, that we have seen the formation of the Securities and Exchange Board of India.

Roles of SEBI:

The main aim of the SEBI is to give such an environment for the financial market that will bring enthusiasm in the smooth working of the securities market. The three main participants of the financial market need to be taken care of, and the list are: ● Issuers of Security ● Investor ● Financial Intermediaries

These are different participants of the financial and security market that need to work at each of the participants need to do their work with efficiently and with smoothly.

Objective of SEBI:

The important objective of SEBI is to protect the interest of the investors and to promote the development of the stock exchange and to regulate the activities of the stock market. Let us see the further more objectives of SEBI:

To regulate and to make the rules for all the activities made in the stock market. The other objective is to protect the right of the investors and make sure that the investments are made by them should be safe and secure in perspective to their investment.

To make the regulation and develop the code of conduct for the intermediaries that includes brokers, underwriters etc. To remove and to prevent all the wrong malpractices and the fraudulent by making the balance between the self-regulation of the business and to maintain a statutory regulations.

Functions of SEBI:

The SEBI performs some functions in order to meet their objectives and they are:

1. Protective Functions:

In the protective functions, the SEBI tries to protect the interest of the investor and provide them the safety towards their investment. Below are the points that are initiated in the protective functions by the SEBI:

● It prohibits the Insider Trading. ● It checks the price rigging. ● It also prohibits the fraudulent and the unfair trade practices. ● SEBI always promotes the code of conduct in security market and fair practices. ● SEBI also takes the steps to make the investor educate about the market so that they made themselves able to evaluate the securities of the various companies and select the most profitable for them.

2. Developmental Functions:

These developmental functions are performed by the SEBI to promote and develop the activities in stock exchange and to increase the business in stock exchange. For this the main pointers that the developmental functions are working on are:

SEBI gives and promotes the training of the intermediaries of the security market. SEBI makes the steps to adopt the flexible approach for increment in the activities of the stock market.

3. Regulatory Functions:

In the regulatory functions, the SEBI tries to regulate the business in the stock exchange. To regulate the activities of the stock market the regulatory functions includes,

● SEBI has framed rules and regulations and code of conduct to regulate the intermediaries. ● These intermediaries have been brought by the regulatory purview and the private placement that has been more restrictive eventually. ● SEBI regulates the working of Mutual Funds. ● SEBI regulates on the takeover of the companies. ● SEBI also conducts inquires and audit of the stock exchange.

The various functions of SEBI are:

1. To protect the interests of investors in securities market,

2. To promote the development of securities market,

3. To regulate the business in stock exchanges and any other securities markets,

4. To register and regulate the working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers and such other intermediaries who may be associated with securities markets in any manner,

5. To register and regulate the working of the depositories, participants, custodians of securities, foreign institutional investors, credit rating agencies,

6. To register and regulate the working of venture capital funds and collective investment schemes including mutual funds,

7. To promote and regulate self-regulatory organizations,

8. To prohibit fraudulent and unfair trade practices relating to securities markets,

9. To promote investors‘ education and training of intermediaries of securities markets,

10. To prohibit insider trading in securities,

11. To regulate substantial acquisition of shares and takeover of companies,

12. To conducting research for efficient working and development of securities market Meaning of Public Issue/Offer:

Public Offer or Public Issue is defined as the process of issuing securities of a company to new investors and making them a part of a company’s shareholders’ group. Public Offer is made to raise more funds and infuse more capital in the company for its financial needs and growth. Public Offer has been categorised as Initial Public Offer (IPO) and Further Public Offer (FPO).

Initial Public Offer (IPO):

When a company which is not yet listed on any stock exchange, i.e. it is an unlisted company and makes a fresh issue of its securities or an offer of its existing securities for sale for the first time to the public, it is known as an Initial Public Offer or IPO. IPO allows the company to list and trade its securities on the different stock exchanges and raise a large amount of capital.

Further Public Offer (FPO) When a company which is already listed on a stock exchange, i.e. it is a listed company, and it makes a fresh issue of securities or an offer for sale to the public, it is known as Further Public Offer (FPO), or Follow-On Offer.

Benefits of Public Offer or Going Public:

A company may opt for making a public offer or going public for numerous reasons such as business expansion, product development, debt repayment, targeting a new market, etc. The various benefits of making a public offer for a company are summarised below:

● To support and branch out the equity base of the company. ● To access an easier and affordable manner of raising capital. ● To boost the company’s image and goodwill in public. ● To provide liquidity to the company’s directors, employees and its pre-IPO investors. ● To enhance the company’s access to the equity market.

SEBI Guidelines for IPO in India:

The Securities Exchange Board of India was established in 1988. It is the primary authority engaged in the regulation of Indian corporate securities market – primary market and the secondary market. Not only private entities, but also the commercial enterprises of the central government can enter the primary market to raise funds from the public to fulfil their financial requirements.

To ensure a healthy and transparent market, SEBI keeps on introducing changes to the process of Initial Public Offer – IPO. SEBI did not have any substantial powers to regulate the securities market until 1992, which was then regulated by the Controller of Capital Issues. When the Securities Exchange Board of India Act, 1992 was passed, SEBI was allotted numerous powers to regulate and supervise the securities market. The SEBI – Securities Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009, otherwise known as the SEBI ICDR lays down the rules regarding the public offer in India. Additionally, the Securities Contract (Regulation) Act, 1957, the Securities Contract (Regulation) Rules, 1957 and the Companies Act, 2013 provide the legal compliances and process followed for filing an IPO.

The SEBI guidelines for IPO are divided into two processes – for unlisted companies and for listed companies.

SEBI GUIDELINES REGARDING NEW ISSUES

MEANING :

It refers to the set-up which helps the industry to raise the funds by issuing different types of securities. These securities are issued directly to the investors (both individuals as well as institutional)

The regulator has introduced the optional pure auction method of book building in share sales. In pure auction format, the company mentions a floor price. Investors are free to bid at any price above the floor price, and shares are allotted on a top-down basis, starting from the highest bidder.

The regulator at its board meeting also took a decision that would help investors avoid waiting for a full year to know the correct financial health of a company as companies would have to disclose their balance sheets on a half-yearly basis. Internationally, most jurisdictions require disclosure of balance sheet items on an interim basis whereas in India companies disclose only interim financial results.

SEBI has proposed to setup a SME (Small and Medium Enterprise) Board dedicated for trading the shares of small and medium scale enterprises (SMEs) who, otherwise, find it difficult to get listed in the main exchanges. The concept originated from the difficulties faced by SMEs in gaining visibility or attracting sufficient trading volumes when listed along with other stocks in the main exchanges.

SEBI has decided that companies listed on the SME exchanges would be exempted from the eligibility norms applicable for IPOs and FPOs prescribed in the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009 (ICDR).

SEBI has made few changes to the existing regulations regarding IPO issues to employees. Currently the ICDR regulations permit reservation up to 10% of issue size to employees in public issues. However, there is no ceiling on number of shares that could be allotted. The Board decided to put a ceiling of Rs.1 lakh on the value of allotment that can be made to an employee under employee reservation category and to permit reservation up to 5% of the post issued capital instead of 10% of issue size.

SEBI has made changes to the minimum number of investors in the SME which stipulates that there has to be minimum 50 investors at the time of IPO. Previously there was no restriction regarding the minimum number of investors SEBI has also made IPO Grading is made compulsory. IPO grading is the grade assigned by a Credit Rating Agency registered with SEBI. All IPOs that come out in India need a mandatory IPO grading

SEBI has changed the norms regarding the merchant bankers/underwriters which stipulate that the merchant bankers to the issue will undertake market making for three years through a stock broker who is registered as market maker with the SME exchange.

Random walk Theory:

Concept of Random Walk Theory:

The efficient market theory is described in three forms. The random walk theory is based on the efficient market hypothesis in the weak form that states that the security prices move at random. The Random Walk Theory in its absolute pure form has within its purview.

Some of the concepts of the efficient market theory are described below:

(1) A perfectly competitive market which according to it operates in an efficient manner in order to bring about the actual stock prices with its present discounted value. This means that the equilibrium value of a stock determined by its demand and supply features represents the value of stock based on the information that the investors have.

(2) It further states that since the market is in its most efficient form the participants in the market have free access to the same information so that the market price which is prevailing reflects the stocks’ present value.

(3) If there is any deviation from this equilibrium theory, it is quickly corrected and the stock find its way back to the equilibrium price. The analyst who is professional in trading of stock takes the advantage of deviations and this forces the stock back to its equilibrium price.

(4) This theory also states that a price change occurs in the value of stock only because of certain changes which affect the company or the stock markets.

(5) The change in price alters the stock prices immediately and the stock moves to a new equilibrium level.

(6) This rapid shift to a new equilibrium level whenever new information is received is the Random Walk Theory.

(7) The instant adjustment is recognition of the fact that all information which is known is truly reflected in the price of stock.

(8) Further change in the price of stock will be only as a result of some other new piece of information which was not available earlier. (9) According to this theory, the changes in prices of stock show independent behaviour and are dependent on the new pieces of information that are received but within themselves are independent of each other. Whenever new piece of information is received in the stock market the stock market independently receives this new information and this is independent and separate of all other pieces of information.

For example, if a stock is selling at Rs. 25 per share based on existing information known to all investors. Soon the news of a textile strike will bring down the stock price and the value goes down to Rs. 20 the next day. The value goes down further to Rs. 10. The first fall in price from Rs. 25 to Rs. 20 per share was caused because of some information about the strike.

The second fall in the price from Rs. 20 to Rs. 10 came only because of additional information on the type of strike. So each stock exchange and separately disseminated. Of course, independent pieces of information when they come together immediately after each other show that the price is failing but each price fall is independent of the other price fall.

The basic essential fact of the Random Walk Theory is that the information on stock prices is immediately and fully spread so that other investors have full knowledge of the information. This response makes the movements of price independent of each other. Therefore, the price of a security two days ago has no information about the price two days later.

It may, therefore, be said that since the prices have an independent nature, the price of each day is different, it may, be unchanged or higher or lower from the previous price. The Random Walk Theory points out the institutional factors and thus brings the theory to some state of logic.

According to this theory, the financial markets are so competitive that there is immediate price adjustment. This is as a result of good communication system through which information can be distributed almost anywhere in the country. It is this speed of spreading of information which determines the efficiency of the market.

Random Walk Theory Hypothesis:

The Random Walk Theory is based on the efficient market hypothesis which is supposed to take three forms — weak form, semi-strong form and strong form. a. Weak Form:

The weak form of the market says that current prices of stocks reflect all information which is already contained in the past. The weak form of the theory is just the opposite of the technical analysis because according to it the sequence of prices occurring historically does not have any value for predicting the future stock prices.

The technical analysts rely completely on charts and past behaviour of prices of stocks. In the weak form of efficient market, the past prices do not provide help in giving any information about the future prices. The short-term trader in this form of the market is in a similar position as another investor who adopts the approach of ‘buy and hold’ strategy. Although, some traders will be able to earn a positive rate of return but an average their performance in the market will not in any way be better than an ordinary native investor who follows the strategy of buying and holding securities. b. Semi-Strong Form:

This form of the market reflects all information regarding historical prices as well as all information about the company which is known to the public. According to the theory, any analyst will find it difficult to make a forecast of stock prices because he will not be able to get superior and consistent information of any company continuously.

No one can, therefore, take undue advantage of the market. The semi-strong market maintains that as soon as the information becomes public the stock prices change and absorb the full information.

Therefore, the stock prices adjust with the information that is received. This information may not be correct but the analyst will still not be able to make superior judgements consistently because the correct adjustment of stock price will soon take place.

Sometimes, there will be over adjustments in the market, while some other time there will be under-adjustments. This makes it difficult for the analyst to form any particular kind of strategy based on the quick adjustment to information received in the market.

But if the analyst has superior internal information then there is a possibility of making profits if he can use the superior information which he has acquired, he must use it quickly.

Again, the profits will not be consistent or continuous in nature because:

(a) Changes and returns are independent because price changes are independent of each other,

(b) That the successive price changes are identically distributed and the distribution will repeat themselves over time. c. Strong Form:

The strong form of the efficient market hypothesis suggests that it is not useful to any investor or analyst to make any future forecast of prices because he can never make any returns which are superior to others consistently.

Each investor is fully aware of the new pieces of information in the market and so even if the analyst has inside information he cannot continuously earn superior investment returns. The strongly efficient market hypothesis is not found to be fully acceptable.

The efficient market model acknowledges that the stock exchange has many imperfections and all information may not be immediately reflected in stock prices due to delays in communication and also transaction cost and delays in information dissemination to far of places.

It is possible to have some profit above the normal profit by developing a kind of trading strategy but the Random Walk Theory is not merely based on price or return levels but all changes of prices between successive levels.

Random Walk — Conclusions:

Any conclusion which may be reflected with the random walk suggests that the successive price changes are independent. Independence means that the prices at any particular time usually reflects the intrinsic value of a security at an average.

If the stock price moves away from its intrinsic value, different investors will evaluate the information which is available differently into the prospects of the firm and the professional investors will be able to make a short- term gain on the random deviations from the intrinsic value but in the long run the stocks will be forced back to its equilibrium position.

Also, according to this theory historical information about price changes alone will be useless for making a gain. In addition to past prices of stocks the investor or the analyst should also have other relevant information which is superior to the information available to other investors to make a profit.

The random walk is not an attempt at selecting securities or giving information about relative price movements. It does not give any information about price movements of market, industry or firm factors.

The random walk hypothesis is consistent with upward and downward movements in prices and to some extent it supports the fundamental analysis because according to it certain short run profits can be made by finding out inside information which is superior to publicly available information.

According to the theory, it is also possible to find out trends in stock prices by taking away the market influences but these trends do not provide a basis for forecast for the future.

The Random Walk Model, — and Fundamental Analysis:

The random walk hypothesis is contrary to the technical analyst’s view of behaviour of stock prices. It does not believe that the past historical prices have any indication to the future of stock prices.

According to the technical analyst, history repeats itself and by studying the past behaviour of stock prices, future prices can be predicted. The random walk hypothesis is in direct opposition to the analysis of the technical school of thought.

The random walk hypothesis is in conjunction and to some extent believes in fundamental analysis. It believes that changes in information helps the superior analyst who has the capability of using inside information to out-perform other investors of the buy and hold strategy during the short runs.

This is entirely possible because of some super analytical power like financial statement analysis or knowledge about inside factors which the public do not know. Therefore, random walk theory in its semi-strong form supports the fundamental school of thought. The random walk theory’ states that fundamental analysis which is superior in nature will definitely lead to superior profits.

The random walk theory does not discuss the long-term trends or how the level of prices are determined. It is a hypothesis which discusses only the short run change in prices and the independence of successive price changes and they believe that short run changes are random about true intrinsic value of the security.

The random walk theory, therefore, suggests that analysis should be able to look in for superior analysis of the firm by making the following considerations:

(a) By finding out the risk and return characteristics of each security.

(b) By trying to combine the risk and return characteristics of securities into an adequate portfolio;

(c) By holding a portfolio for a reasonable length of time and making a continuous evaluation of the securities held by him;

(d) By planning a well-diversified portfolio and by revising it, if need be, after consistent evaluation.

Although the random walk hypothesis has discarded the technical school of thought, there has been some research conducted on the analysis of stock behaviour through technical analysis.

The following results have been reported form the Journal of Future Markets “historical data generated by a random walk process, therefore, will have trends over certain time periods”. Such a trend in one-time period does not preclude the possibility of a trend in the next period. Thus, technical analysis applied to random series should sometimes be successive.

Dow Theory:

The Dow theory on stock price movement is a form of technical analysis that includes some aspects of sector rotation. The theory was derived from 255 editorials in The Wall Street Journal written by Charles H. Dow, journalist, founder and first editor of The Wall Street Journal and co-founder of Dow Jones and Company.

Six Basic Tenets of Dow Theory:

The market has three movements (1) The "main movement", primary movement or major trend may last from less than a year to several years. It can be bullish or bearish.

(2) The "medium swing", secondary reaction or intermediate reaction may last from ten days to three months and generally retraces from 33% to 66% of the primary price change since the previous medium swing or start of the main movement.

(3) The "short swing" or minor movement varies with opinion from hours to a month or more. The three movements may be simultaneous, for instance, a daily minor movement in a bearish secondary reaction in a bullish primary movement. Market trends have three phases Dow theory asserts that major market trends are composed of three phases: an accumulation phase, a public participation (or absorption) phase, and a distribution phase. The accumulation phase (phase 1) is a period when investors "in the know" are actively buying (selling) stock against the general opinion of the market.

During this phase, the stock price does not change much because these investors are in the minority demanding (absorbing) stock that the market at large is supplying (releasing). Eventually, the market catches on to these astute investors and a rapid price change occurs (phase 2).

This occurs when trend followers and other technically oriented investors participate. This phase continues until rampant speculation occurs. At this point, the astute investors begin to distribute their holdings to the market (phase 3).

The stock market discounts all news Stock prices quickly incorporate new information as soon as it becomes available. Once news is released, stock prices will change to reflect this new information. On this point, Dow theory agrees with one of the premises of the efficient-market hypothesis. Stock market averages must confirm each other.

In Dow's time, the US was a growing industrial power. The US had population centers but factories were scattered throughout the country. Factories had to ship their goods to market, usually by rail. Dow's first stock averages were an index of industrial (manufacturing) companies and rail companies. To Dow, a bull market in industrials could not occur unless the railway average rallied as well, usually first.

According to this logic, if manufacturers' profits are rising, it follows that they are producing more. If they produce more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship their output to market, the railroads. The two averages should be moving in the same direction. When the performance of the averages diverge, it is a warning that change is in the air. Both Barron's Magazine and The Wall Street Journal still publish the daily performance of the Dow Jones Transportation Average in chart form. The index contains major railroads, shipping companies, and air freight carriers in the US.

Trends are confirmed by volume Dow believed that volume confirmed price trends. When prices move on low volume, there could be many different explanations. An overly aggressive seller could be present for example. But when price movements are accompanied by high volume, Dow believed this represented the "true" market view. If many participants are active in a particular security, and the price moves significantly in one direction, Dow maintained that this was the direction in which the market anticipated continued movement. To him, it was a signal that a trend is developing.

Trends exist until definitive signals prove that they have ended Dow believed that trends existed despite "market noise". Markets might temporarily move in the direction opposite to the trend, but they will soon resume the prior move. The trend should be given the benefit of the doubt during these reversals. Determining whether a reversal is the start of a new trend or a temporary movement in the current trend is not easy. Dow Theorists often disagree in this determination. Technical analysis tools attempt to clarify this but they can be interpreted differently by different investors.

Efficient Market Hypothesis:

The efficient-market hypothesis is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information.

Capital markets are the place where Spry Plc can meet investor who has finance to offers for long term. This finance may be equity finance involving the issue of new ordinary share or debt finance from a wide range of loans and debts securities. Capitals market is also a place where investors buy and sells company and government securities.

Capital markets are divided by two parts: primary market and secondary market. primary market help the companies to issues new securities to the new or existing shareholders by marking a public issue or right issues. This can help company perform better to influence shareholders that the company is willing to be stronger over the time both financially and operationally.

Secondary market is the market in which previously issued securities are traded. An active secondary market after the Initial Public Offering (IPO) provides the pre-IPO shareholders with a chance to convert some of their wealth into cash makes it easier for the Spry Plc to raise additional capital later and makes it easier for the company to use their stock to acquire other companies. This is to ensure Spry Plc stock will trade in an active secondary market before they incur the high costs of an IPO.

The Role and Importance of Capital Market:

The primary role and importance of the capital market is to raise long term funds for corporation while providing a platform for the trading of securities. This is to protect increment of the market share and price of securities to protect their investments in future.

Efficient Market Hypothesis (EMH): Efficient Market Hypothesis (EMH) asserts that financial markets are efficient or that prices on traded assets such as share and fixed interest securities are already reflect all known information. In can state that the companies may expect that they can develop more efficient market, more random the cycle of price changes generated by such a market and the most efficient market of all is one in which price changes are completely random and changeable.

The role and importance of Efficient Market Hypothesis:

Efficient Market Hypothesis (EMH) information is defined as anything which may affect the share price that is not known in present and appears randomly in the future. The role of EMH is how Spry Plc mangers consist of analyzing and investing appropriately based on an investors tax consideration and risk profiles.

EMH will not consistently outperform the market by using any information that the market already know except through luck. The share prices may not determine to future stock performance example the market may not know about an events which will lead to lower profits. This can not be controlled by anyone when the share prices will be changing depending on the markets.

Weak form of Efficient Market Hypothesis:

In this stage all past market prices and data are fully reflected in the price of securities and stock. It is based on information about event shaping the Spry Plc may not fully replicate in price. This state that future price movements are determined entirely by information not contained in the price series.

Semi-strong form of EMH:

This form emphasize that all publicly available information is fully reflected in securities prices. This implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess return.

Strong form of EMH:

This states that all information is fully reflected in securities price. A markets need to exist where investor can not consistently earn excess return over a long period of time.

UNIT -4 Portfolio Construction and Analysis:

Portfolio Construction:

Portfolio construction is the process of understanding how different asset classes, funds and weightings impact each other, their performance and risk and how decisions ladder up to an investor's objectives.

What is Portfolio Management? Portfolio management’s meaning can be explained as the process of managing individuals’ investments so that they maximise their earnings within a given time horizon. Furthermore, such practices ensure that the capital invested by individuals is not exposed to too much market risk.

The entire process is based on the ability to make sound decisions. Typically, such a decision relates to – achieving a profitable investment mix, allocating assets as per risk and financial goals and diversifying resources to combat capital erosion.

Primarily, portfolio management serves as a SWOT analysis of different investment avenues with investors’ goals against their risk appetite. In turn, it helps to generate substantial earnings and protect such earnings against risks.

Objectives of Portfolio Management:

The fundamental objective of portfolio management is to help select best investment options as per one’s income, age, time horizon and risk appetite.

Some of the core objectives of portfolio management are as follows –

● Capital appreciation ● Maximising returns on investment ● To improve the overall proficiency of the portfolio ● Risk optimisation ● Allocating resources optimally ● Ensuring flexibility of portfolio ● Protecting earnings against market risks

Nonetheless, to make the most of portfolio management, investors should opt for a management type that suits their investment pattern.

Types of Portfolio Management In a broader sense, portfolio management can be classified under 4 major types, namely –

Active portfolio management:

In this type of management, the portfolio manager is mostly concerned with generating maximum returns. Resultantly, they put a significant share of resources in the trading of securities. Typically, they purchase stocks when they are undervalued and sell them off when their value increases.

Passive portfolio management:

This particular type of portfolio management is concerned with a fixed profile that aligns perfectly with the current market trends. The managers are more likely to invest in index funds with low but steady returns which may seem profitable in the long run. Discretionary portfolio management:

In this particular management type, the portfolio managers are entrusted with the authority to invest as per their discretion on investors’ behalf. Based on investors’ goals and risk appetite, the manager may choose whichever investment strategy they deem suitable.

Non-discretionary management:

Under this management, the managers provide advice on investment choices. It is up to investors whether to accept the advice or reject it. Financial experts often recommended investors to weigh in the merit of professional portfolio managers’ advice before disregarding them entirely.

Who should Opt for Portfolio management?

The following should consider portfolio management –

Investors who intend to invest across different investment avenues like bonds, stocks, funds, commodities, etc. but do not possess enough knowledge about the entire process. Those who have limited knowledge about the investment market.

Investors who do not know how market forces influence returns on investment. Investors who do not have enough time to track their investments or rebalance their investment portfolio.

To make the most of the managerial process, individuals must put into practice strategies that match the investor’s financial plan and prospect.

Ways of Portfolio Management:

Several strategies must be implemented to ensure sound investment portfolio management so that investors can boost their earnings and lower their risks significantly.

Typically, professionals use these following ways to manage investment portfolio –

Asset allocation

Essentially, it is the process wherein investors put money in both volatile and non-volatile assets in such a way that helps generate substantial returns at minimum risk. Financial experts suggest that asset allocation must be aligned as per investor’s financial goals and risk appetite.

Diversification

The said method ensures that an investors’ portfolio is well-balanced and diversified across different investment avenues. On doing so, investors can revamp their collection significantly by achieving a perfect blend of risk and reward. This, in turn, helps to cushion risks and generates risk-adjusted returns over time.

Rebalancing

Rebalancing is considered essential for improving the profit-generating aspect of an investment portfolio. It helps investors to rebalance the ratio of portfolio components to yield higher returns at minimal loss. Financial experts suggest rebalancing an investment portfolio regularly to align it with the prevailing market and requirements.

Once investors have selected a suitable strategy, they must follow a thorough process to implement the same so that they can improve the portfolio’s profitability to a great extent. ensures that an investors’ portfolio is well-balanced and diversified across different investment avenues. On doing so, investors can revamp their collection significantly by achieving a perfect blend of risk and reward. This, in turn, helps to cushion risks and generates risk-adjusted returns over time.

Rebalancing:

Rebalancing is considered essential for improving the profit-generating aspect of an investment portfolio. It helps investors to rebalance the ratio of portfolio components to yield higher returns at minimal loss. Financial experts suggest rebalancing an investment portfolio regularly to align it with the prevailing market and requirements.

Once investors have selected a suitable strategy, they must follow a thorough process to implement the same so that they can improve the portfolio’s profitability to a great extent.

Processes of Portfolio Management

Step 1 – Identification of objectives:

For a capable investment portfolio, investors need to identify suitable objectives which can be either stable returns or capital appreciation.

Step 2 – Estimating the capital market:

Expected returns and associated risks are analysed to take necessary steps.

Step 3 – Decisions about asset allocation:

To generate earnings at minimal risk, sound decisions must be made about the suitable ratio or asset combination.

Step 4 – Formulating suitable portfolio strategies:

Strategies must be developed after factoring in investment horizon and risk exposure.

Step 5 – Selecting of profitable investment and securities: The profitability of assets is analysed by factoring in their fundamentals, credibility, liquidity, etc

Step 6 –Implementing portfolio:

The planned portfolio is put to action by investing in profitable investment avenues.

Step 7 –Evaluating and revising the portfolio:

A portfolio is evaluated and revised regularly to evaluate its efficiency.

Step 8 –Rebalancing the composition of the portfolio:

Portfolio’s composition is rebalanced frequently to maximise earnings.

The fact that effective portfolio management allows investors to develop the best investment plan that matches their income, age and risks taking capability, makes it so essential. With proficient investment portfolio management, investors can reduce their risks effectively and avail customised solutions against their investment-oriented problems. It is, thus, one of the inherent parts of undertaking any investment venture.

Fundamental Analysis:

Fundamental analysis is primarily concerned with determining the intrinsic value or the true value of a security. For determining the security’s intrinsic value the details of all major factors (GNP, industry sales, firm sales and expense etc) is collected or an estimates of earnings per share may be multiplied by a justified or normal prices earnings ratio. After making this determination, the intrinsic value is compared with the security’s current market price. If the market price is substantially greater than the intrinsic value the security is said to be overpriced. If the market price is substantially less than the intrinsic value, the security is said to be under priced. However, fundamental analysis comprises:

1. Economic Analysis 2. Industry Analysis 3. Company Analysis

ECONOMIC ANALYSIS:

For the security analyst or investor, the anticipated economic environment, and therefore the economic forecast, is important for making decisions concerning both the timings of an investment and the relative investment desirability among the various industries in the economy. The key for the analyst is that overall economic activities manifest itself in the behavior of the stocks in general. That is, the success of the economy will ultimately include the success of the overall market.

ECONOMIC FORECASTING: The common techniques used are analysis of key economic indicators, diffusion index, surveys and econometric model building. These techniques help him to decide the right time to incest and the type of security he has to purchase i.e. stocks or bonds or some combination of stocks and bonds.

ECONOMIC INDICATORS:

The economic indicators are statistics about the economy that indicate the present status, progress or slow down of the economy. They are capital investment, business profits, money supply, GNP, interest rate, unemployment rate, etc. The economic indicators are grouped into leading, coincidental and lagging indicators. The indicators are selected on the following criteria

∑ Economic significance

∑ Statistical adequacy

∑ Timing

∑ Conformity

The leading indicators:

The leading indicators indicate what is going to happen in the economy. It helps the investor to predict the path of the economy. The popular leading indicators are the fiscal policy, monetary policy, productivity, rainfall, capital investment and the stock indices. The fiscal policy shows what the government aims at and the fiscal deficit or surplus has an effect on the economy.

The coincidental indicators:

The coincidental indicators indicate what the economy is. The coincidental indicators are gross national product, industrial production, interest rates and reserve funds. GDP is the aggregate amount of goods and services produced in the national economy. The gap between the budgeted GDP and the actual GDP attained indicates the present situation. If there is a large gap between the actual growth and potential growth, the economy is slowing down. Low corporate profits and industrial production show that the economy is hit by recession.

The lagging indicators:

The changes that are occurring in the leading and coincidental indicators are reflected in the lagging indicators. Lagging indicators are identified as unemployment rate, consumer price index and flow of foreign funds. These leading, coincidental and lagging indicators provide an insight into the economy s current and future position.

DIFFUSION INDEX: Diffusion index is a composite or consensus index. The diffusion index consists of leading, coincidental and lagging indicators. This type of index has been constructed by the National Bureau of Economic Research in USA. But the diffusion index is complex in nature to calculate and the irregular movements that occur in individual indicators cannot be completely eliminated.

ECONOMETRIC MODEL BUILDING:

For model building several economic variables are taken into consideration. The assumptions underlying the analysis are specified. The relationship between the independent and dependent variables is given mathematically. While using the model, the analyst has to think clearly all the inter-relationship between the variables. When these inter-relationships are specified, he can forecast not only the direction but also the magnitude. But his prediction depends on his understanding of economic theory and the assumptions on which the model had been built. The models mostly use simultaneous equations.

Factors affecting Economic Forecasting:

GDP ( Gross Domestic Product):

● Inflation ● Interest rates ● Government revenu,expenditure and deficits ● Exchange rates ● Infrastructure

Monsoon: ● Economic and political stability

Markowitz Theory:

Modern portfolio theory, introduced by Harry Markowitz in 1952, is a portfolio construction theory that determines the minimum level of risk for an expected return. It assumes that investors will favor a portfolio with a lower risk level over a higher risk level for the same level of return.

1. Introduction to Markowitz Theory:

Harry M. Markowitz is credited with introducing new concepts of risk mea­surement and their application to the selection of portfolios. He started with the idea of risk aversion of average investors and their desire to maximise the expected return with the least risk.

Markowitz model is thus a theoretical framework for analysis of risk and return and their inter-relationships. He used the statistical analysis for measurement of risk and mathematical programming for selection of assets in a portfolio in an efficient manner. His framework led to the concept of efficient portfolios. An efficient portfolio is expected to yield the highest return for a given level of risk or lowest risk for a given level of return.

Markowitz generated a number of portfolios within a given amount of money or wealth and given preferences of investors for risk and return. Individuals vary widely in their risk tolerance and asset preferences. Their means, expenditures and investment requirements vary from individual to individual. Given the preferences, the portfolio selection is not a simple choice of any one security or securities, but a right combination of securities.

Markowitz emphasized that quality of a portfolio will be different from the quality of individual assets within it. Thus, the combined risk of two assets taken separately is not the same risk of two assets together. Thus, two securities of TISCO do not have the same risk as one security of TISCO and one of Reliance.

Risk and Reward are two aspects of investment considered by investors. The expected return may vary depending on the assumptions. Risk index is measured by the variance of the distribution around the mean, its range etc., which are in statistical terms called variance and covariance. The qualification of risk and the need for optimisation of return with lowest risk are the contributions of Markowitz. This led to what is called the Modern Portfolio Theory, which emphasizes the tradeoff between risk and return. If the investor wants a higher return, he has to take higher risk. But he prefers a high return but a low risk and hence the problem of a tradeoff.

A portfolio of assets involves the selection of securities. A combination of assets or securities is called a portfolio. Each individual investor puts his wealth in a combination of assets depending on his wealth, income and his preferences. The traditional theory of portfolio postulates that selection of assets should be based on lowest risk, as measured by its standard deviation from the mean of expected returns. The greater the variability of returns, the greater is the risk.

Thus, the investor chooses assets with the lowest variability of returns. Taking the return as the appreciation in the share price, if TELCO shares price varies from Rs. 338 to Rs. 580 (with variability of 72%) and Colgate from Rs. 218 to Rs. 315 (with a variability of 44%) during 1998, the investor chooses the Colgate as a less risky share.

As against this Traditional Theory that standard deviation measures the vari­ability of return and risk is indicated by the variability, and that the choice depends on the securities with lower variability, the modern Portfolio Theory emphasizes the need for maximization of returns through a combination of securities, whose total variability is lower.

The risk of each security is different from that of others and by a proper combination of securities, called diversification one can arrive at a combi­nation wherein the risk of one is offset partly or fully by that of the other. In other words, the variability of each security and covariance for their returns reflected through their inter-relationships should be taken into account.

Thus, as per the Modern Portfolio Theory, expected returns, the variance of these returns and covariance of the returns of the securities within the portfolio are to be considered for the choice of a portfolio. A portfolio is said to be efficient, if it is expected to yield the highest return possible for the lowest risk or a given level of risk.

A set of efficient portfolios can be generated by using the above process of combining various securities whose combined risk is lowest for a given level of return for the same amount of investment, that the investor is capable of. The theory of Markowitz, as stated above is based on a number of assumptions.

2. Assumptions of Markowitz Theory:

(1) Investors are rational and behave in a manner as to maximise their utility with a given level of income or money.

(2) Investors have free access to fair and correct information on the returns and risk.

(3) The markets are efficient and absorb the information quickly and perfectly.

(4) Investors are risk averse and try to minimise the risk and maximise return.

(5) Investors base decisions on expected returns and variance or standard deviation of these returns from the mean.

(6) Investors choose higher returns to lower returns for a given level of risk.

A portfolio of assets under the above assumptions is considered efficient if no other asset or portfolio of assets offers a higher expected return with the same or lower risk or lower risk with the same or higher expected return. Diversification of securities is one method by which the above objectives can be secured. The unsystematic and company related risk can be reduced by diversification into various securities and assets whose variability is different and offsetting or put in different words which are negatively correlated or not correlated at all.

Diversification of Markowitz Theory:

Markowitz postulated that diversification should not only aim at reducing the risk of a security by reducing its variability or standard deviation, but by reducing the covariance or interactive risk of two or more securities in a portfolio. As by combination of different securities, it is theoretically possible to have a range of risk varying from zero to infinity.

Markowitz theory of portfolio diversification attaches importance to standard deviation, to reduce it to zero, if possible, covariance to have as much as possible negative interactive effect among the securities within the portfolio and coefficient of correlation to have – 1 (negative) so that the overall risk of the portfolio as a whole is nil or negligible.

Then the securities have to be combined in a manner that standard deviation is zero, as shown in the example below:

Possible combinations of securities (1) and (2) In the example, if 2/3rds are invested in security (1) and 1/3rd in security (2), the coefficient of variation, namely = S.D./mean is the lowest.

The standard deviation of the portfolio determines the deviation of the returns and correlation coefficient of the proportion of securities in the portfolio, invested. The equation is-

σ2p = Portfolio variance

σp = Standard deviation of portfolio xi = Proportion of portfolio invested in security i xj = Proportion of portfolio invested in security J rij = Coefficient of correlation between i and J

σi standard deviation of i

σj standard deviation of J

N = number of securities

Given the following example, find out the expected risk of the portfolio.

Parameters of Markowitz Diversification:

Based on his research, Markowitz has set out guidelines for diversification on the basis of the attitude of investors towards risk and return and on a proper quantification of risk. The investments have different types of risk characteristics, some called systematic and market related risks and the other called unsystematic or company related risks. Markowitz diversification involves a proper number of securities, not too few or not too many which have no correlation or negative correlation. The proper choice of companies, securities, or assets whose return are not correlated and whose risks are mutually offsetting to reduce the overall risk.

For building up the efficient set of portfolio, as laid down by Markowitz, we need to look into these important parameters:

(1) Expected return.

(2) Variability of returns as measured by standard deviation from the mean.

(3) Covariance or variance of one asset return to other asset returns.

In general the higher the expected return, the lower is the standard deviation or variance and lower is the correlation the better will be the security for investor choice. Whatever is the risk of the individual securities in isolation, the total risk of the portfolio of all securities may be lower, if the covariance of their returns is negative or negligible. Criteria of Dominance:

Dominance refers to the superiority of one portfolio over the other. A set can dominate over the other, if with the same return, the risk is lower or with the same risk, the return is higher. Dominance principle involves the tradeoff between risk and return.

For two security portfolio, minimise the portfolio risk by the equation-

σp = Wa σa2 + Wb σb2 + 2 (WaWbσaσb σab)

E (Rp) = WaE (Ra) + Wb E (Rb)

R refers to returns and E (Rp) is the expected returns, σp is the standard deviation, W refers to the proportion invested in each security σaσb are the standard deviation of a and b securities and σab is the covariance or interrelations of the security returns.

The above concepts are used in the calculation of expected returns, mean standard deviation as a measure of risk and covariance as a measure of inter-relations of one security return with another.

Measurement of Risk:

Risk is discussed here in terms of a portfolio of assets. Any investment risk is the variability of return on a stock, assets or a portfolio. It is measured by standard deviation of the return over the Mean for a number of observations.

Example:

Standard deviation to be calculated: Average in Mean Observations: 10% – 5% 20% 35% – 10% = 10% will be their Mean.

Portfolio Risk:

When two or more securities or assets are combined in a portfolio, their covariance or interactive risk is to be considered. Thus, if the returns on two assets move together, their covariance is positive and the risk is more on such portfolios. If on the other hand, the returns move independently or in opposite directions, the covariance is negative and the risk in total will be lower.

Mathematically, the covariance is defined as- where Rx is return on security x, Ry return security Y, and R̅ x and R̅ y are expected returns on them respectively and N is the number of observations.

The coefficient of correlation is another measure designed to indicate the similarity or dissimilarity in the behaviour of two variables. We define the coefficient of correlation of x and y as- Cov x y is the covariance between x and y and σx is the standard deviation of x and σy is the standard deviation of y.

Where, N = 2

The covariance equation is as follows:

The coefficient of correlation can be set out as follows:

If the coefficient of correlation between two securities is – 1.0, it is perfect negative correlation. If it is + 1.0 it is perfect positive correlation. If the coefficient is ‘0’ then the returns are said to be independent. To sum up, correlation between two securities depend- (a) on covariance between them, and (b) the standard devia­tion of each.

In Markowitz Model, we need to have the inputs of expected returns, risk measured by standard deviation of returns and the covariance between the returns on assets considered.

Capital Asset Pricing Model:

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.

The CAPM is a model for pricing an individual security or portfolio. For individual securities, we make use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:

Asset Pricing:

Once the expected/required rate of return {\displaystyle E(R_{i})}E(R_{i}) is calculated using CAPM, we can compare this required rate of return to the asset's estimated rate of return over a specific investment horizon to determine whether it would be an appropriate investment. To make this comparison, you need an independent estimate of the return outlook for the security based on either fundamental or technical analysis techniques, including P/E, M/B etc.

Assuming that the CAPM is correct, an asset is correctly priced when its estimated price is the same as the present value of future cash flows of the asset, discounted at the rate suggested by CAPM. If the estimated price is higher than the CAPM valuation, then the asset is overvalued (and undervalued when the estimated price is below the CAPM valuation).[5] When the asset does not lie on the SML, this could also suggest mis-pricing. Since the expected return of the asset at time {\displaystyle t}t is {\displaystyle E(R_{t})={\frac {E(P_{t+1})-P_{t}}{P_{t}}}}E(R_{t})={\frac {E(P_{{t+1}})-P_{t}}{P_{t}}}, a higher expected return than what CAPM suggests indicates that {\displaystyle P_{t}}P_{t} is too low (the asset is currently undervalued), assuming that at time {\displaystyle t+1}t+1 the asset returns to the CAPM suggested price.

INDUSTRY ANALYSIS

The mediocre firm in the growth industry usually out performs the best stocks in a stagnant industry. Therefore, it is worthwhile for a security analyst to pinpoint growth industry, which has good investment prospects. The past performance of an industry is not a good predictor of the future- if one look very far into the future. Therefore, it is important to study industry analysis. For an industry analyst- industry life cycle analysis, characteristics and classification of industry is important.

INDUSTRY LIFE CYCLE ANALYSIS

Many industrial economists believe that the development of almost every industry may be analyzed in terms of following stages

1. Pioneering stage:

During this stage, the technology and product is relatively new. The prospective demand for the product is promising in this industry. The demand for the product attracts many producers to produce the particular product. This lead to severe competition and only fittest companies survive in this stage. The producers try to develop brand name, differentiate the product and create a product image. This would lead to nonprice competition too. The severe competition often leads to change of position of the firms in terms of market share and profit.

2. Rapid growth stage:

This stage starts with the appearance of surviving firms from the pioneering stage. The companies that beat the competition grow strongly in sales, market share and financial performance. The improved technology of production leads to low cost and good quality of products. Companies with rapid growth in this stage, declare dividends during this stage. It is always advisable to invest in these companies.

3.Maturity and stabilization stage: After enjoying above-average growth, the industry now enters in maturity and stabilization stage. The symptoms of technology obsolescence may appear. To keep going, technological innovation in the production process should be introduced. A close monitoring at industries events are necessary at this stage.

4.Decline stage: The industry enters the growth stage with satiation of demand, encroachment of new products, and change in consumer preferences. At this stage the earnings of the industry are started declining. In this stage the growth of industry is low even in boom period and decline at a higher rate during recession. It is always advisable not to invest in the share of low growth industry.

CLASSIFICATION OF INDUSTRY :

Industry means a group of productive or profit making enterprises or organizations that have a similar technically substitute goods, services or source of income. Besides Standard Industry Classification (SIC), industries can be classified on the basis of products and business cycle i.e. classified according to their reactions to the different phases of the business cycle. These are classified as follows:

Growth Industries:

These industries have special features of high rate of earnings and growth in expansion, independent of the business cycle. The expansion of the industry mainly depends on the technological change or an innovative way of doing or selling something. For example-in present scenario the information technology sector have higher growth rate. There is some growth in electronics, computers, cellular phones, engineering, petro-chemicals, telecommunication, energy etc.

Cyclical Industries:

The growth and profitability of the industry move along with the business cycle. These are those industries which are most likely to benefit from a period of economic prosperity and most likely to suffer from a period of economic recession. These especially include consumer goods and durables whose purchase can be postponed until persona; financial or general business conditions improve. For example- Fast Moving Consumer Goods (FMCG) commands a good market in the boom period and demand for them slackens during the recession.

Defensive Industries:

Defensive industries are those, such as the food processing industry, which hurt least in the period of economic downswing. For example- the industries selling necessities of consumers withstands recession and depression. The stock of defensive industries can be held by the investor for income earning purpose. Consumer nondurable and services, which in large part are the items necessary for existence, such as food and shelter, are products of defensive industry.

Cyclical-growth Industries:

These possess characteristics of both a cyclical industry and a growth industry. For example, the automobile industry experiences period of stagnation, decline but they grow tremendously. The change in technology and introduction of new models help the automobile industry to resume their growing path.

CHARACTERISTICS OF AN INDUSTRY ANALYSIS : In an industry analysis, the following key characteristics should be considered by the analyst. These are explained as below:

Post sales and Earnings performance:

The two important factors which play an important role in the success of the security investment are sales and earnings. The historical performance of sales and earnings should be given due consideration, to know how the industry have reacted in the past. With the knowledge and understanding of the reasons of the past behavior, the investor can assess the relative magnitude of performance in future. The cost structure of an industry is also an important factor to look into. The higher the cost component, the higher the sales volume necessary to achieve the firm’s break-even point, and vice-versa.

Nature of Competition:

The numbers of the firms in the industry and the market share of the top firms in the industry should be analyzed. One way to determine competitive conditions is to observe whether any barriers to entry exist. The demand of particular product, its profitability and price of concerned company scrip’s also determine the nature of competition. The investor before investing in the scrip of a company should analyze the market share of the particular company’s product and should compare it with other companies. If too many firms are present in the organized sector, the competition would be severe. This will lead to a decline in price of the product.

Raw Material and Inputs:

Here, we have to look into the industries, which are dependent upon imports of scarce raw material, competition from other companies and industries, barriers to entry of a new company, protection from foreign competition, import and export restriction etc. An industry which has a limited supply of materials domestically and where imports are restricted will have dim growth prospects. Labour is also an input and industries with labour problems may have difficulties of growth.

Attitude of Government towards Industry:

It is important for the analyst or prospective investor to consider the probable role government will play in industry. Will it provide financial support or otherwise? Or it will restrain the industry’s development through restrictive legislation and legal enforcement? The government policy with regard to granting of clearance, installed capacity and reservation of the products for small industry etc. are also factors to be considered for industry analysis.

Management:

An industry with many problems may be well managed, if the promoters and the management are efficient. The management likes Tatas, Birlas, Ambanies etc. who have a reputation, built up their companies on strong foundations. The management has to be assessed in terms of their capabilities, popularity, honesty and integrity. In case of new industries no track record is available and thus, investors have to carefully assess the project reports and the assessment of financial institutions in this regard. A good management also ensures that the future expansion plans are put on sound basis.

Labour Conditions and Other Industrial Problems:

The labour scenario in a particular industry is of great importance. If we are dealing with a labour intensive production process or a very mechanized capital intensive process where labour performs crucial operations, the possibility of strike looms as an important factor to be reckoned with. Certain industries with problems of marketing like high storage costs, high transport costs etc leads to poor growth potential and investors have to careful in investing in such companies.

Nature of Product Line:

The position of the industry in the life cycle of its growthinitial stage, high growth stage and maturing stage are to be noted. It is also necessary to know the industries with a high growth potential like computers, electronics, chemicals, diamonds etc., and whether the industry is in the priority sector of the key industry group or capital goods or consumer goods groups. The importance attached by the government in their policy and of the Planning Commission in their assessment of these industries is to be studied.

Capacity Installed and Utilized:

The demand for industrial products in the economy is estimated by the Planning Commission and the Government and the units are given licensed capacity on the basis of these estimates. If the demand is rising as expected and market is good for the products, the utilization of capacity will be higher, leading to bright prospects and higher profitability. If the quality of the product is poor, competition is high and there are other constraints to the availability of inputs and there are labour problems, then the capacity utilization will be low and profitability will be poor.

Industry Share Price Relative to Industry Earnings:

While making investment the current price of securities in the industry, their risk and returns they promise is considered. If the price is very high relative to future earnings growth, the investment in these securities is not wise. Conversely, if future prospects are dim but prices are low relative to fairly level future patterns of earnings, the stocks in this industry might be an attractive investment.

Research and Development:

For any industry to survive in the national and international markets, product and production process have to be technically competitive. This depends upon the research and development in the particular industry. Proper research and development activities help in obtaining economic of scale and new market for product. While making investment in any industry the percentage of expenditure made on research and development should also be considered.

Pollution Standards:

These are very high and restricted in the industrial sector. These differ from industry to industry, for example, in leather, chemical and pharmaceutical industries the industrial effluents are more.

ECONOMIC FORECASTING:

The common techniques used are analysis of key economic indicators, diffusion index, surveys and econometric model building. These techniques help him to decide the right time to incest and the type of security he has to purchase i.e. stocks or bonds or some combination of stocks and bonds.

ECONOMIC INDICATORS

The economic indicators are statistics about the economy that indicate the present status, progress or slow down of the economy. They are capital investment, business profits, money supply, GNP, interest rate, unemployment rate, etc. The economic indicators are grouped into leading, coincidental and lagging indicators. The indicators are selected on the following criteria

∑ Economic significance

∑ Statistical adequacy

∑ Timing

∑ Conformity

The leading indicators:

The leading indicators indicate what is going to happen in the economy. It helps the investor to predict the path of the economy. The popular leading indicators are the fiscal policy, monetary policy, productivity, rainfall, capital investment and the stock indices. The fiscal policy shows what the government aims at and the fiscal deficit or surplus has an effect on the economy.

The coincidental indicators:

The coincidental indicators indicate what the economy is. The coincidental indicators are gross national product, industrial production, interest rates and reserve funds. GDP is the aggregate amount of goods and services produced in the national economy. The gap between the budgeted GDP and the actual GDP attained indicates the present situation. If there is a large gap between the actual growth and potential growth, the economy is slowing down. Low corporate profits and industrial production show that the economy is hit by recession.

The lagging indicators:

The changes that are occurring in the leading and coincidental indicators are reflected in the lagging indicators. Lagging indicators are identified as unemployment rate, consumer price index and flow of foreign funds. These leading, coincidental and lagging indicators provide an insight into the economy s current and future position.

DIFFUSION INDEX:

Diffusion index is a composite or consensus index. The diffusion index consists of leading, coincidental and lagging indicators. This type of index has been constructed by the National Bureau of Economic Research in USA. But the diffusion index is complex in nature to calculate and the irregular movements that occur in individual indicators cannot be completely eliminated.

ECONOMETRIC MODEL BUILDING:

For model building several economic variables are taken into consideration. The assumptions underlying the analysis are specified. The relationship between the independent and dependent variables is given mathematically. While using the model, the analyst has to think clearly all the inter-relationship between the variables. When these inter-relationships are specified, he can forecast not only the direction but also the magnitude. But his prediction depends on his understanding of economic theory and the assumptions on which the model had been built. The models mostly use simultaneous equations.

Factors affecting Economic Forecasting:

● GDP ( Gross Domestic Product)

● Inflation

● Interest rates

● Government revenue, expenditure and deficits

● Exchange rates

● Infrastructure

● Monsoon

● Economic and political stability Meaning of Technical Analysis:

Technical analysis involves a study of market-generated data like prices and volumes to determine the future direction of price movement. It is a process of identifying trend reversal at an earlier stage to formulate the buying and selling strategy. With the help of several indicators, the relationship between price –volume and supply-demand is analyzed for the overall market and individual stocks.

The basic premises, on which technical analysis is formulated, are as follows: 1.The market value of the scrip is determined by the interaction of demand and supply.

2. Supply and demand is governed by numerous factors, both rational and irrational. These factors include economic variables relied by the fundamental analysis as well as opinions, moods and guesses.

3. The market discounts everything. The price of the security quoted represents the hope, fears and inside information received by the market players. Insider information regarding the issuance of bonus shares and right issues may support the prices. The loss of earnings and information regarding the forthcoming labor problem may result in fall in price. These factors may cause a shift in demand and supply, changing the direction of trends.

4. The market always moves in the trends except for minor deviations.

5. It is known fact that history repeats itself. It is true to stock market also. In the rising market, investors’ psychology has upbeats and they purchase the shares in great volumes driving the prices higher. At the same time in the down trend, they may be very eager to get out of the market by selling them and thus plunging the share price further. The market technicians assume that past prices predict the future.

Tools of Technical Analysis :

Generally used technical tools to analyze the market data are as follows:

Dow theory:

Originally proposed in the late nineteenth century by Charles H Dow, the editor of Wall Street Journal, the Dow theory is perhaps the oldest and best-known theory of technical analysis. Dow developed this theory on the basis of certain hypothesis, which are as follows: a. No single individual or buyer or buyer can influence the major trends in the market. However, an individual investor can affect the daily price movement by buying or selling huge quantum of particular scrip. b. The market discounts everything. Even natural calamities such as earth quake, plague and fire also get quickly discounted in the market. The world trade center blast affected the share market for a short while and then the market returned back to normalcy. c. The theory is not infallible and it is not a tool to beat the market but provides a way to understand the market. Explanation of the Theory Dow described stock prices as moving in trends analogous to the movement of water.

He postulated three types of price movements over time:

(1) major trends that are like tide in ocean, (2) intermediate trends that resemble waves, (3) short run movements that are like ripples.

Followers of the Dow theory hope to detect the direction of the major price trend (tide) known as primary trend, recognizing the intermediate movements (waves) or secondary trends that may occasionally move in the opposite direction.

They recognize that a primary trend does not go straight up, but rather includes small price declines as some investors decide to take profits. It means share prices don’t rise or fall in a straight t manner. Every rise or fall in price experiences a counter move. If a share price is increasing, the counter move will be a fall in price and vice-versa. The share prices move in a zigzag manner. The trend lines are straight lines drawn connecting either the top or bottoms of the share price movement. To draw a trend line, the analyst should have at least two tops or bottoms.

Primary Trend :

The price trend may be either increasing or decreasing. When the market exhibits the increasing trend, it is called bull market. The bull market shows three clear-cut peaks. Each peak is higher than the previous peak and this price rise is accompanied by heavy trading volume.

Here, each profit taking reversal that is followed by an increased new peak has a trough above the prior trough, with relatively light trading volume during the reversals, indicating that there is limited interest in profit taking at these levels. And the phases leading to the three peaks are revival, improvement in corporate profit and speculation.

The revival period encourages more and more investors to buy scrips, their expectations about the future being high. In the second phase, increased profits of corporate would result in further price rise. In the third phase, prices advance due to inflation and speculation.

Secondary Trend:

The secondary trend moves against the main trends and leads to the correction. In the bull market, the secondary trend would result in the fall of about 33-66 percent of the earlier rise. In the bear market, the secondary trend carries the price upward and corrects the main trend. Compared to the time taken for the primary trend, secondary trend is swift and quicker.

Minor Trends: Minor trends are just like the ripples in the market. They are simply the daily price fluctuations. Minor trend tries to correct the secondary price movement. It is better for the investor to concentrate on the primary or secondary trends than on the minor trends

The efficient market hypothesis :

Efficient market theory states that the price fluctuations are random and do not follow any regular pattern. Fama suggested that efficient market hypothesis can be divided into three categories. They are:

(1) the weak form, (2) The semi strong form, (3) The strong form. The level of information being considered in the market is the basis for this segregation.

Weak form of EMH:

The weak form hypothesis says that the current prices of stocks already fully reflect all the information that is contained in the historical sequence of prices. Therefore, there is no benefit in examining the historical sequence of prices forecasting the future. This weak form of the efficient market hypothesis is popularly known as the random-walk theory. Clearly, if this weak form of the efficient market hypothesis is true, it is a direct repudiation of technical analysis. If there is no value in studying past prices and past price changes, there is no value in technical analysis. As we saw in the preceding chapter, however, technicians place considerable reliance on the charts of historical prices that they maintain even though the efficient-market hypothesis refutes this practice.

Empirical tests of the weak form:

Over the years an impressive literature has been developed describing empirical tests of random walk (Paul H. Cootner, 1967). This research has been aimed at testing whether successive or lagged price changes are independent. In this section we will review briefly some of the major categories of statistical techniques that have been employed in this research, and we will summarize their major conclusions. These techniques generally fall into two categories: those that test for trends in stock prices and thus infer whether profitable trading systems could be developed and those that test such mechanical systems directly. Although certain of these studies were conducted many years ago, they are the basis upon which research on the efficient-market theory has been based, and are included here to provide the necessary conceptual basis for the theory and its evolution.

Semi strong form of EMH :

The semi strong form of the efficient-market hypothesis says that current prices of stocks not only reflect all informational content of historical prices but also reflect all publicly available knowledge about the corporations being studied. Further-more, the semi strong form says that efforts by analysts and investors to acquire and analyze public information will not yield consistently superior returns to the analyst. Examples of the type of public information that will not be of value on a consistent basis to the analyst are corporate reports, corporate announcements, information relating to corporate dividend policy, forthcoming stock splits, and so forth. In effect, the semi strong form of the efficient market hypothesis maintains that as soon as information becomes publicly available, it is absorbed and reflected in stock prices. Even if this adjustment is not the correct one immediately, it will in a very short time be properly analyzed by the market. Thus the analyst would have great difficulty trying to profit using fundamental analysis.

Strong form of EMH : we have seen that the weak form of the efficient-market hypothesis maintains that past prices and past price changes cannot be used to forecast future price changes and future prices. Semi strong form of the efficient-market hypothesis says that publicly available information cannot be used to earn consistently superior investment returns.

Some studies that tend to support the semi strong theory of the efficient-market hypothesis were cited. Finally, the strong form of the efficient-market hypothesis maintains that not only is publicly available information useless to the investor or analyst but all information is useless.

Specifically, no information that is available, be it public or ‘inside’, can be used to earn consistently superior investment returns. The semi strong form of the efficient-market hypothesis could only be tested indirectly- namely, by testing what happened to prices on days surrounding announcements of various types, such as earnings announcements, dividend announcements, and stock-split announcements.

To test the strong form of efficient-market hypothesis, even more indirect methods must be used. For the strong form, as has already been mentioned, says that no information is useful. This implies that not even security analysts and portfolio managers who have access to information more quickly than the general investing public are able to use this information to earn superior returns. Therefore, many of the tests of the strong form of the efficient market hypothesis deal with tests of mutual-fund performance.

In technical analysis, market timing becomes a function of the historical performance of the stock and the history of investor behavior. Technical analysis is generally used for a short-term to mid-term investment horizon.

Advantages of Using Market Timing Strategy

The benefits of market timing strategy are as follows: Market timing is used to maximize profits and offset the associated risks with high gains. It is the classic risk-return tradeoff that exists with respect to investment – the higher the risk, the higher the return. It enables traders to curtail the effects of market volatility. It enables traders to reap the benefits of short-term price movements.

Disadvantages of Using Market Timing Strategy Empirical research and real-life incidents show that the costs associated with the market timing strategy greatly surpass the potential benefits given that: It requires a trader to consistently follow up on market movements and trends. It entails higher transaction costs and commissions and includes a substantial opportunity cost. Market timers exit the market during periods of high volatility. Since most market upswings occur under volatile conditions, active investors miss out on the opportunities and ultimately earn less returns than buy-and-hold investors. An investor who succeeds in buying low and selling high must incur tax consequences on their gain. In case the security was held for less than a year, which is mostly true for market timers, the profit is taxed at the short-term capital gains rate, which is higher than the long-term capital gains rate. Precisely timing market entries and exits may be difficult.

Unit 5- Investment Companies

Mutual Funds: A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds.

What are Mutual Funds?

Mutual funds are one of the most popular investment options these days. A mutual fund is an investment vehicle formed when an asset management company (AMC) or fund house pools investments from several individuals and institutional investors with common investment objectives. A fund manager, who is a finance professional, manages the pooled investment. He or she purchases securities such as stocks and bonds that are in line with the investment mandate.

Mutual funds are an excellent investment option for individual investors to get exposure to expert managed portfolios. Also, one can diversify their portfolio by investing in mutual funds as the asset allocation would cover several instruments. Investors would be allocated with fund units based on the amount they spend. Each investor would hence experience profits or losses that are proportional to their investment. The main intention of the fund manager is to provide optimum returns to investors by investing in securities that are in sync with the fund’s objectives. The performance of mutual funds is dependent on the underlying assets.

Types of Mutual Funds

Mutual funds in India are broadly classified into equity funds, debt fund, and balanced mutual funds, depending on their asset allocation. The risk assumed and returns provided by a mutual fund plan would depend on its type. We have broken down the types of mutual funds in detail below:

Equity Funds Equity funds, as the name suggests, invest mostly in equity shares of companies across all market capitalisations. A mutual fund is categorised under equity fund if it invests at least 65% of its portfolio in equity instruments. Equity funds have the potential to offer the highest returns among all classes of mutual funds. The returns provided by equity funds depend on the market movements, which are influenced by several geopolitical and economic factors. The equity funds are further classified as below:

Small-Cap Funds

Small-cap funds are those equity funds that invest in shares of companies with small market capitalisation. SEBI defines small-cap companies as those that are ranked after 251 in market capitalisation.

Mid-Cap Funds

Mid-cap funds are those equity funds that invest primarily in equity and equity-linked instruments of companies with medium market capitalisation. SEBI defines mid-cap companies as those that are ranked between 101 and 250 in market capitalisation.

Large-Cap Funds

Large-cap funds funds are those equity funds that invest mostly in equity and equity-linked instruments of companies with large market capitalisation. SEBI defines large-cap companies as those that are ranked between 1 and 100 in market capitalisation.

Multi-Cap Funds

Multi-Cap Funds Funds invest substantially in equity and equity-linked instruments of companies across all market capitalisations. The fund manager would change the asset allocation depending on the market condition to reap the maximum returns for investors and reduce the risk levels.

Sector or Thematic Funds

Sectoral funds invest principally in equity and equity-linked instruments of companies in a particular sector like FMCG and IT. Thematic funds invest in equities of companies that operate with a similar theme like travel.

Index Funds

Index Funds are a type of equity funds having the intention of tracking and emulating the performance of a popular stock market index such as the S&P BSE Sensex and NSE Nifty50. The asset allocation of an index fund would be the same as that of its underlying index. Therefore, the returns offered by index mutual funds would be similar to that of its underlying index.

ELSS Equity-linked savings scheme (ELSS) is the only kind of mutual funds covered under Section 80C of the Income Tax Act, 1961. Investors can claim tax deductions of up to Rs 1,50,000 a year by investing in ELSS.

Debt Mutual Funds

Debt mutual funds invest mostly in debt, money market and other fixed-income instruments such as treasury bills, government bonds, certificates of deposit, and other high-rated securities. A mutual fund is considered a debt fund if it invests a minimum of 65% of its portfolio in debt securities. Debt funds are ideal for risk-averse investors as the performance of debt funds is not influenced much by the market fluctuations. Therefore, the returns provided by debt funds are very much predictable. The debt funds are further classified as below:

Dynamic Bond Funds

Dynamic Bond Funds Dynamic Bond Funds are those debt funds whose portfolio is modified depending on the fluctuations in the interest rates.

Income Funds

Income Funds Income Funds invest in securities that come with a long maturity period and therefore, provide stable returns over time. The average maturity period of these funds is five years.

Short-Term and Ultra Short-Term Debt Funds

Short-term and ultra short-term debt funds are those debt funds that invest in securities that mature in one to three years. These funds are ideal for risk-averse investors.

Liquid Funds

Liquid funds are debt funds that invest in assets and securities that mature within ninety-one days. Liquid funds are a great option to park surplus funds, and they offer higher returns than a regular savings account.

Gilt Funds

Gilt Funds are debt funds that invest in high-rated government securities. It is for this reason that these funds carry extremely low risk and are apt for risk-averse investors.

Credit Opportunities Funds

Credit Opportunities Funds mostly invest in low rated securities that have the potential to provide higher returns. It is for this reason that these funds are the riskiest class of debt funds.

Fixed Maturity Plans Fixed maturity plans (FMPs) are close-ended debt funds that invest in fixed income securities such as government bonds. You may invest in FMPs only during the fund offer period, and the investment will be locked-in for a predefined period.

Balanced or Hybrid Mutual Funds

Balanced or hybrid funds invest across both equity and debt instruments. The main objective of hybrid funds is to balance the risk-reward ratio by diversifying the portfolio. The fund manager would modify the asset allocation of the fund depending on the market condition, to benefit the investors. Investing in hybrid funds is an excellent way to diversify your portfolio as you would gain exposure to both equity and debt instruments. The debt funds are further classified as below:

Equity-Oriented Hybrid Funds

Equity-oriented hybrid funds invest at least 65% of its portfolio in equities while the rest is spent on money market or debt instruments.

Debt-Oriented Hybrid Funds

Debt-oriented hybrid funds allocate at least 65% of its portfolio in purchasing debt instruments such as treasury bills and government securities, and the rest is invested in equities.

Monthly Income Plans

Monthly income plans (MIPs) mostly invest in debt instruments and aim at providing a steady return over time. The exposure to equities is generally restricted to 20%. Investors can decide if they like to receive dividends on a monthly, quarterly, or annual basis.

Arbitrage Funds

Arbitrage funds aim at maximising the returns by purchasing securities in one market at lower prices and selling them in another market at a premium. However, if the opportunities for arbitrage are not available, the fund manager may choose to invest in debt securities or cash.

Why Should You Invest in Mutual Funds?

Investing in mutual funds provides several advantages for investors. The flexibility and expert management of money make mutual funds a lucrative investment option.

Investment Handled by Experts

Fund managers manage the investments pooled by the asset management companies (AMCs) or fund houses. They are finance professionals with an excellent track record of managing investment portfolios. Furthermore, fund managers are supported by a team of analysts and experts who pick the best-performing stocks and assets that have the potential to provide excellent returns for investors.

No Lock-in Period

Most mutual funds come with no lock-in period. In investments, the lock-in period is a timeframe over which the investments once made cannot be withdrawn. Some investments allow premature withdrawals within the lock-in period in exchange for a penalty. Most mutual funds are open-ended, and they come with no exit load. ELSS is the most popular mutual funds plan which has a lock-in period of three years.

Low Cost

Investing in mutual funds comes at a low cost, and thereby making it suitable for small investors. Fund houses or asset management companies (AMCs) levy a small amount referred to as the expense ratio on investors to manage their investments. It generally ranges between 0.5% to 1.5% of the total amount invested. The Securities and Exchange Board of India (SEB) has mandated expense ratio to be under 2.5%.

Systematic Investment Plan

The most significant advantage of investing in mutual funds is that you can spend a small amount regularly via a systematic investment plan (SIP). The frequency of your SIP can be monthly, quarterly, or bi-annually, as per your comfort. Also, you can decide the ticket size of your SIP. However, it cannot be less than the minimum investable amount. You can initiate or terminate a SIP as and when you need.

Switch Fund Option

If you would like to move your investments to a different fund of the same fund house, then you have an option to switch your investments to that fund from your existing fund. A good investor knows when to enter and exit a particular fund. In case you see another fund having the potential to outperform the market or your investment objective changes and is in line with that of the new fund, then you can initiate the switch option.

Goal-Based Funds

Individuals invest their hard-earned money with the view of meeting financial goals. Mutual funds provide fund plans that help investors meet all their financial goals, be it short-term or long-term. There are mutual fund schemes that suit every individual’s risk profile, investment horizon, and style of investments. Therefore, investors need to assess their profile carefully so that they pick the most suitable fund plan.

Diversification

Unlike stocks, mutual funds invest in various assets and shares of several companies, thereby providing the benefit of diversification. Also, this alleviates the risk of concentration. If one asset class fails to perform up to the expectations, then the other asset classes would make up for the losses. Therefore, investors need not worry about market volatility as the diversified portfolio would provide some stability.

Flexibility

Mutual funds are buzzing these days because they provide the much-needed flexibility to the investors. The combination of investing via a SIP and no lock-in period has made mutual funds an even more lucrative investment option. Also, you can enter and exit a mutual fund plan at any time, which may not be the case with most other investment options. It is for this reason that millennials are preferring mutual funds.

Liquidity

As most mutual funds do not have a lock-in period, it provides investors with high liquidity. This makes it easier for the investor to fall back on their mutual fund investment at times of financial crisis. The redemption requests are processed quickly, unlike other investment options. On placing the redemption request, the fund house or the asset management company would credit your money in just 3-7 days.

Seamless Process

Investing in mutual funds is a relatively simple process. Buying, selling of the fund units are all made at the current net asset value (NAV) of the mutual fund plan. As the fund manager and his or her team of experts and analysts are tasked with choosing shares and assets, investors only need to invest, and the rest would be taken care of by the fund manager.

Regulated All mutual fund houses and mutual fund plans are always under the purview of the Securities and Exchange Board of India (SEBI) and Reserve Bank of India (RBI). Apart from that, the Association of Mutual Funds in India (AMFI), a self-regulatory body formed by all fund houses in the country, also governs fund plans. Therefore, investors need not worry about the safety of their mutual fund investments as they are safe.

Ease of Tracking

One of the most significant advantages of investing in mutual funds is that tracking investments are easy and straightforward. Fund houses understand that it is hard for investors to take some time out of their busy schedules to track their finances, and hence, they provide regular statements of their investments. This makes it a lot easier for them to track their investments and make decisions accordingly.

Benefits and Limitations of Mutual Funds:

Liquidity

Unless you opt for close-ended mutual funds, it is relatively easier to buy and exit a mutual fund scheme. You can sell your open-ended equity mutual fund units when the stock market is high and make a profit. Do keep an eye on the exit load and expense ratio of the mutual fund.

Diversification

Equity mutual funds have their share of risks as their performance is based on the stock market movements. Hence, the fund manager spreads your investment across stocks of companies across various industries and different sectors called diversification. In this way, when one asset class doesn’t perform, the other sectors can compensate to avoid loss for investors.

Expert Management

A mutual fund is good for investors who don’t have the time or skills to do the research and asset allocation. A fund manager takes care of it all and makes decisions on what to do with your investment.

The fund manager and the team of researchers decide on the appropriate securities such as equity, debt or a mix of both depending on the investment objectives of the fund. Moreover, the fund manager also decides on how long to hold the securities.

Your fund manager’s reputation and track record in fund management should be an essential criterion for you to choose a mutual fund. The expense ratio (which cannot be more than 2.25% annualised of the daily net assets as per SEBI) includes the fees of the fund manager.

Less cost for bulk transactions

You must have noticed how price drops with the purchase of increased volumes. For instance, if a 100g toothpaste costs Rs 10, you might get a 500g pack for say, Rs 40.

The same logic applies to mutual fund units as well. If you buy multiple mutual fund units at a time, the processing fees and other commission charges will be lesser as compared to buying one mutual fund unit.

Invest in smaller denominations

By investing in smaller denominations of as low as Rs 500 per SIP instalment, you can stagger your investments in mutual funds over some time. This reduces the average cost of investment – you spread your investment across stock market lows and highs. Regular (monthly or quarterly) investments, as opposed to lump sum investments, give you the benefit of rupee cost averaging.

Suits your financial goals

There are several types of mutual funds available in India catering to investors across all walks of life. No matter what your income is, you must make it a habit to set aside some amount (however small) towards investments. It is easy to find a mutual fund that matches your income, time horizon, investment goals and risk appetite.

Cost-efficiency

You can check the expense ratio of different mutual funds and choose the one with the lowest expense ratio. The expense ratio is the fee for managing your mutual fund.

Quick and hassle-free process

You can start with one mutual fund and slowly diversify across funds to build your portfolio. It is easier to choose from handpicked funds that match your investment objectives and risk tolerance.

Tracking mutual funds will be a hassle-free process. The fund manager, with the help of his team, will decide when, where and how to invest in securities according to the investment objectives. In short, their job is to beat the benchmark index and deliver maximum returns to investors, consistently.

Tax-efficiency

You can invest in tax-saving mutual funds called ELSS which qualifies for tax deduction up to Rs 1.5 lakh per annum under Section 80C of the Income Tax Act, 1961. Though a 10% tax on Long-Term Capital Gains (LTCG) above Rs 1 lakh is applicable, they have consistently delivered higher returns than other tax-saving instruments in recent years.

Automated payments

It is common to delay SIPs or postpone investments due to some reason. You can opt for paperless automation with your fund house or agent by submitting a SIP mandate, where you instruct your bank account to automatically deduct SIP amounts when it’s due. Timely email and SMS notifications make sure you stay on track with mutual fund investments.

Safety

There is a general notion that mutual funds are not as safe as bank products. This is a myth as fund houses are strictly under the purview of statutory government bodies like SEBI and AMFI. One can easily verify the credentials of the fund house and the asset manager from SEBI. They also have an impartial grievance redressal platform that works in the interest of investors.

Systematic or one-time investment

You can plan your mutual fund investment as per your budget and convenience. For instance, starting a SIP (Systematic Investment Plan) on a monthly or quarterly basis in an equity fund suits investors with less money. On the other hand, if you have a surplus amount, go for a one-time lumpsum investment in debt funds. Disadvantages of Mutual Funds:

Costs of managing the mutual fund

The salary of the market analysts and fund manager comes from the investors along with the operational costs of the fund. Total fund management charges are one of the first parameters to consider when choosing a mutual fund. Higher management fees do not guarantee better fund performance.

Exit Load

You have exit load as fees charged by AMCs when exiting a mutual fund. It discourages investors from redeeming investments for some time. It also helps the fund manager garner the required funds to purchase the appropriate securities at the right price and time.

Dilution

While diversification averages your risks of loss, it can also dilute your profits. Hence, you should not invest in many mutual funds at a time.

As you have just read above, the benefits of mutual funds can undoubtedly override the disadvantages, if you make informed choices.

However, investors may not have the time, knowledge or patience to research and analyse different mutual funds. Investing with ClearTax could solve this problem as we have already done the homework for you by handpicking the top-rated funds from the best fund houses in the country.

SEBI Guidelines for Mutual funds:

The Securities and Exchange Board (SEBI) is the designated regulatory body for securities markets in India. The primary function of the board is to protect the interest of the investors in securities, promote and regulate the securities market. SEBI has laid the ground rules for investors to become aware of the functioning of the mutual funds by providing necessary information. They serve to simplify the broad spectrum of mutual fund schemes that may often seem quite confusing to the investors. The guidelines on the merger and consolidation of mutual fund schemes issued by SEBI are aimed at simplifying the process of comparing various mutual fund schemes that are on offer by fund houses.

The structure of mutual funds as per SEBI guidelines:

The SEBI guidelines define the guarantor as one who, in his capacity as an individual or in partnership with a different entity or entities, launches a mutual fund. The role of the guarantor is to generate revenues by putting together a mutual fund and handing it to the fund manager. A sponsor sets up the mutual funds as per the guidelines of the Indian Trust Act, 1882, for Public Trust. They are responsible for listing with the SEBI, having provisions for resource management and ensuring the functioning of the fund takes place as per the SEBI guidelines. The Trustee or Trust is established through a trust deed that is implemented by the sponsors of the funds and is accountable to all the investors of the mutual fund. The trustee company is regulated by the Indian Companies Act 1956, while the firm and the board members are overseen by the Indian Trust Act 1882. The investment management of the trust is done through an Asset Management Company, which is to be listed as per the regulations of Companies Act of 1956.

Role of SEBI in Mutual Fund Regulations:

As far as mutual funds are concerned, SEBI is the policymaker and also regulates the industry. It lays guidelines for mutual funds to safeguard the investors’ interest. Mutual funds are very distinct in terms of their investment strategy and asset allocation activities. This requires bringing about uniformity in the functioning of the mutual funds that may be similar in schemes. This will assist the investors in making investment decisions more clearly. The mutual funds have been categorised as follows to facilitate this standardisation and bringing about uniformity in similar schemes: a. Equity Schemes b. Debt Schemes c. Hybrid Schemes d. Solution Oriented Schemes e. Other Schemes The categorisation and rationalisation of mutual funds into these five broad categories ensures that the mutual fund houses are only able to have one scheme in each sub-category, with some exceptions. The categorisation helps in simplifying the selection of funds and works in the best interest of the investors by allowing them to evaluate their risk options before making decisions about investing in any scheme. Following this consolidation of schemes, the investors can take a more informed decision without much hassle or confusion. To fulfil this purpose, SEBI has come up with some guidelines to help the retail investors in their mutual funds’ investment decisions.

Key Highlights of SEBI guidelines for Mutual Funds: a. The categorisation of schemes into five groups – Equity, Debt, Hybrid, Solution-Oriented, and Others b. Large, mid and small-cap mutual funds have been defined clearly c. There is a lock-in period specified for solution-oriented schemes d. Permission of only one scheme in each category, except for Index Funds/Exchange-Traded Funds (ETF), Sectoral/Thematic Funds and Funds of Funds. Funds

5. SEBI Guidelines to invest in Mutual Funds:

SEBI keeps in place the regulatory framework and guidelines that govern and regulate securities markets in the country. The guidelines for investors are listed below. Mutual funds present the most diversified form of investment options and therefore, may carry a certain amount of risk with it. Investors must be very clear in their assessment of their financial position and the risk-bearing capacity in the event of the poor performance of such schemes. Investors must, therefore, consider the risk appetite of an investment scheme. b) Before venturing into mutual fund investment, it is imperative for you as an investor to obtain detailed information about the mutual fund scheme option. Having the right information when required to make the necessary decision is the key to making suitable investments. This may help in choosing the right schemes, knowing the guidelines to follow and also be informed of the investors’ rights. c) Diversify your portfolios

Diversification of portfolios allows investors to spread out their investments over various schemes, thereby increasing chances of maximizing profits or mitigating risk of potentially huge losses. Diversification is crucial to gaining a long-term and sustainable financial advantage. d) Avoid the clutter of portfolios

Choosing the right portfolio of funds requires managing and monitoring these schemes individually with care. The investor must not clutter the portfolio and decide on the right number of schemes to hold so as to avoid overlap and be able to manage each one of them equally well. Not sure of the right schemes for your portfolio? ClearTax can help simplify this for you. . e) Assign a time dimension to the investment schemes

The investors should assign a time frame to each scheme to encourage the financial growth of the plan. It may help in containing the volatility and fluctuations in the market if the plans are maintained stably over a period.

RBI Guidelines for Mutual Funds

Industry Specific Central

The Reserve Bank of India (RBI) on August 06, 2020 has issued guidelines for banks investing in the debt mutual funds or exchange traded funds (ETFs). Para 8.4.1 of the Master Circular – Basel III Capital Regulations, specifies the capital charge for equities would apply on the current market value in bank’s trading book. Now, RBI has further decided that all the banks that are investing in the debt mutual fund exchange traded fund, shall compute capital charge for market risk as under.

• All the investments in debt mutual funds shall attract general market risk charge of 9% for whom the full constituent debt details are available.

• All the investments in debt mutual funds which contain a mix of the debt instruments, shall have capital risk charge computed based on lowest rated debt instrument attracting the highest specific risk capital charge in the fund.

• For all the debt mutual funds for which the debt details are not available, they shall be treated at par with the equity at month end.

Unit Trust of India:

Unit Trust of India was first Set up in 1st February 1964 under the Unit Trust of India Act, 1963. It is a statutory public sector investment institution having the main objective to encourage and mobilize the savings of the community and canalize them into productive corporate investment. Unit trust is an investment plan in which the funds are pooled together and then invested. The fund which is pooled is then unitized and the investor who is one party to the unit trust is called a unitholder, holding a certain number of units.

A second party i.e the manager is responsible for the day-to-day running of the trust and for investing the funds.

The trustee, governed by the Trust Companies Act 1967, is the third party, and their role is to monitor the manager’s performance against the trust’s deed.

The deed outlines the objectives and vital information about the trust. Also, the assets of the trust are held in the name of the trustee and then they are held “in trust” for the unitholders.

Objectives of Unit Trust of India (UTI)

Unit Trust of India Provides to the investor a safe return of the investment whenever they require funds. UTI provides daily price record and advertises it in the newspapers.

Thus, two prices are quoted on a daily basis, the purchase price and the sale price of the units. This price may fluctuate daily, but the fluctuations are nominal on a monthly basis.

The price varies between the month of July and the month of June. The purchase price of the various units is the lowest in the month of July.

An investor who wants to make an investment may purchase his units at this time of the year and receive the lowest offer price for the units.

The basic objective of the UTI is to offer both small and large investors the means of acquiring shares in the properties resulting from the steady, industrial growth of the country.

Primary Objectives of UTI:

To promote and pool the small savings from the lower and middle-income persons who cannot have direct access to the stock exchange, and to provide them with an opportunity to share the benefits of prosperity resulting from rapid industrialization in India. UTI

Functions of UTI

● Mobilize the saving of the relatively small investors. ● Channelize these small savings into productive investments. ● Distribute the large scale economies among small income groups. ● Encourage savings of lower and middle-class people. ● Sell nits to investors in different parts of the country. ● Convert the small savings into industrial finance. ● To give investors an opportunity to share the benefits and fruits of industrialization in the country. ● Provide liquidity to units. ● Accept discount, purchase or sell bills of exchange, warehouse receipt, documents of title to goods etc., ● To grant loans and advances to investors. ● To provide merchant banking and investment advisory service to investors. ● Provide leasing and hire purchase business. ● To extend portfolio management service to persons residing in other countries. ● To buy or sell or deal in foreign currency. ● Formulate a unit scheme or insurance plan in association with GIC. ● Invest in any security floated by the RBI or foreign bank.

Schemes of UTI:

The familiar schemes of UTI are given below:

(i) Unit scheme—1964.

(ii) Unit Linked Insurance Plan—1971.

(iii) Children Gift Growth Fund Unit Scheme—1986.

(iv) Rajyalakshmi Unit Scheme—1992.

(v) Senior Citizens Unit Plan—1993.

(vi) Monthly Income Unit Scheme.

(vii) Master Equity Plan—1995.

(viii) Money Market Mutual Fund—1997.

(ix) UTI Growth Sector Fund—1999.

(x) Growth and Income Unit Schemes.

Advantages of Unit Trust:

The advantages of Unit Trust are:

(i) The investment is safe and the risk is spread over a wide range of securities. ii) The Unit-holders will be getting regular and good income, as 90 percent of its income will be distributed.

(iii) Dividends up to Rs. 1,000 received by the individual are exempt from income-tax. (iv) There is a high degree of liquidity of investment as the units can be sold back to the trust at any time at prices fixed by trust.