Equity Funds FAQs
Debt Funds FAQs
What is a Mutual
The following are some of the more popular definitions of a Mutual
A Mutual Fund is an investment tool that allows small investors access
to a well-diversified portfolio of equities, bonds and other
securities. Each shareholder participates in the gain or loss of the
fund. Units are issued and can be redeemed as needed. The fund's Net
Asset Value (NAV) is determined each day.
Mutual Funds are financial intermediaries. They are companies set up
to receive your money, and then having received it, make investments
with the money Via an AMC. It is an ideal tool for people who want to
invest but don't want to be bothered with deciphering the numbers and
deciding whether the stock is a good buy or not. A mutual fund manager
proceeds to buy a number of stocks from various markets and
industries. Depending on the amount you invest, you own part of the
The beauty of mutual funds is that anyone with an investible surplus
of a few hundred rupees can invest and reap returns as high as those
provided by the equity markets or have a steady and comparatively
secure investment as offered by debt instruments.
What are the benefits of investing in a
There are several benefits from investing in a Mutual Fund.
- Small investments : Mutual
funds help you to reap the benefit of returns by a portfolio spread
across a wide spectrum of companies with small investments. Such a
spread would not have been possible without their assistance.
- Professional Fund Management :
Professionals having considerable expertise, experience and
resources manage the pool of money collected by a mutual fund. They
thoroughly analyse the markets and economy to pick good investment
- Spreading Risk : An investor
with a limited amount of fund might be able to to invest in only one
or two stocks / bonds, thus increasing his or her risk. However, a
mutual fund will spread its risk by investing a number of sound
stocks or bonds. A fund normally invests in companies across a wide
range of industries, so the risk is diversified at the same time
taking advantage of the position it holds. Also in cases of
liquidity crisis where stocks are sold at a distress, mutual funds
have the advantage of the redemption option at the NAVs.
- Transparency and interactivity :
Mutual Funds regularly provide investors with information on the
value of their investments. Mutual Funds also provide complete
portfolio disclosure of the investments made by various schemes and
also the proportion invested in each asset type. Mutual Funds
clearly layout their investment strategy to the investor.
- Liquidity : Closed ended
funds have their units listed at the stock exchange, thus they can
be bought and sold at their market value. Over and above this the
units can be directly redeemed to the Mutual Fund as and when they
announce the repurchase.
- Choice : The large amount of
Mutual Funds offer the investor a wide variety to choose from. An
investor can pick up a scheme depending upon his risk / return
- Regulations : All the mutual
funds are registered with SEBI and they function within the
provisions of strict regulation designed to protect the interests of
A Mutual Fund is not an alternative investment option to stocks and
bond; rather it pools the money of several investors and invests this
in stocks, bonds, money market instruments and other types of
A Mutual Fund is a trust that pools the savings of a number of
investors who share a common financial goal. The money thus collected
is then invested in capital market instruments such as shares,
debentures and other securities. The income earned through these
investments and the capital appreciation realised are shared by its
unit holders in proportion to the number of units owned by them. Thus
a Mutual Fund is the most suitable investment for the common man as it
offers an opportunity to invest in a diversified, professionally
managed basket of securities at a relatively low cost. The flow chart
below describes broadly the working of a mutual fund :
Mutual Fund Operation Flow Chart
What does a Mutual Fund do with investor's
Anybody with an investible surplus of as little as a few hundred
rupees can invest in mutual funds. The investors buy units of a fund
that best suits their investment objectives and future needs. A Mutual
Fund invests the pool of money collected from the investors in a range
of securities comprising equities, debt, money market instruments etc.
after charging for the AMC fees. The income earned and the capital
appreciation realised by the scheme, are shared by the investors in
same proportion as the number of units owned by them.
How are mutual funds different from portfolio
In case of mutual funds, the investments of different investors
are pooled to form a common investible corpus and gain/loss to all
investors during a given period are same for all investors while in
case of portfolio management scheme, the investments of a particular
investor remains identifiable to him. Here the gain or loss of all the
investors will be different from each other.
How is investment in a Mutual Fund Different
from a Bank Deposit?
When you deposit money with the bank, the bank promises to pay you
a certain rate of interest for the period you specify. On the date of
maturity, the bank is supposed to return the principal amount and
interest to you. Whereas, in a mutual fund, the money you invest, is
in turn invested by the manager, on your behalf, as per the investment
strategy specified for the scheme. The profit, if any, less expenses
of the manager, is reflected in the NAV or distributed as income.
Likewise, loss, if any, with the expenses, is to be borne by you.
What are the types of returns one can expect
from a Mutual Fund?
Mutual Funds give returns in two ways - Capital Appreciation or
Capital Appreciation : An increase in the value of the units of the
fund is known as capital appreciation. As the value of individual
securities in the fund increases, the fund's unit price increases. An
investor can book a profit by selling the units at prices higher than
the price at which he bought the units.
Dividend Distribution : The profit earned by the fund is distributed
among unit holders in the form of dividends. Dividend distribution
again is of two types. It can either be re-invested in the fund or can
be on paid to the investor.
How are Mutual Funds classified?
Why do Mutual Funds come out with different
A Mutual Fund may not, through just one portfolio, be able to meet
the investment objectives of all their Unit holders. Some Unit holders
may want to invest in risk-bearing securities such as equity and some
others may want to invest in safer securities such as bonds or
government securities. Hence, the Mutual Fund comes out with different
schemes, each with a different investment objective.
Does investing in Mutual Funds mean investing
in equities only?
Mutual funds can be divided into various types depending on asset
classes. They can also invest in debt instruments such as bonds,
debentures, commercial paper and government securities apart from
Every mutual fund scheme is bound by the investment objectives
outlined by it in its prospectus. The investment objectives specify
the class of securities a mutual fund can invest in.
What are sector funds?
These are speciality mutual funds that invest in stocks that fall
into a certain sector of the economy. Here the portfolio is dispersed
or spread across the stocks in a particular sector.This type of scheme
is ideal for the investor who has already made up his mind to confine
his risk and return to one particular sector. Thus, a FMCG fund would
invest in companies that manufacture fast moving consumer goods.
What is the difference between Growth Plan
and Dividend Reinvestment Plan?
Under the Growth Plan, the investor realizes the capital
appreciation of his/her investments while under the Dividend
Reinvestment Plan, the dividends declared are reinvested automatically
in the scheme.
What is a Portfolio?
A portfolio of a mutual fund scheme is the basket of financial
assets held by that scheme. It comprises of investments in a variety
of securities and asset classes. This diversification helps reduces
the overall risk. A mutual fund scheme states the kind of portfolio it
seeks to construct as well as the risks involved under each asset
What is Net Asset Value (NAV)?
Net Asset Value (NAV) is the actual value of one unit of a given
scheme on any given business day. The NAV reflects the liquidation
value of the fund's investments on that particular day after
accounting for all expenses. It is calculated by deducting all
liabilities (except unit capital) of the fund from the realisable
value of all assets and dividing it by number of units outstanding.
What is a load?
The charge collected by a Mutual Fund from an investor for selling
the units or investing in it.
When a charge is collected at the time of entering into the scheme it
is called an Entry load or Front-end load or Sales load. The entry
load percentage is added to the NAV at the time of allotment of units.
An Exit load or Back-end load or Repurchase load is a charge that is
collected at the time of redeeming or for transfer between schemes
(switch). The exit load percentage is deducted from the NAV at the
time of redemption or transfer between schemes.
Some schemes do not charge any load and are called "No Load Schemes"
What is a Sale Price?
It is the price paid by an investor when investing in a scheme of
a Mutual Fund. This price may include the sales or entry load.
What is a Redemption/Repurchase Price?
Redemption or Repurchase Price is the price at which an investor
sells back the units to the Mutual Fund. This price is NAV related and
may include the exit load.
What is the Repurchase or Back End Load?
It is the charge collected by the scheme when it buys back the
units from the unit holders.
What is a Switching Facility?
Switching facility provides investors with an option to transfer
the funds amongst different types of schemes or plans. Investors can
opt to switch units between Dividend Plan and Growth Plan at NAV based
prices. Switching is also allowed into/from other select open-ended
schemes currently within the Fund family or schemes that may be
launched in the future at NAV based prices.
While switching between Debt and Equity Schemes, one has to take care
of exit and entry loads. Switching from a Debt Scheme to Equity scheme
involves an entry load while the vice versa does not involve an entry
What is the applicable NAV for switch?
Switch requests are effected the day the request for switch is
received. The Applicable NAV for the switch will be the NAV on the day
that the request for switch is received
What is an Account Statement?
An Account Statement is a non-transferable document that serves as
a record of transactions between the fund and the investor. It
contains details of the investor, the units allotted or redeemed and
the date of transaction. The Account Statement is issued every time
any transaction takes place.
Who is a Registrar?
A Registrar accepts and processes unitholders' applications,
carries out communications with them, resolves their grievances and
despatches Account Statements to them. In addition, the registrar also
receives and processes redemption, repurchase and switch requests. The
Registrar also maintains an updated and accurate register of
unitholders of the Fund and other records as required by SEBI
Regulations and the laws of India. An investor can get all the above
facilities at the Investor Service Centres of the Registrar.
Who is a custodian?
Custodian is the agency which will have the physical possession of
all the securities purchased by the mutual fund.
How do I track the performance of the Fund?
The NAVs are published in financial newspapers and also available
on the AMFI website on a daily basis.
Can the NAV of a debt fund fall?
A debt fund invests in fixed-income instruments, where safety of
capital and regular returns are assured. These include Commercial
Paper, Certificates of Deposit, debentures and bonds. While the rate
of interest on these instruments stays the same throughout their
tenure, their market value keeps changing, depending on how the
interest rates in the economy move.
A debt fund's NAV is the market value of its portfolio holdings at a
given point in time. As interest rates change, so do the market value
of fixed-income instruments - and hence, the NAV of a debt fund. Thus
it is a misnomer that the debt fund's NAV does not fall.
What is a Systematic Investment Plan?
This is an investment technique where you deposit a fixed, small
amount regularly into the mutual fund scheme (every month or quarter
as per your convenience) at the then prevailing NAV (Net Asset Value),
subject to applicable load.
What is a Systematic Withdrawal Plan?
The unitholder may set up a Systematic Withdrawal Plan on a
monthly, quarterly or semi-annual or annual basis to redeem a fixed
number of units.
Besides the NAV, are there any other parameters
which can be compared across different funds of the same category?
Besides Net Asset Value the following parameters should be considered
while comparing the funds :
AVERAGE RETURNS An investor should
look at the returns given by the fund over a period of time. Care
should be taken to see whether all dividends and bonuses have been
accounted for. The higher and more consistent the returns the better
is the fund.
VOLATILITY In addition to the
returns one should also look at the volatility of the returns given by
the fund. Volatility is essentially the fluctuation of the returns
about the mean return over a period of time. A fund giving consistent
returns is better than a fund whose returns fluctuate a lot.
CORPUS SIZE : A Large corpus is
generally considered good because large funds have lower costs, as
expenses are spread over large assets but at the same time a large
corpus has some inefficiencies too. A large corpus may become unwieldy
and thus difficult to manage.
PERFORMANCE VIS A VIS BENCHMARK OTHER SCHEMES
An investor should not only look at the returns given by the
scheme he has invested in but also compare it with benchmarks like BSE
Sensex, S & P Nifty, T-bill index etc depending on the asset class he
has invested in. For a true picture it is advised that the returns
should also be compared with the returns given by the other funds in
the same category.
Thus it is prudent to consider all the above-mentioned factors while
comparing funds and not rely on any one of them in isolation. This is
important because as of today there is no standard method for
evaluation of un-traded securities.
What is CDSC?
Contingent Deferred Sales Charge (CDSC) is a charge imposed on
unit holders exiting from the scheme within 4 years of entry. It is
intended to enable the AMC to recover expenses incurred for promotion
or propagation of the scheme.
Sometimes the selling expenses of the fund are not charged to the fund
directly but are recovered from the unit holders whenever they redeem
their units. This load is called a CDSC and is inversely proportional
to the period of unit holding.
What is the difference between contigent defered
sales load and an exit load?
Contingent Deferred Sales charge (CDSC) is a charge imposed when the
units of a fund are redeemed during the first few years of ownership.
Under the SEBI Regulations, a fund can charge CDSC to unit holders
exiting from the scheme within the first four years of entry.
Exit load is a fee an investor pays to a fund whenever he redeems
his/her units. As per SEBI regulations, the maximum exit load
applicable is 7%. There is a further stipulation by SEBI that the
entry load and exit load put together cannot exceed 7% of the sale
Does out performance of a benchmark index
always connote good performance?
No, it is not necessary that out performance of a benchmark index
always connotes good performance. The volatility does not permit the
investor to rely on one factor only. The index performance is volatile
and may be driven by a few scrips only, which may not be very
reflective. So it is better to keep other factors like risk adjusted
returns (volatility of returns) and NAV movement in mind while
deciding to invest in a fund.
Does higher return necessarily mean a better
Yes, on the face of it high return does connote good fund but
there is also some a risk taken by the scheme to achieve these
returns. Thus it is prudent to measure risk alsowhile considering
returns to rank a scheme. Today there are a lot of statistical tools
like Beta, Sharpe ratio, Alpha and Standard Deviation to measure this
risk. A risk adjusted return is the best measure to use while judging
a scheme. You can also refer to the ratings assigned by a reputed
What should one keep in mind while choosing a
good mutual fund?
Each individual has different financial goals, based on lifestyle,
financial independence and family commitments and level of incomes and
expenses and many other factors. Thus before investing your money you
need to analyze the following factors :
- Define the Investment objective
Your financial goals will vary, based on your age, lifestyle,
financial independence, family commitments and level of income and
expenses among many other factors. Therefore, the first step should
be to assess your needs. You can begin by defining the investment
objectives, which could be regular income, buying a home or finance
a wedding or educate your children or a combination of all these
needs. Also your risk appetite and cash flow requirements need to be
taken into account.
- Choose the right Mutual Fund
Once the investment objective is clear in your mind the next
step is choosing the right Mutual Fund scheme. Before choosing a
mutual fund the following factors need to be considered:
- NAV performance in the past track
record of performance in terms of returns over the last few years
in relation to appropriate yardsticks and other funds in the same
- Risk in terms of volatility of
- Services offered by the mutual
fund and how investor friendly it is.
- Transparency, which is reflected
in the quality and frequency of its communications.
Go for a
proper combination of schemes
Investing in just one Mutual Fund scheme may not meet all your
investment needs. You may consider investing in a combination of
schemes to achieve your specific goals.
What is meant by recurring sales expenses?
The Asset management Company may charge the fund a fee for
operating its schemes, like trustee fee, custodian fee, registrar fee,
transfer fee etc. This fee is called recurring expense and is
expressed as a percentage of the scheme's average net assets. The
recurring expenses are subject to certain limits as per the
regulations of SEBI.
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Debt Funds FAQs
What are Money Markets and money market
Money markets allow banks to manage their liquidity as well as provide
the Central Bank means to conduct monetary policy. Money markets are
markets for debt instruments with a maturity up to one year.
The most active part of the money market is the call money market
(i.e. market for overnight and term money between banks and
institutions) and the market for repo transactions. The former is in
the form of loans and the latter are sale and buyback agreements -
both are obviously not traded. The main traded instruments are
Commercial Papers (CPs), Certificates of Deposit (CDs) and Treasury
A Commercial Paper is a short term unsecured promissory note issued by
the raiser of debt to the investor. In India Corporates, Primary
Dealers (PD), Satellite Dealers (SD) and Financial Institutions (FIs)
can issue these notes.
It is generally companies with very good ratings which are active in
the CP market, though RBI permits a minimum credit rating of
Crisil-P2. The tenure of CPs can be anything between 15 days to one
year, though the most popular duration is 90 days. Companies use CPs
to save interest costs
Certificates of Deposit
These are issued by banks in denominations of Rs 5 lakhs and have
maturity ranging from 30 days to 3 years. Banks are allowed to issue
CDs with a maturity of less than one year while financial institutions
are allowed to issue CDs with a maturity of at least one year.
Treasury Bills are instruments issued by RBI at a discount to the face
value and form an integral part of the money market. In India Treasury
Bills are issued in four different maturities - 14 days, 90 days, 182
days and 364 days.
Apart from the above money market instruments, certain other
short-term instruments are also in vogue with investors. These include
short-term corporate debentures, bills of exchange and promissory
What are debt markets and debt market
Typically those instruments that have a maturity of more than a year
and the main types are -
What is the difference between bonds and
World over, a debenture is a debt security issued by a corporation
that is not secured by specific assets, but rather by the general
credit of the corporation. Stated assets secure a corporate bond,
unlike a debenture. But in India these are used interchangeably.
A bond is a promise in which the issuer agrees to pay a certain rate
of interest, usually as a percentage of the bond's face value to the
investor at specific periodicity over the life of the bond. Sometimes
interest is also paid in the form of issuing the instrument at a
discount to face value and subsequently redeeming it at par. Some
bonds do not pay a fixed rate of interest but pay interest that is a
mark-up on some benchmark rate.
Typically bonds are issued by PSUs, Public Financial Institutions and
Corporates. Another distinction is SLR (Statutory Liquidity Ratio) and
non-SLR bonds. SLR bonds are those bonds which are approved securities
by RBI which fall under the SLR limits of banks.
Statutory liquidity ratio(SLR): It is the percentage of total deposits
a bank has to keep in approved securities.
What affects bond prices?
Largely it will be the interest rates and credit quality of the
- Interest Rates : The price of
a debenture is inversely proportional to changes in interest rates
that in turn is dependent on various factors. When the interest
rates fall down, the existing bonds will become more valuable and
the prices will move up until the yields become the same as the new
bonds issued during the lower interest rate scenario(for a detailed
explanation see "what affects interest rates").
- Credit Quality : When the
credit quality of the issuer deteriorates, market expects higher
interest from the company and the price of the bond falls and vice
Another factor that determines the
sensitivity of a bond is the "Maturity Period" - a longer maturity
instrument will rise or fall more than a shorter maturity instrument.
What affects interest rates?
The factors are largely macro-economic in nature -
- Demand/Supply of money : When
economic growth is high, demand for money increases, pushing the
interest rates up and vice versa.
- Government Borrowing and Fiscal
Deficit : Since the government is the biggest borrower in the
debt market, the level of borrowing also determines the interest
On the other hand, supply of money is done by the Central Bank by
either printing more notes or through its Open Market Operations (OMO).
- RBI : RBI can change the key
rates (CRR, SLR and bank rates) depending on the state of the
economy or to combat inflation. RBI fixes the bank rate which forms
the basis of the structure of interest rates and the Cash Reserve
Ratio (CRR) and Statutory Liquidity Ratio (SLR), which determines
the availability of credit and the level of money supply in the
(CRR is the percentage of its total deposits a bank has to keep with
RBI in cash or near cash assets and SLR is the percentage of its
total deposits a bank has to keep in approved securities. The
purpose of CRR and SLR is to keep a bank liquid at any point of
time. When banks have to keep low CRR or SLR, it increases the money
available for credit in the system. This eases the pressure on
interest rates and interest rates move down. Also when money is
available and that too at lower interest rates, it is given on
credit to the industrial sector that pushes the economic growth)
- Inflation Rate : Typically a
higher inflation rate means higher interest rates. The interest
rates prevailing in an economy at any point of time are nominal
interest rates, i.e., real interest rates plus a premium for
expected inflation. Due to inflation, there is a decrease in
purchasing power of every rupee earned on account of interest in the
future; therefore the interest rates must include a premium for
expected inflation. In the long run, other things being equal,
interest rates rise one for one with rise in inflation.
What is Yield Curve?
The relationship between time and yield on securities is called
the Yield Curve. The relationship represents the time value of money -
showing that people would demand a positive rate of return on the
money they are willing to part today for a payback into the future.
A yield curve can be positive, neutral or flat.
- A positive yield curve, which is
most natural, is when the slope of the curve is positive, i.e. the
yield at the longer end is higher than that at the shorter end of
the time axis. This is as a result of people demanding higher
compensation for parting their money for a longer time into the
- A neutral yield curve is that which
has a zero slope, i.e. is flat across time. This occurs when people
are willing to accept more or less the same returns across
- The negative yield curve (also
called an inverted yield curve) is one of which the slope is
negative, i.e. the long-term yield is lower than the short-term
yield. It is not often that this happens and has important economic
ramifications when it does. It generally represents an impending
downturn in the economy, where people are anticipating lower
interest rates in the future.
What is Yield to Maturity (YTM)?
Simply put, the annualised return an investor would get by holding
a fixed income instrument until maturity. It is the composite rate of
return of all payouts and coupon.
What is Average Maturity Period?
It is a weighted average of the maturities of all the instruments
in a portfolio.
What are LIBOR and MIBOR?
LIBOR : Stands for London Inter Bank
Offered rate. This is a very popular benchmark and is issued for US
Dollar, GB Pound, Euro, Swiss Franc, Canadian Dollar and the Japanese
Yen. The British Bankers Association (BBA) asks 16 banks to contribute
the LIBOR for each maturity and for each currency. The BBA weeds out
the best four and the worst four, calculates the average of the
remaining eight and the value is published as LIBOR.
MIBOR : Stands for Mumbai Inter
Bank Offered Rate and is closely modeled on the LIBOR. Currently there
are two calculating agents for the benchmark - Reuters and the
National Stock Exchange (NSE). The NSE MIBOR benchmark is the more
popular of the two and is based on rates polled by NSE from a
representative panel of 31 banks/institutions/primary dealers
What is a credit rating ?
Credit Rating is an exercise conducted by a rating organisation to
evaluate the credit worthiness of the issuer with respect to the
instrument being issued or a general ability to pay back debt over the
specified period of time. The rating is given as an alphanumeric code
that represents a graded structure or creditworthiness. Typically the
highest credit rating is that of AAA and the lowest being D (for
default). Within the same alphabet class, the rating agency might have
different grades like A, AA and AAA and within the same grade AA+, AA-
where the "+" denotes better than AA and "-" indicates the opposite.
For short term instruments of less than a year maturity, the rating
symbol would be typically "P" (varies depending on the rating agency).
In India, currently we have four rating agencies
What is the "SO" in a rating ? [AAA(SO)]
Sometimes, debt instruments are so structured that in case the
issuer is unable to meet repayment obligations, another entity steps
in to fulfill these obligations. A bond backed by the guarantee of the
Government of India may be rated AAA (SO) with the SO standing for
How is a currency valued?
The floating exchange rate system is a confluence of various demand
and supply factors prevalent in an economy like -
- Current account balance : The
trade balance is the difference between the value of exports and
imports. If India is exporting more than it is importing, it would
have a positive trade balance with USA, leading to a higher demand
for the home currency. As a result the demand will translate into
appreciation of the currency and vice versa.
- Inflation rate :
Theoretically, the rate of change in exchange rate is equal to the
difference in inflation rates prevailing in the 2 countries. So,
whenever, inflation in one country increases relative to the other
country, its currency falls down.
- Interest rates : The funds
will flow to that economy where the interest rates are higher
resulting in more demand for that currency
- Speculation : Another
important factor is the speculative and arbitrage activities of big
players in the forex market which determines the direction of a
currency. In the event of global turmoil, investors flock towards
perceived safe haven currencies like US dollar resulting in a demand
for that currency.
What are the implications of currency
fluctuations on debt markets?
Depreciation of a currency affects an economy in two ways, which
are in a way counter to each other. On the one hand, it makes the
exports of a country more competitive, thereby leading to an increase
in exports. On the other hand, it decreases the value of a currency
relative to other currencies, and hence imports like oil become dearer
resulting in an increase of deficit.
What does one mean by a currency being over
valued? What is Real Effective Exchange Rate (REER)?
When RBI says that the rupee is overvalued, they mean that it has
been appreciating against other major currencies due to their
weakening against dollar which might impact the competitiveness of
REER is the change in the external value of the currency in relation
to its main trading partners. It is Rupee's value on a trade-weighted
basis. It takes into account the Rupee's value not only in terms of
dollar but also Euro, Yen and Pound Sterling.
The exchange rates versus other major currencies are average weighted
by the value of India's trade with the respective countries and are
then converted into a single index using a base period which is called
the nominal effective exchange rate. But the relative competitiveness
of Indian goods increases even when the nominal effective exchange
rate remains unchanged when the rate of price increases of the trading
partner surpasses that of India's. Taking this into account, prices
are adjusted for the nominal effective exchange rate and this rate is
called the "Real Effective Exchange Rate."
- What are equity assets ?
- How does an investor in equities
- Why do stock prices move up and
- What are main approaches used for
analyzing stocks and forecasting future movements?
- What are equity markets?
- What are bonus issues and stock
splits? What is their impact?
- What are ADRs and GDRs? What is
- What are derivatives?
- What are the derivative products
that are currently allowed in India?
- What are index futures?
- What are Options?
equity assets ?
Corporate can raise money in two ways; by either borrowing (debt
instruments) or issuing stocks (equity instruments) that represent
ownership and a share of residual profits. The equity instruments are
in turn typically of two types - common stock and preferred stocks.
Common stock (or a share) : This
represents an ownership position and provides voting rights.
Preferred stock : It is a "hybrid"
instrument since it has features of both common stock and bonds.
Preferred-stock holders get paid dividends which are stated in either
percentage-of-par (the value at which the stock is issued) or rupee
terms. If the preferred stock had a Rs.100 par value, then a Rs.6
preferred stock would mean that a Rs. 6 per share per annum in
dividends will be paid out. This fixed dividend gives a bond-like
characteristic to the preferred stock.
How does an investor in equities make money?
Investors get returns on their investments in two ways - dividend
and capital gains. The former depends on earning levels of the
particular company and the decision of its management. The latter
arises happens when the market price of the shares rises above the
level at which the investment was made. Say, you invested Rs.10,000 by
buying 100 shares of X company at a price of Rs.50 and sold all the
100 shares later at a price of Rs.100, you would have made a capital
gain of Rs.5000.
Sale value of Shares
(Rs.100 x 100)
Value of original
investment (Rs.50 x 100)
Capital gain Rs.
Why do stock prices move up and down?
The market price of a particular share is dependent on the
demand/supply for that particular scrip. If the players in the market
feel that a particular company has a track record of good performance
or has the potential to do well in the future, the demand for the
shares of the company increases and players are willing to pay higher
prices to buy the share. And since the number of shares issued by the
company is constant at a given point in time, any increase in demand
would only increase the market price.
Fluctuations in a stock's price occur partly because companies make or
lose money. But that is not the only reason. There are many other
factors not directly related to the company or its sector. Interest
rates, for instance. When interest rates on deposits or bonds are
high, stock prices generally go down. In such a situation, investors
can make a decent amount of money by keeping their money in banks or
Money supply may also affect stock prices. If there is more money
floating around, some of it may flow into stocks, pushing up their
prices. Other factors that cause price fluctuations are the time of
year and public sentiments. Some stocks are seasonal, i.e cyclical
stocks; they do well only during certain parts of the year and worse
during other parts. Publicity also affects stock prices. If a
newspaper story reports that Xee Television has bought a stake in Moon
Television, odds are that the price of Xee's stock will rise if the
market thinks its a good decision. Otherwise it will fall. The price
of Moon Television stocks may also go up because investors may feel
that it is now in better hands. Thus, many factors affect the price of
What are main approaches used for analyzing
stocks and forecasting future movements?
The behaviour of the price movement of a stock is said to predict
its future movement. One such approach is called technical analysis
and is based on the historical movements of the individual stocks as
well as the indices. Their belief is that by plotting the price
movements over time, they can discern certain patterns which will help
them to predict the future price movements of the stocks. On the other
hand we have "fundamental analysis", where the forecasting is done on
the basis of economic, industry and company data. Technical analysis
is used more as a supplement to fundamental analysis rather than in
What are equity markets?
These are markets for financial assets that have long or
indefinite maturity i.e, stocks. Typically such markets have two
segments - primary and secondary markets. New issues are made in the
primary market and outstanding issues are traded in the secondary
market (i.e., the various stock exchanges)
There are three ways a company can raise capital in the primary market
- Public Issue : Sale of fresh
securities to the public
- Rights Issue : This is a
method of raising capital existing shareholders by offering
additional securities to them on a pre-emptive basis.
- Private Placement : Issuers
make direct sales to investor groups i.e., there is no public issue.
What are bonus issues and stock splits? What
is their impact?
Bonus Issues : Instead of cash
dividends, investors receive dividends in the form of a stock. The
investor receives more shares when a bonus issue is announced. For
example, when there is a bonus issue in the ratio of 1:1, the number
of shares owned by an investor would double in number. However, the
market price of the share would decrease as well at times the decrease
might not be proportionate to the extent of bonus because market
players might push the price up if they view the bonus issue as a
positive development. Some companies might announce bonus issues to
bring the market price of its share to a more popular range and also
promote active trading by increasing the number of outstanding shares.
Stock Splits : Whenever a stock
split occurs, the company ends up with more outstanding shares which
will not only have a lower market price but also lower par value.
Stock splits are prompted when the company thinks its stock price has
risen to a level that is out of the "popular trading range".
For example, X corporation has 1 million
outstanding shares. The par value is Rs.10 and the current market
price is Rs.1000 per share. If the management feels this price is
resulting in a decrease in trading volumes, they can declare a 1-for-1
split. By doing this, there will be 2 million outstanding shares with
a par value of Rs.5 and a theoretical market price of Rs.500 per
share. Sometimes when the market price is very low, the company might
announce a "reverse split" which has the opposite effect of the normal
In the case of splits, there is no change in the reserves and surplus
of the company unlike the bonus issue.
What are ADRs and GDRs?
American Depositary Receipt (ADR): A
security issued by a company outside the U.S. which physically remains
in the country of issue, usually in the custody of a bank, but is
traded on U.S. stock exchanges. ADRs are issued to offer investment
routes that avoid the expensive and cumbersome laws that apply
sometimes to non-citizens buying shares on local exchanges. The first
ADR was issued in 1927. ADRs are listed on the NYSE, AMEX, or NASDAQ.
Global Depository Receipt (GDR) : Similar
to the ADR described above, except the GDR is usually listed on
exchanges outside the U.S., such as Luxembourg or London. Dividends
are usually paid in U.S. dollars. The first GDR was issued in 1990.
They are shares without voting rights. The ratio of one depository
receipt to the number of shares is fixed per scrip but the quoted
prices may not have strict correlation with the ratio. Any foreigner
may purchase these securities whereas shares in India can be purchased
on Indian Stock Exchanges only by NRIs or PIOs or FIIs. The purchaser
has a theoretical right to exchange the receipt without voting rights
for the shares with voting rights (RBI permission required) but in
practice, no one appears to be interested in exercising this right.
What is margin trading?
Securities can be paid for in cash or a mix of cash and some
borrowed funds. Buying with borrowed funds permits the investors to
buy a security at a good price at a good time. This act of borrowing
money from a bank or a broker to execute a securities transaction is
referred to as using "margin". As of now in India, only brokers are
allowed to provide the margins. Traders can put up part of the
payment. Brokers borrow the remaining funds from a moneylender with
whom they would lodge the shares as collateral for the loan. The
safety of this mechanism rests on the risk management capabilities of
both the stockbroker and the lender.
However, recently SEBI has proposed to RBI that banks could lend to
exchanges on margin trading and the exchanges could provide assistance
to brokers. When this happens, the volumes should increase in the
markets making them more vibrant.
What are derivatives?
s A derivative is an instrument whose value is derived from the
value of one or more underlying security, which can be commodities,
precious metals, currency, bonds, stocks, stocks indices, etc. Four
most common examples of derivative instruments are Forwards, Futures,
Options and Swaps.
What are the derivative products that are
currently allowed in India?
The index futures were introduced in June 2000. One year later,
index options and stock options were introduced as SEBI banned the
age-old badla system (which was a combination of both forward and
What are index futures?
In a forward contract, two parties irrevocably agree to settle a
trade at a future date, for a stated price and quantity. No money
changes hands at the time the trade is agreed upon.
Currently in India, index futures are allowed. These are nothing but
future contracts with the underlying security being the cash market
Index futures of different maturities would trade simultaneously on
the exchanges. For instance, BSE may introduce three contracts on BSE
sensitive index for one, two and three months maturities. These
contracts of different maturities may be called near month (one
month), middle month (two months) and far month (three months)
contracts. The month in which a contract will expiry is called the
contract month. For example, contract month of "Nov. 2001 contract"
will be November, 2001.
All these contracts will expire on a specific day of the month (expiry
day for the contract) say on last Wednesday or Thursday or any other
day of the month; this would be defined in the contract specification
before introduction of trading.
What are Options?
Options give a buyer the right to buy a scrip and the seller the
right to sell a scrip at a pre-determined price on a particular date.
Unlike futures contract, there is no obligation only a "right" There
are two types of Options:
- Call Option : Here, the buyer
decides to buy a scrip at a particular price on a particular date.
For e.g the buyer takes a call Option on RIL @Rs.150 after 3 months.
For this, he pays a premium which is determined by the demand-supply
equation. For e.g, if a particular stock is in favour with
investors, there would be more people willing to buy the stock at a
future date, resulting in a higher premium. In this example, let us
assume the premium is Rs.10.
- Put Option : This is used to
manage downside risk. A seller today agrees to sell TISCO @Rs.130
after 3 months and pays the required premium. If the price of TISCO
is in excess of Rs.130, he decides not to sell and loses the premium
(which is the profit of the Option Writer). However, if the price is
below Rs.130, he "calls" his right and cushions his loss.
The Option Buyer has the right to
exercise his choice of buying or selling in the Call and Put Option
respectively. The Option Writer or Seller has to meet his commitment
based on the choice exercised by the Option Buyer.
Options have finite maturities. The expiry date of the Option is the
last day (which is pre-determined) when the owner can exercise his
What are the main differences between options
- With futures, both parties are
obligated to perform. With options only the seller (writer) is
obligated to perform.
- With options, the buyer pays the
seller (writer) a premium. With futures, no premium is paid by
- With futures, the holder of the
contract is exposed to the entire spectrum of downside risk and has
the potential for all the upside return. With options, the buyer
limits the downside risk to the option premium but retains the
- The parties to a futures contract
must perform at the settlement date. They are not obligated to
perform before that date. The buyer of an options contract can
exercise any time prior to the expiration date.