Finance interview notes Index

Investment Risk in investment Rules of successful global investors Regulators

Venture capital Method of venture financing

Core and satellite investing Stock exchange Types of equities SEBI Market participants Types of market

Primary and secondary market Money market Debt market

Security identifiers Participants in trade flow

Depository in US US trade cycle

Stock market indicators NSE

Segments of capital market Applications

Front end applications

Back end applications Primary market

American depository receipts (ADR) Indian depository receipts (IDR)

Secondary market Difference between trader and investor Difference between bank and depository Indices custodian

mutual funds advantages and disadvantages risks in mutual funds types of mutual funds NAV Entry load & exit load

Corporate actions Types of corporate actions Dates

How to go about systematically analyzing a company Dematerialization

Market phases Basket trading / index trading Orders

Types of orders Trading rules Transaction cycle Settlement process

Risk in settlement Rolling settlement Risk management

Methodology for index construction Price weighted index market capitalization weighted index Free float market capitalization weighted index

Debt market instruments Accrual basis Interest calculation methods Credit rating of bonds Participants in debt market

MBS Types of MBS issuers Features of MBS

Money market Money market instruments Repo and reverse repo Interest rate derivative Zero coupon yield curve

Derivative market Participants

Hedgers

Speculators

Arbitragers Types of derivatives

Forwards

Futures

Options Types of margin Companies act 1956 Types of risk

Systematic risk Unsystematic risk

Measurement of a risk of a single asset Capital asset pricing model (CAPM) Global investing and foreign exchange Security lending Money laundering factoring

Global financial system – International institutions –

IMF – keeps account of international balance of payments accounts of member states. IMF acts as lender of last resort for members in financial distress.

E.g – currency crisis, Problems meeting balance of payment when in deficit and debt default. Membership is based on quotas, or the amount of money country provides to the fund relative to the size of its role in the international trading system

World Bank – aims to provide funding take up credit risk or offer favorable terms to development projects mostly in developing countries that couldn’t be obtained by the private sector. The other multilateral development banks & other international financial institutions also play specific regional or functional role.

WTO – settles trade disputes and negotiates international trade agreements in its round of talks (currently the Doha Round)

Also important is the bank for international settlements, the intergovernmental organization for central banks worldwide.

It has two subsidiary bodies that are important actors in the global financial system in their own right – the Basel committee on banking supervision, and the financial stability board.

In private sector, an important organization is the Institute of International Finance, which includes most of the world’s largest commercial banks & investment banks.

Government institutions – Government acts in various ways as actors in GFS, primarily through their finance ministries: they pass the laws and regulations for financial markets, and set the tax burden for private players. E.g – Banks, Funds and Exchanges.

They also participate actively through discretionary spending. They are closely tied (in mostly countries independent of) to central banks that issue government debt, set interest rates and deposit requirements, and intervene in foreign exchange market. Private participants – Players active in the stock, bond, foreign exchange, derivatives, commodity markets and investment banking including –

*Commercial banks *Hedge funds and private equity *pension funds *insurance companies *mutual funds *Sovereign wealth funds

Regional institutions -

*commonwealth of independent states (CIS) *Euro zone *Mercosur *North American Free Trade Agreement (NAFTA)

Investment – Money that you earn is partly spent and rest saved for meeting future expenses. Instead of keeping saving idle

you would like to receive returns on it, it's called investment. It refers to commitment of funds to one or more assets that will be held over some future period.

It is postponing/forego of current consumption. It is tradeoff between risk & return. We invest in response to rate of return which must be suitably adjusted for inflation & risk.

Rate if interest/return on investment must be at least enough to meet cost of inflation.

Investing is the act of seeking value at least sufficient to justify the amount paid. -Benjamin Graham (Father of value investing) Investing is dynamic exercise that requires review and modification both for a given situation & for the

performance of the holding. Normal investment – Generally for returns from investment Strategic investment – for some specific purpose in mind like to take control over Financial planning is the process of meeting of your life goals through the proper management of your finances. Diversification & gradual investment have been the corner stone’s of financial planning.

Difference between yield and return – Because investors are very concerned with how well their investments are performing or how they are

expected to perform, knowing how to gauge such performance is essential. This makes understanding the difference between yield and return important. While both terms are often used to describe the performance of an investment, yield and return are not one and the same thing. Knowing what each measure takes into account and recognizing that each considers different time periods is key. Return, also referred to as "total return", expresses what an investor has actually earned on an investment during a certain time period in the past. It includes interest, dividends and capital gain (such as an increase in the share price). In other words, return is retrospective, or backward-looking. It describes what an investment has concretely earned. Returns are always year to date Yield, on the other hand, is prospective, or forward-looking. Furthermore, it measures the income, such as interest and dividends, that an investment earns and ignores capital gains. This income is taken in the context of a certain time period and then annualized, with the assumption that the interest or dividends will continue to be received at the same rate. Yield is often used to measure bond or debt performance; in most cases, total return will not be the same as the quoted yield due to fluctuations in price

Rule of global successful global investment management firms – 1. Do not loose shareholders/clients money. 2. Do not forget rule no. 1

Why should one invest – 1. Earn return on idle resources 2. Generate specified sum of money for meeting for specific goal in life 3. Make provision for uncertain future

When to start investing – 1. Invest early 2. Invest regularly 3. Invest for long term not short term

Before investing there is need to analysis o Economy o Industry o Company

Top down approach – EIC Model Bottom up approach – from company fundamentals to industry & then to economy

Risk in investments – Risk in investment – probability that actual return on an investment will e different from its expected return.

o Systematic risk – cant be minimized

o Unsystematic risk – can be minimized through diversification However diversification does not reduce risk in the overall portfolio completely. Diversification reduces unsystematic risk

What makes stock riskier – o Inconsistent revenue / order inflows o Fluctuating sells o Volatility in material cost o High interest for debt o Fraudulent practices

Every stock price moves for two reasons – o News about company – micro economic factors o News about economy – macro economic factors

Fundamental analysis provides the investor a real benchmark in terms of intrinsic value. If the economic outlook suggests purchase at the time, the industry analysis will aid the investor in selecting the proper industry in which to invest.

Real test of analyst's competence lies in his ability to see not only the forest but also the trees.

Investment analyst also aims at measuring "upside" potential and downside "danger". In investment parlance this is known as investment risk.

Portfolio analysis builds on the estimates of future return & risk of holding various combinations of assets.

Why do lenders expect high returns for risky funding….? Because they want to cover capital employed as soon as possible, because company future is not known (company is expected to do business for 5 years, what if…..it defaulted on 3rd year)

Technical analysis – it is a method of evaluating securities by analyzing the statistics generated by market activity such as

past prices, volume. Technical analysis does not attempt to measure a securities intrinsic value but instead use charts & other tools to identify patterns that can suggest future activity. It attempts to explain & forecast changes in security prices by studying the market data rather than a company.

Efficient market – Efficient capital market is the one in which security prices adjust rapidly to the arrival of new

information & therefore current prices of security reflect all information about the security. Speed with which stock market incorporates the information about the economy, industry and

company.

Where to invest – shares, government securities, derivative products, units of mutual funds etc.

Options for investment – physical and financial asset.

Short term financial options – Saving account, money market funds and fixed deposits.

Long term financial options – Post office saving, public provident fund, company fixed deposits, bonds, mutual funds

Regulators – responsibility to regulate capital market lies with department of economic affairs (DEA), department of company affairs (DCA), RBI, and SEBI.

Assets under custody and management –

Assets under custody and administration – - Financial properties managed by financial institutions or banks on behalf of clients - Assets owned by clients and also investment decisions taken by clients - Services offered include custodial and tax related duties.

Assets under management – - Assets actively managed by fund managers & portfolio managers on behalf of investors

Venture capital –

Venture capital refers to the commitment of capital as share holding for the formulation and setting up of small firms specializing in new ideas or new technologies. It finances high technology projects which involves high risk.

Venture capital pools their resources including managerial abilities. Once the project reaches the stage of profitability, they sell their equity holding at high premium.

Methods of venture financing – o Equity participation – venture capital firms can participate in equity through direct purchase of shares but

their holding can’t exceed 49%. Later shares are sold to promoter with negotiated price under buyback agreement or to the public in secondary market at profit.

o Conventional loan – lower fixed rate of interest is charged until project becomes commercially operational then after loan carries normal/higher rate of interest.

o Conditional loan – interest free loan is provided during implementation period but has to pay royalty on sales

o Income notes – it is combination of conventional & conditional loan. Both interest and royalty are payable at much lower rates than conditional loans.

Core & satellite investing – This refers to strategic asset allocation is implemented utilizing core & satellite investment strategy.

This strategy employs broad based index linked funds as the core of an investor's portfolio with other more specialized investment options representing the satellite. According to this 70-80 % of the allocation should be in core funds (large & large mid-cap funds), remaining in satellite funds (mid & small cap funds)(multicap & sectorial funds) This investment will allow the absorption of shocks & may have potential to earn high returns over various market cycles.

Subprime lending – (Near prime, non prime, Second chance lending) It means making loans to people who may have difficulty in maintaining the repayment schedule. Proponents of subprime lending maintain that practice extends credit to people who would otherwise not have access to the credit market.

Subprime risk –

As people become economically active, records are created relating to their borrowing, earning and lending history. This is called credit rating. And though covered by privacy laws the information is readily available to people with a need to know (in some countries, loan applications specifically allow the lender to access such record)

Subprime borrowers have credit rating that might include – *Limited debt experience (So the lender’s assessor simply doesn’t know & assumes the worst) or *No possession of property assets that could be used as security (for the lender to sell in case of default) *excessive debt (the known income of the individual or family is unlikely to be enough to pay living expenses + interest + repayment) *a history of late or sometimes missed payments (morose debt) so that the loan period had to be extended * failure to pay debt completely (Default debt) * Any legal judgments such as “orders to pay” or bankruptcy (In Britain known as county Court Judgements or CCJs)

Lenders Standards for determining risk categories may also consider size of the proposed loan & also take into account the way the loan and the repayment plan is structured , if it is a conventional repayment loan a mortgage loan, an endowment mortgage interest only loan, standard repayment loan, amortized loan, credit card limit or some other arrangement. The originator is also taken into consideration. Because of this it was possible for a loan to a borrower with “prime” characteristics (e.g – high credit score, low debt) to be classified as subprime.

Industry – It is a group of homogenous companies.

Stock exchange – Any body of individual's whether incorporated or not, constituted for purpose of assisting, regulating or controlling

the business of buying, selling or dealing in securities. It is a place where buying and selling of securities takes place. Provides trading facility. (Shares, bonds & pooled investment products)

NYSE – New York stock exchange (oldest and largest in us), called big board (1792) Requires I million publicly held shares for listing (value at least 10 million dollar) Require total market value – 16 million $ 2000 holders of 100 shares or more AMEX - American stock exchange (1921) Securities of small & medium sized companies. till 1952 known as new York curb exchange because it was open air ,market NASDAQ – National association of securities dealers automated quotation system.

Computerized communication system serves dual function of providing security information to members & acting as a exchange Rank 3rd in trading volume (NYSE, Tokyo Exchange, NASDAQ) Contains all blue chip companies. (SATYAM was the first INDIAN company to list as well as to delist from NYSE exchange)

In India BSE & NSE are two major exchanges nationwide, others are regional exchanges

Introduction –

Equity/share – Proportionate share in the company’s profit / loss Equity/stock signifies ownership in a corporation

Fungible asset / security – have to give back the same security in terms of quantity after paying liability Non fungible asset / security – same or identical can be returned as liability

Securities – (Equity, debt, derivative) Financial instruments such as shares, bonds, scrip's, stocks and other marketable securities of similar

nature which carries financial value. Issued for raising funds.

Types of equities – common & preferred

COMMON PREFERRED Voting rights no voting rights

Dividend rights first to receive dividends on quarterly basis @ predetermined rates

Subscription rights first to receive Dissolution rights first to receive

For preferred stock holders dividends are advantageous if profits are low, & disadvantageous if

profits are high

Common stock – is a class of a capital stock that represents ownership in a corporation voting rights in case of - election

of BOD, hiring independent auditors Capital stock –

The stock authorized by a company’s charter, can be issued in categories or classes like common or preferred Subscription rights –

Allows common stock holder to buy additional share of stock before new investors, also called preemptive right for additional distribution of shares

Outstanding shares –

Stocks that are currently owned by stockholders Categories of common stock –

o Authorized – corporation has legal authority to sell o Issued & outstanding – issued and owned by stock holders o Unissued – authorized for sell but not yet been purchased o Treasury stock – originally authorized, purchased by stock holders, and now bought back by the

corporation

In Equity security money is owned by company by sharing proportionate ownership / profit or loss, but it is exactly opposite of debt investment where money is loaned to a company in a negotiated lending arrangement.

Debt instrument – Represents contracts where one party lends money to another on predetermined terms with regards

to rate, periodicity of interest and repayment of principal amount. Debt – amount of money borrowed by one party from another. A debt arrangement gives borrowing party permission to borrow money under the condition that is to be paid back at a later date, usually with interest.

Corporate bonds Money market instruments (CD, Bill of exchange, commercial paper)

Commercial paper – represents post dated cheques with maturity not more than 270 days Euro debt securities Govt. bonds Sub soverian govt. bonds Suprational bonds- WORLD BANK, IMF

Hybrid Security – Preference shares – safer than equities but riskier than debt Convertible bonds – if it is a convertible bond, holder gets one month to get it converted, if not

converted company will pay the holder the price which is lower than the converted stock. So the holder will unwillingly convert it. This is called forced conversion.

Equity warrants – allows to purchase a specific no of shares at a specified price within a specified time. Like other convertible securities increases no. of shares outstanding & accounted in financial reports as fully diluted earnings per share.

Derivative – Have no value of their own, is a product whose value is derived from one or more basic variables called

underlying. Underlying could be equity, index, foreign exchange, commodity or any other asset.

Interest – Charge for privilege of borrowing money typically expressed as annual percentage rate.

Calculated using two methods, simple interest / compound interest calculation. It can be a cost or a income, two types of interest,

o Interest on a bond – it is a cost to a company but is a income for a shareholder. o Interest on a loan – it is a cost to a borrower but is a income to the lender.

Accrued interest – interest has been recognized either payable or receivable but not yet paid or received.

On bond interest accrues from one day after settlement date to maturity period or next settlement date. Interest is paid on coupon dates i.e. one day after settlement date.

Ammortized income – Capital appriciation

Capital market regulator - SEBI For Indian capital market SEBI acts as a watchdog. The securities market has essentially three categories of

participants, namely the issuers of securities, investors in securities and the intermediaries. The issuers and investors are the consumers of services rendered by the intermediaries while the investors are consumers (they subscribe for and trade in securities) of securities issued by issuers.

To ensure effective regulation of the market, SEBI Act, 1992 was enacted to establish SEBI with statutory powers for:

(a) Protecting the interests of investors in securities, (b) Promoting the development of the securities market, and (c) Regulating the securities market.

SEBI consists of the following members, namely:- (a) A Chairman (b) Two members from amongst the officials of the Ministry of the Central Government dealing with Finance and administration of Companies Act, 1956; (c) One member from amongst the officials of the Reserve Bank of India; (d) five other members of whom at least three shall be whole time members to be appointed by the Central Government.

To enhance the effectiveness of SEBI as the capital market regulator rolling settlement on T+5 basis was

introduced in respect of most active 251 securities from July 2, 2001 and in respect of balance securities from 31st December 2001. Rolling settlement on T+3 basis commenced for all listed securities from April 1, 2002 and subsequently on T+2 basis from April 1, 2003.

The derivatives trading on the NSE commenced with the S&P CNX Nifty Index Futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001.

The Indian stock market regulator, Securities & Exchange Board of India (SEBI) allowed the direct market access (DMA) facility to investors in India on April 3, 2008. To begin with DMA was extended to the institutional investors. In addition to the DMA facility, SEBI also decided to permit all classes of investors to short sell and the facility for securities lending and borrowing scheme was operationalized on April 21, 2008.

Savings are linked to investments by a variety of intermediaries through a range of complex financial products called “securities” which is defined in the Securities Contracts (Regulation) Act, 1956.

Security litigation – Litigation is the process of taking a case through court. The litigation or legal process is most common

in civil lawsuits. In litigation, there is a plaintiff (one who brings the charge) and a defendant (one against whom the charge is brought).

To litigate is to file a charge against someone and bring a case to court. The alternative to litigation in business cases is arbitration.

Examples: The company chose to go through the litigation process, charging its competitor with stealing its

trademark. Arbitration-

Some securities disputes arise in the context of a stock broker/client relationship. In most circumstances, a customer will enter into an agreement to arbitrate any disputes that arise between him and his broker in connection with his brokerage account. For example, a dispute may arise when a broker is involved with the solicitation or sale of an unregistered security which leads to a loss of the customer’s investment. Often the brokerage agreements specify that such disputes will be resolved before FINRA dispute resolution.

Arbitration can differ drastically than litigation in state and federal courts for securities attorney.

Market participants – Securities Appellate Tribunal

Regulators Depositories Stock Exchanges Brokers Corporate Brokers Sub-brokers FIIs Portfolio Managers Custodians Primary Dealers Merchant Bankers Bankers to an Issue Debenture Trustees Underwriters Venture Capital Funds Foreign Venture Capital Investors Mutual Funds Collective Investment Schemes * DCA, DEA, RBI & SEBI The securities market, thus, has essentially three categories of participants, namely the issuers of securities,

investors in securities and the intermediaries. The issuers and investors are the consumers of services rendered by the intermediaries while the investors are consumers (they subscribe for and trade in securities) of securities issued by issuers.

Markets – primary, secondary, capital market, money market Primary & secondary market-

The securities market has two interdependent and inseparable segments, the new issues (primary market) and the stock (secondary) market.

The primary market provides the channel for sale of new securities. Primary market provides opportunity to issuers of securities; government as well as corporates, to raise resources to meet their requirements of investment and/or discharge some obligation. They may issue the securities at face value, or at a discount/premium and these securities may take a variety of forms such as equity, debt etc. They may issue the securities in domestic market and/or international market.

The primary market issuance is done either through public issues or private placement. A public issue does not limit any entity in investing while in private placement, the issuance is done to select people. In terms of the Companies Act, 1956, an issue becomes public if it results in allotment to more than 50 persons. This means an issue resulting in allotment to less than 50 persons is private placement.

There are two major types of issuers who issue securities. The corporate entities issue mainly debt and equity instruments (shares, debentures, etc.), while the governments (central and state governments) issue debt securities (dated securities, treasury bills).

Secondary market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondary market. Secondary market comprises of equity markets and the debt markets.

The secondary market enables participants who hold securities to adjust their holdings in response to changes in their assessment of risk and return. They also sell securities for cash to meet their liquidity needs.

The secondary market has further two components, namely the over-the-counter (OTC) market and the exchange-traded market.

OTC markets are essentially informal markets where trades are negotiated. Most of the trades in government securities are in the OTC market. Closest to spot market is the cash market where settlement takes place after some time. Trades executed on the National Stock Exchange of India Limited (NSE) are cleared and settled by a clearing corporation which provides settlement guarantee.

A variant of secondary market is the forward market, where securities are traded for future delivery and payment. The versions of forward in formal market are futures and options.

In case of options, securities are traded for conditional future delivery. There are two types of options–a put option permits the owner to sell a security to the writer of options at a predetermined price while a call option permits the owner to purchase a security from the writer of the option at a predetermined price.

Capital market – long term debt and equity security securities, (Equities, corporate bonds, treasury bonds & notes, MBS, zero coupon bonds, municipal bonds)

Money market – Includes short term instrument – promissory notes, (Bill of exchange, commercial paper, banker’s acceptance, treasury bills & dealer paper – issued by corporations & governments)

Grey Market – Gray / Grey market is the trade of commodity through distribution channels which is legal but

unofficial, unauthorized by the original manufacturer. In contrast black market is the trade of goods and services that are illegal & are distributed through illegal channels, such as selling of stolen goods, certain drugs or unregistered handguns. Unlike black market goods, grey market goods are not usually illegal; instead they are sold outside normal distribution channels by companies which may have no relationship with the producer of the goods.

Two main types of grey market are imported manufactured goods that would normally be unavailable or more expensive & unissued securities that are not yet traded in official markets. Because of the nature of the grey markets, it is difficult or impossible to track the precise number of grey-market sales. Grey market goods are often new, but some grey market goods are used goods. A market in used goods is sometimes nicknamed as green market.

Sometimes term dark market is used to describe secretive, unregulated (though often technically legal) trading in commodity futures, notably crude oil in 2008. This can be considered as third type of grey market.

IPO in India – Cities like Ahmadabad, Kolkata & Rajkot are the most active centers for the IPO grey market. Peoples

can sell their IPO applications to the grey market operators for a secured interest. Many investors look at Ahmadabad’s grey market premium rates as an indicator of the price at which the issue is likely to get listed.

SECURITY IDENTIFIERS – CUSIP – Committee on Uniform Security Identification Procedure (For US & Canadian securities, 9 digit alpha numeric code) SEDOL – Stock Exchange Daily Official List Issued & traded in UK only (7 digit alpha numeric code) ISIN – International Security Identification Number (Universal Identifier, 12 digit alpha numeric code) CINS – 9 digits number, starts with letter A (north American)

Security industry in US – SEC (security exchange commission) Participants in trade flow – IM, Broker, Depository, Custodian

IM initiates the trade, Broker implements the trade & custodian facilitates the trade

Depository – organization which holds securities in electronic form through a registered depository

participant. It is the person or institution taking responsibility for the deposit, rather than the place itself. Custodian – financial institution that has legal responsibility for safeguarding firms or individuals

financial assets Custodian bank - institution that keeps custody of assets. Sub custodian – it is a agent bank or a subsidiary hired by a custodian to provide services within the

local market on the behalf of custody. Usually it is one for each country. Between issuer and investor there may be one or more intermediaries.

Investor – Custodian – Depository - Issuer Usually for each market/ type of security there is only one depository. Depository is a sort of official entity.

In US, DTC depository for corporate securities and FED is depository for govt. securities. But there can be many custodians (State Street, BNY Mellon, BBH, BofA etc.) which compete.

Securities in the depository generally stay there; they are immobilized or dematerialized or both. When ownership changes depository will update its records to reduce one participants holding and increase another participants holdings. But depository’s total balance won’t change. On the other hand you can instruct you can instruct your custodian to deliver shares out of your account to another custodian or broker. Your custodians total holdings will decrease in this case.

Depositories in US (settlement locations)-

DTC –Depository Trust & Company (central securities depository for corporate stocks & bonds) FED –

Federal Reserve Bank (US treasury & MBS securities)(for govt securities) 12 banks make up federal reserve system Role of each bank is to monitor the commercial & saving banks in its region Also act depository for banks in their region & provide money transfers & other

services o NYC – New York Vault ( vault for physical securities)

Depositories in India – There are 2 depositaries and approximately 390 Depository participants (DP) registered with SEBI at present.

National Securities Depositories Limited (NSDL) Central Depository Services (I) Limited. (CDSL)

Benefits of availing depository services –

Safe and convenient way to hold securities Instant transfer of securities Stamp duty not required on transfer of securities Elimination of risk associated with physical certificates such as bad deliveries, fake securities,

delays, thefts etc. Reduction in paperwork involved in transfer of securities Reduction in the cost of transaction No odd lot problem even one share can be sold Facility of nomination Change in address recorded with DP get registered with all companies in which investor holds

securities electronically eliminating the need to correspond with each of them separately Transmission of securities is done by DP eliminating correspondence with companies Credited automatically into demat account of shares, arising out-of bonus or split or

consolidation or merger

US trade cycle – T+3 India trade cycle – T+2 TD – Book the trade TD+1 – Inform custodian TD+2 – Process & verify TD+3 – actual settlement (pay in or pay out date)

Stock Market Indicators: Indicator of stock market development is the size of the market

Size of market = stock market capitalization (the value of listed shares on the country’s exchanges) / GDP ratio.

This ratio has improved significantly in India in recent years. At the end of year 2001, the market capitalization ratio stood at 23.1 and this has significantly increased to 114.57 % at end of December 2010 liquidity of the market can be gauged by the turnover ratio

Turnover ratio = total value of shares traded / stock market capitalization Pursuant to the recommendations of the Secondary Market Advisory Committee (SMAC) of SEBI and the

decision of the SEBI Board, it was decided to permit all classes of investors to short sell. Short selling is defined as selling a stock which the seller does not own at the time of trade. It increases liquidity in the market, and makes price discovery more efficient.

Exchanges in India -

Bombay stock exchange National Stock Exchange of India Limited (NSE)- National Stock Exchange of India Limited (NSE) was given recognition as a stock exchange in April 1993. NSE was

set up with the objectives of, (a) Establishing a nationwide trading facility for all types of securities, (b) Ensuring equal access to all investors all over the country through an appropriate communication network, (c) Providing a fair, efficient and transparent securities market using electronic trading system, (d) Enabling shorter settlement cycles and book entry settlements, and (e) Meeting the international benchmarks and standards

Pink sheets – (OTC Counter group) Stock of companies in the OTC pink tier are not required to register with SEC.

Segments of capital market at NSE -

Wholesale Debt Market segment provides the trading platform for trading of a wide range of debt securities. FIMMDA NSE MIBID/MIBOR is used as a benchmark rate for majority of deals struck for Interest

Rate Swaps, Forwards Rate Agreements, Floating Rate Debentures and Term Deposits in the country. Zero Coupon Yield Curve’ as well as NSE-VaR for Fixed Income Securities have also become very popular for

valuation of sovereign securities across all maturities irrespective of its liquidity Capital Market segment offers a fully automated screen based trading system, known as the National

Exchange for Automated Trading (NEAT) system, which operates on a strict price/time priority. Futures & Options segment provides trading of a wide range of derivatives like Index Futures, Index Options,

Stock Options and Stock Futures Currency Derivatives segment provides trading on currency futures contracts on the US $-INR which

commenced on August 29, 2008. In February 2009, trading on additional pairs such as GBP-INR, EUR-INR and JPY-INR was allowed

NSE is the first exchange in the world to use satellite communication technology for trading. Its trading

system, called National Exchange for Automated Trading (NEAT), is a state of-the art client server based applications.

The application systems used for the day-to-day functioning of the Exchange can be divided into (a) Front end applications and (b)Back office applications In the front end the following important application systems are operative: NEAT – CM system takes care of trading of securities in the Capital Market segment that includes equities,

debentures/notes as well as retail Gilts. NEAT – WDM system takes care of trading of securities in the Wholesale Debt Market (WDM) segment that

includes Gilts, Corporate Bonds, CPs, T-Bills, etc. NEAT – F&O system takes care of trading of securities in the Futures and Options (F&O) segment that includes

Futures on Index as well as individual stock and Options on Index as well as individual stocks NEAT – IPO system is an interface to help the initial public offering of companies which are issuing the stocks to

raise capital from the market.

NEAT – MF system is an interface with the Trading members of the CM segment for order collection of designated Mutual Funds units.

NEAT- CD system is trading system for currency derivatives. Currently, currency futures are trading in the segment.

In the back office, the following important application systems are operative: NCSS (Nationwide clearing and Settlement System) is the clearing and settlement system of the NSCCL for the

trades executed in the CM segment of the Exchange. FOCASS is the clearing and settlement system of the NSCCL for the trades executed in the F&O segment of the

Exchange OPMS – the online position monitoring system that keeps track of all trades executed for a trading member vis-

a-vis its capital adequacy. PRISM is the parallel risk management system for F&O trades using Standard Portfolio Analysis (SPAN). It is a

system for comprehensive monitoring and load balancing of an array of parallel processors that provides complete fault tolerance. It provides real time information on initial margin value, mark to market profit or loss, collateral amounts, contract-wise latest prices, contract-wise open interest and limits.

Data warehousing that is the central repository of all data in CM as well as F&O segment of the Exchange, Listing system that captures the data from the companies which are listed in the Exchange for corporate

governance and integrates the same to the trading system for necessary broadcasts for data dissemination process and Membership system that keeps track of all required details of the Trading Members of the Exchange.

PRIMARY MARKET – Primary market provides opportunity to issuers of securities, Government as well a corporate, to raise

resources to meet their requirements of investment and/or discharge some obligation. The issuers create and issue fresh securities in exchange of funds through public issues or as private placement. They may issue the securities at face value, or at a discount / premium and these securities may take a variety of forms such as equity, debt or some hybrid instrument. They may issue the securities in domestic market and/or international market through ADR/GDR/ECB route.

Face value – nominal or stated amount in rupees assigned to security by a issuer. For stock it is original cost of a stock shown on the certificate. (Usually Rs. 5 or 10) May quote higher in

markets. May issue at par, premium, or discount. For bonds it is amount paid to the holder at maturity. (Called as par value) Government securities and

corporate bonds generally have face value of 100

Types of issue – PUBLIC (IPO & FPO), RIGHTS ISSUE, PREFERENCIAL ISSUE.

Issue price (cutoff price) – price at which companies shares are offered to public in primary market. IPO & FPO fall under primary market.

Floor price – it is the minimum price at which bids can be made.

Market capitalization – total value of company's outstanding shares at particular market price.

Bids should remain open for minimum 3 days during book building and it takes 3 weeks for shares to listed after closure of book built issue.

Prospectus – it is disclosure of information to the public. Disclosure includes information like reason for raise of money, the way money is proposed to spent, return expected on money, size of issue, current status of company, its equity capital, current and past performance, promoters, project, cost of project, means of financing, product, capacity etc.

Draft offer document – It is prospectus in case of public issue or offer for sale and letter of offer in case of rights issue which is

filled with registrar of companies (ROC) & stock exchanges. Draft offer document means offer in draft stage. Draft offer document are filed with SEBI at least 21 days

prior to the filing the offer document with the ROC/SEs. It is available on SEBI'S website for public comments for 21 days from filing draft offer document with SEBI. If issue is more than 50 lakh required to fill draft offer document. Validity period of SEBI is 3 months. Within 3 months after draft offer Document, Company has to open its issue.

Arbitraged prospectus – shorter version of prospectus and contains all the salient features of prospectus. It contains application form of public issues.

Lock-in period – indicates a freeze on sale of shares for a certain period of time. It is generally for promoters to hold minimum percentage in the company after the public issue.

Pricing in Public Issues The issuer determines the price of the equity shares and convertible securities in consultation with the lead

merchant banker or through the book building process. In case of debt instruments, the issuer determines the coupon rate and conversion price of the convertible debt instruments in consultation with the lead merchant banker or through the book building process.

An issuer may offer equity shares and convertible securities at different prices; to share holder applicants and to retail investors.

in case of a book built issue, the price of the equity shares and convertible securities offered to an anchor investor cannot be lower than the price offered to other applicants; Book Building means a process undertaken to elicit demand and to assess the price for determination of the quantum or value of specified securities or Indian Depository Receipts, bids collected from investors at various prices. Price determined after bid closing date.

In case of a composite issue, the price of the equity shares and convertible securities offered in the public issue may be different from the price offered in rights issue and justification for such price difference should be given in the offer document.

Composite issue” means an issue of equity shares and convertible securities by a listed issuer on public cum rights basis, wherein the allotment in both public issue and rights issue is proposed to be made simultaneously.

Anchor investor” means a qualified institutional buyer who makes an application for a value of Rs.10 cores or more in a public issue through the book building process

Promoters’ Contribution The promoters’ minimum contribution varies from case to case. The promoters of the issuer are required to

contribute in the public issue as follows: In case of an initial public offer, the minimum contribution should not be less than 20% of the post issue

capital; In case of further public offer, it should be either to the extent of 20 % of the proposed issue size or to the

extent of 20% of the post-issue capital; In case of a composite issue, either to the extent of 20% of the proposed issue size or to the extent of 20% of

the post-issue capital excluding the rights issue component

Indian Depository Receipts A foreign company can access Indian securities market for raising funds through issue of Indian Depository

Receipts (IDRs). An IDR is an instrument denominated in Indian Rupees in the form of a depository receipt created by a

Domestic Depository (custodian of securities registered with the Securities and Exchange Board of India) against the underlying equity of issuing company to enable foreign companies to raise funds from the Indian securities markets.

ADRs/GDRs Indian companies are permitted to raise foreign currency resources through two main sources: (a) Issue of Foreign Currency Convertible Bonds (FCCBs) –more commonly known as ‘Euro Issues’ (b) issue of ordinary equity shares through depository receipts, namely, Global Depository Receipts

(GDRs)/American Depository Receipts (ADRs) to foreign investors i.e. institutional investors or individuals (including NRIs) residing abroad.

An American Depository Receipt (ADR) is a negotiable U.S. certificate representing ownership of shares in a non-U.S. corporation. ADRs are quoted and traded in U.S. dollars in the U.S. securities market. Also, the dividends are paid to investor in U.S. dollars. ADRs were specifically designed to facilitate the purchase, holding and sale of non-U.S. securities by U.S. investor, and to provide a corporate finance vehicle for non-U.S. companies.

DR- A depository receipt is any negotiable instrument in the form of a certificate denominated in US dollars. The certificates are issued by an overseas depository bank against certain underlying stock/shares. The shares are deposited by the issuing company with the depository bank. The depository bank in turn tenders DRs to the investors. A DR represents a particular bunch of shares on which the receipt holder has the right to receive dividend, other

payments and benefits which company announces from time to time for the share holders. DRs facilitate cross border trading and settlement, minimize transactions costs

SECONDARY MARKET –

Secondary market is the place for sale and purchase of existing securities. It enables an investor to adjust his holdings of securities in response to changes in his assessment about risk and return. It also enables him to sell securities for cash to meet his liquidity needs

NSE and BSE are the major exchanges having nationwide operations.

Corporatization & Demutualization of Stock Exchanges: ‘Corporatization’ means the succession of a recognized stock exchange, being a body of individuals or a society

registered under the Societies Registration Act 1860 (21 of 1860) by another stock exchange, being a company incorporated for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities carried on by such individuals or society.

Demutualization means the segregation of ownership and management from the trading rights of the members of a recognized stock exchange in accordance with the scheme approved by the Securities and Exchange Board of India. Demutualization is the process through which a member-owned company becomes shareholder owned company.

It is legal structure of an exchange whereby ownership, management and trading rights are segregated from each other.

NSE & OTCEI (over the counter exchange of India) are two demutualised exchanges.

Index- it consists of group of shares. It denotes direction of entire market. index is nothing but a security whose price or level is a weighted average of securities constituting the index Index consist of high market capitalization & high liquidity shares. High market capitalization–companies having highest no. of shares & highest price of each share. High liquidity shares – shares in the market with the high volume.

Listing of securities Listing means admission of securities of an issuer to trading privileges on a stock exchange through a formal

agreement. The prime objective of admission to dealings on the Exchange is to provide liquidity and marketability to securities, as also to provide a mechanism for effective management of trading.

Indices – Nifty – national index for fifty (scientifically developed), reflects accurately market movement of Indian markets. (Consist shares of 50 companies). Comprises most largest and most liquid traded stocks on NSE. Nifty index is maintained by India index services & products limited (IISL) which is joint venture between NSE & CRISIL. Index has been co-branded by standard & poor's (S&P)

Nifty is barometer of Indian market. Sensex – sensitive index (consist shares of 30 companies) BSE – Bombay stock exchange & NSE – national stock exchange, these two are countries economic barometer.

Listing agreement At the time of listing securities of a company on a stock exchange, the company is required to enter into a

listing agreement with the exchange. The listing agreement specifies the terms and conditions of listing and the disclosures that shall be made by a company on a continuous basis to the exchange for the dissemination of information to the market.

Difference between trader and investor – Trader – Buying and selling of shares based on technical analysis or market trend. They trade for a very short duration

like from a single day to couple of days. Mostly trading is done through the day & is called intraday trading. Trader buys and sells stock, and he is not worried about company's fundamentals/performance.

Investor – Buys shares only after analyzing company fundamentals/worth. They hold them for long term like couple of

months to couple of years. If current price is at discount (undervalued) he buys it for a long term perspective.

Bid price- it is the price at which buyers are ready to buy the shares. Also called buying price.

Ask price – it is the price at which sellers are ready to sell the shares. Also called selling price / offer price.

Important terms – Open - price at which stock opens when market opens in the morning High – it is the highest stock price on the day. Low - it is the lowest stock price on the day. Close – it is final stock price when it is closed in the market. Squaring off – term used to complete one transaction. Means if you buy, you have to sell.

And if you sell, you have to buy to square off.

Types of trading - online and offline

Contract note – it is a confirmation of a trade done on a particular day on behalf of a client by a trading member. It imposes legal enforceable relation between client and trading member with respect to purchase/sale and settlement of trades. It also helps to settle disputes/claims between investor & trading member. In case of dispute it is a prerequisite for filing a complaint against trading member.

A valid contract note should be in prescribed form, contains details of trades, stamped with requisite value & duly signed by authorized signatory. Contract notes must kept in duplicate, trading member & client should one copy each.

Brokerage – maximum brokerage can be charged by a broker from his clients as a commission cannot be more than 2.5% of the value mentioned in respective purchase or sale note.

Portfolio – it is a combination of different investment asset mixed and matched for the purpose of achieving an investors goals. Assets in portfolio could include shares, debentures, bonds, fixed deposits, mutual fund units, gold and real estate etc.

Front running – Increase the cost of acquisition of share or reduce the realization for the sale of shares

Diversification – it is a risk management technique that mixes a wide variety of investments within a portfolio. It is designed to minimize impact of any one security on overall portfolio performance. Diversification is possibly the best way to reduce the risk in a portfolio.

Diversification beyond certain limit marginally reduces chances of risk minimization Well diversification can be achieved through asset allocation. Asset allocation depends on factors like

age, risk tolerance level, time horizon and saving capacity of an individual. Investor should focus on asset allocation rather than time between equity and debt; they should take into account their investment horizon & risk appetite before deciding on asset allocation. Being diversified didn’t save investors from the crash because when entire economy is in doldrums, diversification is not of any help. Beyond sector based diversification, there is a geographical diversification

Depository – holds the SECURITIES for the depositors, Depositories in India – National Securities Depository Limited (NSDL)

Central Depository Services (India) Limited (CDSL)

DIFFERENCE BETWEEN BANK AND DEPOSITORY – BANK DEPOSITORY

Holds funds in an account Holds securities in an account Transfer funds between accounts transfer securities between accounts Facilitates transfer without having Facilitates transfer of ownership without

to handle money. having to handle securities. Facilitates safekeeping of money Facilitates safekeeping of shares

Depository Participant (DP) – Depository provides its services to investors through its agents called depository participants. These

agents are appointed by depository with the approval of SEBI. According to SEBI regulations banks, financial institutions, & SEBI registered trading members can become depository participants.

Custodian- it is a legal financial institution/organization which helps to register & safeguard the securities of its clients. DUTIES - maintaining a client's securities account. Monitoring & processing corporate action.

Sub-custodian – it performs same duties like custodian but on behalf of custodian. It is appointed by custodian. Located in foreign country. Only one for each country.

Mutual funds – It is a trust that pools the saving of no. of investors who shares a common financial goal, money gets

invested in capital market instruments such as shares, debentures and other securities.

Collective investment scheme that pools money from many investors to buy securities.

Income earned and capital appreciation realized are shared

Mutual fund investment refers to parts of shares of large companies. Mutual fund is setup in the form of a trust, which has a sponsor, trustees, asset management company

(AMC) and custodian.

Advantages –

Professional management

Diversification – risk spread out and minimized to extent

Economies of scale (reduce transaction cost)

Liquidity

Simplicity

Tax benefits

Prospectus - prospectus is a legal document that includes information about mutual funds.

Terms of offer

Investment objective

Investment strategy

Fees and expenses

Account information

Risks

Performance

Management

Statement of additional information

SEBI is the regulatory body for mutual funds. All mutual funds must get registered with SEBI.

Benefits of investing in mutual funds – 1. Small investments 2. Professional fund management 3. Spreading risk 4. Transparency

5. Choice 6. Regulations

NAV – price per share at which shares are redeemed is known as net asset value (NAV) Net asset value of the fund is the cumulative market value of the assets of the fund net of its liabilities.

NAV per unit is simply the net value of assets divided by number of units outstanding. Buying and selling into fund is done on a basis of NAV related prices.

NAV of an open ended fund should be disclosed on a daily basis. NAV of an close ended fund should be disclosed at least on a weekly basis.

Highest NAV guaranteed products are those that promise to pay the highest value the fund achieves during a certain period. These led to systematic risk associated with the way funds were managed & posed the risk of heavy sell off in equities when stock markets fell.

Federal law requires that fund’s NAV should be calculated at least once each trading day

Entry load & Exit load – Load is charged to cover the up-front cost incurred by the mutual fund for selling the fund. It also covers one time processing cost. EXAMPLE –

Assume investor invests Rs. 10000/- & current NAV is Rs. 13/- . if entry load is 1%, the price at which investor invests is Rs. 13.13 per unit. Investor receives 10000/13.13 = 761.6146 units. (Units are allotted to investor based on the amount invested & not on basis of no. of units purchased) Now assume that the same investor redeem his 761.6146 units at NAV Rs. 15/- & exit load is 0.50%. [15*0.50% = 0.075] [15 – 0.075 = 14.925] Therefore investor receives (761.6146 * 14.925) = 11367.10 Rs.

Risks involved in mutual funds – Mutual funds do not provide assured returns. Their returns are linked to their performance. They invest

in shares, bonds, debentures etc. all these elements involve element of risk. 1. Market risk – if overall stock market falls on account of overall economic factors, the value of stock in

fund’s portfolio falls, thereby impact the fund’s performance. 2. Non market risk – bad news about a company can pull down its price. This risk can be reduced by

having a diversified portfolio containing variety of stocks from different industries. 3. Interest rate risk – bond prices and interest rates move in opposite directions. When interest rates rise,

bond prices fall & this decline in underlying securities affects the fund negatively. 4. Credit risk- bonds are debt obligations. So when fund invests in corporate bonds, they run the risk of

defaulting on their principal & interest payment obligations and when that risk crystallizes it leads to fall in value of a bond which affects NAV of fund.

Risk quotient will be determined by the time you need to achieve your goals.

It would be foolish to judge a fund’s performance based on a narrow time frame in volatile market. For this we have to categories the performance according to bull and bear periods.

For ETF, if fund is not beating the market it would be better of investing in an index fund/ETF. Because the fund must be able to at least mirror the returns of the broader market.

Very few funds boast the ability not only to deliver higher returns during a bull phase but also to limit the losses during a downturn.

Types of mutual funds –

Mutual fund landscape has changed drastically in last 10 years. A] On the basis of objective equity funds –

Funds that invest in equity shares called equity funds. They carry principal objective of capital appreciation on the investment over the medium to long term.

Diversified funds – these funds invest in companies of different sectors. Funds generally meant for risk-averse investors.

Sector funds – these funds invest primarily in equity shares of companies of particular sector or industry. Funds are targeted at investors who are bullish about a particular sector.

Index funds – money collected from investors is invested only in the stocks which represent the INDEX. Example – nifty index fund will invest only in the nifty 50 stocks. Objective of these funds is not to beat the market but to give a return equivalent to market return i.e. our returns should be in line with index or market.

Tax saving funds – these funds offer tax benefits to investors under the income tax act. Opportunity provided in the form of tax rebates.

Liquid funds/money market funds- fund invest in highly liquid money market instruments. Period of investment is as short as a day. Provide more liquidity. Emerged as a alternative for saving & short term fixed deposit accounts with comparatively higher returns.

Gilt fund – these funds invest in central & state government securities. They give secured return & safety of principal amount.

B] On the basis of flexibility/structure –

Open ended funds – these funds do not have fixed date of redemption/maturity. They are open for subscription & redemption throughout the year. Prices are linked to daily NAV & are more liquid than close ended funds.

Close ended funds – funds are open initially for entry during IPO & thereafter closed for entry as well as exit. Have fixed date of redemption (stipulated maturity of 5-7 years). Traded at a discount to NAV but discount narrows as maturity nears. These funds are tradable & subscribers are able to exit from a fund at any time from secondary market.

Interval funds – interval funds combine the feature of both open ended and close ended funds. They are open for sale or redemption during predetermined intervals at NAV related prices.

Investment plans of mutual fund – Growth plan – returns from investment are reinvested and very few income distributions if any.

Investor only realizes capital appreciation on investment. Dividend plan – income is distributed from time to time. Plan is idle for those who require regular

income. Dividend reinvestment plan – dividends declared by the fund are reinvested in the fund on behalf of

investor, thus increasing no. of units held by investor. Balanced funds – these funds invest both in equity & fixed income instruments (debts) in same

proportion. They provide steady return and reduce volatility of fund while providing some upside for capital appreciation. Suitable for those who are willing to take moderate risk.

Balanced funds with 75% equity exposure can be split into two 75% equity & 25% debt. Debt/income funds – funds invest predominantly in high rated fixed income bearing instruments like

bonds, debentures, govt. securities, commercial paper, T-bills, certificate of depository etc. they provide regular income to investors. They are safer than equities but are not completely free from risk.

Factors that can impact are - interest rate, exchange rate, inflation and policies of central bank. Also weakening of credit rating of issuer is a source of risk for non govt. debt papers.

Buy & hold – passive debt management strategy. Duration management – duration is measure of sensitivity of a debt instrument ( longer the

duration, higher the sensitivity and vice-a-versa) Systematic investment plan – the unit holders of the scheme can benefit by investing specific rupee

amount periodically, for a continuous period. Mutual fund SIP allows the investor to invest a fixed amount of rupees every month or quarter for purchasing additional units of the scheme at NAV related prices.

Active fund management – When fund manager decides which company, instrument or class of asset the fund should invest in

based on research analysis, market news etc. such a fund is called actively managed fund. Fund buys & sells securities actively based on changed perceptions of investment from time to time.

The risk appetite & investment objective is clearly defined for each fund keeping in mind the investment horizon, liquidity requirements.

Test of fund manager’s skills doesn’t lie in a good performance only when markets are going up, what makes him standout is the fund’s performance when the chips are down.

Investments styles of mutual fund managers –

Growth investing style – Primary objective of equity investment is capital appreciation. Manager looks for companies that are expected to give above average earnings growth, where the manager feels earning prospectus and therefore stock prices in future will be even higher. Identifying such sectors is challenge to growth investment manager.

Value investment style – Value manager looks to buy companies which are currently undervalued in market, which they estimate to be highly recognized in valuation in future.

Hybrid funds make sense to investment only in those funds that provide additional advantage. MIP (Hybrid product) – 70 % debt, 10 % gold, 20 % equity.

Passive fund management –

In active fund management there is an element of going wrong with selection of funds to invest. Passive investment managers do not analyze companies, markets, economic factors, & then narrow down on stocks to invest in. instead to choose a portfolio on their own they choose market index. Therefore they generate guaranteed returns in line with the market.

ETF – (exchange traded fund) ETF represents basket of stocks that reflects an index such as nifty. An ETF however, isn't a mutual

fund; it trades like any other company on a stock exchange. Unlike mutual fund it has its NAV calculated at the end of each trading day.

ETF's attempt to replicate the return on indexes, there is no guarantee that they will do so exactly. By owning an ETF we get diversification of an index fund plus the flexibility of a stock. Like stocks we

can short sell them, buy them on margin & purchase as little as one share. Also expense ratio of most ETF's is lower than the average mutual funds. While buying and selling ETF's

we pay the same commission to broker as on regular trade. Example – NIFTY BeES, junior BeES, SUNDER, Liquid BeES, Bank BeES.

Corporate actions –

Any action that is taken by company's board of directors (BOD)/ issuing corporation which can affect physical as well as financial status of a company is called corporate action. Example – dividends, stock split, rights issue & bonus issue. Bondholders also subject to the effects of corporation which might include calls or issuance of a new debt.

Ex – if interest rates fall sharply company may call in bonds and pay off existing bondholders and will again issue new debt at lower interest rate.

Corporate actions will be processed by securities entitlement services in US(SES) o identify the action o identify the holders o verify entitlement & reconcile o complete the corporate action Types of dividend – Cash, stock & property(product is given as a dividend)

Companies give stock dividend to increase publicly owned shares. Letter of intent –

An agreement that describes in detail a corporation’s intention to execute a corporate action. It is created by corporation with its management and legal counsel Used during merger and acquisition process to outlines a firms plan to buy or take over another company

Ex.- letter of intent will disclose specific terms of the of the transaction whether it is cash or stock deal Types of corporate action – (may be taxable or non taxable)

o Voluntary – action that requires choice by shareholders [RED CT – rights issue, exchange offer, dividend reinvestment, conversion, tender offer]

o Non voluntary – action that is mandatory, share holders have no choice

Corporate action dates - o Declaration date – date on which corporate action declares. o Ex-dividend date – the date that determines entitlement. The date on or after which security begins

trading without the dividend included in price. It is the first date of no delivery period. Buyer on the date will not be getting dividend.

o Ex-dividend date rule - Stockholders entitled to receive dividend if he holds security on this date in morning before trading begins (a receivable is created)

o Record date - determines which holders will receive compensation (ownership registered), on the date books of transfer agents close.

Exchange setup no delivery period for a security. During the period only trading is permitted. Trades are settled only after no delivery period is over. It is done to ensure that investor's entitlement for corporate benefits is clearly determined.

Date that determines who will proceeds the corporate action o Record date rule – holder must be registered as a holder before the record date o Effective date – on the date corporate action is effective. Action should be accounted for shareholders

books. o Expiration date - option of participating in voluntary corporate action ends.

Payable date – any compensation (cash or shares) due will be paid. Board of directors decides this date. After 7 days of payable date shares are paid

o Call date – date on which callable security may be redeemed.

Corporate actions – Cash dividend –

Non voluntary distribution of cash profit declared by a BOD. [Shares owned * dividend rate declared = dividend payment] Price of security decreases proportionately to cash dividend Price of security decreases proportionately as to increase in shares Dividend rate (Bloomberg)* Share PAR = Amount If there are ADR Fees then, ADR fees * Share PAR = Charge Net dividend = Amount – charge

Cash and stock dividends both are funded from retained earnings. This means that these dividends have no effect on the market capitalization of the company, thus the divisor does not change.

Special dividends require a change in the divisor because the money does not come out of retained earnings and thus does change the market capitalization of the company

Stock Split –

Non voluntary CA in which existing shares are divided into multiples ones. Though share count increases value remains same compared to pre split value, because no real value has been added due to split. In UK it is referred as “Scrip issue”, “Bonus issue”, “Capitalization issue” or “free issue”

Reverse stock split – Non voluntary corporate action to decrease no. of shares outstanding, it increases PAR value of share & may increase earnings per share. A company may also do a reverse split to avoid being delisted.

[Higher the price of stock, attract the selected investors] It can be expressed in terms of rate and ratio.

sEx – Reverse split off Ratio – 1:5 Rate - 0.2 (1/5) (less than 1 for reverse stock split)(more than 1 for forward split)

Spin-off – non voluntary action that where a corporation separates a portion of its operation from its core operations to create an independent company. Shares of new are issued to original corporation stockholders. For every 10 shares in parent company you will receive 1 share of new company

[Spin-off usually takes place when a corporation decides not to contribute additional capital to its subsidiary]

Call –

Non voluntary action where a bond is issued with a provision that issuer has the right to redeem the bond prior to maturity date.

[Why issues – provides control outstanding security which allows the issuer to refinance the debt at a lower interest rate] Current position * call price = call proceeds

Merger – To different entities merge together to form a new legal entity. Both entities lose their original existence and come up with a new name.

[Why merges – to increase financial leverage & service opportunities] Combine shares of both entities at the ratio specified by the BOD

Bonus shares – Comes with no cost to existing stockholders [Why – to conserve cash & increase publicly held shares 1000 (current shares) * 0.1 (share ratio) = 100 1000 (old position) + 100 = 1100 (new share position)

Rights issue – Issue at a discounted price before offered to public

[Why – to raise additional capital and allow share holders to maintain their ownership] Calculation –

Current position/5 (no. may vary) = shares available for purchase Rights are considered as separate assets in a portfolio

Conversion – Convert existing bonds / preferred stocks to common stock

[Why – to offer flexibility to investors]

Tender offer –

Voluntary public offering to buy shares from existing shareholders of its own or of one corporation by another company. Usually it is done at a premium above market price.

Current position * tender price = tender proceeds

Exchange offer – Voluntary/non voluntary action where corporation offers to retire its securities by exchanging outstanding shares for another security.

Corporate actions can be broadly classified under stock benefits and cash benefits. The various stock benefits

declared by the issuer of capital are bonus, rights, merger/de-merger, amalgamation, splits, consolidations, hive-off, warrants and secured premium notes (SPNs) among others. The cash benefit declared by the issuer of capital is cash dividend.

Dividend- A distribution of a portion of a company’s earnings decided by BOD to its class of shareholders. The

dividend is most often quoted in terms of dollar amount each share receives. It can also be quoted in terms of percent of the current market price referred as dividend yield. In case of mutual fund investors, interest and dividend income received from portfolio holding distributed to fund shareholders. In addition capital gains are generally paid out as a year end dividend. Dividend rate (Bloomberg)* Share PAR = Amount If there are ADR Fees then, ADR fees * Share PAR = Charge Net dividend = Amount – charge Cash dividend – Book value goes down Stock dividend – Book value remains same

Interim dividend- Part of total dividend is paid in advance, in same quarter itself, in order to reduce future onetime cost of

dividend. Generally it is in small amount.

Dividend yield – A financial ratio that shows how much a company pays out dividends each year relative to its share

price. In the absence of any capital gains the dividend yield is the return on investment for a stock. It gives relation between the current price of stock & the dividend paid by its issuing company during last 12 months. It is calculated by aggregating past years dividend & dividing it by current stock price.

EXAMPLE – share price is Rs. 360/- Annual dividend Rs. 10/- Dividend yield = 10/360 = 2.77% High dividend yield has been considered to be desirable among investors.

High dividend yield is considered to be evidence that stock is underpriced and low dividend yield is considered to be evidence that stock is overpriced. Dividend yield can be only one of factor in determining future performance of a company.

Buyback of shares – it is a method for a company to invest in itself by buying shares from other investors in the market. Buyback reduce the no. of shares outstanding in the market. It is done with the aim of improving the liquidity in its shares to enhance shareholders wealth. Buy SEBI's act company can buy back its shares from –

Existing shareholders on a proportionate basis through the offer document. (Tender offer) Open market through stock exchanges using book building process

Shareholders holding odd lot shares. (big holders/Institutional holders)

Company has to disclose pre & post buyback holding of shares In case of purchase through stock exchange, an offer for buyback should not remain open for more than 30

days. Within 15 days after closing of an offer verification of shares received has to be done. After completion of verification within 7 days payment has to be made for accepted securities & within 7 days of after payment bought back shares have to be extinguished.

Share buyback effects – Base case C 60 A 100 Asset (A) = Liability (L) + Capital (C)

L 40 ---

BVPS – Book value per Share MVPS - Market Value per share

Suppose investor has 5 shares only then, (total 10 shares in market) Share holder’s Wealth = (5*9)

= 45

Assume following cases…

Cash Dividend (30 Rs) Share Repurchase (30 Rs.) Stock Split (2:1)

C 30 A 70 C 30 A 70 C 60 A 100

L 40 --- L 40 --- L 40 ---

Book Value 60-30=30

Book Value 30

Book Value 60

Market Value 90-30=60

Market Value 90-30=60

Market Value 90

No. of Shares 10

No. of Shares** 6.67

No. of Shares 10*2=20

BVPS 30/10 = 3

BVPS 4.49

BVPS 6/2=3

MVPS 60/10=6

MVPS 9

MVPS 9/2=4.5

Wealth of Holder

Wealth of Holder

Wealth of Holder

Cash 3*5=15

Cash 1.67*9=15

Cash ---

Shares 6*5=30

Shares left*** 3.33*9=30

Shares 4.5*20=45

Dividend/share = 30/10

= 3

** Shares after repurchasing = Old Shares – Buy backed shares

= 10- 3.33

= 6.67 Shares

Book Value 60

Market Value 90

No. of Shares 10

BVPS 6

MVPS 9

***Buy backed Shares = Amount for buyback/MVPS

= 30/9

= 3.33

NOTE –

While repurchasing shares by premium, seller worth increases by amount of premium received, but worth of remaining shareholders decreases.

Market value doesn’t change on repurchase.

Share Repurchase (1000 Shares)

Has the Cash Do not have the cash (Internal cash)

Will my EPS goes up..? (Loan amount 400 $), as loan goes , Capital EPS = Net Income /No. of share holders EPS = Net Income /No. of share holders EPS Ratio will go up EPS Ratio will go down

Relation between Cost of debt (Kd) and Cost of Equity (Ke) If Kd (After tax)> Ke if Kd (After tax) < Ke

EPS will EPS will

Cost of Equity = EPS (Before Repurchase) / MPS (After Repurchase)

= 6/30 (it means, investor pays Rs. 30 to earn Rs. 6) Yield Repurchase Impact on BVPS –

Repurchase of Shares BVPS (Before) > MPS BVPS (Before) < MPS

Book value will go Book value will go

Book Value 40

Book Value 40

Market Value 30

Market Value 50

Shares 10

Shares 10

BVPS 4

BVPS 4

MPS 3

MPS 5

4 Shares repurchased

4 Shares repurchased

Cash Given 4*3=12

Cash Given 4*5=20

Book Value 40-12=28

Book Value 40-20=20

Market Value 30-12=18

Market Value 50-20=30

New Shares 10-4=6

New Shares 10-4=6

BVPS 4.666667

BVPS 3.333333

MPS 3

MPS 5

Pay in & pay out – Pay in is the day when securities sold are delivered to exchange by the sellers & funds for the securities

purchased are made available to the exchange by the buyers Payout is the day when securities purchased are delivered to buyers & the funds for the securities sold

are given to the sellers by the exchange. At present pay-in and pay-out happens on a second working day after the trade is executed on the

stock exchange. On account of non delivery of securities by the trading member on the paying day, securities are put

up for the auction by the exchange. Exchange purchases the requisite quantity in auction market and gives it to the buying trading member.

How to go about systematically analyzing a company – Top down approach – EIC Analysis Bottom up approach

o Industry analysis – companies producing similar products form a part or industry. It is a group of

homogenous companies. Example – NTPC (National thermal power corporation) NHPC (National hydroelectric power corporation) TPC (Tata Power Company)

o Corporate analysis – company's current operations, managerial capabilities, growth plans and its past performance is compared with its competitors. This is called corporate analysis.

o Financial analysis- in this certain financial parameters like EPS, PE Ratio, current size of equity, current price of equity are analyzed. Also need to understand financial statements of a company.

Annual report – It is a formal financial statement issued yearly by a corporate. Annual report shows assets, liabilities,

revenues, expenses, and earnings. Companies publish annual reports and send abridged versions to shareholders free of cost. A detailed annual report is sent on a request.

Annual report of a company is the best source of information about the financial health of a company. Points to emphasize in annual report –

o Director's report and chairman's statement which are related to current and future operational performance of a company.

o Auditors report (including annexure to the auditor’s report) o Profit & loss o Balance sheet o Notes to accounts attached to the balance sheet.

DEMATERILISATION – It is process of converting physical share certificates into electronic form to facilitate efficient trading.

NEAT SYSTEM The NEAT system supports an order driven market, wherein orders match on the basis of price and time

priority. All quantity fields are in units and prices are quoted in Indian Rupees. The regular lot size and tick size for various securities traded is notified by the Exchange from time to time.

Normal Market: Normal market consists of various book types in which orders are segregated as Regular Lot

Orders, Special Term Orders, and Stop Loss Orders depending on the order attributes. Auction Market: In the auction market, auctions are initiated by the exchange on behalf of trading members

for settlement related reasons. The main features of this market are detailed in a separate section (3.13) on auction.

Odd Lot Market: The odd lot market facility is used for the Limited Physical Market and for the Block Trades Session. The main features of the Limited Physical Market are detailed in a separate section (3.14). The main features of the Block Trades Session are detailed in a separate section (3.15).

Retail Debt Market: The RETDEBT market facility on the NEAT system of capital market segment is used for transactions in Retail Debt Market session. Trading in Retail Debt Market takes place in the same manner as in equities (capital market) segment. The main features of this market are detailed in a separate section (3.16) on RETDEBT market

Market Phases- Opening: The trading member can carry out the following activities after login to the NEAT system and before the market opens for trading: (a) Set up Market Watch (the securities which the user would like to view on the screen (b) View Inquiry screens At the point of time when the market is opening for trading, the trading member cannot login to the system. A

message ‘Market status is changing. Cannot logon for sometime’ is displayed. If the member is already logged in, he cannot perform trading activities till market is opened.

Pre-open: The pre-open session is for duration of 15 minutes i.e. from 9:00 am to 9:15 am. The pre-open

session is comprised of Order collection period and order matching period. The order collection period of 8* minutes is provided for order entry, modification and cancellation.(* - System driven random closure between 7th and 8th minute). During this period orders can be entered, modified and cancelled.

Equilibrium price determination- In a call auction price mechanism, equilibrium price is determined as shown below. Assume that NSE received

bids for particular stock xyz at different prices in between 9.00 am & 9:07/08 am. Based on the principle of demand supply mechanism, exchange will arrive at the equilibrium price - price at which the maximum number of shares can be bought / sold. In below example, the opening price will be 105 where maximum 27,500 shares can be traded.

Shares price Order book Demand / supply schedule Maximum tradable quantity

Buy Sell Demand Supply

100 13500 11500 50500 11500 11500

104 9500 9500 37000 21300 21300

105 12000 15000 27500 36300 27500

106 6500 12000 15500 48300 15500

107 5000 12500 9000 60800 9000

108 4000 8500 4000 69300 4000

During order matching period order modification, order cancellation, trade modification

and trade cancellation is not allowed. The trade confirmations are disseminated to respective members on their trading terminals before the start of normal market. After completion of order matching there is a silent period to facilitate the transition from pre-open session to the normal market. All outstanding orders are moved to the normal market retaining the original time stamp. Limit orders are at limit price and market orders are at the discovered equilibrium price. In a situation where no equilibrium price is discovered in the pre-open session, all market orders are moved to normal market at previous day’s close price or adjusted close price / base price following price time priority. Accordingly, Normal Market / Odd lot Market and Retail Debt Market opens for trading after closure of pre-open session i.e. 9:15 am. Block Trading session is available for the next 35 minutes from the open of Normal Market.

The opening price is determined based on the principle of demand supply mechanism. The equilibrium price is the price at which the maximum volume is executable. In case more than one price meets the said criteria, the equilibrium price is the price at which there is minimum unmatched order quantity. In case more than one price has same minimum order unmatched quantity, the equilibrium price is the price closest to the previous day’s closing price. In case the previous day’s closing price is the mid-value of pair of prices which are closest to it, then the previous day’s closing price itself will be taken as the equilibrium price. In case of corporate action, previous day’s closing price is adjusted to the closing price or the base price. Both limit and market orders are reckoned for computation of

equilibrium price. The equilibrium price determined in pre-open session is considered as open price for the day. In case if only market orders exists both in the buy and sell side, then order is matched at previous days close price or adjusted close price / base price. Previous day’s close or adjusted close price / base price is the opening price. In case if no price is discovered in pre-open session, the price of first trade in the normal market is the open price.

Normal Market Open Phase: The open period indicates the commencement of trading activity. To signify the start of trading, a message is

sent to all the trader workstations. The market open time for different markets is notified by the Exchange to all the trading members. Order entry is allowed when all the securities have been opened. During this phase, orders are matched on a continuous basis.

Market Close: When the market closes, trading in all instruments for that market comes to an end. A message to this effect is sent to all trading members. No further orders are accepted, but the user is permitted to perform activities like inquiries and trade cancellation.

Post-Close Market: This closing session is available only in Normal Market Segment. Its timings are from 3.50 PM to 4.00 PM. Only market price orders are allowed. Special Terms, Stop Loss and Disclosed Quantity Orders, Index Orders are not allowed. The trades are considered as Normal Market trades. Securities not traded in the normal market session are not allowed to participate in the Closing Session.

Surcon: Surveillance and Control (SURCON) is that period after market close during which, the users have inquiry access only. After the end of SURCON period, the system processes the data for making the system available for the next trading day. When the system starts processing data, the interactive connection with the NEAT system is lost and the message to that effect is displayed at the trader workstation.

Basket Trading The purpose of Basket Trading is to provide NEAT users with a facility to create offline order entry file for a

selected portfolio. On inputting the value, the orders are created for the selected portfolio of securities according to the ratios of their market capitalizations. All the orders generated through the offline order file are priced at the available market price.

Quantity of shares of a particular security in portfolio is calculated as under: No. of Shares of a security in portfolio = amount*issued capital for a security / current portfolio capitalization Where:

Current Portfolio Capitalization = Summation [Last Traded Price (Previous close if not traded) * No. of Issued shares]

Index Trading The purpose of Index Trading is to provide users with a facility of buying and selling of Indexes, in terms of

securities that comprises the Index. The users have to specify the amount, and other inputs that are sent to the host, and the host generates the orders. The Index Trading enables the users for buying or selling an Index Basket. Putting orders in securities in proportion that comprises the chosen index, simulates the buying and selling of Index basket.

Formula Used to calculate no of shares of each security is Amount * Issued Capital for the security * Free Float Factor No of Shares of a security in index = _______________________________________________ Current Market Capitalization of the Index Current Market Capitalization of the Index = Summation [Last Traded Price (Previous close if not traded) * No of

Issued shares]

Orders – Market order – when you put buy or sell price of a stock at a market rate or when we select market order

option while trading then trade gets immediately executed at market rates. It is used when you want your order very fast and at available market price. Limit order – in limit order buying or selling price has to be mentioned and when share price comes to that

price order gets executed automatically.

Stop loss order – as the name suggests, used to reduce or minimize the losses. Trigger price has to be mentioned by the trader and once the price reaches the trigger price order gets executed with the best price available between trigger price and limit price.

Example – suppose trader bought the reliance industries at 1000 Rs. So he will put following order to protect his losses Limit order of Rs. 990 and stop loss trigger price at Rs. 985 So if stock price starts falling & if reaches stop trigger price Rs, 985 then his trade executes with the

current market available price

Note- the stop loss trigger price is placed below the limit price in buy order & above the limit price in sell order. Order entry in a security is not possible if that security is either suspended from trading or not eligible to

trade in a particular market.

Quantity: Quantity should be mentioned in multiples of regular lot size for that security. Price: A user has the option to either enter the order at the default price or overwrite it with any other desired

price. If a user mentions a price, it should be in multiples of the tick size for that particular security and within the day’s minimum/maximum price range. In case of stop loss orders, a user has the flexibility of specifying a limit price along with the trigger price.

For putting orders conditions are broadly divided into Time Conditions, Quantity Conditions, Price Conditions and Other Conditions

a) Time Conditions DAY: A DAY, as the name suggests is an order that is valid for the day on which it is entered. If the order is not

executed during the day, the system cancels the order automatically at the end of the day. IOC: An Immediate or Cancel (IOC) order allows the user to buy or sell a security as soon as the order is

released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately.

b) Quantity Conditions DQ: An order with a Disclosed Quantity (DQ) allows the user to disclose only a portion of the order quantity to

the market. For e.g. if the order quantity is 10,000 and the disclosed quantity is 2,000, then only 2,000 is disclosed to the market.

c) Price Conditions Market Orders: Market orders are orders for which price is specified as ‘MKT’ at the time the order is entered.

For such orders, the system determines the price. Stop-Loss: This facility allows the user to release an order into the system, after the market price of the security

reaches or crosses a threshold price called trigger price. Trigger Price: Price at which an order gets triggered from the stop loss book. Limit Price: Price of the orders after triggering from stop loss book. Price Freeze: Since no price bands are applicable in respect of securities on which derivative products are

available or securities included in indices on which derivative products are available, in order to prevent members from entering orders at non-genuine prices in such securities, the exchange has decided to introduce operating range of 20% for such securities. Any order above or below 20% over the base price should come to the exchange as a price freeze

d) Other Conditions PRO/CLI: A user can enter orders on his own account or on behalf of clients. By default, the system assumes

that the user is entering orders on the trading member’s own account. Participant Code: By default, the system displays the trading member id of the user in the participant field.

Thus, all trades resulting from an order are to be settled by that trading member.

Branch Order Value Limit Check: In addition to the checks performed for the fields explained above, every order entry is checked for the branch order value limit. In case the set order value limit is exhausted the subsequent order is rejected by the system

Order Modification All orders can be modified in the system till the time they do not get fully traded and only during market hours.

Once an order is modified, the branch order value limit for the branch gets adjusted automatically. Order modification is rejected if it results in a price freeze, message displayed is ‘CFO request rejected’.

Order Cancellation Order cancellation functionality can be performed only for orders which have not been fully or partially traded

(for the untraded part of partially traded orders only) and only during market hours and in preopen period. Order Matching The buy and sell orders are matched on Book Type, Symbol, Series, Quantity and Price. Matching Priority: The best sell order is the order with the lowest price and a best buy order is the order with

the highest price. (a) By Price: A buy order with a higher price gets a higher priority and similarly, a sell order with a lower price

gets a higher priority. E.g. consider the following buy orders: 1) 100 shares @ Rs. 35 at time 10:30 a.m. 2) 500 shares @ Rs. 35.05 at time 10:43 a.m. The second order price is greater than the first order price and therefore is the best buy order. (b) By Time: If there is more than one order at the same price, the order entered earlier gets a higher priority. E.g. consider the following sell orders: 1) 200 shares @ Rs. 72.75 at time 10:30 a.m. 2) 300 shares @ Rs. 72.75 at time 10:35 a.m. Both orders have the same price but they were entered in the system at different time. The first order was

entered before the second order and therefore is the best sell order. Example 1: Member A places a buy order for 1000 shares of ABC Ltd. in the NEAT system At 11:22:01 for Rs.155 per share. Member B places a sell order for 2000 shares of ABC Ltd. At 11:22:02 for Rs.150 per share. Assume that no other orders were available in the system during this time.

Whether the trade will take place and if yes, at what price? Yes, 1000 shares will get traded at Rs.155 per share (the passive price). Example 2: Auction is held in TISCO for 5,000 shares. a) The closing price of TISCO on that day was Rs.155.00 b) The last traded price of TISCO on that day was Rs.150.00 c) The price of TISCO last Friday was Rs.151.00 d) The previous days’ close price of TISCO was Rs.160.00 What is the maximum allowable price at which the member can put a sell order in the auction for TISCO?

(Assuming that the price band applicable for auction market is +/-15%) Max price applicable in auction = Previous days’ close price * Price band

= Rs.160*1.15 =Rs.184.00

Trading Rules- Insider Trading Insider trading is prohibited and is considered an offence. The SEBI (Prohibition of Insider Trading) Regulations,

1992 prohibit an insider from dealing (on his own behalf or on behalf of others) in listed securities when in possession of ‘unpublished price sensitive information’ or communicate, counsel or procure directly or indirectly any unpublished price sensitive information to any person who while in possession of such unpublished price sensitive information should not deal in securities.

Price sensitive information is any information, which if published, is likely to materially affect the price of the securities of a company

Unfair Trade Practices The SEBI (Prohibition of Fraudulent and Unfair Trade Practices in relation to the Securities Market) Regulations,

2003 enable SEBI to investigate into cases of market manipulation and fraudulent and unfair trade practices.

Buy back Buy back aims at improving liquidity in the shares of companies and helps corporate in enhancing the

shareholders’ wealth. Under the SEBI (Buy Back of Securities) Regulations, 1998, a company is permitted to buy back its shares from:

a) The existing security holders on a on a proportionate basis through the tender offer, b) The open market through stock exchanges, and book building process; and c) Shareholders holding odd lot shares. Price Bands Stock market volatility is generally a cause of concern for both policy makers as well as investors. To curb

excessive volatility, SEBI has prescribed a system of price bands. The price bands or circuit breakers bring about a coordinated trading halt in all equity and equity derivatives markets nation-wide

Flash crash – Value of stock or index gets severely beaten within seconds due to punching error or manipulative trade

Transaction cycle –

Settlement Process in CM segment of NSE –

Risks in Settlement-

The following two kinds of risks are inherent in a settlement system: o Counterparty Risk: This arises if parties do not discharge their obligations fully when due or at any time

thereafter. This has two components, namely replacement cost risk prior to settlement and principal risk during settlement.

(a) The replacement cost risk arises from the failure of one of the parties to transaction. While the non-defaulting party tries to replace the original transaction at current prices, he loses the profit that has accrued on the transaction between the date of original transaction and date of replacement transaction. The seller/buyer of the security loses this unrealized profit if the current price is below/above the transaction price. Both parties encounter this risk as prices are uncertain. It has been reduced by reducing time gap between transaction and settlement and by legally binding netting systems.

(b) The principal risk arises if a party discharges his obligations but the counterparty defaults. The seller/buyer of the security suffers this risk when he delivers/makes payment, but does not receive payment/delivery. This risk can be eliminated by delivery vs. payment mechanism which ensures delivery only against payment. This has been reduced by having a central counterparty (NSCCL) which becomes the buyer to every seller and the seller to every buyer.

(c) A variant of counterparty risk is liquidity risk which arises if one of the parties to transaction does not settle on the settlement date, but later. The seller/buyer who does not receive payment/delivery when due, may have to borrow funds/securities to complete his payment/delivery obligations.

(d) Another variant is the third party risk which arises if the parties to trade are permitted or required to use the services of a third party which fails to perform.

For example, the failure of a clearing bank which helps in payment can disrupt settlement. This risk is reduced by allowing parties to have accounts with multiple banks.

o System Risk: This comprises of operational, legal and systemic risks. The operational risk arises from possible operational

failures such as errors, fraud, outages etc. The legal risk arises if the laws or regulations do not support enforcement of settlement obligations or are uncertain. Systemic risk arises when failure of one of the parties to discharge his obligations leads to failure by other parties

Rolling Settlement

Under rolling settlement, all trades executed on a trading day are settled X days later. This is called ‘T+X’ rolling settlement, where ‘T’ is the trade date and ‘X’ is the number of business days after trade date on which settlement takes place. The rolling settlement has started on T+2 basis in India, implying that the outstanding positions at the end of the day ‘T’ are compulsorily settled 2 days after the trade date.

In January 2000, SEBI made rolling settlement compulsory for trades in 10 scripts selected on the basis of the criteria that they were in the compulsory demat list and had daily turnover of about Rs.1 crore or more.

SEBI introduced T+5 rolling settlement in equity market from July 2001. Subsequently shortened the settlement cycle to T+3 from April 1, 2002. After having gained experience of T+3 rolling settlement and also taking further steps such as introduction of STP (Straight Through Processing), it was felt appropriate to further reduce the settlement cycle to T+2 thereby reducing the risk in the market and to protect the interest of investors. As a result, SEBI, as a step towards easy flow of funds and securities, introduced T+2 rolling settlement in Indian equity market from 1st April 2003. The time schedule prescribed by SEBI for depositories and custodians for T+2 rolling settlement

Table 3.5: Time schedule of Rolling Settlement:

Sr. No. Day Time Description of activity

1 T Trade day

2 T+1 By 1.00 pm confirmation of all trades ( including custodial trades)

By 2.30 pm processing and downloading of obligation files to brokers / custodians

3 T+2 By 11.00

am pay-in of securities and funds

By 1.30 pm pay-out of securities and funds

As per SEBI directive, the Custodians should adhere to the following activities for implementation of T+2 rolling

settlement w.e.f. April 1, 2003: 1. Confirmation of the institutional trades by the custodians latest by 1.00 p.m. on T+1. 2. Pay-in to be made before 11:00 a.m. on T+2.

Risk Management-

A sound risk management system is integral to/pre-requisite for an efficient clearing and settlement system. The National Securities Clearing Corporation Ltd. (NSCCL), a wholly owned subsidiary of NSE, was incorporated in August 1995. It was set up to bring and sustain confidence in clearing and settlement of securities; to promote and maintain, short and consistent settlement cycles; to provide counter-party risk guarantee, and to operate a tight risk containment system. NSCCL commenced clearing operations in April 1996.

Capital Adequacy Requirements The core of the risk management is the liquid assets deposited by members with the exchange / clearing

corporation. Members are required to provide liquid assets which adequately cover various margins & base minimum capital requirements. Liquid assets of the member include their Initial membership deposits including the security deposits. Members may provide additional collateral deposit towards liquid assets, over and above their minimum membership deposit requirements.

Margins Margins form a key part of the risk management system. In the stock markets there is always an uncertainty in

the movement of share prices. This uncertainty leads to risk which is addressed by margining system of stock markets. Let us understand the concept of margins with the help of a following example.

Example: Suppose an investor, purchases 1000 shares of ‘xyz’ company at Rs.100/- on January 1, 2008. Investor has to give the purchase amount of Rs.1,00,000/- (1000 x 100) to his broker on or before January 2, 2008. Broker, in turn, has to give this money to stock exchange on January 3, 2008. There is always a small chance that the investor may not be able to bring the required money by required date. As an advance for buying the shares, investor is required to pay a portion of the total amount of Rs.1,00,000/- to the broker at the time of placing the buy order. Stock exchange in turn collects similar amount from the broker upon execution of the order. This initial token payment is called margin.

It is important to remember that for every buyer there is a seller and if the buyer does not bring the money, seller may not get his / her money and vice versa. Therefore, margin is levied on the seller also to ensure that he/she gives the 100 shares sold to the broker who in turn gives it to the stock exchange.

In the above example, assume that margin was 15%. That is investor has to give Rs.15,000/- (15% of Rs.1,00,000/) to the broker before buying. Now suppose that investor bought the shares at 11 am on January 1, 2008. Assume that by the end of the day price of the share falls by Rs.25/-. That is total value of the shares has come down to Rs.75,000/-. That is buyer has suffered a notional loss of Rs.25,000/-. In our example buyer has paid Rs.15,000/- as margin but the notional loss, because of fall in price, is Rs.25,000/-. That is notional loss is more than the margin given.

In such a situation, the buyer may not want to pay Rs.1,00,000/- for the shares whose value has come down to Rs.75,000/-. Similarly, if the price has gone up by Rs.25/-, the seller may not want to give the shares at Rs.1,00,000/-. To ensure that both buyers and sellers fulfill their obligations irrespective of price movements, notional losses are also need to be collected. Prices of shares keep on moving every day. Margins ensure that buyers bring money and sellers bring shares to complete their obligations even though the prices have moved down or up.

Daily margins payable by members consists of the following: 1. Value at Risk Margin 2. Extreme Loss Margin 3. Mark-To-Market Margin Daily margin, comprising of the sum of VaR margin, Extreme Loss Margin and mark to market margin is

payable.

Capping of margins In case of a buy transaction, the VaR margins, Extreme loss margins and mark to market losses together shall

not exceed the purchase value of the transaction. In case of a sale transaction, the VaR margins and Extreme loss margins together shall not exceed the sale value of the transaction and mark to market losses shall also be levied.

Penalty The Clearing Corporation levies penalties on trading members for non-compliances and defaults like: 1. Funds Shortages 2. Securities Shortages 3. Margin Shortages 4. Security Deposit Shortages 5. Client Code Modification 6. Non-acceptance / rejection / allocation of Institutional trades 7. Ineligible client in Inter-institutional deals

Investor Protection Fund Investor Protection Fund (IPF) has been set up as a trust under Bombay Public Trust Act, 1950 under the name

and style of National Stock Exchange Investor Protection Fund Trust and is administered by the Trustees. The IPF is maintained by NSE to make good investor claims, which may arise out of non-settlement of obligations by the trading member, who has been declared defaulter / expelled, in respect of trades executed on the Exchange. The IPF is utilized to settle claims of such investors where the trading member through whom the investor has dealt has been declared a defaulter or expelled by the Exchange. Payments out of the IPF may include claims arising on account of non payment of funds by the defaulter /expelled member or non receipt of securities purchased by the investor through the trading member who has been declared a defaulter/expelled member .

Transaction Costs Liquidity to a large extent depends on transaction costs. Lower the transaction cost, the lower is the bid-ask

spread and higher the volumes.

Index – index is a number which measures change in the set of values over a period of time. Index is nothing but a security, whose price or level is a weighted average of securities constituting the index, It is a statistical measure of change in an economy or a securities market. Index is an imaginary portfolio of securities representing a particular market or portion of it. Index is usually expressed in terms of change from a base value. Thus percent change is more important than actual numerical change.

Stock index – it represents the change in the value of set of stocks which constitute the index It is current relative value of weighted average of the prices of predefined group of equities. A good index is a tradeoff between diversification and liquidity. Well diversifies index is more representative of

the market or the economy. If diversification goes beyond certain limit there will be diminishing returns i.e. over the time risk reduction goes to zero.

Indices acts as,

o Barometer for market behavior o Benchmark for portfolio performance o Underlying for index futures or index options o For passive fund management by index funds / ETF's

India Index Services Limited (IISL) is a joint venture between NSE & Crisil. Service is being provided for following indices

o S & P CNX Nifty It is float adjusted market capitalization weighted index. It consists of large 50 stocks. Selected stocks

must be liquid by impact cost criteria; contract size is limited to fifty. It covers 21 sectors of economy. o S & P CNX Defty o S & P CNX Nifty Junior o CNX 100

Dow Jones Industrial Average (DJIA) - Price-weighted average of 30 actively traded shares of blue-chip US industrial corporations listed on the New

York Stock Exchange.

FTSE - The Financial Times Stock Exchange 100 stock index, a market cap weighted index of stocks traded on the

London Stock Exchange

Tombstone - The advertisements that appear in publications like Financial Times or The Wall Street Journal announcing the

issuance of a new security. The tombstone ad is typically placed by the investment bank to publicize that it has completed a major deal. This term can also refer to the Lucite made to commemorate a debt or equity offering.

Underwriting - The function performed by investment banks when they help companies issue securities to investors.

Technically, the investment bank buys the securities from the company and immediately resells the securities to investors for a slightly higher price, making money on the spread. This spread is often pre-agreed with the borrower, and is commonly known as the fee paid by the borrower on the transaction

Impact cost – Market impact cost is a measure of the liquidity of the market. It reflects the costs faced when actually trading

an index. It indicates how much additionally trader must pay over the initial price due to market slippages i.e. cost

incurred because the transaction itself changed the price of the asset. It is type of transaction cost. Suppose a stock trades at bid 99 and ask 101. We say the “ideal” price is Rs. 100. Now, suppose a buy order for

1000 shares goes through at Rs.102. Then we say the market impact cost at 1000 shares is 2%. If a buy order for 2000 shares goes through at Rs.104, we say the market impact cost at 2000 shares is 4%.

For a stock to qualify for possible inclusion into the S&P CNX Nifty, it has to have market impact cost of below 0.50% when doing S&P CNX Nifty trades of 2 crore rupees and market impact cost below 0.75 % when doing nifty trades ½ crore rupees.

Base value of nifty is 1000 on the start date i.e. 3rd Nov. 1995 BSE Mid-Cap - base value 1000 based on free float methodology, base year 2002-03, launched in April 2005

Flip – A Point when trader resorts to exact opposite positions.

If someone has long positions, he goes for all short positions and vice-a-versa. Such shift indicates, bullish market outlook on specific currency could be coming to end.

Methodology for index construction-

WEIGHTING METHOD- In a value-weighted index, the weight of each constituent stock is proportional to its market share in terms of

market capitalization. In an index portfolio, we can assume that the amount of money invested in each constituent stock is proportional to its percentage of the total value of all constituent stocks. Examples include all major stock market indices like S&P CNX Nifty. There are three commonly used methods for constructing indices:

o Price weighted method o Market capitalization weighted methods o Free float Market capitalization weighted methods o Equal weighted

A price-weighted index

Value of index is generated by adding the prices of the each of the stock in the index and dividing by total no of stocks. Generally stocks with higher price will be given more weight and will have greater influence over the performance of the index.

It is also computed by summing up the prices, of the various securities included in the index, at time 1, and dividing it by the sum of prices of the securities at time 0 multiplied by base index value. Each stock is assigned a weight proportional to its price. Each stock influences the index in proportion to its price per share.

Price weighting would consist of buying an equal number of shares of each stock in the index. The higher the price, the more weight the stock has in the index.

The Dow Jones Industrial Average is price weighted Example:

Assuming base index = 1000, price weighted index consisting of 5 stocks tabulated below would be:

Market capitalization weighted index – In this type of index calculation each stock in the index affects the index value in proportion to the

market value of all shares outstanding. Cap weighting is weighting by market capitalization, which is shares times price.

The S&P 500 Index is Cap weighted. Index = [current mkt. capitalization / base mkt. capitalization] * base value of index

Current mkt. capitalization = sum of (current market price*issue size) of all securities in the index Base mkt. capitalization = sum of (market price*issue size) of all securities as on base date.

Index Shares are the same as the company’s shares outstanding. That is the case when a company first goes into an S&P index, but after that it may vary by up to 5%

If a company changes its shares outstanding and the new number varies by more than 5% from the Index Shares, S&P will change the Index Shares immediately to reflect the change.

If a company changes its shares outstanding and the new number varies by less than 5% from the Index Shares, S&P will not change the Index Shares until its next quarterly rebalancing.

Cash and stock dividends both are funded from retained earnings. This means that these dividends have

no effect on the market capitalization of the company, thus the divisor does not change. Special dividends require a change in the divisor because the money does not come out of retained

earnings and thus does change the market capitalization of the company

Equal weighted – Equal weighting would consist of giving each stock equal representation in the index. In this example

that’s a weight of 20%. To design such an index, we would designate some amount of fictional money (say $10,000) to be

invested in each stock. Then divide that amount by the stock price to get how many shares to buy.

Comparison of returns -

Deviser –

Free float mkt. capitalization weighted index –

For each company index is determined based on the public shareholding of a company as disclosed in the shareholding pattern submitted to the stock exchange.

Free float mkt. capitalization = issue size * price * investable weight factor = total mkt. capitalization * investable weight factor = total cost of buying all shares in open market INDEX = [Free float current mkt. capitalization / Free float base mkt. capitalization] * base value Free float mkt. capitalization = share price * (# shares outstanding – locked in shares)

Index uses shares that are readily available in the market It is adopted by Dow Jones industrial average and S &P 500

Investible weight factor = free float factor (decided by BSE & NSE)

Volatility – Volatility measures indicate the extent of price movement compared with its average change. High

volatility in a stock means that its price fluctuations can be very high. Low volatility implies that scrip’s value doesn’t change dramatically but moves up and down at a steady pace over a period of time.

Volatility is usually measured on a historical basis (Past price movements). The BSE provides volatility data for the SENSEX for its site as “Realized volatility” for one, two & three months.

Implied Volatility –

The volatility indicator from NSE, the India Vix, on the other hand is based on expected volatility in the near future.

India Vix is based on the best bid & ask price of the out of money index option prices of the nifty. Only the near month & mid month nifty option contracts are considered. The variances of these two periods computed separately are interpolated to get a single variance value with a constant maturity of 30 days to expiration. This is done by changing the weights on a daily basis, that is, higher weights are given to near month contract when the number of days to expiry is high, while the weight is reduced when the number of days to expiry is low.

The square root of the computed variance value is the expected standard deviation or volatility. This is multiplies by 100 to get India Vix value.

If Vix is 15, it represents an expected annualized volatility of 15%over the next 30 days. To get the monthly figure, the annualized number is divided by square root of 12. So, if the value is 15, the index options are priced with the assumption of 68% likelihood that the magnitude of the change in the nifty in the next 30 days will be less than 4.33%. A jump to 30 indicates that indicates that option players expecting that the next 30 days change can go up to 8.67%.

The India Vix is based on index option prices & the option premium jumps up when there is excessive fear or greed in the market. That is why it is also referred as “fear Index”.

Option premium usually go up by the following reasons due to market volatility,

o Traders may assume that the future will also be as volatile o When the market is heading towards a major event whose outcome is unknown. In this

case too everyone tries to hedge their positions, jacking up the option premium rates. Factors used in calculating Vix –

o Value of the index in the future market o Bid/Ask prices of the out-of-the money Put/Call options contracts. o Prevailing risk free interest rates o Number of days to expiration of the option series.

Strategy – Buy the F & Os tied to the Vix index when the volatility is low & sell them when volatility is high. Since the index will certainly go up at some time, buying at current low level would be profitable

Difficulties in index construction: The major difficulties encountered in constructing an appropriate index are:

• deciding the number of stocks to be included in the index, • selecting stocks to be included in the index • selecting appropriate weights, and • selecting the base period and base value.

Introduction to Indian Debt Markets- Debt – amount of money borrowed by one party from another. A debt arrangement gives borrowing party

permission to borrow money under the condition that is to be paid back at a later date, usually with interest. Corporate bonds Money market instruments (CD, Bill of exchange, commercial paper)

Commercial paper – represents post dated cheques with maturity not more than 270 days Euro debt securities Govt. bonds Sub soverian govt. bonds Suprational bonds- WORLD BANK, IMF

The debt market in India comprises of two main segments, viz., the government securities market and the corporate securities market. The market for government securities is the most dominant part of the debt market in

terms of outstanding securities, market capitalization, trading volume and number of participants. It sets benchmark for the rest of the market.

The short-term instruments in this segment are used by RBI as instrument of monetary policy. The main instruments in the government securities market are fixed rate bond, floating rate bonds, zero coupon bonds and inflation index bonds, partly paid securities, securities with embedded derivatives, treasury bills and the state government bonds. The corporate debt segment includes private corporate debt, bonds issued by public sector units (PSUs) and bonds issued by development financial institutions (DFIs). This segment is not very deep and liquid.

Market Subgroups –

1. Government securities form the oldest and most dominant part of the debt market in India. The market for government securities comprises the securities issued by the central government, state governments and state-sponsored entities. In the recent past, local bodies such as municipal corporations have also begun to tap the debt market for funds. The Central Government mobilizes funds mainly through issue of dated securities and T-bills, while State Governments rely solely on State Development Loans. major investors in sovereign papers are banks, insurance companies and financial institutions, which generally do so to meet statutory requirements.

2. Bonds issued by government-sponsored institutions like DFIs, infrastructure-related institutions and the PSUs, also constitute a major part of the debt market. The preferred mode of raising capital by these institutions has been private placement, barring an occasional public issue. Banks, financial institutions and other corporate have been the major subscribers to these issues.

3. The Indian corporate sector relies, to a great extent, on raising capital through debt issues, which comprise of bonds and Commercial Papers (CPs). Of late, most of the bond issues are being placed through the private placement route. These bonds are structured to suit the requirements of investors and the issuers, and include a variety of tailor-made features with respect to interest payments and redemption.

4. In addition to above, there is another segment, which comprises of short-term paper issued by banks, mostly in the form of certificates of deposit (CDs). This segment is, however, comparatively less dominant

5. The Indian debt market also has a large non-securitized, transactions-based segment, where players are able to lend and borrow amongst themselves. This segment comprises of call and notice money markets, inter-bank market for term money, market for inter-corporate loans, and market for ready forward deals (repos). Typically, short-term instruments are traded in this segment.

6. The market for interest rate derivatives like FRAs, IRSs, and OISs (Overnight Index Swaps) is emerging to enable banks, PDs and FIs to hedge interest rate risks.

Instruments / Debt security – Also known as fixed income securities

Debt instruments /securities represent contracts whereby one party lends money to another on predetermined terms with rate and periodicity of interest & repayment of principal amount.

They are classified and grouped by their level of default risk, type of issuer and income payment cycles In the Indian securities markets, we use the term ‘bond’ for debt instruments issued by the Central and State

governments and public sector organizations, and the term ‘debentures’ for instruments issued by private corporate sector.

Debt security is a paper or electronic obligation that enables the issuing party to raise funds by promising to repay to lender with accordance to terms of contract.

Debt securities on the whole are safer investments than equity securities but riskier than cash.

principal features of a bond are: Bond signifies creditor relationship with a corporation or government body. Bond is a long-term promissory note issued by a business or a business firm. Value of the bond price is the sum of present value of annuities (or coupon) over the life of the bond

and present value of the face value of the bond. Bond value or price of the bond is calculated on the basis of face value, coupon rate, market rate and

maturity period of the bond Depending on periodicity of payment debt securities are classified as semiannual, annual etc, and depending

upon life span of debt security classified as short term, long term and flat.

The bonds price and the bonds yield are important factors to be consider when investing in bonds. Normal saving bonds issued at face value and redeemed at their face value plus interest.

Price of the bond does not necessarily reflect face value. Once the bond is issued, it may trade on the open market for more or less than its issue price. This fluctuation in price will affect bonds yield.

General rule of thumb for bonds is that bond prices move in opposite direction of interest rates. Yield on a bond that is sold for a price other than its face value is determined by dividing annual interest

payment by the price of the bond. Bonds rated lower (Riskier, high interest rate) are considered junk bonds (high yielding bonds). Higher the rating, lower the yield.

Bonds issued by agencies of the federal government are not rated by any rating company, because they are backed by the full faith and credit of the US government.

For individual investors, primary there are three types of bonds available, Federal government bonds, Municipal bonds and corporate bonds. Municipal bonds have advantage of paying interest that is free from federal income tax.

In case of normal bond, as inflation goes up bond value gets decreased E.x. – face value 100 Bond at inflation rate 10%, face value becomes 200 if inflation goes down to 5% and vice-

a-versa. In the same way, if interest rate falls value of bond increases to pay same amount as committed at maturity

and vice-a-versa. High interest, low bond price…. bought….we may get(capital gain + interest)

Low interest rates, high bond price……sold….we may get (capital gain + low interest) As price of bond falls, yield on bond increases, as rates goes on increasing buy the bond and if a rate

goes on decreasing sell the bond.

Suppose if market rate (interest rate) rises to 16% then, price of the bond falls and yield increases, but

coupon factor remains same. Only changes are bonds price and Yield.

If one changes the maturity period, it will affect as follows,

If payment schedule is revised to semiannually, there will be slight change in bonds price, but

compared to annual payments, in semiannual payments number of payments will increase to 10 (Double)

Inflationary bond – (Also known as inflation linked bonds or colloquially as linkers) Inflation indexed bonds are bonds where the principal is indexed to inflation. They are designed to cut out inflation risk of investment. First known inflation indexed bond was

issued by the Massachussets Bay Company in 1870. The inflation linked market primarily consists of sovereign bonds, with privately issued inflation linked

bonds constituting a small portion of the market. Structure – inflation indexed bonds pay a periodic coupon that is equal to the product of the inflation index and normal coupon rate. Relation between coupon payments, breakeven inflation and real interest rate

is given by Fisher Equation. Rise in coupon payments is a result of an increase in inflation expectation, real rates or both.

For some bonds such as series 1 saving bonds (US), interest rate is adjusted according to inflation. For other bonds such as, in case of TIPS, underlying principal of a bond changes, which results in a

higher interest payment when multiplies by the same rate. Example – if the annual coupon of the bond was 5% and the underlying principal of the bond were 100

units, the annual payments would be 5 units. If the inflation index increased by 10% principal of the bond would increase to 110 units. Coupon rate would remain at 5%, resulting in an interest payment of 110 * 5% = 5.5 units. In case of inflationary bond, if inflation goes up rate on inflationary bond also goes up and vice-a-versa.

Inflation rate may remain high or low, so the returns are not sure, rate may fluctuate up & down. In every month current face of a bond on accounting goes on decreasing as interest is gets paid every month.

On custody original face remains same till maturity. Also factor for paydown securities goes on decreasing and finally becomes zero & factor for payup securities goes on increasing.

For inflation adjusted inflationary bonds, if rate of interest is 10%, inflation rate is 7%, then we will be taxed

only for 3% interest rate if as effective tax rate(indexation) applicable. Short term debt security –

o mature in less than one year o TD = SD o Interest paid on maturity & not on coupon dates o Accrual method – Act/360 o Traded on money market o Always issued at PAR/discount (never at premium) o Includes – municipal bonds, banker acceptance, treasury bills, REPO's, time deposits, commercial paper

and certificate of deposit.

Long term debt security- o Maturity period of more than one year o TD is not equal to SD o Interest paid on coupon dates based on coupon frequency o Accrual method – 30/360 o Issued at PAR, at discount or at premium o Includes – corporate bonds, municipal bonds, treasury bonds, treasury notes, debentures, ABS, MBS,

collateralized mortgage obligation (CMO), Foreign government long term debt securities

Maturity: have fixed maturity period with stated rate, PAR value & price. In the bond markets, the terms maturity and term-to-maturity, are used quite frequently.

Maturity of a bond refers to the date on which the bond matures, or the date on which the borrower has agreed to repay (redeem) the principal amount to the lender. The borrowing is extinguished with redemption, and the bond ceases to exist after that date.

Term to maturity on the other hand, refers to the number of years remaining for the bond to mature. Term to maturity of a bond changes every day, from the date of issue of the bond until its maturity.

Coupon: income on a bond referred as interest. Coupon refers to the periodic interest payments that are made

by the borrower (who is also the issuer of the bond) to the lender (the subscriber of the bond). Coupon rate is the rate at which interest is paid, and is usually represented as a percentage of the par value of a bond.

Principal: Principal is the amount that has been borrowed, and is also called the par value or face value of the

bond. The coupon is the product of the principal and the coupon rate

ID 1st CD 2nd CD 3rd CD MD Coupon period ends the day before next coupon date & interest is paid on coupon dates

Accrual basis – Accounting method whereby income & expense items are recognized as they are earned even though

they might not have actually been paid. It defines how the days in the payment period are counted. US – act/act Corp & municipal bonds – 30/360 Money market instruments - act/ 360 Few securities – act/ 365

Accrued interest – interest on investment earned but not received Coupon – annual % of face amount, debt securities interest rate Coupon period – time between interest payments on debt security Discount – difference between bonds current market value & face value or redemption value Net amount - buyer needs to settle a security transaction includes principal & interest for debt securities

Net amount = principal amount + purchasing/selling interest PAR – it is amount on which interest payments are calculated

Interest – it is a cost incurred for using a investors’ money.s

It is a compensation for using ones money. For company it is a cost & for investor it is income. o Simple interest –

Amount at the end = P + SI +N Future value = Po + SI

o Compound interest – CI = Po (1+i)^n – Po Future value = Po (1+i)^n Future value = present value (1+i)^n Present value = future value / (1+r)^n

Interest calculation methods –

Daily interest calculation methods - Act / 360 = PAR*ROI% / 360

Total interest = [PAR*ROI% / 360] * no. of days 30 / 360 = PAR*ROI% / 360

Total interest = [PAR*ROI% / 360] * no. of days Act / 365 = PAR*ROI% / 365

Total interest = [PAR*ROI% / 365] * no. of days 30 / 360 = PAR*ROI% / 365

Total interest = [PAR*ROI% / 360] * no. of days Act / act = [(PAR*ROI%/no. of periods) / no. of day in pay period]

= [(100000*10% / 2) / 181] = 5000 / 181 = 27.6243

Total interest = (27.6243)*(no. of days)

Amortization (loss) – adjustment of difference between price of a bond originally bought at a premium & PAR value of a bond. Amortization starts from settlement date.

Amortization (income) is realized through increase in book value of debt security. If in case of interest only bonds, instead of paying interest on regular basis book value of bond is increased and is paid on maturity.

Accretion (profit) – it is a adjustment of difference between price of a bond originally bought at a discount & PAR value of a bond.. Amortization or Accretion amount = (purchase amount – sell amount) = (PAR * Price in %) – PAR

Daily amortization / accretion = (PAR * Price %) – PAR / No. of days [Depreciation is shown annually, while amortization is shown daily in the books]

Net amount payable or receivable - Dollar amount, buyer needs to settle a security transaction includes principal & interest for debt

securities Net amount = principal amount + purchasing/selling interest Principal amount = purchase amount = PAR * Price %

Example –

If security is bought at premium Rs. 110, sold at discount Rs. 80 and its face value is Rs. 100. (BOUGHT) Premium Rs. 110 > Rs.- 10 (Amortization – loss) Face value is Rs. 100. >Rs. 20 (Accretion – income) (SOLD) Discount Rs. 80 Net gain / loss = purchase amount – sell amount = (PAR * Price %) - PAR = 110 – 80 = 30 Rs.

If difference is positive them it is amortization/loss If difference is negative them it is accretion/income/profit

If debt security issued at PAR there is only interest income at maturity & if it is issued at discount there is accrued income on maturity & if issued at premium there will be loss.

Annuity – fixed payment or receipt of each period for a specific number of periods. Sinking fund – fund which is created out of fixed payments each year for a specified period of time.

credit rating of bonds –

Importance of credit rating is to protect the investor who cannot get inside information about the instruments for the investment due to lack of time and lack of expertise. Credit rating is not a onetime evaluation of credit risk of a security. Most bond or debenture issues are rated by specialized credit rating agencies. Credit rating agencies in India are

CRISIL (jointly promoted by ICICI & UTI in 1988, went public in 1992) – Credit rating & information service of India limited

CARE (1992) – credit analysis and research ICRA (1991) - investment information credit rating agency of India DCR – Duff and Phelps credit rating India

S & P - Standard & Poor. & Fitch, Moody.

Types of credit rating – o Bond rating o Equity rating o Commercial paper rating o Rating the borrowers o Sovereign rating – rating the country as its creditworthiness, probability to risk.

Yield on a bond varies inversely with its credit (safety) rating. The safer the instrument, lower is the rate of

interest offered. Rating determined by subtracting fund risk score from its return score.

Rating symbols – o AAA – highest safety of timely payment of interest & principal o AA – high safety payment of interest & principal is timely o A – moderate safety – sufficient safety of payment of interest and principal

Participants –

Government issues securities through the following modes: Government securities are issued for a minimum amount of Rs.10,000/- (face value) and in multiples of Rs.10,000/- thereafter

Issue of securities through auction: The securities are issued through auction either on price basis or on yield basis. Where the issue is on price basis, the coupon is pre-determined and the bidders quote price per Rs.100 face value of the security, at which they desire to purchase the security. Where the issue is on yield basis, the coupon of the security is decided in an auction and the security carries the same coupon till maturity. On the basis of the bids received, RBI determines the maximum rate of yield or the minimum offer price as the case may be at which offers for purchase of securities would be accepted at the auction.

The auctions for issue of securities (on either yield basis or price basis) are held either on ‘Uniform price’ method or on ‘Multiple prices’ method.

Bids quoted higher than the maximum rate of yield or lower than the minimum price are rejected. Issue of securities with pre-announced coupon rates: The coupon on such securities is announced before the

date of floatation and the securities are issued at par. In case the total subscription exceeds the aggregate amount offered for sale, RBI may make partial allotment to all the applicants.( page 137)

Issue of securities through tap sale: No aggregate amount is indicated in the notification in respect of the securities sold on tap. Sale of such securities may be extended to more than one day and the sale may be closed at any time on any day.

Issue of securities in conversion of maturing treasury bills/dated securities: The holders of treasury bills of certain specified maturities and holders of specified dated securities are provided an option to convert their holding at specified prices into new securities offered for sale.

Government issues the following types of Government securities: (a) Securities with fixed coupon rates: These securities carry a specific coupon rate remaining fixed during the

term of the security and payable periodically. These may be issued at a discount, at par or at a premium to the face value and are redeemed at par.

(b) Floating Rate Bonds: These securities carry a coupon rate which varies according to the change in the base rate to which it is related. The coupon rate may be subject to a floor or cap.

(c) Zero Coupon Bonds: These are issued at a discount and redeemed at par. No interest payment is made on such bonds before maturity.

STRIPS

STRIPS is the acronym for Separate Trading of Registered Interest and Principal of Securities. STRIPS let investors hold and trade the individual interest and principal components of eligible Treasury notes

and bonds as separate securities. STRIPS are popular with investors who want to receive a known payment on a specific future date. STRIPS are called “zero-coupon” securities. The only time an investor receives a payment from STRIPS is at

maturity. STRIPS are not issued or sold directly to investors. STRIPS can be purchased and held only through financial

institutions and government securities brokers and dealers. When a Treasury fixed-principal note or bond or a Treasury inflation-protected security (TIPS) is stripped

through the commercial book-entry system each interest payment and the principal payment becomes a separate zero-coupon security. Each component has its own identifying number and can be held or traded separately.

For example, a Treasury note with 10 years remaining to maturity consists of a single principal payment, due at maturity, and 20 interest payments, one every six months over a 10 year duration. When this note is converted to STRIPS form, each of the 20 interest payments and the principal payment becomes a separate security.

(d) Indexed Bond: Interest payments of these bonds are based on Wholesale Price Index/ Consumer Price

Index.

Asset backed security (ABS) – These are type of securities issued against asset other than home. ABS generally issued by banks and

financial institutions. ABS is shorter in duration than MBS. ABS has credit risk.

Mortgage Backed Security (MBS) – It is a security that represents ownership of an undivided interest in a group of mortgages.

Created in 1970 as a way to turn non liquid (mortgages) into liquid assets (securities) Represents claim on cash flows from mortgage loans through a process called securitization. Mortgage loans are purchased from banks, mortgage companies and other originators. This is done by

Govt. agencies, govt. sponsored enterprises & private entities. These securities usually sold as bonds Allow lending institutions to continue to make loans for home purchases by providing the lender with

cash.

Types of MBS – RMBS- Residential MBS CMBS- Commercial MBS Striped MBS- each mortgage payment partly used to pay down loan’s principal & partly used to pay

interest on it. o Interest only (IO)SMBS o Principal only(PO) SMBS

Net interest margin security (NIMS)- Restructured residual interest of MBS. Features of MBS –

Attractive yield - Higher yields than govt. bonds Credit quality –

Credit risk affected by homeowners or borrowers defaulting on their loans. Credit risk is considered minimal for mortgages backed by federal agencies or federally sponsored agencies.

High current income – Investors may receive high payments compared to the income generated by investment grade

corporate issues; a portion of these payments may represent return of principal, not just interest payments.

Liquidity – secondary market can be large & relatively liquid with active trading with dealers and investors. Benefits – higher yields than other treasury securities, liquidity, monthly income, guarantees

against default. Risks – prepayment and interest rate risk. As interest rate fall, prepayments increase. Also monthly

payment is not known in advance. For MBS down payment should be less than 20% of property value.

MBS Issuers – 1. Govt. national Mortgage Association 2. Federal Home Loan Mortgage Corporation 3. Federal National Mortgage Association

Types of MBS issuers –

GNMA-1 GNMA-2 FNMA FHLMC

Commonly known

Ginnie Mae Ginnie Mae Fannie Mae Freddie Mac

Type Govt. agency/HUD (Housing & urban department)

Govt. agency/HUD (Housing & urban department)

Govt. sponsored enterprise & public company

Public company

Founded 1968 1968 1938 1970

Payment of principal & interest

Guarantees both, timely interest & principal payments

Guarantees both, timely interest & principal payments

Guarantees both, timely interest & principal payments

Guarantee timely interest & ultimate principal payments

Lag time 15 days delay 20 days delay 25 days delay 45 days delay

Example – Mortgage amount = $ 100000 = original face (face amount of MBS when issued) Suppose monthly payment is $1000 # Payment 1 – Principal Interest

Paydown $ 1 $ 999 Principal balance $ 99999 (current face) i.e. remaining principal balance left to

be paid

# Payment 2 – Principal Interest

Paydown $ 2 $ 998 Principal balance $ 99997 (current face) i.e. remaining principal balance left to

be paid

Last month’s principal balance will now be called PRIOR CURRENT FACE

Original face = principal outstanding on MBS/PAR Value at its issue date = never changes

Current face = Principal outstanding on MBS right now/current PAR value It is determined by multiplying the current pool factor by original face value. It represents outstanding principal balance

= original face * current paydown factor = usually decreases every month

Paydown factor = percentage of original face amount outstanding at a given pt. of time = It is reciprocal of outstanding amount

= usually gets smaller every month = expressed as a decimal Paydown = principal portion of loan payment(Loan payments splits between principal & interest)

A payment made towards an outstanding loan balance. Every time you make a mortgage payment you are “paying down” your loan.

Over the time outstanding principal balance of MBS will be reduce, original face remains an important and distinguishing piece of information associated with MBS. By definition newly issued MBS security will have pool factor 1. In other words original face equals current face. As principal is paid down the current face will be less than the original face. Current face is derived by multiplying the original face by the current pool factor.

Different MBS with same issue date, same coupon and same original face can have greatly different current faces. Because MBS pays at different rate based on characteristics of the underlying loans and actual prepayment speed of underlying mortgages.

Lag time = time between MBS coupon date (1st day of month) & actual payment date which varies by MBS type Coupon date = date on which payment is made Coupon period = time between two coupon payments of a security.

MBS accrues by 30/360 Payup factors are same as like Paydown factor but only difference is Payup factors goes on increasing

every month & also expressed as a decimal.

Paydown factor calculation –

Factors OF Paydowns

100000 -5000

0.9500 95000 -4800

0.9020 90200 -4500

0.8570 85700 -5300

0.8040 80400 -5677

0.7472 74723 -3466

0.7126 71257 -8955

0.6230 62302 -10000

0.5230 52302 -12645

Pass-Through Security(securitized instrument)/collateral mortgage obligation - A pool of fixed-income securities backed by a package of assets. A servicing intermediary collects the monthly

payments from issuers, and, after deducting a fee, remits or passes them through to the holders of the pass-through security. Also known as a "pass-through certificate" or "pay-through security."

The most common type of pass-through is a mortgage-backed certificate, where homeowners' payments pass from the original bank through a government agency or investment bank to investors

- Mortgage on no. of different collateral assets - Assets have diff. maturities (different classes)

o Different priorities for receipt of principal & some case of interest. o For tax purpose it is important to be classified as debt for income tax purpose

Incomes or receivables are distributed accordingly among investors.

money market – Segment of financial market in which financial instruments with high liquidity and very short

maturities are traded It is the market for dealing in monetary assets of short term nature. Short term funds up to one year & financial assets that are close substitute for money are dealt in money

market. Characteristics – liquidity, minimum transaction cost, no loss in value, short maturity period Rate struck between borrower & lender represents an array of money market rates. Money market is the major mechanism through which reserve bank influences liquidity and the general level of

interest rates. A well developed money market contributes to an effective implementation of monetary policy.

Money market instruments - o Call money (overnight & short notice up to 14 days)

Volume of call loans depends upon the extent of trading in bills of exchange, treasury bills. Interbank overnight money rate is called call rate. Rate of interest paid on call loans is called call rate

o Term money (1,3 and 6 months) o Certificate of deposit (CD) o Money market mutual funds o Commercial bills o Treasury bills o Inter corporate funds o Forward rate agreements/interest rate swap

Treasury Bill (in less than 1 year) – marketable securities from US called treasuries.

Treasury bills of the central govt. have been issued since the inception of the bank. They offer short term investment opportunity to financial institutions.

Treasury bills are claims against govt. As they are negotiable instrument/securities and since they can be rediscounted with the bank. Treasury bills (T-bills) are short-term debt instruments issued by the Central government. Types of T-bills are issued:

0.3966 39657 -7465

0.3219 32192 -9835

0.2236 22357 -20000

0.0236 2357 -2357

0.0000 0 Nil

o 14 Day intermediate treasury bills – issued for short term cash surplus by state governments. o 91 day (13 week) – (ordinary & ad-hoc)

Ordinary – issued to public & RBI by central government Usually sold at discount & redeemed at PAR at maturity.

(Difference between amounts paid at purchase & amount received at maturity gives interest earned or discount)

o 182 day (26 week) – introduced to enable the market for govt. securities, cannot be discounted with RBI, can be auctioned for sell

o 364 day (52 week)– issued to generate market loans, auction of bills is done fortnightly. T-bills are sold through an auction process announced by the RBI at a discount to its face value. RBI issues a

calendar of T-bill auctions. It also announces the exact dates of auction, the amount to be auctioned and payment dates. T-bills are available for a minimum amount of Rs. 25,000 and in multiples of Rs. 25,000. Banks and PDs are major bidders in the T-bill market.

Auction of all the Treasury Bills are based on multiple price auction method at present. The notified amounts of the auction is decided every year at the beginning of financial year (Rs.500 crore each for 91-day and 182-day Treasury Bills and Rs.1,000 crore for 364-day Treasury Bills for the year 2008-09) in consultation with GOI. RBI issues a Press Release detailing the notified amount and indicative calendar in the beginning of the financial year.

Treasury bills are short-term securities maturing in one year or less. Bills are sold at a discount or at par (face value). When a bill matures, the investor receives the face value. The difference between the purchase price and the face value equals the interest earned.

For example, if a $1,000 26-week bill sells at auction for a 0.145% discount rate, the purchase price would be $999.27, a discount of $0.73. The purchase price can be determined from the following formula:

P = F (1 - (d x t)/360), thus P = 1000 (1- (.00145 x 182)/360), solving

P = $ 999.27

Where, P = Price F = Face value d = rate of discount t = days to maturity

Cut-Off Yields T-bills are issued at a discount and are redeemed at par. The implicit yield in the T-bill is the rate at which the

issue price (which is the cut-off price in the auction) has to be compounded, for the number of days to maturity, to equal the maturity value.

Yield = ((100-Price)*365)/ (Price * No of days to maturity)

Similarly, Price = 100 / (1+ (yield% * (No of days to maturity/365)) For example, a 182-day T-bill, auctioned on January 18, at a price of Rs. 95.510 would have an implicit yield of

9.4280% computed as = ((100-95.510)*365)/(95.510*182) 9.428% is the rate at which Rs. 95.510 will grow over 182 days, to yield Rs. 100 on maturity.

Treasury bill cut-off yields in the auction represent the default-free money market rates in the economy, and

are important benchmark rates.

Treasury notes –(1 to 10 years)

Treasury notes are interest-bearing debt security in US that have a fixed maturity of not less than 1 year and not more than 10 years from date of issue.

Treasury currently issues notes in 2, 3, 5, 7, and 10-year maturities. Treasury notes pay interest on a semi-annual basis. When a note matures, the investor receives the

face value. These are issued by competitive (quoting system) or non competitive bids (auction). With a noncompetitive bid, a bidder agrees to accept the yield determined at auction. A bidder is

guaranteed to receive the full amount of the security bid. With a competitive bid, a bidder specifies the yield that is acceptable. This bid may be accepted in the

full amount if the rate specified is less than the yield set by the auction, accepted in less than the full amount requested if the bid is equal to the high yield, or not awarded if the rate specified is higher than the yield set at the auction.

2-year note auctions are usually announced in the second half of the month and generally auctioned a few business days later. They are issued on the last day of the month. If the last day of the month is a Saturday, Sunday, or federal holiday, the securities are issued on the first business day of the following month.

3-year note auctions are usually announced in the first half of the month and generally auctioned a few business days later. They are issued on the 15th of the month. If the 15th falls on a Saturday, Sunday, or federal holiday, the securities are issued on the next business day.

5-year note auctions are usually announced in the second half of each month and generally auctioned a few business days later. They are issued on the last day of the month. If the last day of the month is a Saturday, Sunday, or federal holiday, the securities are issued on the first business day of the following month.

7-year note auctions are usually announced in the second half of each month and generally auctioned a few business days later. They are issued on the last day of the month. If the last day of the month is a Saturday, Sunday, or federal holiday, the securities are issued on the first business day of the following month.

10-year note auctions are usually announced in the first half of February, May, August, and November. The re-openings of a 10-year note are usually announced in the first half of January, March, April, June, July, September, October, and December. All 10-year notes are generally auctioned during the second week of the above-mentioned months and are issued on the 15th of the same month. If the 15th falls on a Saturday, Sunday, or federal holiday, the securities are issued on the next business day.

Treasury Bonds – (more than 10 years) Short term corporate bonds – less than 5 year Intermediate – 5-12 years can be convertible or callable bonds. Long term – over 12 years

Bonds bid price is traded in percentage. Eg- if bonds bid price is 93, it is trading at 93% of PAR value. Bonds with “C13” denotes, bond is callable and may be redeemed in early 2013.

Treasury bonds are interest-bearing securities with maturities over 10 years. Treasury bonds pay interest on a semi-annual basis. When a bond matures, the investor receives the face value.

30-year bond auctions are usually announced in the first half of February, May, August, and November. The re-openings of a 30-year bond are usually announced in the first half of January, March, April, June, July, September, October, and December. All 30-year bonds are generally auctioned during the second week of the above-mentioned months and are issued on the 15th of the same month. If the 15th falls on a Saturday, Sunday, or federal holiday, the securities are issued on the next business day.

Price vs. Yield to Maturity

Yield = coupon amount / Price………… at PAR Yield = interest rate

As price goes up, yield decreases and vice-a-versa.

The price of a fixed rate security depends on the relationship between its yield to maturity and the interest rate. If the yield to maturity (YTM) is greater than the interest rate, the price will be less than par value; if the YTM is equal to the interest rate, the price will be equal to par; if the YTM is less than the interest rate, the price will be greater than par.

Yield to maturity = total return received till bonds maturity. = All interest payments till maturity & assumed all the interest payments are reinvested at a rate equal to current yield on a bond plus any capital gain or loss.

YTM is more accurate and enables you to compare bonds with different maturities & coupons. When interest rates rise, price of a bond falls, thereby raises the yield of older bonds and brings them into

line with newer bonds with higher coupons. When interest rate falls, price of a bond in market rises, thereby lowers the yield of older bonds and brings

them into line with newer bonds issued with higher coupons. When purchasing a Treasury bond, any interest accrued since the last interest payment is added to the bond

purchase price. At the next interest payment date the investor receives the full interest payment. Use the following formula to figure accrued interest:

A= P*r(d/t) / 2 Where,

A- Accrued interest P - Face value R – interest rate of a treasury bond D - # of days since last coupon period T - # of days in current coupon period

Example: A 5% 30-year bond ($1,000 principal) is purchased 91 days after the last coupon payment. The current coupon period contains 182 days.

A = 1000 x .05 (91/182)/2 , solving A = $12.50

Treasury Inflation-Protected Securities (TIPS) The U.S. Treasury has been issuing Treasury Inflation-Protected Securities (TIPS) since 1997. TIPS

provide investors with protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the consumer price index.

When a TIPS matures, the investor is paid the inflation-adjusted principal or original principal, whichever is greater. Since a TIPS investor won't receive less than the original principal, the investor's original principal amount is protected against deflation as well.

TIPS pay interest semiannually at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation (Rise in index) and fall with deflation (Fall in index). Amount of each interest payment is determined by multiplying the adjusted principal by one-half the interest rate.

Relationship between TIPS and Index affects both the sum you are paid when your TIPS matures. The 5-year TIPS is auctioned as an original issue in April. The 5-year TIPS is auctioned as a reopening in August and

December. The 10-year TIPS is auctioned as an original issue in January and July. The 10-year TIPS is auctioned as a reopening

in March, May, September, and November. The 30-year STIPS is auctioned as an original issue in February. The 30-year TIPS is auctioned as a reopening in

June and October. All TIPS accrue interest from the 15th of the month and are issued on the last business day of the month. For

original issue TIPS, accrued interest is payable by the investor from the 15th until the issue date. For reopened TIPS, accrued interest is payable from the dated date on the announcement until the issue date of the reopening.

All reopened securities have the same maturity date, coupon interest rate, and interest payment dates as the original security but have a different issue date and usually a different price. Auction Pattern 5-year TIPS - April, August*, December* 10-year TIPS - January, March*, May*, July, September*, November* 30-year TIPS - February, June*, October* * This is a reopening. In a reopening, we sell an additional amount of a previously issued security. The reopened security has the same maturity date and interest rate as the original security. However, as compared to the original security, the reopened security has a different issue date and usually a different purchase price.

Price of the TIPS can be less than, Equal to, or greater than face value.

You can bid for TIPS in either of two ways: With a noncompetitive bid, you agree to accept the yield determined at auction. With this bid, you are

guaranteed to receive the TIPS you want, and in the full amount you want. With a competitive bid, you specify the yield you are willing to accept. Your bid may be: 1) accepted in the full

amount you want if your bid is less than the yield determined at auction, 2) accepted in less than the full amount you want if your bid is equal to the high yield, or 3) rejected if the yield you specify is higher than the yield set at auction.

Key Facts: TIPS are issued in terms of 5, 10, and 30 years. The interest rate on a TIPS is determined at auction. TIPS are sold in increments of $100. The minimum purchase is $100. TIPS are issued in electronic form. You can hold a TIPS until it matures or sell it in the secondary market before it matures. In a single auction, an investor can buy up to $5 million in TIPS by non-competitive bidding or up to 35% of the

initial offering amount by competitive bidding. The price of a fixed rate security depends on its yield to maturity and the interest rate. If the yield to

maturity (YTM) is greater than the interest rate, the price will be less than par value; if the YTM is equal to the interest rate, the price will be equal to par; if the YTM is less than the interest rate, the price will be greater than par.

Inflationary bond –

- Generally inflationary factor is above 1. - May fluctuate up & down over the time

Information on Negative Rates and TIPS-

Treasury TIPS auction rules allow for negative real yield bids and describe how the interest (coupon) rate on the original issue would be set if the auction stops at a negative real yield. TAAPS handles negative-yield bids for all TIPS auctions, both for original auctions and reopening auctions.

TAAPS® -

TAAPS is an application for the exclusive use of institutions that provides direct access to U.S. Treasury auctions. This system electronically receives and processes tenders sent into U.S. Treasury auctions. It allows institutions to purchase marketable securities directly and reduce or eliminate intermediary costs, bringing direct bidding to your desktop.

To submit through TAAPS: Access the TAAPS website using a standard Internet connection. Enter your user ID and password (secured by a Secure Socket Layer [SSL] with 128 bit encryption).

Complete and submit an electronic tender. If the tender is accepted, we will debit and deliver the awarded securities to the Federal Reserve funds and

securities account of either the institution or a custodian.

STRIPS - STRIPS is the acronym for Separate Trading of Registered Interest and Principal of Securities. STRIPS let investors hold and trade the individual interest and principal components of eligible Treasury notes

and bonds as separate securities. STRIPS are popular with investors who want to receive a known payment on a specific future date. STRIPS are called “zero-coupon” securities. The only time an investor receives a payment from STRIPS is at

maturity. STRIPS are not issued or sold directly to investors. STRIPS can be purchased and held only through financial

institutions and government securities brokers and dealers. When a Treasury fixed-principal note or bond or a Treasury inflation-protected security (TIPS) is stripped

through the commercial book-entry system each interest payment and the principal payment becomes a separate zero-coupon security. Each component has its own identifying number and can be held or traded separately.

For example, a Treasury note with 10 years remaining to maturity consists of a single principal payment, due at maturity, and 20 interest payments, one every six months over a 10 year duration. When this note is converted to STRIPS form, each of the 20 interest payments and the principal payment becomes a separate security.

Commercial bill market – Commercial bill is a document expressing the commitment of the borrowing firm to repay short term debt at a

fixed date in the future. o Organized subsectors –

Call money market – Short period loans less than 7 days are given without any security. consist borrowing by one

commercial bank from other. There is no stability in the call money rates. In India they are not prominent as accounts to only 1% of total deposits.

Bill market – Commercial bills arise out of trade transactions. These are besides treasury bills sold by RBI by tender or tap

method. Indian banks prefer treasury bills rather than commercial bills as they are more secured & issued by govt. o Unorganized sector – Consist money lenders, indigenous banks deal in hundis which are trade bills/finance bills. They charge high

rate of interest as high as 80-85%.

Bill of exchange – They are negotiable instruments drawn by the seller (drawer) on the buyer (drawee) for the value of goods

delivered to him. Also called trade bills & when accepted by commercial bank called commercial bill.

If the seller wishes to give some period for payment the bill would be payable at a future date (usance bill) If during the period seller is in need of fund, he can go to bank to discount bill at predetermined discount

rate. Bank will receive the maturity proceeds (face value) from drawee. In the meanwhile if bank is in need of funds it can rediscount the bill in the commercial bill rediscount market at market related rediscount rate.

Commercial paper -

Introduced in 1990 to enable highly rated investors to diversify their sources of short term surplus funds. Issued by non-banking companies & all India financial institutions as an unsecured promissory note.

Issued in the form of usance promissory note, redeemable at PAR to the holder at maturity. Issued for minimum period of 15 days to maximum period of 1 year, minimum size 5 lakh & in multiple of 5

lakh. If maturity fails on holiday it should be paid on previous working day. Permitted to issue by companies whose net worth not less than 5 crore & working capital not less than 4 crore. Must have credit rating of P2/A2/PP2 by CRISIL.

In case of commercial paper investors need to be aware of the default risk.

Certificate of deposit –

Introduced in June 1989, are negotiable term deposit certificates issued by commercial banks/ financial institutions at discount.

These make sound investments as these are liabilities of banks/financial institutions. Minimum lock in period 15 days Minimum issue size is 5 lakh & in its multiple.

Money market mutual funds – Introduced to enable small investor to participate in the money market Promoted by scheduled commercial banks, brokerage firms and mutual funds Purpose is to provide investors a safe place to invest. Investors can obtain a yield close to money market rates as MMMF's invest the money in corporate

bonds with residual maturity up to one year within the ceiling for CP. Portfolios comprised of short term securities representing high quality , liquid debt & monetary

instruments

Repo and Reverse Repo- Repo or Repurchase Agreements are short-term money market instruments. Repo is nothing but

collateralized borrowing and lending through sale/purchase operations in debt instruments. Under a repo transaction, a holder of securities sells them to an investor with an agreement to repurchase at a predetermined date and rate. In a typical repo transaction, the counterparties agree to exchange securities and cash, with a simultaneous agreement to reverse the transactions after a given period. To the lender of cash, the securities lent by the borrower serves as the collateral; to the lender of securities, the cash borrowed by the lender serves as the collateral. Repo thus represents a collateralized short term lending.

A reverse repo is the mirror image of a repo. When one is doing a repo, it is reverse repo for the other party. For, in a reverse repo, securities are acquired with a simultaneous commitment to resell.

Hence, whether a transaction is a repo or a reverse repo is determined only in terms of who initiated the first leg of the transaction. When the reverse repurchase transaction matures, the counter-party returns the security to the entity concerned and receives its cash along with a profit spread.

In a repo transaction, the securities should be sold in the first leg at market related prices and repurchased in second leg at derived price. The sale and repurchase should be accounted for in the repo account. On the other hand, in a reverse repo transaction, the securities should be purchased in the first leg at market related prices and sold in second leg at derived price. The purchase and sale should be accounted for in the reverse repo account.

Illustration: Details of Repo in a coupon bearing security:

Interest Rate Derivatives- Deregulation of interest rate exposed market participants to a wide variety of risks. To manage and control

these risks and to deepen money market, scheduled commercial banks, primary dealers and all India financial institutions have been permitted to undertake forward rate agreements (FRAs) and interest rate swaps (IRSs).

A FRA is a financial contract between two parties to exchange interest payments for a ‘notional Principal’ amount on settlement date, for a specified period from start date to maturity date. Accordingly, on the settlement date, based on contract (fixed) and the settlement rate, cash payments are made by the parties to one another. The settlement rate is the agreed benchmark/ reference rate prevailing on the settlement date. An IRS is a financial contract between two parties exchanging or swapping a stream of interest payments for a ‘notional principal’ amount on multiple occasions during a specified period. Such contracts generally involve exchange of a ‘fixed to floating’ rates of interest. Accordingly, on each payment date–that occurs during the swap period–cash payments based on fixed/ floating and floating rates, are made by the parties to one another. FRAs/IRSs provide means for hedging the interest rate risk arising on account of lending’s or borrowings made at fixed/ variable interest rates.

Scheduled commercial banks (excluding Regional Rural Banks), primary dealers (PDs) and all-India financial institutions (FIs) undertake FRAs/ IRSs as a product for their own balance sheet management or for market making. Banks/FIs/PDS offer these products to corporate for hedging their (corporate) own balance sheet exposures. There are no restrictions on the minimum or maximum size of ‘notional principal’ amounts of FRAs/ IRSs. There are also no restrictions on the minimum or maximum tenor of the FRAs/ IRSs.

Zero Coupon Yield Curve- The ‘zero coupon yield curve’ (ZCYC) starts from the basic premise of ‘time value of money’– that a given

amount of money due today has a value different from the same amount due at a future point of time Fixed income instruments can be categorized by type of payments. Most fixed income instruments pay to the

holder a periodic interest payment, commonly known as the coupon, and an amount due at maturity, the redemption value. There exist some instruments that do not make periodic interest payments; the principal amount together with the entire outstanding amount of interest on the instrument is paid as a lump sum amount at maturity.

These instruments are also known as ‘zero coupon’ instruments (Treasury Bills provide an example of such an instrument). These are sold at a discount to the redemption value, the discounted value being determined by the interest rate payable (yield) on the instrument.

The ZCYC depicts the relationship between interest rates in the economy and the associated term to maturity. It

provides daily estimates of the term structure of interest rates using information on secondary market trades in government securities from the WDM segment. The term structure forms the basis for the valuation of all fixed income instruments. Changes in the economy cause shifts in the term structure, changing the underlying valuations of fixed income instruments. The daily ZCYC captures these changes, and is used to track the value of portfolios of government securities on a day-to-day basis.

NSE-VaR System- NSE has developed a Value-at-Risk (VaR) system for measuring the market risk inherent in Government of India

(GOI) securities. NSE-VaR system builds on the NSE database of daily yield curves-the NSE-ZCYC which is now well accepted in terms of its conceptual soundness and empirical performance, and is increasingly being used by market participants as a basis for valuation of fixed income instruments. The NSE-VaR system provides measures of VaR using 5 alternative methods (normal (variance-covariance), weighted normal, historical simulation, weighted historical simulation and extreme value theory). Together, these 5 methods provide a range of options for market participants to choose from.

NSE-VaR system releases daily estimates of security-wise VaR at 1-day and multi-day horizons for securities traded on WDM segment of NSE and all outstanding GOI securities with effect from January 1, 2002. Participants can compute their portfolio risk as weighted average of security-wise VaRs, the weights being proportionate to the market value of a given security in their portfolio.

DERIVATIVES MARKET – Derivative is a product whose value is derived from the value of one or more basic variables, called bases

(underlying asset, index or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity, bond or any other asset.

Most derivatives are characterized by high leverage (Unlimited profit, limited loss) The International Monetary Fund defines derivatives as “financial instruments that are linked to a specific

financial instrument or indicator or commodity and through which specific financial risks can be traded in financial markets in their own right. The value of a financial derivative derives from the price of an underlying item, such as an asset or index. Unlike debt securities, no principal is advanced to be repaid and no investment income accrues”.

Through the use of derivative products, it is possible to partially or fully transfer price risks by locking–in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk adverse investors. By using derivative products investor can guard themselves against uncertainties arising out of fluctuations in asset prices.

Individuals and firms who wish to avoid or reduce risk can deal with the others who are willing to take risk for a price. Common place where such transactions takes place is called derivative market.

Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. The following three broad categories of participant's hedgers, speculators, and arbitrageurs trade in the derivatives market.

• Hedgers – these are the investors with present or anticipated exposure to the underlying asset which is

subject to price risks. They face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate

this risk. They use derivative market for price risk management of assets and portfolios. • Speculators – these are investors who take a view on future direction of the market. They wish to bet on future movements in the price of an asset. Futures and options contracts can give them an

extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. • Arbitrageurs – they take positions in financial markets to earn riskless profits. Take short and long positions in

same or different contracts at the same time to create a position to make riskless profit. They are in business to take advantage of a discrepancy between prices in two different markets. If, for

example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

First derivative product to be introduced in the Indian securities market is "Index Futures"

The derivatives market performs a number of economic functions. First, prices in an organized derivatives market reflect the perception of market participants about the future

and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus, derivatives help in discovery of future as well as current prices.

Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.

Third, derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

Fourth, speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets.

Fifth, an important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. Finally, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

Types of Derivatives- The most commonly used derivatives contracts are forwards, futures and options which we shall discuss in

detail later. Here we take a brief look at various derivatives contracts that have come to be used. Forwards: A forward contract is a customized contract between two entities, where settlement takes place on

a specific date in the future at today’s pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the

future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

Options: Options are of two types – calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Interest Rate Derivatives- Deregulation of interest rate exposed market participants to a wide variety of risks. To manage and control

these risks and to deepen money market, scheduled commercial banks, primary dealers and all India financial institutions have been permitted to undertake forward rate agreements (FRAs) and interest rate swaps (IRSs).

A FRA is a financial contract between two parties to exchange interest payments for a ‘notional Principal’ amount on settlement date, for a specified period from start date to maturity date. Accordingly, on

the settlement date, based on contract (fixed) and the settlement rate, cash payments are made by the parties to one another. The settlement rate is the agreed benchmark/ reference rate prevailing on the settlement date.

An IRS is a financial contract between two parties exchanging or swapping a stream of interest payments for

a ‘notional principal’ amount on multiple occasions during a specified period. Such contracts generally involve exchange of a ‘fixed to floating’ rates of interest. Accordingly, on each payment date–that occurs during the swap period–cash payments based on fixed/ floating and floating rates, are made by the parties to one another. FRAs/IRSs provide means for hedging the interest rate risk arising on account of lending’s or borrowings made at fixed/ variable interest rates.

Scheduled commercial banks (excluding Regional Rural Banks), primary dealers (PDs) and all-India financial institutions (FIs) undertake FRAs/ IRSs as a product for their own balance sheet management or for market making. Banks/FIs/PDS offer these products to corporate for hedging their (corporate) own balance sheet exposures. There are no restrictions on the minimum or maximum size of ‘notional principal’ amounts of FRAs/ IRSs. There are also no restrictions on the minimum or maximum tenor of the FRAs/ IRSs.

Credit derivative – privately held negotiable bilateral contracts that allows users to manage their exposure to credit risk. Credit derivative are financial assets like forward contracts, swaps and options for which the price is driven by credit risk of economic agents (private investors or Governments)

Ex – bank concerns that one of its customers may not be able to repay can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books.

Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

A derivative security that gives the holder the right to purchase securities (usually equity) from the issuer at a specific price within a certain time frame. Warrants are often included in a new debt issue as a "sweetener" to entice investors

The main difference between warrants and call options is that warrants are issued and guaranteed by the company, whereas options are exchange instruments and are not issued by the company. Also, the lifetime of a warrant is often measured in years, while the lifetime of a typical option is measured in months.

YA function is applicable to warrants only. LEAPS: The acronym LEAPS means Long Term Equity Anticipation Securities. These are options having a

maturity of up to three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving

average or a basket of assets. Equity index options are a form of basket options. Swaps: (when two parties exchange financial instrument)

Swaps can happen over interest rates, currency, commodity (crude oil, gold), Stocks and bonds. Exchange of one security for one another to change the maturity (Bonds), quality of issues (stocks or bonds),

or because investment objectives has changed (interest or currency) Firms in different countries may have comparative advantage on interest rates. Swaps are private agreements between two parties to exchange cash flows in the future according to a

prearranged formula. They can be regarded as portfolios of forward contracts. Also traded over the counter. Two streams of cash flows also called legs of swap. Cash flows are determined by random or uncertain variable

such as an interest rate which is depending on a reference rate arrives from third party. e.g. – LIBOR (LIBOR rates determined by trading between banks and change continuously as economic conditions change.

Foreign exchange rate, equity price or commodity price. Cash flows are calculated over notional principal amount which is usually not exchanged. Swaps can be in cash or collateral. Cash flow generated by swap is equal to an interest rate times notional amount.

They can be regarded as portfolio of forward contracts. Firstly introduced in 1981 & are the most heavily traded contracts in the world. Swap has effect of transforming a fixed rate loan into a floating rate loan or vice-a-versa. Ex – firms in separate countries have comparative advantage on interest rates, and then a swap could

benefit both firms. One firm may have a lower fixed interest rate while another has access to a lower fixed interest rate. These firms could swap to take advantage of the lower interest rates. Value of a swap is the NPV of all estimated future cash flows. A swap is worth zero when it is first initiated.

Valuation of swaps – using bond prices As portfolio of forward contracts The commonly used swaps are:

• Interest rate swaps These entail swapping only the interest related cash flows between the parties in the same currency. Banks take a spread from swap payments.( popular & highly liquid financial derivative instrument)

Interest rate swaps commonly used for both hedging and speculating. “Plain vanilla” interest rate swap – it is exchange of fixed rate of loan to floating rate of loan. Life of

swap can vary between 2-15 years. Why – to limit or manage exposure to fluctuations in interest rates - to obtain marginally lower interest rates.

• Currency Swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

It is considered as FX transaction It is not required by law to be shown in company’s balance sheet.

• Credit swap:

• Commodity swap: in this swap floating (or market or spot) price is exchanged for a fixed price over a specified period. Majority involves crude oil. Exchanged cash flows depends on price of the underlying commodity.

Consumer – use to secure maximum price for oil. In return company receives payments based on the market price (usually oil price index) Producer – would agree to pay market price to financial institution in return receive fixed payments for commodity.

• Credit default swap: it is a contract in which buyer of a CDS makes a series of payments to the seller and in exchange receives a payoff(usually face value of loan) from a seller to buyer if an instrument- typically a bond or loan goes into default (fails to pay) (Buyer does not hold the loan instrument & who have no insurable interest in the loan called naked CDS.)

CDS contracts have been compared with insurance, because buyer pays a premium and in return receives a sum of money if one of the events specified in the contract occurs.

• Equity swaps: it is a financial derivative instrument where a set of future cash flows are agreed to be exchanged between two counter parties at set dates in the future. Two cash flows are referred as legs of swap, one of the leg is usually pegged to a floating rate such as LIBOR. This is called floating leg. Other leg is based on the performance of the either share of a stock or stock market indices. This leg is called equity leg.

• Total return swap: party A pays total return of an asset and party B makes periodic interest payments. Total return is capital gain or loss plus any interest or dividend payments. If total return is negative, then it is loss of party B, and party A receives this from party B.

• Bullet swap: parties agree to make periodic payments or a single payment at the maturity of the swap.

• CMS: it is a swap that allows a purchaser to fix the duration of received flows on a swap.

• Amortizing swap: an interest rate swap in which the notional principal for the interest payments declines during the life of a swap.

• Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Provide one party with the right but not the obligation at a future time to enter into swap.

Thus, swaptions is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

International swaps and derivatives association – (ISDA) Association created by private negotiated derivatives market that representing participating parties.

Association helps to improve the private negotiated derivatives market by identifying and reducing risks in the market. It was created in 1985.

It is principal derivatives industry trade organization. ISDA develops and publishes master agreements for swaps and other over the counter derivatives contracts. ISDA agreements serves as industry standard documentation for variety of financial instruments.

Caps floor collar:

Forward Contract A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the

parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price.

Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges.

The salient features of forward contracts are:

• They are bilateral contracts and hence exposed to counter–party risk.

• Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.

• The contract price is generally not available in public domain. • Transfer of ownership occurs on the spot but on the expiration date the contract has to be settled by delivery

of the asset.

• If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.

• Secondary market does not exist for forward contracts.

Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward.

If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract.

The use of forward markets here supplies leverage to the speculator.

FUTURE CONTRACT – A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a

certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More

than 99% of futures transactions are offset this way. The standardized items in a futures contract are: • Quantity of the underlying • Quality of the underlying • The date and the month of delivery • The units of price quotation and minimum price change • Location of settlement Also trading of fractional contracts is not allowed. Facilitates secondary market trading.

Types of future contract – Commodity futures – underlying is commodity or physical asset such as wheat, cotton, butter, eggs etc. Financial futures – underlying is financial asset such as foreign exchange, interest rate, shares, treasury

bills or stock exchange. Interest rate future – Currency future -

Security features do not represent ownership in corporation and holder not regarded as shareholder.

For trading in futures one need to open future trading account.

Buying a future is said to be going long, selling a future is said to be going short FUTURE PRICE = spot price + cost of carrying

BASIS = futures – spot price = cash prices – future prices Spread = difference between price of two future contracts. If the basis is low, market is efficient; it also means supply and demand for underlying commodity is in equilibrium.

If the spot price & future price don’t converge at maturity, there would be arbitrage opportunity.

(Basis can be either positive or negative, in index features basis is generally –ve, Basis may change its sign several times during the life of contract, it turns to zero at maturity)

(Basis will decrease with time and on expiry basis is zero, futures price equals spot price) If future price is greater than spot price is called contango. Future price tend to fall over time towards the spot, equaling spot price on delivery day i.e. basis is zero on delivery. If spot price is greater than future price it is called backwardation. Future price tend to rise over time to equal the spot price on the delivery day i.e. basis is zero on delivery.

Features of future contract – Standardization – standard specific quantity, grade, coupon rate, maturity etc. Clearing house – an organization called future exchange, will act as clearing house. Time spreads – there is a relationship between the spot price & future price of contract. Relationship

also exists between the price of future contract which are on the same commodity but which have different expiry dates. The difference between prices of two contracts is known as time spread, which is the basis of future market.

Margins – as clearing house takes default risk, to protect itself from risk it requires participants to keep margin money from 5-10% of face value of contract.

It is a difference between spot rate and estimated future rate of a certain commodity or any other contract. (Typically specified as no. of points over or under the spot rate)

Future payoffs – they have linear or symmetrical payoffs. It implies that losses as well as profits for the buyer and seller of futures are unlimited. They have potential unlimited upside as well as downside.

Payoff for a buyer of Nifty futures -

The figure above shows the profits/losses for a long futures position. The investor bought futures when the index was at 2220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses.

Payoff for a seller of Nifty futures -

The figure shows the profits/losses for a short futures position. The investor sold futures when the index was at 2220. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses.

Buyer will perform his obligation to purchase when spot price is above contract price but when contract price is

above the spot price loss occurs by buyer. Distinction between futures and forwards contracts:

Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty.

However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity.

Distinction between futures and forwards Futures Forwards Trade on an organized exchange OTC in nature Standardized contract terms Customized contract terms Hence more liquid Hence less liquid Requires margin payments No margin payment Follows daily settlement Settlement happens at end of period

Futures terminology- • Spot price: The price at which an asset trades in the spot market. • Futures price: The price at which the futures contract trades in the futures market. • Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one month,

two-month and three-month expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading.

• Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.

• Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size. • Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will

be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.

• Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.

• Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

• Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing price. This is called marking–to–market.

• Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

1. Value at risk margin- All securities are classified into three groups for the purpose of VaR margin For the securities listed in Group I, scrip wise daily volatility calculated using the exponentially weighted moving

average methodology is applied to daily returns. The scrip wise daily VaR is 3.5 times the volatility so calculated subject to a minimum of 7.5%.

For the securities listed in Group II, the VaR margin is higher of scrip VaR (3.5 sigma) or three times the index VaR, and it is scaled up by root 3.

For the securities listed in Group III the VaR margin is equal to five times the index VaR and scaled up by root 3. The index VaR, for the purpose, is the higher of the daily Index VaR based on S&P CNX NIFTY or BSE SENSEX,

subject to a minimum of 5%. NSCCL may stipulate security specific margins from time to time. The VaR margin rate computed as mentioned above is charged on the net outstanding position (buy value-sell

value) of the respective clients on the respective securities across all open settlements. There is no netting off of positions across different settlements. The net position at a client level for a member is arrived at and thereafter, it is grossed across all the clients including proprietary position to arrive at the gross open position.

For example, in case of a member, if client A has a buy position of 1000 in a security and client B has a sell position of 1000 in the same security, the net position of the member in the security is taken as 2000. The buy position of client A and sell position of client B in the same security is not netted. It is summed up to arrive at the member’s open position for the purpose of margin calculation.

The VaR margin is collected on an upfront basis by adjusting against the total liquid assets of the member at the

time of trade. The VaR margin so collected is released on completion of pay-in of the settlement or on individual completion of

full obligations of funds and securities by the respective member/custodians after crystallization of the final obligations on T+1 day.

2. Extreme loss margin- The Extreme Loss Margin for any security is higher of: 5%, or 1.5 times the standard deviation of daily logarithmic returns of the security price in the last six months. This

computation is done at the end of each month by taking the price data on a rolling basis for the past six months and the resulting value is applicable for the next month.

The Extreme Loss Margin is collected/ adjusted against the total liquid assets of the member on a real time basis. The Extreme Loss Margin is collected on the gross open position of the member. The gross open position for this

purpose means the gross of all net positions across all the clients of a member including its proprietary position. There is no netting off of positions across different settlements. The Extreme Loss Margin collected is released on

completion of pay-in of the settlement or on individual completion of full obligations of funds and securities by the respective member/custodians after crystallization of the final obligations on T+1 day.

3. Mark to market margin- Mark to market loss is calculated by marking each transaction in security to the closing price of the security at

the end of trading. In case the security has not been traded on a particular day, the latest available closing price at NSE is considered as the closing price. In case the net outstanding position in any security is nil, the difference between the

buy and sell values shall be is considered as notional loss for the purpose of calculating the mark to market margin payable.

The mark to market margin (MTM) is collected from the member before the start of the trading of the next day. The MTM margin is collected/adjusted from/against the cash/cash equivalent component of the liquid net worth

deposited with the Exchange. The MTM margin is collected on the gross open position of the member. The gross open position for this purpose

means the gross of all net positions across all the clients of a member including its proprietary position. For this purpose, the position of a client is netted across its various securities and the positions of all the clients of a member are grossed.

There is no netting off of the positions and setoff against MTM profits across two rolling settlements i.e. T day and T+1 day. However, for computation of MTM profits/losses for the day, netting or setoff against MTM profits is permitted.

Options Options are fundamentally different from forward and futures contracts. An option gives the holder of the option

the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an upfront payment.

In forwards and futures both the parties have an obligation. In option only the seller (option writer) has the obligation and not the buyer (option purchaser)

Buyer has the right to buy (call options) & sell put options. In case buyer of the option does not exercise his right, seller of the option must fulfill whatever his obligation. [For call options seller has to deliver the asset to the buyer of options a7nd for a put option seller has to receive the asset from the buyer of the option]

Options terminology-

Options are like derivative Products, they protect you from the down side at the same time allowing you to reap the benefits of any upside.

Call and put options becomes more valuable as time to maturity increases, it is because of risk as the time increases.

• Index options: These options have the index as the underlying. Like index futures contracts, index options

contracts are also cash settled. • Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the

United States. A contract gives the holder the right to buy or sell shares at the specified price. • Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not

the obligation to exercise his option on the seller/ writer. • Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby

obliged to sell/buy the asset if the buyer wishes to exercise his option. There are two basic types of options, call options and put options.

• Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price.

• Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

• Option price: Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.

• Option premium - at the buying of an option contract the buyer has to pay premium. Premium is price for acquiring the right to buy or sell. It is the price paid by the option buyer to the option seller for acquiring the right to buy or sell.

Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.

• Strike price: The price specified in the options contract is known as the strike price or the exercise price. • American options: American options are options that can be exercised at any time Up to the expiration date.

• European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.

• knock-out (KO) option An option with a built-in mechanism to expire worthless should a specified underlying price level be exceeded. Such

options are used in commodities and currencies markets. For example, consider a 1Y 100.00 USD call JPY put KO 115.00

This is a one year US dollar call, Japanese yen put struck at 100.00. It expires worthless (its KO, knock-out, property) should the USDJPY spot rate exceed 100.00.

digital option, binary option, all-or nothing option

An option whose payoff is either some fixed amount of some asset or nothing at all.

In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised

immediately. A call option on the index is said to be in-the-money when the current value of index stands at a level higher than the strike price (i.e. spot price > strike price). If the value of index is much higher than the strike price, the call is said to be deep ITM. On the other hand, a put option on index is said to be ITM if the value of index is below the strike price.

• At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the money when the value of current index equals the strike price (i.e. spot price = strike price).

• Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow it was exercised immediately. A call option on the index is said to be out-of-the-money when the value of current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. On the other hand, a put option on index is OTM if the value of index is above the strike price. “Out of the money options becomes worthless at the expiry date”

• Intrinsic value of an option: The option premium can be broken down into two components–intrinsic value and time value. Intrinsic value of an option is the difference between the market value of the underlying security/index in a traded option and the strike price. The intrinsic value of a call is the amount when the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.

• Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option’s time value, all else equal. At expiration, an option should have no time value. While intrinsic value is easy to calculate, time value is more difficult to calculate. Historically, this made it difficult to value options prior to their expiration. Various option pricing methodologies were proposed, but the problem wasn’t solved until the emergence of Black-Scholes theory in 1973.

Actions You Can Take on Options Expiration Day There are four actions you can choose to take for existing positions on options expiration day and they are; Close Out, Exercise, Roll Forward or Let Expire.

Closeout You could choose to close out your options position on expiration day in order to end the position. This is useful whens your options are profitable and in the money. All in the money options would be liable for assignment upon expiration, as such, you should choose to close out your existing in the money options positions if you do not intend to take position in the underlying stock itself. Closing out the position means to Sell To Close existing long positions or Buy To Close existing short options positions.

Exercise All in the money options will be automatically exercised upon expiration, as such, there isn't a real need for you to manually exercise your position but you could still choose to do it.

RollForward If you wish to stay invested in the price movement of the underlying asset but your current options contracts are expiring, you could choose to roll forward your positions. This means closing out your current options contracts and then simultaneously opens the same number of contracts in a further expiration month. Read more about Roll Forward.

Letexpire If your options contracts are way out of the money and has no more extrinsic value left to salvage by expiration, you could simply do nothing and let the options contracts expire out of the money. These contracts will simply disappear from your account after expiration and you will no longer hold a position in those contracts.

Option payoffs – Losses for the buyer of an option are limited; however the profits are potentially unlimited. For a writer, the

payoff is exactly the opposite. Profits are limited to the option premium; and losses are potentially unlimited. Call option gives the option to buy at a certain price, so the buyer would want the stock (spot price) to go up. More

spot price rises; more is the profit to buyer of call option.

Put option gives the option to sell at a certain price, so the buyer would want the stock (strike price) to go down. More spot price follows; more is the profit to buyer of put option.

o Payoff profile for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option.

The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price more is the

profit. If the spot price of the underlying is less than the strike price, the option expires un-exercised. The loss in this case is the premium paid for buying the option.

The above figure shows the profits/losses for the buyer of a three-month Nifty 2250 call option. As can be seen,

as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However if Nifty falls below the strike of 2250, he lets the option expire. The losses are limited to the extent of the premium paid for buying the option.

o Payoff profile for writer of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying.

For selling the option, the writer of the option charges a premium. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price, more are the losses. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire unexercised and the writer gets to keep the premium.

The above figure shows the profits/losses for the seller of a three-month Nifty 2250 call option. As the spot Nifty

rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60 charged by him.

o Payoff profile for buyer of put options: Long put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option.

The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Upon expiration, if the spot price is below the strike price, there is a profit. Lower the spot price more is

the profit. If the spot price of the underlying is higher than the strike price, the option expires un-exercised. His loss in this case is the premium he paid for buying the option.

The above figure shows the profits/losses for the buyer of a three-month Nifty 2250 put option. It can be seen, the as spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of 2250, the option expires worthless. The losses are limited to the extent of the premium paid for buying the option.

o Payoff profile for writer of put options: Short put A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option.

For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying.

Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot price of the underlying is more than the strike price, the buyer lets his option go un-exercised and the writer gets to keep the premium.

The above figure shows the profits/losses for the seller of a three-month Nifty 2250 put option. As the spot Nifty

falls, the put option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price (Since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged by him.

Distinction between Futures and options- Options are different from futures in several interesting senses. At a practical level, the option buyer faces an

interesting situation. He pays for the option in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from futures, which is free to enter into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions.

Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating ‘guaranteed return products’. The Nifty index fund industry will find it very useful to make a bundle of a Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which gives the investor protection against extreme drops in Nifty. Selling put options is selling insurance, so anyone who feels like earning revenues by selling insurance can set himself up to do so on the index options market.

More generally, options offer ‘non-linear payoffs’ whereas futures only have ‘linear payoffs’. By combining futures and options, a wide variety of innovative and useful payoff structures can be created.

Distinction between futures and options Futures Options Exchange traded, with novation - Same as futures. Exchange defines the product - Same as futures. Price is zero, strike price moves - Strike price is fixed, price moves. Price is zero - Price is always positive. Linear payoff - Non-linear payoff. Both long and short at risk - Only short at risk. Both parties are obligated to perform - only seller (writer) is obligated to perform

the contract No premium is paid by either party - buyer pays the premium Must perform at settlement date, not - can exercise contract at any time prior to expiry before the date

Pricing Futures: The cost of carry model: We use fair value calculation of futures to decide the no-arbitrage limits on the price of a futures contract. This is the basis for the cost-of-carry model where the price of the contract is defined as:

F = S + C

Where, F = Futures price; S = Spot price; C = Holding costs or carry costs. This can also be expressed as:

F = S (1 + r)T

r = Cost of financing and T = Time till expiration of futures contract If F < S(1 + r)T Or F > S(1 + r)T

Arbitrage opportunities would exist i.e. whenever the futures price moves away from the fair value, there would

be chances for arbitrage. We know what the spot and futures prices are, but what are the components of holding cost?

The components of holding cost vary with contracts on different assets. At times the holding cost may even be negative. In the case of commodity futures, the holding cost is the cost of financing plus cost of storage and insurance purchased etc. In the case of equity futures, the holding cost is the cost of financing minus the dividends returns.

The concept of discrete compounding is used, where interest rates are compounded at discrete intervals, for example, annually or semi-annually. In case of the concept of continuous compounding, the above equation would be expressed as:

F= Se(Rt)

Where, r = Cost of financing (using continuously compounded interest rate) T = Time till expiration; and e = 2.71828

Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested at 11% p.a. The fair value of a one-month futures contract on XYZ is calculated as follows:

F= Se(Rt)

F= 1150*e(0.11)*(1/12)

F= 1160 Pricing equity index futures -

A futures contract on the stock market index gives its owner the right and obligation to buy or sell the portfolio of stocks characterized by the index. Stock index futures are cash settled; there is no delivery of the underlying stocks. In their short history of trading, index futures have had a great impact on the world’s securities markets. Its existence has revolutionized the art and science of institutional equity portfolio management.

The main differences between commodity and equity index futures are that: • There are no costs of storage involved in holding equity. • Equity comes with a dividend stream, which is a negative cost if you are long the stock and positive costs if you are short the stock.

Therefore, Cost of carry = Financing cost - Dividends.

Let us assume that ABC Ltd. will be declaring a dividend of Rs.20 per share after 15 days of purchasing the contract. Current value of Nifty is 4000 and Nifty trades with a multiplier of 100. Since Nifty is traded in multiples of 100, value of the contract is 100*4000 = Rs.400, 000.

If ABC Ltd. has a weight of 7% in Nifty, its value in Nifty is Rs.28, 000 i.e. (400,000 *0.07). If the market price of ABC Ltd. is Rs.140, then a traded unit of Nifty involves 200 shares of ABC Ltd. i.e. (28,000/140).

To calculate the futures price, we need to reduce the cost-of-carry to the extent of dividend received. The amount of dividend received is Rs.4000 i.e. (200*20). The dividend is received 15 days later and hence compounded only for the remainder of 45 days. To calculate the futures price we need to compute the amount of dividend received per unit of Nifty. Hence we divide the compounded dividend figure by 100.

Thus, the futures price is calculated as;

A two month futures contract trades on the NSE. The cost of financing is 10% and the dividend yield on Nifty is

2% annualized. The spot value of Nifty 4000. What is the fair value of the futures contract?

Fair value = 4000e (0.1-0.02) × (60 / 365) = Rs. 4052.95

Beta – Beta measures the sensitivity of stocks responsiveness to market factors. Generally, it is seen that when

markets rise, most stock prices rise and vice versa. Beta measures how much a stock would rise or fall if the market rises / falls.

A stock with a beta of 1.5% will rise / fall by 1.5% when the Nifty 50 rises / falls by 1%. Which means for every 1% movement in the Nifty, the stock will move by 1.5% (β = 1.5%) in the same direction as the index. A stock with a beta of - 1.5% will rise / fall by 1.5% when the Nifty 50 falls / rises by 1%. Which means for every 1% movement in the Nifty, the stock will move by 1.5% (β = 1.5%) in the opposite direction as the index.

delta

Sensitivity of the option price to the change in the underlying asset's price

gamma Sensitivity of the option's delta to the change in the underlying asset's price

theta

Expected change in the option's price with the passage of time assuming risk-neutral growth in the asset

vega

Sensitivity of the option's price to the change in implied volatility.

Implied volatility – Volatility indicator from NSE, the India Vix. It is based on the expected volatility in the near future. India

Vix is based on the best bid and ask price of the out of the money index option price of the nifty. Only the near month and mid month option contracts are considered. The variance of these two periods computed separately are interpolated to get a single variance value with a constant maturity of 30 days to expiration. This is done by changing the weights on daily basis that is higher weights are given to the near month contract when the number of days to expiry is high, while the weight is reduced when number of days to expiry is low. Square root of the computed variance value is the expected standard deviation or volatility. This is multiplied by 100 to get India Vix value.

If the Vix is 15, it represents an expected annualized volatility of 15% over the next 30 days. To get the monthly figure annualized number is divided by the square root of 12. So if the Vix value is 15, index options are prices with the assumption of 68% likelihood that the magnitude of the change in the niftyin the next 30 days will be less than 4.33%. A jump to 30 indicates that option players expecting that next 30 days change can go up to 8.67%.

India Vix is based on index option prices & the option premium usually jumps up when there is excessive fear or greed in the market, that is why also referred as fear index. s

Speculative analysis – Bullish security, buy futures Bearish security, sell futures

Arbitrage analysis – Overpriced futures: buy spot, sell futures Underpriced futures: buy futures, sell spot

Hedging using Stock Index Futures or Single Stock Futures is one way to reduce the Unsystematic Risk.

o By Selling Index Futures – On March 12 2010, an investor buys 3100 shares of Hindustan Lever Limited (HLL) @ Rs. 290 per share

(approximate portfolio value of Rs. 9, 00,000). However, the investor fears that the market will fall and thus needs to hedge. He uses Nifty March Futures to hedge.

HLL trades as Rs. 290 Nifty index is at 4100 A March Nifty future is trading at Rs. 4110. The beta of HLL is 1.13.

To hedge, the investor needs to sell [Rs. 9, 00, 000 *1.13] = Rs. 10, 17,000 worth of Nifty futures (10,17,000/4100 = 250 Nifty Futures) On March 19 2010, the market falls.

HLL trades at Rs. 275

March Nifty futures is trading at Rs. 3915 Thus, the investor’s loss in HLL is Rs. 46,500 (Rs. 15 × 3100). The investor’s portfolio value now drops to Rs.

8,53,500 from Rs. 9, 00,000. However, March Nifty futures position gains by Rs. 48,750 (Rs. 195 × 250). Thus increasing the portfolio value to Rs. 9,02,250 (Rs. 8,53,500 + Rs. 48,750). Therefore, the investor does not face any loss in the portfolio. Without an exposure to Nifty Futures, he would have

faced a loss of Rs. 46,500.

o Selling Stock Futures and Buying in Spot market

An investor on March 12, 2010 buys 2000 shares of Infosys at the price of Rs. 390 per share. The portfolio value being Rs. 7,80,000 (Rs. 390x2000). The investor feels that the market will fall and thus needs to hedge by using Infosys Futures (stock futures).

The Infosys futures (near month) trades at Rs. 402. To hedge, the investor will have to sell 2000 Infosys futures.

On futures expiry day: The Infosys spot price is Rs. 300. Thus the investor’s loss is Rs. 90 (Rs. 390-Rs. 300) and the portfolio value would reduce to Rs.6,00,000

(Rs. 7,80,000–Rs. 1,80,000). On the other hand the investors profit in the futures market would be Rs. 102 (Rs. 402-Rs. 300). The portfolio

value would now become Rs. 8,04,000 (Rs. 6,00,000+ Rs. 2,04,000).

Pricing options: An option buyer has the right but not the obligation to exercise on the seller. The worst that can happen to a

buyer is the loss of the premium paid by him. His downside is limited to this premium, but his upside is potentially unlimited. This optionality is precious and has a value, which is expressed in terms of the option price. Just like in other free markets, it is the supply and demand in the secondary market that drives the price of an option.

There are various models which help us get close to the true price of an option. Most of these are variants of the celebrated Black-Scholes model for pricing European options. Today most calculators and spread-sheets come with a built-in Black-Scholes options pricing formula

That framework was a direct result of work by Robert Merton as well as Fisher Black and Myron Scholes. In 1997, Scholes and Merton won the Nobel Prize in economics for this work. Black had died in 1995, but otherwise would have shared the prize.

Option prices are affected by six factors. These are Spot Price (S), Strike Price (X), Volatility (σ) of spot price, Time for expiration of contract (T) risk free rate of return (r) and Dividend on the asset (D).

The option price is higher for an option which has a longer period to expire. Option prices tend to fall as contracts are close to expiry. This is because longer the term of an option higher is the likelihood or probability that it would be exercised

It should be noted that the time factor is applicable only for American options and not European types. The rise in risk free rate tends to increase the value of call options and decrease the value of put options.

Similarly price of a call option is negatively related with size of anticipated dividends. Price of put option positively related with size of anticipated dividends.

All option contracts have price limits. This implies that one would pay a definite maximum or a definite minimum price for acquiring an option.

Time value of an option – The time value of an option is the difference between its premium and its intrinsic value

Speculative analysis – Bullish security, buy calls or sell puts Bearish security, sell calls or buy puts

The factors affecting the option price are:

(i) The spot price of the underlying, (ii) exercise price, (iii) risk-free interest rate, (iv) Volatility of the underlying (v) Time to expiration and

(vi) Dividends on the underlying (stock or index).

Black and Scholes then propose that the option’s price is determined by only two variables that are allowed to change: time and the underlying stock price. The other factors, namely, the volatility, the exercise price, and the risk–free interest rate do affect the option’s price but they are not allowed to change.

By forming a portfolio consisting of a long position in stock and a short position in calls, the risk of the stock is eliminated. This hedged portfolio is obtained by setting the number of shares of stock equal to the approximate change in the call price for a change in the stock price. This mix of stock and calls must be revised continuously, a process known as delta hedging.

Black and Scholes then turn to a little–known result in a specialized field of probability known as stochastic calculus. This result defines how the option price changes in terms of the change in the stock price and time to expiration. They then reason that this hedged combination of options and stock should grow in value at the risk–free rate. The result then is a partial differential equation. The solution is found by forcing a condition called a boundary condition on the model that requires the option price to converge to the exercise value at expiration. The end result is the Black and Scholes model.

Products and Contract specifications The F&O segment of NSE provides trading facilities for the following derivative products/ instruments: 1. Index futures 2. Index options 3. Individual stock options 4. Individual stock futures NSE allows trading in individual stock & index based futures and option contracts having one month, two month and three-month expiry cycles. All contracts expire on the last Thursday of every month. Thus a January expiration contract would expire on the last Thursday of January and a February expiry contract would cease trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry would be introduced for trading. Depending on the time period for which you want to take an exposure in index futures contracts, you can place buy and sell orders in the respective contracts.

Commodity (goods) – every kind of movable property other than actionable claims, money and securities. At present all products of agriculture (including plantation), mineral and fossil origin are allowed for future trading under the auspices of commodity exchanges recognized under FCRA (forward contract regulation act)

Commodity exchange – it is a place where buying and selling of commodities takes place.

Commodity derivative market - Commodity derivative market trade contracts for which the underlying asset is commodity. It can be agricultural commodity like wheat, soybeans, rapeseed, cotton, rice etc.

Difference between commodity derivative and financial derivative – 1. Financial derivatives are cash settled & commodity derivatives are physically settled. 2. Financial derivatives are not bulky, commodity derivatives are bulky. 3. Financial derivatives do not need space for storage. Commodity derivatives need space for storage. 4. Quality can vary in commodity derivatives, in financial derivatives no quality change as they are standardized.

Your guide to derivatives – (Understand how these sophisticated financial instruments work before you start trading in them)

Financial planners abhor them, invest advisors avoid recommending about them & experts call them weapons of mass destruction. F & O is not suitable for everyone. It is risky field, and you can lose your shirt in the game. “Investment in equity itself is risky and F &O is mathematically 5-6 times riskier.

Derivatives are highly risky investments, but if you adopt safeguards they can be rewarding as well. “Derivatives are most sophisticated segment of the capital markets, so raise your financial knowledge

to that level before you enter” “Besides minimum net worth, there should be a basic test of awareness before an investor is allowed

into F & O.”……Siddharth Bhamre (Head Equity & derivatives, Angel Broking)

Stock investing takes a medium to long term perspective, while F & O is explicitly a short term gambit. “Never made a mistake of turning an F & O trade into an investment, while entering the trade you need

to have a clear exist strategy in mind. Set yourself a target and strict stop loss and don’t let emotions cloud your decision”

Stock investors can afford to buy and forget their holdings but F & O trading requires your undivided attention. “Out of the money options becomes worthless at the expiry date”

Derivative trading is a leveraged position. With Rs. 50000 one can take Exposure up to Rs. 2.5 Lakh. If your position suffers a loss, your broker will deduct this from your margin and ask you to pay additional margin. If you can’t pay, your shares will be sold off, forcing you to book a loss even though you don’t want to. To avoid this keep at least 50% as a buffer.

“Invest in F & O, only the money you can afford to lose but exposure is not be so high that the impact of the loss exceeds 5% of the total investment portfolio of the individual.

While trading in F & O, don’t expect a strategy to yield positive returns always, play only when you can stomach the risk.

8 F & O Strategies for you – Use these derivative strategies to hedge your portfolio also learn safe and steady returns from your

investments.

Types of margins-

The margining system for F&O segment is explained below: • Initial margin: Margin in the F&O segment is computed by NSCCL up to client level for open positions of

CMs/TMs. These are required to be paid up-front on gross basis at individual client level for client positions and on net basis for proprietary positions. NSCCL collects initial margin for all the open positions of a CM based on the margins computed by NSE-SPAN. A CM is required to ensure collection of adequate initial margin from his TMs and his respective clients. The TM is required to collect adequate initial margins up-front from his clients.

• Premium margin: In addition to initial margin, premium margin is charged at client level. This margin is required to be paid by a buyer of an option till the premium settlement is complete.

• Assignment margin: Assignment margin is levied in addition to initial margin and premium margin. It is required to be paid on assigned positions of CMs towards exercise settlement obligations for option contracts, till such obligations are fulfilled. The margin is charged on the net exercise settlement value payable by a CM.

Risk arrays - The SPAN risk array represents how a specific derivative instrument (for example, an option on NIFTY index at a

specific strike price) will gain or lose value, from the current point in time to a specific point in time in the near future, for a specific set of market conditions which may occur over this time duration. In the risk array, losses are represented as positive values, and gains as negative values. Risk array values are represented in Indian Rupees, the currency in which the futures or options contract is denominated.

The Companies Act, 1956 There are two types of Companies, viz., private and Public. Private company means a company which has a minimum paid-up capital of one lakh rupees or such higher paid-up as may be prescribed and by its articles: (a) restricts the right to transfer its shares, if any; (b) limits the number of its members to fifty; (c) Prohibits any invitation to the public to subscribe for any shares in or debentures of the company; (d) Prohibits any invitation or acceptance of deposits from persons other than its members, directors or their relatives (e) Minimum number of persons required to form a private company is two. Public company means a company which – (a) is not a private company; (b) Has a minimum paid-up capital of five lakh rupees or such higher paid-up capital, as may be prescribed; (c) Is a private company which is a subsidiary of a company which is not a private company. (d) Minimum number of persons required to form a public company is seven

Shares - The shares or debentures or other interest of any member in a company shall be moveable property, transferable in the manner provided by the articles of the company (section82).

Share Capital - According to section 86, the share capital of a company limited by shares formed after the commencement of this Act, or issued after such commencement, shall be of two kinds only, namely:

a) Equity share capital with voting rights; or with differential rights as to dividend, voting or otherwise, and b) Preference share capital

Annual General Meeting (Section 166) AGM shall be called for a time during business hours, on a day that is not a public holiday, and shall be held either at the registered office of the company or at some other place within the city, town or village in which the registered office of the company is situated. The annual general meeting should be held on the earliest of the three relevant dates as prescribed under section 166 together with section 210: a) 15 months from the previous annual general meeting; b) last day of the calendar year. c) 6 months from the close of the financial year, A general meeting of a company may be called by giving at least twenty-one days’ notice in writing.

Income-tax Income-tax is generally chargeable for any assessment year in respect of total income of the previous year of every person. Further tax is also required to be deducted at source or paid in advance under certain provisions of this Act (section 4). “Assessment year” means the period of twelve months commencing on 1st day of April every year (clause 9 of section 2). “Previous year” means the financial year immediately preceding the assessment year (section 3). For the purpose of this Act, a “person” includes an individual, a Hindu undivided family, a company, a firm, an association of persons or a body of individuals, a local authority, every artificial juridical person, not falling above. (Clause 31 of section 2) “Assessee” means a person by whom any tax or any other sum of money is payable under this Act and includes every person in respect of whom any proceedings under this Act has been taken for the assessment of his income, loss or refund or income, loss or refund of any other person in respect of which he is assessable. (Clause 7 of section 2) Heads of income (section 14) The income should be classified under the following heads of income for the purpose of computation of total income and charge of income-tax thereon– 1. Salaries 2. Income from house property 3. Profits and gains of business or profession 4. Capital gains 5. Income from other sources

RETURN AND RISK- Return and risk are the two key determinants of security prices or values. Return on an investment/asset for given period, say a year, consists of annual income (dividend) receivable plus change in market price.

Risk may be described as variability/fluctuation/deviation of actual return from expected return from a given asset/investment. Higher the variability, greater is the risk. In other words, the more certain the return from an asset, lesser is the variability and thereby lesser is the risk.

Types of Risks: The risk of a security can be broadly classified into two types such as systematic risk and unsystematic risk. Standard deviation has been used as a proxy measure for total risk.

Systematic Risk- Systematic Risk refers to that portion of total variability (risk) in return caused by factors affecting the prices of all securities. Economic, political, and sociological changes are the main sources of systematic risk. Though it affects all the securities in the market, the extent to which it affects a security will vary from one security to another. Systematic risk cannot be diversified. Systematic risk can be measured in terms of Beta (β), a statistical measure. The beta for market portfolio is equal to one by definition. Beta of one (β=1), indicates that volatility of return on the security is same as the market or index; beta more than one (β>1) indicates that the security has more unavoidable risk or is more volatile than market as a whole, and beta less than one (β<1) indicates that the security has less systematic risk or is less volatile than market. Generally, a falling overall market would see most stocks falling (and vice versa). This is the market specific risk.

Unsystematic risk- Unsystematic Risk refers to that portion of total risk that is unique or peculiar to a firm or an industry, above and beyond that affecting securities markets in general. Factors like consumer preferences, labor strikes, management capability etc. cause unsystematic risk (variability of returns) for a company’s stock. Unlike systematic risk, the unsystematic risk can be reduced /avoided through diversification. Total risk of a fully diversified portfolio equals to the market risk of the portfolio as its specific risk becomes zero. Diversification is a risk management technique which reduces the risk. However, diversification does not reduce risk in the overall portfolio completely. Diversification reduces unsystematic risk

Measurement of Risk for a Single Asset: The statistical measures of a risk of an asset are: (a) Standard Deviation and (b) Co-efficient of variation. (a) Standard Deviation of Return: Standard deviation, as discussed earlier, is the most common statistical measure of risk of an asset from the expected value of return. It represents the square root of average squared deviations of individual returns from the expected return. (b) Co-efficient of variation: is a measure of risk per unit of expected return. It converts standard deviation of expected values into relative values to enable comparison of risks associated with assets having different expected values. The coefficient of variation (CV) is computed by dividing the standard deviation of return, R σ , for an asset by its expected value, R . The larger the CV, the larger the relative risk of the asset. Return and Risk of a portfolio - Investors prefer investing in a portfolio of assets (combination of two or more securities/ assets) rather than investing in a single asset. The expected returns on a portfolio is a weighted average of the expected returns of individual securities or assets comprising the portfolio. The weights are equal to the proportion to amount invested in each security to the total amount. Illustration: What is the portfolio return, if expected returns for the three assets such as A, B, and C, are 20%, 15% and 10% respectively, assuming that the amount of investment made in these assets are Rs. 10,000, Rs. 20,000, and Rs. 30,000 respectively. Weights for each of the assets A, B, and C respectively may be calculated as follows: Total Amount invested in the portfolio of 3 assets (A, B, and C) = Rs. 10,000 + Rs. 20,000 + Rs.30,000 = Rs. 60,000. Weight for the asset A = 10000/60000 = 1/6 = 0.1667 Weight for the asset B = 20000/60000 = 1/3 = 0.3333 Weight for the asset C = 30000/60000 = 1/2 = 0.5 Given expected returns for the three assets A, B, and C, as 20%, 15% and 10% respectively,

Returns on Portfolio= (0.1667*0.20)+(0.3333*0.15)+(0.5*0.10) = 0.13334*100 =13.33% Measurement of Risk for a portfolio According to the Modern Portfolio Theory, while the expected return of a portfolio is a weighted average of the expected returns of individual securities (or assets) included in the portfolio, the risk of a portfolio measured by variance(or standard deviation) is not equal to the weighted average of the risk of individual securities included in the portfolio. The risk of a portfolio not only depends on variance/risk of individual securities but also on co-variances between the returns on the individual securities.

Capital Asset Pricing Model (CAPM) Portfolio Theory developed by Harry Markowitz is essentially a normative approach as it prescribes what a rational investor should do. On the other hand, Capital Asset Pricing Model (CAPM) developed by William Sharpe and others is an exercise in positive economics as it is concerned with

(i) What is the relationship between risk and return for efficient portfolio? And (ii) What is the relationship between risk and return for an individual security? CAPM assumes that individuals are risk averse.

CAPM describes the relationship/trade-off between risk and expected/required return. It explains the behavior of security prices and provides mechanism to assess the impact of an investment in a proposed security on risks and return of investors’ overall portfolio. The CAPM provides framework for understanding the basic risk-return trade-offs involved in various types of investment decisions. It enables drawing certain implications about risk and the size of risk premiums necessary to compensate for bearing risks.

Model emphasizes the risk factor in a portfolio theory is a combination of two risks, systematic and unsystematic. Model suggest that securities return directly related to it's systematic risk, which cannot be neutralized through diversification. Combination of both type of risk gives total risk. Total variance of return is equal to market related variance plus companies' specific variance. CAPM suggests that prices of securities are determined in such a way that the risk premiums or excess returns are proportional to systematic risk which is indicated by beta (β) coefficient. (β) beta is the measure of asset sensitivity to the movement in the overall market.Using beta (β) as the measure of non diversifiable risk, the CAPM is used to define the required return on a security according to the following equation: Rs = Rf + Bs (Rm-Rf) Where, Rs = the return required on the investment Rf = the return that can be earned on a risk-free investment (e.g. Treasury bill) Rm = the average return on all securities (e.g., S&P 500 Stock Index) Bs = the security’s beta (systematic) risk, Major of risk, volatility of security compared to market CoE = Risk free rate + market risk Premium + levered beta (debt considered) = Rf + (Rm-Rf)* Bs More risky stock will have a higher beta and will be discounted at a higher rate, less sensitive stocks will have lower beta & be discounted at a lower rate. Beta of the market portfolio is always 1. There are few investments which are having zero betas, like…Fixed Deposits, Govt. Bonds etc. Also there are few stocks with –ve beta but it only happens into particular situation only. Example – during war prices of defensive stocks will go up (weapons creating companies, hospitality) According to Morgan Stanley report, Market risk premium for Developed economies is 4% and Market risk premium for emerging economies is 7% It is easy to see the required return for a given security increases with increase in its beta and vice-a-versa. Application of the CAPM can be demonstrated. Assume a security with a beta of 1.2 is being considered at a time when the risk-free rate is 4 percent and the market return is expected to be 12 percent. Substituting these data into the CAPM equation, we get = 4%+ [1.20* (12%-4%)] = 4%+ [1.20* 8%] = 4%+ 9.6% = 13.6% The investor should therefore require a 13.6 percent return on this investment a compensation for the non-diversifiable risk assumed, given the security’s beta of 1.2. If the beta were lower, say 1.00, the required return would be 12 percent [4%+ [1.00*(12%-4%)]: and if the beta had been higher, say 1.50, the required return would be 16 percent [4%+ [1.50* (12%-4%)]. Thus, CAPM reflects a positive mathematical relationship between risk and return, since the higher the risk (beta) the higher the required return.

Unlevered beta = beta before any payment towards debt

Levered beta = beta after taking into consideration debt

More the debt, more volatile the stock/investment

LB(Company) = UB (Industry) *[1+D/E(1-t)](Company)

UB (Industry) = LB(Industry) / [1+D/E(1-t)](Industry)

For listed companies we will get beta value from Bloomberg, Reuters or Websites, for unlisted

companies beta value derived from comparable companies having no debt or industry beta neglecting beta.

(Because, company’s debt to equity will be quite different from industry, therefore it is always better to remove debt effect from industries beta value and add companies’ debt effect into unlevered beta of industry.

Normalization of earnings –

Most of the companies have different financial year endings, then how one can compare their performance, ….one must take a particular quarter ending for all the companies and take last 12 months numbers for each company. From this it will be easier to analyze companies based on their performance. It removes one year effect of earnings. As EPS goes up, PE will go down.

Indexation – - It is intended to minimize or eliminate the impact of inflation on those

receiving or making payments. - Generally involves comparing current values against historical

values(quarter, month, year or same period last year) - Ratio of change is the actual amount

Global investing and foreign exchange – Risks involved in global investing –

o NAV fluctuation – o Restriction on investments o Communication issues o Timely recording of transactions o Delayed income receipt o Additional tax expense

Foreign exchange contract – An agreement between two parties to exchange one currency for another at a specified date on a agreed upon date.

o Exchange rate – it is a ratio used to convert one currency into another. Why execute Fx – to hedge a portfolio, for speculation, to settle trade /income

o Repatriation – act of converting foreign currency into investor's base currency.

o Hedging – practice of taking on e investment in order to protect against a loss in other.

o Speculating – undertaking an investment in the hopes of realizing gains. Currencies are always quoted in pairs. The first currency is called the base currency, and the second currency is called the counter currency. In general terms, the base currency you choose should be the currency in which you maintain your accounts. For example, if your business is in the United States and your systems are based in USD, then you would want to select USD as your "base currency". That means that all the currency rates in your feed (the counter currencies) will be in quoted in relation to your base currency

Example:

Base Currency ► 1 USD = .99534 CAD ◂ Counter Currency

A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The currency that is used as the reference is called the counter currency or quote currency and the currency that is quoted in relation is called the base currency or transaction currency Direct Quote (American currency option)= Quoted currency is foreign currency = Variable domestic currency and fixed unit of quoted foreign currency. Indirect Quote (European currency option) = Quoted currency is domestic currency = variable domestic currency & Fixed domestic currency. EUR/USD – Units of counter currency are per unit of base currency. (EUR – Base currency, USD – counter currency) It is quoted as, 1 EUR per × US dollar If EUR becomes stronger, value of EUR/USD will fall.

EUR,GBP,CHF = Have positive correlation EUR/USD = Have –ve co-relation with USD/CHF = Have +ve co-relation with GBP/USD. Permitted currency – A currency that is free from legal and regulatory restrictions to be converted into another currency, It is often a minor currency. If the quote changes from EUR/USD 1.2500 to 1.2510, the euro has increased in relative value, because either the dollar buying strength has weakened or the euro has strengthened, or both The currency pairs that do not involve the US dollar are called cross currency pairs, such as GBP/JPY. Pairs that involve the euro are often called euro crosses, such as EUR/GBP

EUR/CHF 1.6652 "EUR/CHF" denotes a currency pair. Here "EUR" and "CHF" are the three-letter ISO currency codes for the euro and Swiss frank. The first (left-hand) currency is known as the foreign currency. The second (right-hand) currency is known as the domestic currency. (Note: The foreign currency is sometimes referred to as the base currency or simply base. The domestic currency is sometimes referred to as the variable currency, counter currency or simply counter, quote or quoted currency, or terms currency.) The quote expresses the value of a single unit of the foreign currency in terms of units of the domestic currency. In our case, the quote is saying that one euro is worth 1.6652 Swiss franks. The number 1.6652 is the exchange rate, or the spot price of EUR in terms of CHF. When we buy foreign currency for domestic currency we go long or establish a long position. When we sell foreign currency for domestic currency we go short or establish a short position. In each case we enter a trade, which results in an open position. It remains open until it is closed out by entering into an equal and opposite trade. For example, if we are long 300 euros (we have bought them for 300 × 1.6652 Swiss franks), we close the position by selling 300 euros. (Note: Presumably also for 300 × 1.6652 Swiss franks; although FX rates don't tend to stay constant over time.) Thus we no longer have an open position (it is now closed), nor are we long EUR (we are flat). When we say that we are long EUR/CHF, we mean that we are long EUR (the foreign currency), short CHF (the domestic currency); i.e. we have bought euros for Swiss franks. Similarly, when we say that we are short EUR/CHF, we mean that we are short EUR, long CHF; i.e. we have sold euros for Swiss franks. Thus "long" or "short" is always referring to the foreign currency, our "commodity". It is, however, uncommon for a broker or market maker to quote the same exchange rate for buying and selling. The quote will usually include two rates. Hence the name, a two-way quote:

EUR/CHF 1.6652/1.6655 The first number, which is almost always smaller, is the bid (pbid); this is the rate at which the quoting broker or market maker is prepared to buy the foreign currency for the domestic currency. The second number, which is almost always larger, is the ask or offer (pask); this is the rate at which the quoting broker or market maker is prepared to sell the foreign currency for the domestic currency. The difference, s = pask − pbid, is known as the bid-ask spread (sometimes simply spread). In our example, the bid-ask spread is s = 1.6655 − 1.6652 = 0.0003, or 3 pips. A point or pip (Note: Pip is an acronym for "percentage-in-point".) is the smallest incremental price movement for a given currency pair in the interbank market. Pips are most basic unit of measure in forex trading.

For EUR/CHF it is 0.0001, or exactly one basis point Although one pip is often equal to one basis point, this is not always the case. For USD/JPY one pip equals 0.01 Japanese yen, not 0.0001 It is important to learn how pips value relates to currency positions. Suppose, USD/CAD = 1.1005 If one wants to buy $10000 CAD then he have to pay following,

(1/1.1005)*10000 = $ 9086.7787 Now assume if rate changes to USD/CAD = 1.1006 then for $ 10000 CAD, one have to pay following, (1/1.1006)*10000 = $ 9085.9531 It means, if quoted currency becomes weak (rate increases), we have to pay less. Now difference in paid currency amount is 0.83 (9086.7787-9085.9531) ₡ (cents) Therefore PIP = 0.83 * 50 = 41.50 $ A currency can easily move 70 pips a day. Our position, 10000 * 50 = +/- 3000 Value of 1 PIP = (0.0001/current exchange rate)*notional principal amount = (0.0001/1.1005)*10000 = 9.08677 USD Value of 1 PIP is always different between currency pairs, because there are difference between exchange rates of different currencies.

Alternatively, since the first few digits are unlikely to change over a short period of time, only the last two digits are given:

EUR/CHF 1.6652/55

This is known as the small figure. The big figure is given by the two digits preceding the last two:

EUR/CHF 52/55

Group of Ten (G10) Currencies

ISO Currency Code

Currency Name Country/Entity Symbol HTML Old ISO Currency Code

Nickname

AUD Australian dollar Australia Aussie

CAD Canadian dollar Canada Loonie, Cad, Canada

CHF Swiss franc Switzerland Swissy, Swiss

EUR Euro European Union

€ &euro; Euro

GBP British pound sterling

United Kingdom

£ &pound; Sterling

JPY Japanese yen Japan ¥ &yen; Gopher, Yen; GBP/JPY = Geppy

NOK Norwegian krone Norway Nokee

NZD New Zealand dollar

New Zealand Kiwi

SEK Swedish krona Sweden Stockee

USD US dollar United states

Emerging Markets (EM) Currencies

ISO Currency Code Currency Name Country/Entity Symbol HTML Old ISO Currency Code Nickname

ARS Argentine peso Argentine

BRL Brazilian real Brazil

CLP Chilean peso Chile

CNY Chinese yuan renminbi China

CZK Czech koruna Czech Republic CSK Czech

HKD Hong Kong dollar Hong Kong

HUF Hungarian forint Hungary

IDR Indonesian rupiah Indonesia

ILS Israeli shekel Israel ₪ &#8362; Shekel

INR Indian rupee India Rp

ISK Iceland krona Iceland

KRW South Korean won South Korea ₩ &#8361;

MXN Mexican peso Mexico MXP

MYR Malaysian ringgit Malaysia

PHP Philippine peso Philippines

PLN Polish zloty Poland Poland

RON Romanian new leu Romania ROL

RUB Russian ruble Russian Federation

SGD Singapore dollar Singapore

SKK Slovak koruna Slovakia

THB Thai baht Thailand ฿ &#3647;

TRY Turkish new lira Turkey TRL Turkey

TWD Taiwan new dollar Taiwan

ZAR South African rand South Africa ZAL

A standard way to identify the currencies is by their three-letter ISO currency codes (Note: The three-letter ISO currency codes were established by the International Organization for Standardization (ISO) in its international standard ISO 4217. In general, the first two letters of the code are the two letters of ISO 3166-1 alpha-2 country codes and the 3rd is the initial of the currency name.

ISO Currency Codes

INR 356 2 Indian Rupee Bhutan, India

E = (2)Number of digits after the decimal point INR = Code 356 = Number The commodity-sensitive currencies are positively correlated with commodity prices. They include the Norwegian krone (oil), Australian dollar (copper), and New Zealand dollar (milk). These currencies are closely linked to growth cycles.

1. YEN (Japan)

The Japanese yen is a low-yielding currency, and as such it is frequently used for carry trades. Investors can borrow the Japanese yen cheaply to fund the purchase of higher-yielding assets, usually currencies such as the Australian dollar or New Zealand dollar. They sell the yen, thus driving it down. Risk aversion boosts the Japanese yen. When investors are worried about the slowing global economy or equity market sell-offs, they tend to buy the yen acting as a safe haven For example, following the credit crunch of 2007, yen rallied in the early 2008 despite its relatively weak economic fundamentals. A similar yen rally was observed during the major credit shock of the late 1990s

2. Pound Sterling (GBP) Sterling has historically been the currency most positively correlated to global growth. Global economic slowdowns tend to have a negative effect on its exchange rate. It is a counter-cyclical currency.

3. Swiss Franc (CHF)

The Swiss franc is negatively correlated with\textit{global growth}. It is generally seen by investors as a safe haven, so in times of global economic slowdowns the franc tends to strengthen. It is a pro-cyclical currency.

4. Australian Dollar (AUD) Australia is the world's fourth largest producer of copper after Chile, the United States, and Peru, with mine production estimated to reach 950 million ton per year in 2006

The Australian dollar tends to be positively correlated with copper prices

5. Norwegian Krone (NOK) Norway is one of the world's top oil producers (ranking 10th in 2006 with 2,785 thousand barrels per day) and oil net exporters (ranking 3rd in 2006 with 2,542 thousand barrels per day after Saudi Arabia and Russia)

Therefore oil prices exert a major influence on the krone.

6. New Zealand Dollar (NZD) New Zealand dollar tends to be correlated with milk prices

Counter cyclical currency - A currency that falls when the economy surges and rises when the economy turns down. Counter-cyclical currencies tend to be negatively correlated with equities in general and their local equities in particular. Euro (EUR) and US dollar (USD) are examples of counter-cyclical currencies

Foreign exchange classification – The currencies are often classified into two groups based on their liquidity. The most liquid currencies are those of the Group of Ten (G10).

Depending upon length – 1. Spot Fx – Fx with usually 3 days or less 2. Forward Fx – Fx with more than 3 days between trade And settlement

date

Depending upon transaction – 1. Fx Buy – using USD to buy foreign currency. 2. Fx sell – selling foreign currency and receiving USD 3. Cross deal – buying and selling 2 foreign currencies.

Foreign exchange rates – Direct rates – (multiply by rates)

1. Great Briton Pounds – GBP

2. Austrian dollars – AUD 3. New Zealand Dollars – NZD 4. Euro Dollars – EUR

Example – 100000 GBP * 1.7876 = 178760 USD Indirect rates - (divide by rates)

Any currency other than above 4 currencies Example – 100000/5.9946 = 16.681 USD

Currency gain or loss – Difference between USD equivalent at trade date or contract exchange rate and the USD equivalent at the current exchange rate.

Security lending –

Temporary transfer of idle securities within a portfolio to a borrower for a fee in a fully collateralized transaction

Security lending benefits to Borrower – for trade settlement, short sale, tax arbitrage, price arbitrage Lender – it is a low risk method to enhance returns, offset custody fees, transparent to investment managers, greater utilization of dormant (idle) securities. Example – Loan value = $ 5000000 Collateral = $ 52500000 (105% of value) Rebate rate = 95 % (annual)(360 day assumed) Duration = 10 days Yield = 1.25 % (reinvestment fund) Gross earnings for the loan = ($ 52500000)*(0.0125) / (10/360) = $ 18229 Rebate owned by borrower = ($ 525000000)*(0.0095) / (10/360) = $ 13854 Net earnings for the loan = $ 18229 - $ 13854 = $ 4375 40% of $4375 = $ 1750 (goes towards agent) 60% of 4375 = $ 2625 (goes towards lender) NOTE – required collateral amount are typically 105% of the loan value for non US securities and 102% for all other securities. Net investment earnings divided proportionately between agent (40%) and lender (60%)

Types of collateral used while lending securities – 1. Cash (USD, GBP, Euro primarily) 2. US Government, Govt. agencies or G10 & super national's securities 3. Other US and Foreign securities as allowed by the lending by the institution 4. Letter of Credit (By importers / borrowers Bank)

Money laundering – Process of converting money gained from illegal activity into money that appears legitimate

Stages in Money laundering – o Placement – introducing illegally gained money o Layering – moving assets within financial system creating complex net o Structuring – breaking large financial transactions into smaller one o Integration – placing laundered funds back into economy to get legitimacy

Factoring –

Factoring is the financial service covering the financing and collection of receivables in domestic as well as international trade.

Functions of factoring – o Providing finance against bills receivables and trade debts o Providing debt insurance facility to client against possible losses arising

insolvency/ bankruptcy of debtors o Undertaking sales ledger administration responsibilities of the client

including maintenance of books, accounting, asset management, collection of debts.

Classification of factoring – o Notified / disclosed factoring – customer is intimated about the

assignment of debt to the factor and also directed to make the payments to the factor instead of firm. This is invariably stated on the face of invoice that receivables arising out from the invoice have been assigned to the factor.

o Non notified / confidential / undisclosed factoring – supplier / factor arrangement is not declared to the customer until there is a breach of agreement.

o Recourse factoring – supplier will carry the credit risk in respect of receivables he has sold to the factor. It is similar to bills discounting schemes.

o Non recourse factoring – bad debts are borne by factoring agent or factor. Factor commission would be higher.

Characteristics of factoring – o General period for factoring is 90 – 150 days. o Costly source of finance compared to short term borrowing. o Credit rating not mandatory o It is a method of off balance sheet financing. o Cost of factoring = finance cost + operating cost ( may vary according to

transaction size) o Cost of factoring varies from 1.5 % to 3 % per month. o Indian firm offer factoring for invoices as low as Rs. 1000/- o For delayed payments beyond approved credit period charge penalty

around 1-2% per month over & above the normal cost. (it varies like 1% for first month and thereafter 2%)

Factoring involve two types of cost 1. Factoring commission – (2-4% of face value of receivables) 2. Interest on fund advances – against uncollected and un-due receivables

It is the practice to advance up to 80% of value of such outstanding at rate of interest 2-4% above the base rate.

Valuation methods – 1. Trading valuation method – (comparable company analysis)

P/E is a trading measure

P/E of companies Infosys 25 if EPS of Mahindra & mahindra satyam is 40 Rs. Tcs 30 then, Wipro 20 Market value of Equity of MS = 22*40 Hcl 20 = 440 Average 22

2. Transaction valuation method – o Precedent transaction analysis (PPAIDS) – Patni, I gate, Mind tree

(We refer previous transactions of competitor) o Leveraged buyout methods (LBO)

(In LBO small company takeover large company & give the assets of acquired companies as collateral for loan)

o Asset replacement method (It determines how much money required to replace old assets & produce similar capacity)

3. Extrinsic valuation method –

o Company comparables (COMPS) o Precedent transaction analysis (PPAIDS) o Leveraged buyout methods (LBO) o Asset replacement method

4. Intrinsic valuation method – o Dividend discount model – Based on Dividend o Discounted cash flow method

Terminal value – value of company at steady stage. 10% 3 Stage model

-5%

5% (Steady stage) terminal value 10% 2 Stage model -5%

10% (Steady stage) terminal value

If market is going up by 5% & company is going up 10% - company will gain more market share in future If economy is going up by 5% & company is going up 10% - company will be economy in future (theoretically it is not possible) Terminal value must be less than long term economic growth. PRESENT VALUE TERMINAL VALUE FUTURE CASH FLOW

Interview process in each Multi National Companies (MNC)

HR interview (to check your profile)

Aptitude test- Quantitative aptitude

Logical reasoning (verbal/non verbal) General knowledge Excel knowledge/shortcuts Typing test (at least 15-25 words per min – depends on company)

Operational round (to test your domain( theoretical/practical ) knowledge)

These are key points to be asked in interviews of Account/ Finance domain

Please clear all above basic key points to crack the interview

Matter consist only theoretical knowledge & doesn’t consist practical life HR questions

Please pass on to the needy persons

Feel free to contact for any queries Vishal Mane Mob: +91 8055082858 Vishal_4489@rediffmail.com Mon-Fri: 9:00 am-12:00 pm IST Sat-Sun: 9:00 am-6:00 pm IST Best of Luck for future endeavor…!!!