Sapm all chapters

INTRODUCTION OF INVESTMENTAND

INVESTMENT ALTERNATIVES

MODULE- 1

Investment is the allocation of monetary resources to assets that are expected to yield some returns over a period of time. It involves the commitment of resources which have been saved with the expectation that some benefits will accrue in future.

In other words, Investment is a commitment of funds to derive the future income in the form of interest, dividend, rent, premium or appreciation in the value of principal capital .

MEANING OF INVESTMENT

Liquidity Safety of principal Tax benefits Income stability Purchasing power Capital growth

FEATURES OF INVESTEMENT

Minimum comforts Future return or income Capital appreciation Choice of investment

IMPORTANCE OF INVESTMENT

The process on investment involves the following steps: Objective specification Mix of assets Portfolio formulation strategy Selection of securities Portfolio revision Portfolio evaluation

INVESTMENT PROCESS

It is considered as an involvement of funds of high risk and more uncertain expectation of returns. It is basically a short term phenomenon where people tend to buy assets with the hope that a profit can be earned from a subsequent price change. It is based on the expectation that some change will occur.

The stock brokers may be cited as an example. Some brokers buy shares with a view to make quick profit by selling within few days, when the prices of such shares shoot up.

MEANING OF SPECULATION

BASIS SPECULATION INVESTMENT

Contract Type Ownership Creditor

Source of income Change in market price

Earning of enterprise

Objective of purchase Tips, Hunches etc. Higher Return

Stability of income Uncertain Stable

Risk involved High Low

Duration Short Long

Acquisition On margin Outright purchase

Attitude Aggressive Conservative

INVESTMENT Vs SPECULATION

BASIS INVESTOR SPECULATOR

Planning Horizon

An investor has a relatively longer planning horizon.

A speculator has a very short planning horizon.

Time His holding period is usually at least one year.

His holding period may be a few days to a few months.

Risk disposition An investor is normally not willing to assume more than moderate risk.

A speculator is ordinarily willing to assume high risk.

Return expectation

An investor usually seeks a moderate rate of return.

A speculator looks for a high rate of return.

Basis of decisions

An investor attaches greater significance to fundamental factors and attempts a careful evaluation of the prospects of the firm.

A speculator relies more on technical charts and market psychology.

Leverage An investor uses his own funds and eschews borrowed funds.

A speculator normally resorts to borrowings, which can be very substantial, to supplement his personal resources.

INVESTOR Vs SPECULATOR

A gamble is a very short term investment in a game of chance. Gambling involved high risk and the expectations of high returns. It consists of uncertainty and high stackers for thrill and excitement.

The example of gambling are horse racing, card game, lottery etc.

GAMBLING

Compared to investment and speculation, the result of gambling is known more quickly.

Rational people gamble for fun, not for income. Gambling does not involve a bet on an economic activity.

It is based on risk that is created artificially.

GAMBLING Vs SPECULATION AND INVESTMENT

Arbitrage is a planned methods of putting the savings safely into different investments to get a better return. An investor can also be an arbitrageur if he buys and sells securities in more than one stock exchange to take advantage of the price differentials in such exchanges. Derivative market is an example of Arbitrage transactions.

ARBITRAGE

Non – Marketable Financial Assets:-

- Bank Deposits (Savings account, Current account, Fixed

Deposits, Recurring Deposits etc.)

- Post office Savings Accounts.

- Post office Time Deposits.

- Monthly Income Scheme of the Post Office.

- National Savings Certificate (NSC).

- Company Deposits.

- Employee Provident Fund Scheme.

- Public Provident Fund Scheme.


Money Market Instruments :-

- Treasury Bills

- Certificates of Deposits

- Commercial Paper

- Repos Bonds or Debentures and Preference Shares

- Government Securities

- Savings Bonds

- Private Sector Debentures

- Public Sector Undertaking Bonds

- Preference Shares


Equity SharesMutual Fund SchemesLife InsuranceFinancial Derivatives


MODULE – 2

INTRODUCTION OF

FINANCIAL MARKETS &

FINANCIAL SYSTEM

Financial Market is the place or location to buy and sell the financial products or instruments.

Or,

Financial Markets can be referred to as those center and arrangements which facilitate buying and selling of financial assets, claims and services.

FINANCIAL MARKET

STRUCTURE OF FINANCIAL MARKETFinancial Market

Organized Market Unorganized Market

Capital Market Money Market

Industrial Securities

Market

Govt Securities

Market

Long term loan

Market

Primary Market

Secondary Market

Term loan Market

Market for Mortgages

Market for Financial

Guarantees

Money Lenders, Indigenous, Bankers etc.

Call Money Market

Commercial Bill Market

Treasury Bill Market

Short Term Loan Market

At the time of Independence in 1947, there was no strong financial institutions mechanism in the country. There are absence of issuing institutions and non-participation of intermediary financial institutions. The industrial sector also had no access to the savings of the community. The capital market was very primitive and shy. The private as well as the unorganized sector played a key role in the provision of ‘liquidity’.

With the adoption of the theory of mixed economy, the development of the financial system took a different turn so as to fulfill the socio-economic and political objectives. The government started creating new financial institutions to supply finance both for agricultural and industrial development and it also progressively started nationalising some important financial institutions so that the flow of finance might be in the right direction.

DEVELOPMENT OF FINANCIAL SYSTEM IN INDIA

The new issues first placed in the new issue market can be disposed of subsequently in the stock exchange.

The stock exchange provides the mechanism for regular and continuous purchase and sale of securities which is of immense utility to potential investors. The two markets are complimentary.

Both the markets are connected to each other even at the time of new issue.

The company which makes new issue applies for listing shares on a recognized stock exchange.

Listing of shares adds prestige to the firm and widens the market for investors.

The two markets act and react upon each other in the same direction.When the stock prices go up in the market, the new issues increase and

when the stock prices show a downward trend the new issues decline.

RELATIONSHIP BETWEEN NEW ISSUE MARKET AND STOCK EXCHANGE

The new issue market is to facilitate transfer of resources from savers to the users.

The saver are individuals, commercial banks, insurance companies etc.

The users are public companies and the government.The new issue market plays an important role of mobilizing

the funds from the savers and transfers them to borrowers for productive purposes.

It is not only a platform for raising finance to establish new enterprises but also for expansion, diversification, and modernization of existing units.

ROLE OF THE NEW ISSUE MARKET

The various methods which are used in the floatation of securities in the new issue market are:-

1. Public Issues

2. Offer for Sale

3. Placement

4. Right Issues

METHODS OF FLOATING NEW ISSUES

All issues by a new company have to be made at per and for existing companies the issue price should be justified as per Malegam Committee’s recommendations which are as follows:-

The issue price should be justified by:-

1. The earning per share(EPS) for the last three years and comparison of pre-issue price to earning ratio to the price to earnings (P/E) of the industry.

2. The latest Net Asset Value (NAV).

3. The minimum return on increased net worth to maintain pre-issue EPS. A company may also raise funds from the international markets by issuing Global Depository Receipts(GDR) and American Depository Receipts (ADR).

GENERAL GUIDELINES FOR NEW ISSUE

The SEBI does not play any role in price fixation. In fact the issuers in consultation with the Merchant Bankers will decide the price. However, they are required to give full disclosures of the parameters which they had considered while deciding the issue price. In actual practice, there are two types of issue pricing namely:-

1. In the first type, the company and the lead manager fix the price which is called fixed price.

2. In the second type, the company and the lead manager stipulate a floor price or a price band and leave it to market forces to determine the final price which is called book building price.

GENERAL GUIDELINES FOR NEW ISSUE

The stock exchange operations at floor level are highly technical in nature. Non-members are not permitted to enter into the stock market. Hence, various stages have to be completed in executing a transaction at a stock exchange. The steps involved in the methods of trading have been given below:-

1. Choice of a Broker

2. Placement of Order

3. Execution of Order

4. Preparation of Contract notes

5. Settlement of Transactions

METHOD OF SECURITY TRADING IN STOCK EXCHANGE

To become a member of a recognized stock exchange, a person must possess the following qualifications:-

1. He should be a citizen of India.

2. He should not be less than 21 years of age.

3. He should not have been adjudged bankrupt or insolvent.

4. He should not have been convicted for an offence involving fraud or dishonesty.

5. He should not be engaged in any other business except dealing in securities.

6. He should not have been declared a defaulter by any other stock exchange.

Apart from individuals, a company is also eligible to become a member provided it satisfies the conditions imposed by the stock exchange concerned.

MEMBERSHIP RULES IN A STOCK EXCHANGES

A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions. These transactions may be executed on a futures exchange or securities exchange, as well as off-exchange in the over- the-counter (OTC) market. A clearing house stands between two clearing firms (also known as member firms or clearing participants) and its purpose is to reduce the risk of one (or more) clearing firm failing to honor its trade settlement obligations.

CLEARING HOUSE

A company which desires its securities to be listed on a recognized stock exchange must satisfy the following conditions:-

1. At least 60% of each class of securities issued must be offered to the public for subscription and minimum issued capital should be Rs. 3 crores.

2. The minimum public offer for subscription must be at least 25% of each issue and it must be offered through advertisement in newspapers at least for a period of 2 days.

3. The company should be of a fair size having broad based capital structure and public interest in its securities.

4. The existing companies must adhere to the ceiling in expenditure of public issues.

5. A certificate to the effect that shares from promoter’s quota are not sold or transferred for a period of 3years must be submitted.

CRITERIA FOR LISTING OF SECURITIES

6. There must be at least 10 public shareholders for every Rs. 1 lakh share of fresh issue of capital and it is 20 in the case of subsequent issue of shares. This criteria is different for investment companies.

7. A company having more than Rs. 5 crore paid up capital must list its securities on more than one stock exchange. Listing on the regional stock exchange is compulsory.

8. The company must pay interest on the excess application money received at the rates ranging between 4% and 15% depending on the delay beyond 10 weeks from the date of closure of the subscription list.


9. The Articles of Association of the company must provide for the following:-

i. A common form of transfer shall be used.

ii. Fully paid shares will be completely free from lien.

iii. Partly paid up shares will be subject to lien only to the extent of call money due at a fixed time.

iv. Calls in advance carry only interest and not dividend rights.

v. Unclaimed dividends shall not be forfeited before the claim becomes time barred.

vi. The right to call of shares shall be given only after the necessary sanction by the general body meeting.

vii. Transfer of shares shall be registered within 30 days of deposit of request and the balance certificates shall be issued within the same period.


The Government felt the need for setting up of an apex body to develop and regulate the stock market in India. Eventually the SEBI was set up on 12th April, 1988. To start with, SEBI was set up a non-statutory body.

It took almost 4 years for the government to bring about a separate legislation in the name of SEBI Act, 1992 conferring statutory powers. The Act, changed to SEBI with comprehensive powers over practically all aspects of capital market operations.

SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)

According to the SEBI Act, the primary objective of the SEBI is to promote healthy and orderly growth of the securities market and secure investor protection. For this purpose, the SEBI monitors the activities of not only stock exchanges but also merchant bankers etc.

The objectives of SEBI are as follows:-

1. To protect the interest of investors so that there is a steady flow of savings into the capital market.

2. To regulate the securities market and ensure fair practices by the issuers of securities so that they can raise resources at minimum cost.

3. To promote efficient services by brokers, merchant bankers and other intermediaries so that they become competitive and professional.

OBJECTIVES OF SEBI

Section II of the SEBI Act specifies the functions as follows:-

1. Regulatory Functions:-

i. Regulation of stock exchange and self regulatory organizations.

ii. Registration and regulation of stock brokers, sub-brokers, registrar to all issue, merchant bankers, underwriters, portfolio managers and such other intermediaries who are associated with securities market.

iii. Registration and regulation of the working of collective investment schemes including mutual funds.

iv. Prohibition of fraudulent and unfair trade practices relating to securities market.

v. Prohibition of insider trading in securities.

vi. Regulating substantial acquisitions of shares and takeover of the companies .

FUNCTIONS OF SEBI

2. Developmental Functions:-

i. Promoting investor’s education.

ii. Training of intermediaries.

iii. Conducting research and published information useful to all market participants.

iv. Promotion of fair practices. Code of conduct for self regulatory organizations.

v. Promoting self regulatory organizations.

FUNCTIONS OF SEBI

i. Power to call periodical returns from recognized stock exchanges.

ii. Power to call any information or explanation from recognized stock exchanges on their members.

iii. Power to direct enquiries to be made in relation to affairs of stock exchanges or their members.

iv. Power to grant approval to bye-laws of recognized stock exchanges.

v. Power to make or amend bye-laws of recognized stock exchanges.

vi. Power to compel listing of securities by public companies.

vii. Power to control and regulate stock exchanges.

viii. Power to grant registration to market intermediaries.

ix. Power to levy fees or other charges for carrying out the purpose of regulation.

x. Power to declare applicability of section 17 of the Securities Contract (Regulation) Act is any state or area to grant licenses to dealers in securities.

POWERS OF SEBI

MODULE – 3 RISK AND RETURN

Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome.

In other words, risk is the possibility of loss or the probable outcome of all the possible events. Most investors are concerned about the actual outcome being less than the expected outcome. The degree of risk depends upon the features of assets, investment instruments, mode of investment etc. the wider the range of possible outcomes, the grater the risk.

RISK

CLASSIFICATION OF RISK

RISK

SYSTEMATIC UNSYSTEMATIC

Market RiskInterest

Rate RiskPurchasing Power Risk

Business Risk

Financial Risk

Credit Risk

The Return on an asset or investment for a given period is the annual income received plus any change in market price expressed as a percent of opening market price.

Return is the primary motivating force that drives investment. It represents the reward for undertaking investment.

RETURN

CAPM refer to the way in which the securities are valued in line with their anticipated risks and returns. A risk averse investor prefers to invest in risk free securities. A small investor having few securities in his portfolio has greater risk. To reduce the unsystematic risk, he must build up a well diversified portfolio of securities. A diversified and balanced portfolio will bring down the investor’s systematic risk in the stock market. The systematic risks of two portfolios remain the same. An individual is assumed to rank alternatives in the order of his preference. However, due to constraints he can avail only some of the alternatives. An individual acts in a way in which he can maximize the return on his investment under conditions of risk and uncertainty. Thus, CAPM is a linear relationship in which the required rate of return from an asset is determined by that asset’s systematic risk.

In the year 1964, William Sharpe published the Capital Asset Pricing Model. CAPM extended Harry Markowitz’s portfolio theory to introduce the notions of systematic and specific risk.

CAPITAL ASSET PRICING MODEL (CAPM) THEORY

The model establishes that the required rate of return of a security must be related to its contribution. Following are the assumption of CAP model.

Investors are risk averse and need diversification to minimize risk.The investors can borrow or lend an unlimited amount of funds at risk

free rate of interest.No transaction cost are involved.Investors prefer to maximize returns and select a portfolio purely on the

basis of risk and return assessment.The purchase or sale by a single investor cannot affect the prices of

securities because the market is efficient.Investors eliminate the unsystematic risk through diversification. It is the

systematic risk that determines the estimated return.The investors have identical estimates of risk and return of all securities.

ASSUMPTIONS OF CAPM

The security market line expresses the basic theme of CAPM i.e, expected return of a security increases linearly with risk as measured by beta. It is an upward sloping straight line with an intercept at the risk free return securities and passes through the market portfolio. The upward slope line indicates that greater excepted returns accompany higher levels of beta. In equilibrium, each security or portfolio lies on the SML. An investor will come forward to take risk only if the return on investment also includes risk premium.

SECURITY MARKET LINE (SML)


---------------------------------------------

-------------------------------------

-----------------------------------------------------

----

----

----

----

----

----

----

---

---------------------------------------

Expected Return

Risk (Beta)1.51.00.50

Rf

E (Rm)R3

R2

R1

Risk Premium

Risk free return

SML

SML is used to find the fair return that a security should offer according to its beta factor, the risk free return and the market return. The fair return is compare with the actual return earned from the security. If the fair return is less than the actual return, it is an indication that the security is under priced. On the other hand, if the fair return is more than the actual return, the security is over priced. The under pricing or over pricing of a security will be of immense use to an investor.


The Capital Market Line (CML) defines the relationship between total risk and expected return for portfolios consisting of the risk free asset and the market portfolio. If all the investors hold the same risky portfolio, then in equilibrium it must be the market portfolio. CML generates a line on which efficient portfolio can lie. Those which are not efficient will however lie below the line. It is worth mentioning here the CAPM risk return relationship is separate and distinct from risk return relationship of individual securities as represented by CML. An individual security’s expected return and systematic risk statistics should lie on the CAPM but below CML. In contrast the risk less end ( R) statistics of all portfolios, even the inefficient ones should plot on the CAPM. The CML will never include all points, if efficient portfolios, inefficient portfolio and individual securities are placed together on one graph. The individual assets and inefficient portfolios should plot as points below the CML because their total risk includes diversifiable risk.

CAPITAL MARKET LINE (CML)

K represents the market portfolio and R represents risk less rate of return. RKZ line represents preferred investment strategies, showing alternative combinations of risk and return obtainable by combining the market portfolio with borrowing or lending.

CAPITAL MARKET LINE (CML)

----------------------------------

----

----

----

----

----

----

----Expected

Return

R

K

Z

E (Rm – R)

Defensive Assets Aggressive Assets

Risk

CAPM shows the risk and return relationship of an investment in the formula given below:

E ( R) = Rf + βi (Rm – Rf)

Where,

E ( R) = Expected rate of return on any individual

security or portfolio of securities.

Rf = Risk free rate of return

Rm = Expected rate of return on the market portfolio

Rm – Rf = Risk Premium

βi = Market sensitivity index of individual security or

portfolio of securities.

CAPM FORMULA

Calculation of beta is a tedious and time consuming process as it requires ample amount of information. Again beta may or may not reflect the future variability of returns and it cannot be expected to be same all the time. It will change with time and situation.

The specified required rate of return can be considered as only approximation.Perfect capital market exists i.e, the market is efficient market.Lending and borrowing can take place at risk free rates.All investors have the same expectations about return and risk.Risk is measured on the basis of historic returns patterns and assumption is

that returns pattern will repeat in the future. It also assumes that in the financial markets there are no transaction costs, no

taxes and no limitations on investments.The CAPM also assumes that investors are fully diversified. In practice many

investors, particularly small investors, do not hold highly diversified asset portfolio.

LIMITATIONS OF CAPM

The APT Model states that the security returns are influenced by a number of factors. These several factors appear to have been identified as being important such as inflation, interest rate, personal consumption, money supply, industrial production, demand, population factor or other economic factor. Some stocks are more sensitive to some factors than other stocks. For example, the increase in inflation is more than expected, then the securities which are subject to inflation pressure will decrease in price and the security which is not sensitive to inflation may not show change in the price of the security. The sensitivity of the particular factor is incorporated through ‘â’ for that factor. The random error ‘e’ represents the unexpected portion of the return on the security, and which is not explained by other factors. It shows the unexpected events unique to the security. APT states that the risk premium on stock should depend on the expected risk premium associated with each factor and the stock’s sensitivity to each of these factors. The APT model can be expressed using the following equation:

Ri = λo + λ1b1 + λ2b2 + λ3b3…………..+ λjbj

Where, Ri = Average expected return

bi = beta co-efficient relevant to the particular factor

λ1 = sensitivity of return to bi

ARBITRAGE PRICING THEORY (APT)

MODULE – 4

SECURITY ANALYSIS AND

VALUATION

Fundamental analysis relates to an examination of the intrinsic worth of the company, to find out whether the current market price is fair, overpriced or underpriced. This is done by studying the various aspects of the company in the background of the performance of the industry to which the company belongs and the general economic and socio-political scenario of the country. Fundamental analysis is about using real data to evaluate a security’s value.

FUNDAMENTAL ANALYSIS

Economic information is only as reliable as the raw data collection and the credibility of its interpretation.

Gross Domestic Product Savings and Investment Inflation Interest Rates Budget Tax structure Monsoon and Agriculture Infrastructure facilities Demographic factors

ECONOMIC ANALYSIS

An Industry is a homogenous group of firm that have similar technological structure of production and produce similar products. But the industry broadly covers all the economic activities happening in the country to bring growth.

While analysis industry the main three are:-

a) Technology

b) Competitive pressure

c) Economic and customer activity in a country.

INDUSTRY ANALYSIS

MODULE – 5

PORTFOLIO MANAGEMENT

Portfolio Management is the art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institution, and balancing risk against performance.

Portfolio Management is all about strengths, weaknesses, opportunities and threats in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and many other tradeoffs encountered in the attempt to maximize return at a given appetite for risk.

PORTFOLIO MANAGEMENT

Choice of asset mixFormulation of portfolio strategySelection of securitiesPortfolio executionPortfolio revisionPerformance evaluation

INVESTMENT OBJECTIVES FOR PORTFOLIO

Portfolio Rebalancing:- Portfolio Rebalancing involves reviewing and revising the portfolio composition (i.e. the stock – bond mix). There are three basic policies with respect to portfolio rebalancing –

1. buy and hold policy

2. Constant mix policy

3. Portfolio insurance policy

TECHNIQUES OF PORTFOLIO REVISION

William F Sharpe has developed a formula in 1966 which measure the performance of a portfolio. Sharpe’s performance index gives a single value to be used for the performance ranking of various funds or portfolios. It is expressed as the ratio of the excess return per unit of risk where risk is measured by the standard deviation of the rate of return. It measures the risk premium of the portfolio relative to the total amount of risk in the portfolio. The risk premium is the difference between the portfolio’s average rate of return and the risk less rate of return.

Sharpe Index (SI) = [Portfolio Average Return (Rp) – Risk free Rate of Return (Rf) ] ÷ Standard deviation of Return (σp)

SHARPE'S PERFORMANCE INDEX

To understand the Treynor Index, an investor should know the concept of characteristic line. The relationship between a given market return and the fund’s return is given by the characteristic line. The fund performance is measured in relation to the market performance. The ideal fund’s return rises at a faster rate than the general market performance when the market is moving upwards and its rate of return declines slowly than the market return. A poorly diversified portfolio could have a higher ranking under the Treynor measure than for the Sharpe measure. The Treynor measures the performance of the fund with the help of the characteristic line.

Treynor Index (TI) = (Rp – Rf) ÷ βp

TREYNOR'S PERFORMANCE INDEX

The absolute risk adjusted return measure was developed by Michael Jensen which is mentioned as a measure of absolute performance because a definite standard is set and against that the performance is measures. The standard is based on the manager’s predictive ability to judge the fund’s performance. The successful prediction of the stock price enables the manager to earn better return than the ordinary investor expects to earn in a given level of risk.

Rp = αp + Rf + β (Rm – Rf)

Where, Rp = Average return on portfolio

Rm = Market return

Rf = Risk free return

αp = Intercept or, αp = (Rp – Rf) – β (Rm – Rf)

β = Measure of systematic risk

JENSEN'S PERFORMANCE INDEX

According to SEBI, Mutual Fund is a mechanism for pooling the resources by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in offer document.

A Mutual Fund is a portfolio of stocks, bonds, or other securities that is collectively owned by hundreds or thousands of investors and managed by a professional investment company.

MUTUAL FUND

ORGANIZATION OF A MUTUAL FUND

Unit Holder

SEBI

Sponsors

Trustees AMC

The MutualFund

Transfer Agent

Custodian

The Sponsor - A Sponsor is a person who acting alone or in combination with another body or corporate, establishes a mutual fund and applies to SEBI for its registration. The sponsor is also closely associated with the AMC. As per SEBI regulations, the sponsor has to contribute a minimum of 40% of the net worth of the AMC.

The Board of Trustees(BOT) – A person or a group of persons having an overall supervisory authority over the fund managers, they ensure that the managers keep to the trust deed that the unit prices are calculated correctly and the assets of the funds are held safely.


The Asset Management Company (AMC) – A company set up primarily for managing the investment of mutual funds. It makes investment decisions in accordance with the scheme objectives, deed of trust and provisions of the Investment management Agreement.

The Custodian – Custodian is registered with SEBI, holds the securities and other assets of various schemes of the fund in its custody.

The Unit Holders – A person who holds Unit(s) a Mutual Fund.


MODULE – 6

NEW DIRECTIONS IN

INVESTMENT MANAGEMENT

A Derivative is an instrument whose value depends on the value of some underlying assets. The underlying assets may be commodity, equity or currency.

Derivative is a modern financial instrument in hedging risk. The individuals and firms who wish to avoid or reduce risk can deal with others who are willing to accept risk for a price.

MEANING OF DERIVATIVES

It is an agreement between buyer and seller to exchange the commodity or instrument for cash at a predetermined future date at a certain price agreed today.

For example:-

A farmer growing onions may sell some portion of his crop before harvest to the buyer at a fixed price, for delivery after harvest. For the farmer this transaction reduces the risk of selling in the market after harvest at lower prices. He has locked in a profit by this operation. This profit would have been more or less if he had waited until the harvest to sell onions at the spot price then prevailing in the cash market. Thus farmer has hedged himself against the risk of a downward movement in onion prices by entering into a forward contract in the forward market.

FORWARD

Financial swaps are private contractual agreements between two parties to exchange cash flow in the future according to specified terms and conditions. They are mutual obligations among the swap parties.

Currency Swaps:- A currency swap is a contract involving exchange of interest payments on a loan in one currency for fixed or floating interest payments on equivalent loan in a different principal.

Forward Swaps:- Forward swaps are those swaps in which the commencement date is set as a future date. Thus, it helps in locking the swap rates and use them later as and when needed. It is also called as deferred swaps as the start date of the swap is delayed. It is useful to the users who do not need funds immediately.

Interest Rate Swaps:- An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party’s stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities.

SWAPS

It is a contract between two parties to contract which facilitates trading in secondary market. A futures market can be defined as an agreement to buy or sell a standard quantity of a specific instrument at a predetermined future date and at a price agreed between the parties on the floor of an organized futures exchange.

Future contracts better compare to forward contract as they are standardized, carry liquidity, traded in secondary market and safeguards against default.

FUTURES

BASIS FUTURES FORWARDS

Size of contract Standardized contract size No standard size

Valuation Marked to market every day

No unique method of valuation

Place Futures exchange No fixed place

Variation Variation on daily basis No variation

Settlement Made by clearing house Client or bank

Risk Risk is little High risk

Cost of transaction Commission and exchange fees are high

Low cost as contract is direct

Market place Central exchange floor with worldwide network

Over the telephone or direct contact

DIFFERENCES BETWEEN FUTURES AND FORWARDS

An Option means choice. An Option in a financial market is created through a financial contract. This financial contract gives a right to its holder to enter into a trade at or before a future specified date.

The underlying assets on options include stocks, stock indices, foreign currencies and debt instruments, commodity, and futures contracts. These are called stock options, index options, commodity options, currency options, and future options.

OPTIONS

Call Option:- A call option is one which provides the holder the right to purchase an underlying asset at a specified price. But he has no obligation to buy a given quantity of the underlying assets. It gives the right to the buyer to buy a fixed number of shares or commodities at the exercise price up to the date of expiration of contract. The buyer has to pay the writer the option price called premium. The seller of an option is known as writer.

Put Option:- A put option on the other hand are one which provides the holder the right to sell an underlying asset at a specified price. It gives 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. The put option gives the buyer the right to sell the underlying asset at the exercise price up to the date of the contract. The seller of the put option is called the writer. He has no choice regarding the fulfillment of the obligation under the contract. If the buyer wants to exercise his put option, the writer must purchase at the exercise price.

MAJOR FORMS OF OPTION

FUTURES OPTIONS

Both seller and buyer are obliged to perform the contract

Only seller is obliged to perform the contract

The holder of the contract is exposed to risk and has potential

for profit

The buyer’s loss is the risk of losing the premium

No premium is paid by either party

The buyer pays the premium to the seller

The parties to the contract must perform on the settlement date

only

The buyer can exercise the option any time before to the expiry date

DIFFERENCES BETWEEN FUTURES AND OPTIONS

If we assume that there are two possible stock prices at the end of each 6 month period, the number of possible end of year prices increases. As the period is further shortened (from 6 to 3months or 1 month), we get more frequent changes in stock price and a wider range of possible end of year prices. Eventually, we would reach a situation where prices change more or less continuously, leading to a continuum of possible prices at the end of the year. Theoretically, even for this situation we could set up a portfolio which has a payoff identical to that of a call option. However, the composition of this portfolio will have to be change continuously as the year progresses.

BLACK – SCHOLES MODEL

Calculating the value of such a portfolio and through that the value of the callσ option in such a situation appears to be an unwieldy task, but Black and Scholes developed a formula that does precisely that. Their formula is:

Co=So N(d1)- E/ert N(d2)

Where Co is the equilibrium value of a call option now, So is the price of the stock now, E is the exercise price, e is the base of natural logarithm, r is the annualized continuously compounded risk free interest rate, t is the length of time in years to the expiration date and N(d) is the value of the cumulative normal density function.

BLACK – SCHOLES MODEL

Documents

Sapm all chapters