Basics of Financial Markets and Financial Planning

GUIDE MANUAL

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Guide Manual: Basics of Financial Markets and Financial Planning

1.Financial Market is a place where the savings from various sources like households, government, firms and corporates are mobilized towards those who need it. Alternatively put, financial market is an intermediary which directs funds from the savers (lenders) to the borrowers.In other words, financial market is the place where assets like equities, bonds, currencies, derivatives and stocks are traded.

• Some of the salient features of financial market are:• Transparent pricing• Basic regulations on trading• Low transaction costs• Market determined prices of traded securities

2.Six key functions of Financial Market are :• Borrowing & Lending : Financial market transfers fund from one economic agent (saver/lender) to another

(borrower) for the purpose of either consumption or investment.• Determination of Prices : Prices of the new assets as well as the existing stocks of financial assets are set in

financial markets. Determination of prices is major function of financial market.• Assimilation and Co-ordination of Information : It gathers and co-ordinates information regarding the value

of financial assets and flow of funds in the economy.• Liquidity : The asset holders can sell or liquidate their assets in financial market.• Risk Sharing : It distributes the risk associated in any transaction among several participants in an

enterprise.• Efficiency : It reduces the cost of transaction and acquiring information. It help to increase efficiency in

financial market.3.The principle participants in the financial market are as follows:

• BANKS : Largest provider of funds to business houses and corporates through accepting deposits. Banks are the major participant in the financial market.

• INSURANCE COMPANIES : Issue contracts to individuals or firms with a promise to refund them in future in case of any event and thereby invest these funds in debt, equities, properties, etc.

• FINANCE COMPANIES : Engages in short to medium term financing for businesses by collecting funds by issuing debentures and borrowing from general public.

• MERCHANT BANKS : Funded by short term borrowings; lend mainly to corporations for foreign currency and commercial bills financing.

• COMPANIES : The surplus funds generated from business operations are majorly invested in money market instruments, commercial bills and stocks of other companies.

• MUTUAL FUNDS : Acquire funds mainly from the general public and invest them in money market, commercial bills and shares. Mutual fund is also principle participant in financial market.

• GOVERNMENT : Authorized dealers basically look after the demand-supply operations in financial market. Also works to fill in the gap between the demand and supply of funds.

4.Major participants and players in financial markets• In the financial markets, there is a flow of funds from one group of parties (funds-surplus units) known as

investors to another group (funds-deficit units) which require funds. However, often these groups do not have direct link. The link is provided by market intermediaries such as brokers, mutual funds, leasing and finance companies, etc. In all, there is a very large number of players and participants in the financial market. These can be grouped as follows :

• The individuals: These are net savers and purchase the securities issued by corporates. Individuals provide funds by subscribing to these security or by making other investments.

• The Firms or corporates: The corporates are net borrowers. They require funds for different projects from time to time. They offer different types of securities to suit the risk preferences of investors’ Sometimes, the corporates invest excess funds, as individuals do. The funds raised by issue of securities are invested in real assets like plant and machinery. The income generated by these real assets is distributed as interest or dividends to the investors who own the securities.

• Government: Government may borrow funds to take care of the budget deficit or as a measure of controlling the liquidity, etc. Government may require funds for long terms (which are raised by issue of

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Government loans) or for short-terms (for maintaining liquidity) in the money market. Government makes initial investments in public sector enterprises by subscribing to the shares, however, these investments (shares) may be sold to public through the process of disinvestments.

• Regulators: Financial system is regulated by different government agencies. The relationships among other participants, the trading mechanism and the overall flow of funds are managed, supervised and controlled by these statutory agencies. In India, two basic agencies regulating the financial market are the  Reserve Bank of India  (RBI ) and Securities and Exchange Board of India (SEBI). Reserve Bank of India, being the Central Bank, has the primary responsibility of maintaining liquidity in the money market’ It undertakes the sale and purchase of T-Bills on behalf of the Government of India. SEBI has a primary responsibility of regulating and supervising the capital market. It has issued a number of Guidelines and Rules for the control and supervision of capital market and investors’ protection. Besides, there is an array of legislations and government departments also to regulate the operations in the financial system.

• Market Intermediaries: There are a number of market intermediaries known as financial intermediaries or merchant bankers, operating in financial system. These are also known as investment managers or investment bankers. The objective of these intermediaries is to smoothen the process of investment and to establish a link between the investors and the users of funds. Corporations and Governments do not market their securities directly to the investors. Instead, they hire the services of the market intermediaries to represent them to the investors. Investors, particularly small investors, find it difficult to make direct investment. A small investor desiring to invest may not find a willing and desirable borrower. He may not be able to diversify across borrowers to reduce risk. He may not be equipped to assess and monitor the credit risk of borrowers. Market intermediaries help investors to select investments by providing investment consultancy, market analysis and credit rating of investment instruments. In order to operate in secondary market, the investors have to transact through share brokers. Mutual funds and investment companies pool the funds(savings) of investors and invest the corpus in different investment alternatives.

5.Financial Markets can be categorized into six types:

1.Capital Markets: Stock markets and Bond markets2.Commodity Markets3.Money Markets4.Derivatives Markets: Futures Markets5.Insurance Markets6.Foreign Exchange Markets

6. Capital market: Classification

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The Primary market consists of issue of initial public offers wherein the issuer directly allots the shares/debt to the investor. In the Primary Capital Market, the public issue could be either equity i.e. equity shares or debts like debentures, bonds etc.In the secondary market, one investor sells to another investor through the stock exchange.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. The issuers create and issue fresh securities in exchange of funds through public issues and/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.

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. It essentially comprises of the stock exchanges which provide platform for trading of securities and a host of intermediaries who assist in trading of securities and clearing and settlement of trades. The securities are traded, cleared and settled as per prescribed regulatory framework under the supervision of the Exchanges and SEBI.

7. Initial Public Offer(IPO)

The first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded.

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Equity shares are instruments issued by companies to raise capital and it represents the title to the ownership of a company. You become an owner of a company by subscribing to its equity capital (whereby you will be allotted shares) or by buying its shares from its existing owner(s).

The public issue can be kept open to public or on private placement basis.

In private placement, specified informed investors invest i.e. the general public or individual investors are not allowed to invest. In such cases the issue is also not publicized.

Primary issue could be at par i.e. is sold at the face value of the share/debenture or it could be at a premium or discount.

The primary issue is publicized by issue of an offer document called prospectus containing the details of the issue and the past performance/future plans of the issuer. Public issues are offered by public limited companies.

Profit is shared with the share holders in the form of Dividend annually.

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8. Debt Market:

The debt market in India can be classified into Government Securities market and Corporate debt Market.

The common instruments in the debt market are:

• Corporate Fully

Convertible Debentures(FCDs)/• Party Convertible Debentures (PCDs)/• Non Convertible Debentures (NCDs)/

• PSU Bonds/Zero Coupon Bonds/Deep Discount Bonds• Gilt Edged Securities etc.

9.Money Market

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TYPE OF EQUITY ISSUES

a. Public issueSecurities are issued to the members of the public, and anyone eligible to invest can participate in the issue. This is primarily retail issue of securities. b. Private placement Securities are issued to a select set of investors who can bid and purchase the securities on offer. This is primarily a wholesale issue of securities to institutional investors by an unlisted company. c.Preferential issue A private placement of securities by a listed company is called a preferential issue. Securities are issued to an identified set of investors, on preferential terms, along with or independent of a public issue. This may include promoters, strategic investors, employees and such specified preferential groups.d. Qualified Institutional Placement (QIP) A private placement of securities by a listed company to a set of institutional investors termed as qualified institutional buyers is a QIP. Qualified institutional buyers include institutions such as mutual funds.e. Rights and Bonus issues Securities are issued to existing investors as on a specific cut-off date, enabling them to buy more securities at a specific price (rights) or get an allotment of additional shares without any consideration (bonus).

Types of Investors

• Resident individuals• Hindu undivided

family (HUF)• Minors through

guardians• Registered societies

and clubs• Non-resident Indians

(NRI)• Persons of Indian

Origin (PIO)• Qualified Foreign

investors (QFI)• Banks• Financial institutions• Association of persons• Companies• Partnership firms• Trusts• Foreign institutional

investors (FIIs)• Limited Liability

Partnerships (LLP

Individual investors are further categorized based on the amount invested as

• Retail, who invests less than Rs.2 lakhs in a single issue and

• Non-Institutional Buyers (NIBs), who invest more than Rs. 2 lakhs in a single issue.

• The other categories of investors are classified as institutional investors and are also known as qualified institutional buyers (QIBs)

Money market deals with short-term money and financial assets that are near substitutes for money. By short term it is meant generally a period less than 12 months. Near substitute to money means any financial asset which can be converted into cash quickly with minimum transaction cost.

What is traded in the Indian money market? Treasury Bills Call Money Commercial Paper (CP) Certificates of Deposit (CD) Inter Bank Participation Certificates Inter Bank Term Money

Major players: Reserve Bank of India Private banks Public sector banks, Development banks and other Non-Banking Financial Companies(NBFCs) such as Life Insurance

Corporation of India (LIC), Unit Trust of India (UTI), the International Finance Corporation, mutual funds, FIIs, Provident Funds and Trusts.

Commercial PaperCommercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note.

Issuers: Highly rated corporate borrowers, primary dealers (PDs) and satellite dealers (SDs) and all-India financial institutions (FIs).

Rating: All eligible participants should obtain the credit rating for issuing CP. Minimum and maximum period of maturity: Minimum of 7 days and a maximum of up to one year from the date of issue. The maturity date of the CP should not go beyond the date up to which the credit rating of the issuer is

valid. Denomination - Rs.5 lakh or multiples thereof.Who can invest?Individuals, banking companies, other corporate bodies (registered or incorporated in India) and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs) etc. can invest in CPs.However, investment by FIIs would be within the limits set for them by Securities and Exchange Board of India (SEBI) from time-to-time.

Certificate of Deposit (CD)Certificate of Deposit (CD) is a negotiable money market instrument.

Issuers- (i) Scheduled commercial banks except Regional Rural Banks& Local Area Banks (ii) select All-India Financial Institutions (FIs) that have been permitted by RBI to raise short-term resources within the umbrella limit fixed by RBI.

Minimum and maximum period of maturity- 7 days and not more than one year, from the date of issue Denomination - Rs.1 lakh or multiples thereof.Who can invest?Individuals, Corporations, Companies (including banks and PDs), Trusts, Funds, Associations, etc.

10.Call/Notice Money Market/Term Money

The call/notice money market forms an important segment of the Indian Money Market. Under call money market, funds are transacted on an overnight basis and under notice money market, funds are transacted for a period between 2 days and 14 days.

The money market primarily facilitates lending and borrowing of funds between banks and entities like Primary Dealers (PDs). Banks and PDs borrow and lend overnight or for the short period to meet their short term mismatches in fund positions. This borrowing and lending is on unsecured basis. ‘Call Money’ is the borrowing or

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lending of funds for 1day. Where money is borrowed or lend for period between 2 days and 14 days it is known as ‘Notice Money’ and ‘Term Money’ refers to borrowing/lending of funds for period exceeding 14 days.

Interest rates in these markets are market determined i.e. by the demand and supply of short term funds. In India, 80% demand comes from the public sector banks and rest 20% comes from foreign and private sector banks. Then, around 80% of short term funds are supplied by Financial Institutions such as IDBI and Insurance giants such as LIC. Rest 20% of the short term funds come from the banks. Since banks work as both lenders and borrowers in these markets, they are also known as Inter-Bank market.

The short term fund market in India is located only in big commercial centres such as Mumbai, Delhi, Chennai and Kolkata. The intervention of RBI is prominent in the short term funds money market in India.

Call Money / Notice Money market is most liquid money market and is indicator of the day to day interest rates. If the call money rates fall, this means there is a rise in the liquidity and vice versa.

11.Market Capitalisation = Current Stock Price x Number of Shares outstanding

Company XYZ has 10,000,000 shares outstanding and its current share price is Rs 8. Based on the above formula, we can calculate that Company XYZ's market capitalisation is Rs 80 million, or 10,000,000 shares x Rs 8 per share.

12.PFRDA

The Pension Fund Regulatory & Development Authority Act was passed on 19th September, 2013 and the same was notified on 1st February, 2014. PFRDA is regulating NPS, subscribed by employees of Govt. of India, State Governments and by employees of private institutions/organizations & unorganized sectors. The PFRDA is ensuring the orderly growth and development of pension market. The Government of India had, in the year 1999, commissioned a national project titled “OASIS” (an acronym for old age social & income security) to examine policy related to old age income security in India. Based on the recommendations of the OASIS report, Government of India introduced a new Defined Contribution Pension System for the new entrants to Central/State Government service, except to Armed Forces, replacing the existing system of Defined Benefit Pension System. On 23rd August, 2003, Interim Pension Fund Regulatory & Development Authority (PFRDA) was established through a resolution by the Government of India to promote, develop and regulate pension sector in India. The contributory pension system was notified by the Government of India on 22nd December, 2003, now named the National Pension System (NPS) with effect from the 1st January, 2004. The NPS was subsequently extended to all citizens of the country w.e.f. 1st May, 2009 including self employed professionals and others in the unorganized sector on a voluntary basis.

13.RBI

Main Functionsa.Monetary Authority:Formulates, implements and monitors the monetary policy. Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors.b.Regulator and supervisor of the financial system:Prescribes broad parameters of banking operations within which the country's banking and financial system functions.Objective: maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public.c.Manager of Foreign ExchangeManages the Foreign Exchange Management Act, 1999.

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It is common to consider the top 50 stocks by market capitalisation as large cap, the next 200 as mid cap, and the

Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.d.Issuer of currency: Issues and exchanges or destroys currency and coins not fit for circulation. Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality.e.Developmental rolePerforms a wide range of promotional functions to support national objectives.Related Functionsf.Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker. g.Banker to banks: maintains banking accounts of all scheduled banks.

14.SEBI

Securities and Exchange Board of India (SEBI) was first established in the year 1988 as a non-statutory body for regulating the securities market. It became an autonomous body in 1992 and more powers were given through an ordinance. Since then it regulates the market through its independent powers. Objectives of SEBI:

• As an important entity in the market it works with following objectives:• 1. It tries to develop the securities market. • 2. Promotes Investors Interest.• 3. Makes rules and regulations for the securities market.

Functions Of SEBI:• Find below SEBI's important functions:• 1. Regulates Capital Market• 2. Checks Trading of securities.• 3. Checks the malpractices in securities market.• 4. It enhances investor's knowledge on market by providing education.• 5. It regulates the stockbrokers and sub-brokers. • 6. To promote Research and Investigation

SEBI In India's Capital Market:• SEBI from time to time have adopted many rules and regulations for enhancing the Indian capital

market. The recent initiatives undertaken are as follows:Sole Control on Brokers:

• Under this rule every brokers and sub brokers have to get registration with SEBI and any stock exchange in India.

• For Underwriters:• For working as an underwriter an asset limit of 20 lakhs has been fixed.

For Share Prices• According to this law all Indian companies are free to determine their respective share prices and

premiums on the share prices. •

For Mutual Funds• SEBI's introduction of SEBI (Mutual Funds) Regulation in 1993 is to have direct control on all mutual

funds of both public and private sector.

15. Stock exchanges An Index is used to give information about the price movements of products in the financial, commodities or any other markets. Financial indexes are constructed to measure price movements of stocks, bonds, T-bills and other forms of investments. Stock market indexes are meant to capture the overall behaviour of equity markets. A stock

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market index is created by selecting a group of stocks that are representative of the whole market or a specified sector or segment of the market. An Index is calculated with reference to a base period and a base index value.

Stock exchanges are players in the Secondary Markets: Stock exchange is a platform where buyers and sellers meet. (Market where existing securities can be exchanged).For example:

Bombay Stock Exchange (BSE) National Stock Exchange (NSE) New York Stock Exchange (NYSE)

Stock market indexes are useful for a variety of reasons. Some of them are :• They provide a historical comparison of returns on money invested in the stock market against other forms

of investments such as gold or debt. • They can be used as a standard against which to compare the performance of an equity fund. • In It is a lead indicator of the performance of the overall economy or a sector of the economy • Stock indexes reflect highly up to date information • Modern financial applications such as Index Funds, Index Futures, Index Options play an important role in

financial investments and risk management Stock ExchangesMajor stock exchange in India

Bombay Stock Exchange (BSE). National Stock Exchange (NSE).

Major stock indices in India BSE Sensex: a stock market index of 30 well-established and financially sound companies listed on

the BSE.NSE Nifty: is an indicator of the 50 top major companies on the National Stock Exchange (NSE).

15.NIFTY 50• The Nifty 50 is a well diversified 50 stock index accounting for 13

sectors of the economy. It is used for a variety of purposes such as benchmarking fund portfolios, index based derivatives and index funds.

• Nifty 50 is owned and managed by India Index Services and Products Ltd. (IISL). IISL is India's first specialised company focused upon the index as a core product.

• The Nifty 50 Index represents about 66.17% of the free float market capitalization of the stocks listed on NSE as on March 31, 2015.

• The total traded value of Nifty 50 index constituents for the last six months ending March 2015 is approximately 46.22% of the traded value of all stocks on the NSE.

• Impact cost of the Nifty 50 for a portfolio size of Rs.50 lakhs is 0.06% for the month March 2015. • Nifty 50 is professionally maintained and is ideal for derivatives trading.

16.Large cap stocks

The first category based on market capitalisation is that of 'large cap stocks'.

1.One can look at the BSE-Sensex or BSE-100 Index as a reference point for large cap stocks. Market capitalisation for stocks in the BSE-100 Index, for instance, ranges from Rs 200 bn to Rs 3,500 bn.

2.These are stocks of usually large and well-established companies that have a strong market presence and are generally considered as safe investments.

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ROLE OF NSE IN INDIAN SECURITIES MARKET

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

3.One important fact about large caps is that information regarding these companies is readily available in newspapers and magazines.

4.Most of the large cap companies have good disclosures and therefore there is no dearth of information for an investor looking into them. Large companies such as Infosys, TCS, and Wipro are classified as large cap stocks. These companies have been around in the industry long enough and have firmly established themselves as leading players. Their stocks are publicly traded and have large market capitalisations.

17.Mid cap stocks

1.Mid caps lie between large cap stocks and small cap stocks. Mid cap stocks are those that generally have a market capitalisation within the range of Rs 50 bn and Rs 200 bn.

2.These represent mid-sized companies that are relatively more risky than large cap as investment options yet, they are not considered as risky as small cap companies. They rank between the two extremes on all the important parameters like size, revenues, employee and client base.

When one invests in mid caps for the long term, he may be investing in companies that could become tomorrow's runaway success stories.

Generally speaking, mid cap stocks as an investment can bring you higher returns in 3 to 5 years as opposed to their big brother large cap stocks that can bring you moderate (yet safer) returns during this timeframe.

18. Small cap stocks

Lying at the lowest end of market capitalisation, Small cap stocks are generally viewed under the misconception of being hazardous or 'quick rich' stocks. However, both these labels are untrue.

Small cap companies have smaller revenue and client bases, and usually include the start-ups or companies in the early stage of development.

Small cap stocks are potentially big gainers as they are yet to be discovered within the sector and can show growth potential in large numbers once unfurled in the market.

A thorough research is required regarding the promoters' credentials, management strength and track record, and long and short term growth plans of the company before investing.

Small caps can prove to be a very wise 'long term' investments especially if the chosen companies are good businesses and are well-managed.

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19.Debt Instruments (loan instruments) A. CORPORATE DEBTB. GOVERNMENT DEBT

A.CORPORATE DEBT i) Debentures and ii) Bonds i) Debentures are instrument issued by companies to raise debt capital. As an investor, you lend you money to the company, in return for its promise to pay you interest at a fixed rate (usually payable half yearly on specific dates) and to repay the loan amount on a specified maturity date say after 5/7/10 years (redemption).Normally specific asset(s) of the company are held (secured) in favour of debenture holders. This can be liquidated, if the company is unable to pay the interest or principal amount. Unlike loans, you can buy or sell these instruments in the market. Types of debentures:

• Non convertible debentures (NCD) – Total amount is redeemed by the issuer• Partially convertible debentures (PCD) – Part of it is redeemed and the remaining is converted to equity

shares as per the specified terms• Fully convertible debentures (FCD) – Whole value is converted into equity at a specified price

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ii). Bonds are broadly similar to debentures.

Bonds are broadly similar to debentures .They are issued by companies, financial institutions, municipalities or government companies and are normally not secured by any assets of the company (unsecured).

Types of bonds

i)Regular Income Bonds provide a stable source of income at regular, pre-determined intervalsii)Tax-Saving Bonds offer tax exemption up to a specified amount of investment, depending on the scheme and the Government notification. Examples are:

– Infrastructure Bonds under Section 88 of the Income Tax Act, 1961– NABARD/ NHAI/REC Bonds under Section 54EC of the Income Tax Act, 1961

iii)RBI Tax Relief Bonds iv)Fixed Rate Bonds – These are bonds on which the coupon rate is fixed for the entire life of the bond. Most Government bonds are issued as fixed rate bonds.For example – 8.24%GS2018 was issued on April 22, 2008 for a tenor of 10 years maturing on April 22, 2018. Coupon on this security will be paid half-yearly at 4.12% (half yearly payment being the half of the annual coupon of 8.24%) of the face value on October 22 and April 22 of each year.v)Floating Rate Bonds – Floating Rate Bonds are securities which do not have a fixed coupon rate. The coupon is re-set at pre-announced intervals (say, every six months or one year) by adding a spread over a base rate. In the case of most floating rate bonds issued by the Government of India so far,the base rate is the weighted average cut-off yield of the last three 364- day Treasury Bill auctions preceding the coupon re-set date and the spread is decided through the auction. Floating Rate Bonds were first issued in September 1995 in India.For example, a Floating Rate Bond was issued on July 2, 2002 for a tenor of 15 years, thus maturing on July 2, 2017. The base rate on the bond for the coupon payments was fixed at 6.50% being the weighted average rate of implicit yield on 364-day Treasury Bills during the preceding six auctions. In the bond auction, a cut-off spread (markup over the benchmark rate) of 34 basis points (0.34%) was decided. Hence the coupon for the first six months was fixed at 6.84%.vi)Zero Coupon Bonds – Zero coupon bonds are bonds with no coupon payments. Like Treasury Bills, they are issued at a discount to the face value. The Government of India issued such securities in the nineties, It has not issued zero coupon bond after that.vii)Capital Indexed Bonds – These are bonds, the principal of which is linked to an accepted index of inflation with a view to protecting the holder from inflation. A capital indexed bond, with the principal hedged against inflation, was issued in December 1997. These bonds matured in 2002. The government is currently working on a fresh issuance of Inflation Indexed Bonds wherein payment of both, the coupon and the principal on the bonds, will be linked to an Inflation Index (Wholesale Price Index). In the proposed structure, the principal will be indexed and the coupon will be calculated on the indexed principal. In order to provide the holders protection against actual inflation, the final WPI will be used for indexation.viii)Bonds with Call/ Put Options – Bonds can also be issued with features of optionality wherein the issuer can have the option to buy-back (call option) or the investor can have the option to sell the bond (put option) to the issuer during the currency of the bond. 6.72%GS2012 was issued on July 18, 2002 for a maturity of 10 years maturing on July 18, 2012. The optionality on the bond could be exercised after completion of five years tenure from the date of issuance on any coupon date falling thereafter. The Government has the right to buyback the bond (call option) at par value (equal to the face value) while the investor has the right to sell the bond (put option) to the Government at par value at the time of any of the half-yearly coupon dates starting from July 18, 2007B. GOVERNMENT DEBTGovernment Securities A government security is a tradable instrument issued by the central government or the state governments.

It acknowledges the government’s debt obligation. Government paper with tenor beyond one year is known as dated security. At present, there are central government dated securities with a tenor up to 30 years in the market.

Treasury Bills

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1.Treasury bills or T-bills, which are money market instruments, are short term debt instruments issued by the Government of India and are presently issued in three tenors, namely, 91 day, 182 day and 364 day. 2.Treasury bills are zero coupon securities and pay no interest. They are issued at a discount and redeemed at the face value at maturity.3. For example, a 91 day Treasury bill of Rs.100/- (face value) may be issued at say Rs. 98.20, that is, at a discount of say, Rs.1.80 and would be redeemed at the face value of Rs.100/-. 4.The return to the investors is the difference between the maturity value or the face value (that is Rs.100) and the issue price (for calculation of yield on Treasury Bills please see answer to question no. 26). 5.The Reserve Bank of India conducts auctions usually every Wednesday to issue T-bills. Payments for the T-bills purchased are made on the following Friday. The 91 day T-bills are auctioned on every Wednesday. The Treasury bills of 182 days and 364 days tenure are auctioned on alternate Wednesdays. T-bills of of 364 days tenure are auctioned on the Wednesday preceding the reporting Friday while 182 T-bills are auctioned on the Wednesday prior to a non-reporting Fridays. The Reserve Bank releases an annual calendar of T-bill issuances for a financial year in the last week of March of the previous financial year. The Reserve Bank of India announces the issue details of T-bills through a press release every week.

A Government security is a tradable instrument issued by the Central Government or the State Governments. It acknowledges the Government’s debt obligation. Such securities are

• 1.Short term (usually called treasury bills, with original maturities of less than one year) or • 2.Long term (usually called Government bonds or dated securities with original maturity of one year or

more). In India, the Central Government issues both, treasury bills and bonds or dated securities while the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs). Government securities carry practically no risk of default and, hence, are called risk-free gilt-edged instruments.

Government of India also issues savings instruments (Savings Bonds, National Saving Certificates (NSCs), etc.) or special securities (oil bonds, Food Corporation of India bonds, fertiliser bonds, power bonds, etc.).

They are, usually not fully tradable and are, therefore, not eligible to be SLR securities.

20.How is the yield of a Treasury Bill calculated?

ILLUSTRATION:

Assuming that the price of a 91 day Treasury bill at issue is Rs.98.20, the yield on the same would be

After say, 41 days, if the same Treasury bill is trading at a price of Rs. 99, the yield would then be

Note that the remaining maturity of the treasury bill is 50 days (91-41).

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Wherein;P – Purchase price D – Days to maturityDay Count: For Treasury Bills, D = [actual number of days to maturity/365]

22. Fixed income Instruments: Fixed income securities, or bonds, include the debt obligations of governments, agencies, municipalities

and corporations. The borrower (issuer) promises to pay the lender (investor) interest at a specified rate over the life of the

bond (maturities typically range from one to 30 years) and repay face value at maturity.Fixed income securities market:They consist of: Money market Debt or bond marketCharacteristics of Fixed Income Securities Regular interest income—Interest payments can be monthly, quarterly or semi-annually, depending on

the security type. Capital protection — The borrower promises to repay the face value when the securities mature, and

some will pledge collateral to support interest and principal payments. Diversification—Bonds can be an integral part of a diversified investment portfolio that includes other

asset classes such as stocks and alternative investments. Liquidity—Liquidity is a measure of how easily a security can be sold in a secondary market, and fixed

income securities can range from highly liquid to relatively illiquid.Tax exemptions—Interest income from securities issued by government entities may be fully or partially exempt from local, state or federal income taxes.

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Mutual Funds23. Mutual Funds Mutual funds are a 1.Vehicle to mobilize moneys from (Pool of Money)2.Investors, 3.To invest in different markets and securities,4. In line with the investment objectives agreed upon, between the mutual fund and the investors.Mutual funds collect money from many investors and invest this corpus in equity, debt or a combination of both, in a professional and transparent manner. In return for your investment, you receive units of mutual funds which entitle you to the benefit of the collective return earned by the fund, after reduction of management fees.

Working of a Mutual Fund:

There are multiple entities involved in the activities of a mutual fund business. All these entities are regulated by SEBI for their eligibility in terms of experience and financial soundness, range of responsibilities and accountability. A mutual fund is set up by a sponsor, who is its promoter. Trustees are appointed to take care of the interests of the investors in the various schemes launched by the mutual fund. An asset management company (AMC) is appointed to manage the activities related to launching a scheme, marketing it, collecting funds, investing

the funds according to the scheme’s investment objectives and enabling investor transactions. In this, they are assisted by other entities such as banks, registrars to an issue and transfer agents, investor service centres (ISC), brokers or members of stock exchanges, custodians, among others. For example, the sponsor of the HDFC Mutual Fund is HDFC and Standard Life Investments Ltd and the trustees are the HDFC Trustee Company Ltd. The AMC is HDFC Asset Management Company Ltd.

24.Cllassification of Mutual Funds1.Open-Ended Funds, Close-Ended Funds and Interval Funds

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MARK TO MARKET

The current value of the portfolio forms the base of the net assets of the scheme and therefore the NAV. It means that if the portfolio was to be liquidated, then this would be the value that would be realised and distributed to the investors. Therefore the portfolio has to reflect the current market price of the securities held. This process of valuing the portfolio on a daily basis at current value is called marking to market. The price is taken from the market where the security is traded. If the security is not traded or the price available is stale, then SEBI has laid down the method for valuing such securities.

NEW FUND OFFERWhen a scheme is first made available for investment, it is called a ‘New Fund Offer’ (NFO). During the NFO, investors may have the chance of buying the units at their face value. Post-NFO, when they buy into a scheme, they need to pay a price that is linked to its NAV.

2.Actively Managed Funds and Passive Funds 3.Debt, Equity and Hybrid Funds i)Debt Funds

• a. Gilt funds • b.Diversified debt funds • c.Junk bond schemes • d.Fixed maturity plans • e.Floating rate funds• f.Liquid schemes

ii) Equity Funds • a.Diversified equity fund • b.Sector funds • c.Thematic funds• d.Equity Linked Savings Schemes (ELSS), • e.Equity Income / Dividend Yield • f.Arbitrage Funds

iii) Hybrid Funds • a.Monthly Income Plan • b.Capital Protected Schemes

4.Gold Funds • a.Gold Exchange Traded Fund, • b.Gold Sector Funds

5.Real Estate Funds 6.Commodity Funds 7.International Funds8. Fund of Funds9. Exchange Traded Funds

A mutual fund can also be classified based on the structure and/or investment objective as under:(A) By Structure

1.Open ended,2.Closed ended and 3.Interval

An Open-ended scheme allows investors to invest in additional units and redeem investment continuously at current NAV. The scheme is for perpetuity unless the investors decide to wind up the scheme. The unit capital of the scheme is not fixed but changes with every investment or redemption made by investors. A Closed-ended scheme is for a fixed period or tenor. It offers units to investors only during the new fund offer (NFO). The scheme is closed for transactions with investors after this. The units allotted are redeemed by the fund at the prevalent NAV when the term is over and the fund ceases to exist after this.In the interim, if investors want to exit their investment they can do so by selling the units to other investors on a stock exchange where they are mandatorily listed. The unit capital of a closed end fund does not change over the life of the scheme since transactions between investors on the stock exchange does not affect the fund.

Interval funds are a variant of closed end funds which become open-ended during specified periods. During these periods investors can purchase and redeem units like in an open-ended fund. The specified transaction periods are for a minimum period of two days and there must be a minimum gap of 15 days between two transaction periods. Like closed-ended funds, these funds have to be listed on a stock exchange.

(B) By Investment Objective1.Growth Schemes

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Aim to provide capital appreciation over the medium to long term. These schemes normally invest a majority of their funds in equities and are willing to bear short term decline in value for possible future appreciation. These schemes are NOT for investors seeking regular income or needing their money back in the short term.

Ideal for: • Investors in their prime earning years. • Investors seeking growth over the long term.

2.Income Schemes Aim to provide regular and steady income to investors. These schemes generally invest in fixed income securities such as bonds and corporate debentures. Capital appreciation in such schemes may be limited.

Ideal for:• Retired people and others with a need for capital stability and regular income. • Investors who need some income to supplement their earnings.

3.Balanced Schemes Aim to provide both growth and income by periodically distributing a part of the income and capital gains they earn. They invest in both shares and fixed income securities in the proportion indicated in their offer documents. In a rising stock market, the NAV of these schemes may not normally keep pace or fall equally when the market falls.

Ideal for: • Investors looking for a combination of income and moderate growth.

4.Money Market / Liquid Schemes Aim to provide easy liquidity, preservation of capital and moderate income. These schemes generally invest in safer, short term instruments such as treasury bills, certificates of deposit, commercial paper and interbank call money. Returns on these schemes may fluctuate, depending upon the interest rates prevailing in the market.

Ideal for: • Corporates and individual investors as a means to park their surplus funds for short periods or awaiting a

more favorable investment alternative. 5. Growth Fund1.A diversified portfolio of stocks that has capital appreciation as its primary goal, with little or no dividend payouts. 2.Portfolio companies would mainly consist of companies with above-average growth in earnings that reinvest their earnings into expansion, acquisitions, and/or research and development. 3.Most growth funds offer higher potential capital appreciation but usually at above-average risk. Growth funds are more volatile than funds in the value and blend categories. 4.The companies in a growth fund portfolio are in an expansion phase and they are not expected to pay dividends. Investing in growth funds requires a tolerance for risk and a holding period with a time horizon of five to 10 years. 6. Equity and equity related fundsThese would entail two types of funds:

• An equity fund (invests in shares)• A balanced fund (invests in shares and fixed income instruments) that has more than 50% of its

investments in shares. If investor sells the units of such funds within a year of purchase, the profit on this sale is called a short-term capital gain. Investor will be taxed 10% on short-term capital gain. If investor make a profit by selling the units after a year, it is called long-term capital gain. This is not taxed. 7.Debt FundsDefinition: Debt funds are mutual funds that invest in fixed income securities like bonds and treasury bills. Gilt fund, monthly income plans (MIPs), short term plans (STPs), liquid funds, and fixed maturity plans (FMPs) are some of the investment options in debt funds. Apart from these categories, debt funds include various funds investing in short term, medium term and long term bonds.Description: Debt funds are preferred by individuals who are not willing to invest in a highly volatile equity market. A debt fund provides a steady but low income relative to equity. It is comparatively less volatile.

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DEBT FUNDS1.Gilt funds invest in only treasury bills and government securities, which do not have a credit risk (i.e. the risk that the issuer of the security defaults). 2.Diversified debt funds on the other hand, invest in a mix of government and non-government debt securities. 3.Junk bond schemes or high yield bond schemes invest in companies that are of poor credit quality. Such schemes operate on the premise that the attractive returns offered by

8.Income FundsA type of mutual fund that emphasizes current income, either on a monthly or quarterly basis, as opposed to capital appreciation. Such funds hold a variety of government, municipal and corporate debt obligations, preferred stock, money market instruments, and dividend-paying stocks.

Share prices of income funds are not fixed; they tend to fall when interest rates are rising and to increase when interest rates are falling. Generally, the bonds included in the portfolios of these funds are of investment grade. The other securities are of sufficient credit quality to assure a preservation of capital.

There are two popular high-risk funds that also focus mainly on income: high-yield bond funds and bank loan funds. The former invests primarily in corporate "junk" bonds and the latter in floating-rate loans issued by banks or other financial institutions. 9.Actively managed funds Funds where the fund manager has the flexibility to choose the investment portfolio, within the broad parameters of the investment objective of the scheme. Since this increases the role of the fund manager, the expenses for running the fund turn out to be higher. Investors expect actively managed funds to perform better than the market

10.Passive funds Passive funds invest on the basis of a specified index, whose performance it seeks to track. Thus, a passive fund tracking the BSE Sensex would buy only the shares that are part of the composition of the BSE Sensex. The proportion of each share in the scheme’s portfolio would also be the same as the weightage assigned to the share in the computation of the BSE Sensex. Thus, the performance of these funds tends to mirror the concerned index. They are not designed to perform better than the market. Such schemes are also called index schemes.11. Equity Funds Diversified equity fund is a category of funds that invest in a diverse mix of securities that cut across sectors. Sector funds however invest in only a specific sector. For example, a banking sector fund will invest in only shares of banking companies. Gold sector fund will invest in only shares of gold-related companies. Thematic funds invest in line with an investment theme. For example, an infrastructure thematic fund might invest in shares of companies that are into infrastructure construction, infrastructure toll-collection, cement, steel, telecom, power etc. The investment is thus more broad-based than a sector fund; but narrower than a diversified equity fund. Equity Linked Savings Schemes (ELSS), as seen earlier, offer tax benefits to investors. However, the investor is expected to retain the Units for at least 3 years. Equity Income / Dividend Yield Schemes invest in securities whose shares fluctuate less, and therefore, dividend represents a larger proportion of the returns on those shares. The NAV of such equity schemes are expected to fluctuate lesser than other categories of equity schemes.

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DEBT FUNDS1.Gilt funds invest in only treasury bills and government securities, which do not have a credit risk (i.e. the risk that the issuer of the security defaults). 2.Diversified debt funds on the other hand, invest in a mix of government and non-government debt securities. 3.Junk bond schemes or high yield bond schemes invest in companies that are of poor credit quality. Such schemes operate on the premise that the attractive returns offered by

Arbitrage Funds take contrary positions in different markets / securities, such that the risk is neutralized, but a return is earned. For instance, by buying a share in BSE, and simultaneously selling the same share in the NSE at a higher price. 12.Types of Hybrid Funds

• Monthly Income Plan seeks to declare a dividend every month. It therefore invests largely in debt securities. However, a small percentage is invested in equity shares to improve the scheme’s yield e.g. debt (80%) and equity (20%)..

• Capital Protected Schemes are close -ended schemes, which are structured to ensure that investors get their principal back, irrespective of what happens to the market. This is ideally done by investing in Zero Coupon Government Securities whose maturity is aligned to the scheme’s maturity. (Zero coupon securities are securities that do not pay a regular interest, but accumulate the interest, and pay it along with the principal when the security matures).

Hybrid funds: Balanced funds Monthly Income Plans: It seeks to declare a dividend every month though not guaranteed. They invest

mostly in debt (80%) and equity (20%). Flexible Asset Allocation for fund manager

13. Gold Funds

• These funds invest in gold and gold-related securities. They can be structured in either of the following formats:

• Gold Exchange Traded Fund, which is like an index fund that invests in gold. The structure of exchange traded funds is discussed later in this unit. The NAV of such funds moves in line with gold prices in the market.

• Gold Sector Funds i.e. the fund will invest in shares of companies engaged in gold mining and processing. Though gold prices influence these shares, the prices of these shares are more closelylinked to the profitability and gold reserves of the companies. Therefore, NAV of these funds do not closely mirror gold prices

14. Real Estate Funds They take exposure to real estate. Such funds make it possible for small investors to take exposure to real estate as an asset class. Although permitted by law, real estate mutual funds are yet to hit the market in India.15. Commodity Funds Commodities, as an asset class, include:

• food crops like wheat and chana • spices like pepper and turmeric • fibres like cotton • industrial metals like copper and aluminium • energy products like oil and natural gas • precious metals (bullion) like gold and silver

As with gold, such funds can be structured as Commodity ETF or Commodity Sector Funds. In India, mutual fund schemes are not permitted to invest in commodities. Therefore, the commodity funds in the market are in the nature of Commodity Sector Funds, i.e. funds that invest in shares of companies that are into commodities. Like Gold Sector Funds, Commodity Sector Funds too are a kind of equity fund.

16. Fund of Funds

Funds can be structured to invest in various other funds, whether in India or abroad. Such funds are called fund of funds. These ‘fund of funds’ pre-specify the mutual funds whose schemes they will buy and / or the kind of schemes they will invest in. They are designed to help investors get over the trouble of choosing between multiple schemes and their variants in the market.A fund of funds allows investors to achieve a broad diversification and an appropriate asset allocation with investments in a variety of fund categories that are all wrapped up into one fund. However, if the fund of funds

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carries an operating expense, investors are essentially paying double for an expense that is already included in the expense figures of the underlying funds.

17.Exchange Traded Funds Exchange Traded funds (ETF) are open-ended index funds that are traded in a stock exchange. A feature of open -ended funds, which allows investors to buy and sell units from the mutual fund, is made available only to very large investors in an ETF.

27.Systematic TransactionsMutual funds offer investors the facility to automate their investment and redemption transactions to meet their needs from the investment. Systematic investment plans (SIP), systematic withdrawal plans (SWP), systematic transfer plans (STP) and switches are some of the facilities provided.

i.Systematic Investment Plans (SIP) In a systematic investment plan, investors commit to invest a fixed sum of money at regular intervals over a period of time in a mutual fund scheme.

SIP Date Investment Amount (Rs) (A) NAV(B) Units Allotted(A/B)10-Feb-14 2500 10.50 238.1010-Mar-14 2500 11.70 213.6810-Apr-14 2500 12.30 203.2510-May-14 2500 12.10 206.6110-Jun-14 2500 11.95 209.2110-Jul-14 2500 10.25 243.90

Total 15000 1314.75

Average cost per unit 11.41

ii.Systematic Withdrawal Plan (SWP) Investors can structure a regular payout from the balance held in a mutual fund investment by registering for a systematic withdrawal plan. An SWP enables recurring redemptions from a scheme over a period of time at the applicable NAV on the date of each redemption. It is a facility that provides a defined payout from a fund for investors who need it. The SWP is redemption from a scheme. Exit loads will apply to each redemption transaction and there will be tax implications for the investor on redemption in the form of capital gains. iii.Systematic Transfer Plan (STP)A systematic transfer plan combines redemption from one scheme and an investment to another scheme of the same mutual fund. The scheme from which units are redeemed is called the source scheme and the scheme into which investments are made is called the target scheme. iv.SWICHA switch is a single transfer from one scheme or option of a scheme to another scheme, or option of the same scheme. The investor redeems units from scheme and simultaneously invests it in another scheme of the same mutual fund in an inter-scheme switch.

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In an intra-scheme switch, the investor redeems from one option of a scheme and invests in another option of the same scheme. In a switch, an investor can transfer all or a portion of the funds held in the investment. The applicable NAV for the switch-out (redemption) from the source scheme or option and switch-in (purchase) into the target scheme or option will depend upon the type of schemes. Since there is a redemption that happens in a switch, exit loads and taxes will apply. The investor will need to specify the source and target schemes and options and the amount to be switched.28.Small savings InstrumentsThe Indian government has instituted a number of small saving schemes to encourage investors to save regularly. The main attraction of these schemes is the implicit guarantee of the government, which is the borrower. These schemes are offered through the post office and select banks.The saving schemes currently offered by the government are:

• Public Provident Fund (PPF)• Senior Citizens’ Saving Scheme (SCSS)• National Savings Certificate (NSC)• Post Office Schemes and Deposits

29.Fixed Income InstrumentsThe Indian debt markets are largely wholesale markets dominated by institutional investors. There is however a few retail products that are offered from time to time. Some bonds are offered to retail investors but do not have a liquid secondary market. Therefore retail investors do not participate in such bond issues or end up buying and holding the bonds to maturity.

The following are bonds and deposits available to retail investors:• Government securities• Corporate bonds• Company deposits

30.Limitations of a Mutual Fundi.Lack of portfolio customization:The unit-holder cannot influence what securities or investments the scheme would buy.ii.Choice overload :Over 800 mutual fund schemes offered by 38 mutual funds – and multiple options within those schemes.iii.No control over costs31.ULIP and MF

Description

Unit Linked Insurance Plans refer to Unit Linked Insurance Plans offered by insurance companies. These plans allow investors to direct part of their premiums into different types of funds (equity, debt, money market, hybrid etc.).

A mutual fund pools the money from investors and uses it to invest in various securities according to a pre-specified investment objective.

Objective

Unit Linked Insurance Plans are long term plans offering you a dual benefit of insurance and investment.

Mutual funds are ideal investment tool for the short to medium term.

Tax Benefit

All Unit Linked Plans offer tax benefits under section 80C.

Only investments in tax saving funds are eligible for section 80C benefits.

Switching options

Unit Linked Plans (ULIP) allows you to switch your investment between the funds linked to the plan. This enables you to change the risk return.

No switching option is available. If you are not satisfied with the performance of the fund you can exit completely from the same by paying exit charges, if applicable.

Additional Benefits

Some of the Unit Linked Plans give you an additional There are no additional benefits issued by mutual

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benefit or loyalty benefit by issuing extra fund units. funds.

Liquidity

Unit Linked Plans have limited liquidity. One needs to stay invested for a minimum period of time as specified in the policy before redeeming the units.

You can easily sell mutual fund units (except for ELSS and funds that have a minimum lock-in period).

Charges structure

Charges in a unit linked plan include mortality charges for the life insurance provided. In addition, premium allocation charge, fund management charge and administration charges are applicable.

Mutual fund charges include an entry load, the annual fund management charge and an exit load, if applicable.

Benefit Snapshot

1. Dual benefit of investment and insurance. 2. Suitable for the long term. 3. Option to switch between the funds is

permitted. 4. Offers tax benefits.

1. Investment tool suitable for short to medium term.

2. Easy exit possible. 3. Tax benefit available

only on tax saving funds

32. TAX IMPACT The tax impact

• Dividends from a mutual fund are not taxed. • When you sell the units of a mutual fund and make a profit, it is

known as capital gain. Equity and equity related fundsAn equity fund (invests in shares)

• A balanced fund (invests in shares and fixed income instruments) that has more than 50% of its investments in shares.

• If investor sells the units of such funds within a year of his purchase, the profit on this sale is called a short-term capital gain. He will be taxed 10% on short-term capital gain.

• If he makes a profit by selling the units after a year, it is called long-term capital gain. This is not taxed. Debt funds

• These are funds that invest in fixed income instruments (investments that give a fixed return, like fixed deposits and bonds) and not in the stock market.

• If investor sells the units of such a fund within a year of his purchase, the profit he make is called is short-term capital gain. It will be added to his total income and he will be taxed as per the tax bracket he now fall under.

• If he makes a profit by selling these units after a year, it is called a long-term capital gain.

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Let us revise: Investment AvenuesFinancial forms of investment:

Fixed income securities, Shares, Mutual funds etc.

Non-Financial forms of investments: Real estate, precious metals,

commodities, art etc.Security Form

A. Money Market Securities• T-bills and dated

securities• Commercial papers

and certificate of deposit

• OthersB. Capital Market Securities

• Equity shares• Preferences shares• Debentures

Non-Security Form• Bank Deposit• Post Office Deposit• Insurance Schemes• Mutual Fund• Deposit Schemes of

NBFCExercise: Indicate the type of returns i.e. yield/capital appreciation by mentioning (Yes or No) ,Risk(High/Low) and Liquidity (High/Low) in the table given next to this box:

• In this case, indexation is taken into account (a type of computation that takes inflation into account). • So the tax is the lower of these: • 20% (of the long-term capital gain) + surcharge and cess levied by the government after taking indexation

into account.• 10% (of the long-term capital gain) + surcharge and cess without taking indexation into account.

Indexation is a technique to adjust income payments by means of a price index, in order to maintain the purchasing power of the public after inflation, while indexation refers to the unwinding of indexation.The automatic adjustment of an economic variable, such as wages, taxes, or pension benefits, to a cost-of-living index, so that the variable rises or falls in accordance with the rate of inflation.

33. Real and Nominal Rates1.Nominal Rate of interest is the interest that is visible in the market. Which is quoted by the financial institutions.2.Real rate is the rate that is effective rate after taking into account the impact of inflation on the Nominal rate.

34.RISK

Risk is defined as deviation of actual returns from expected return. Risk in investment is categorized as Systematic and Unsystematic also called Non diversifiable and Diversifiable risk. Unsystematic risk can be reduced through Diversification. Systematic risk is a Market Risk which can not be reduced through Diversification.

Systematic risk or market risk refers to those risks that are applicable to the entire financial market or a wide range of investments. These risks are also known as undiversifiable risks, because they cannot be eliminated through diversification. Systematic risk is caused due to factors that may affect the economy/markets as a whole, such as changes in government policy, external factors, wars or natural calamities.

Inflation risk, exchange rate risk, interest rate risk and reinvestment risk are systematic risks. Inflation risk affects all investments, though its highest impact is on fixed rate instruments. All overseas investments are subject to exchange rate risk. Interest rate and reinvestment risk impact all debt investments.

Unsystematic risk is the risk specific to individual securities or a small class of investments. Hence it can be diversified away by including other assets in the portfolio. Unsystematic risk is also known as diversifiable risk. Credit risk, business risk, and liquidity risks are unsystematic risks. Diversification can be achieved through:

• Across different asset classes e.g. equity, debt, commodities, precious metals, real estate.(Product Diversification)

• Across different countries.• Across different securities e.g. Different Stocks, Different Bonds etc.• Across maturities e.g. short term, long term, for life etc.(Time Diversification).

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Correct Real rate=[(1+NR)/(1+IR)-1]*100

Nominal Rate 7% 12% 18% 22

Inflation Rate 4% 6% 8% 10%

Real Rate(By rule of Thumb) 3 6 12 12

Correct Real rate 2.88 5.66 9.26 10.91

Hedging: Systematic risk cannot be diversified out of portfolio. It can be Hedged. This is done with the help of derivative products like futures, options, swaps.What is risk appetite?The amount and type of risk an individual is willing to take in order to meet his investment objectives.Risk appetite and Risk tolerance:While risk appetite i.e risk an individual is willing to take differs from person to person, risk tolerance is usually estimated keeping in mind the present financial circumstances and other factors of the individual. Factors that help to determine risk appetite are:Age,Experience,Knowledge,Income ,ExpensesRisk Profiling is understanding the risk appetite of the Client.Balancing the Risk: Spreading the investment among different asset classes (Equity,Bond,G-Sec, Debentures, Gold,Real Estate)

35.Risk Return Trade off

The trade off which an investor faces between risk and return while considering investment decisions is called the risk return trade off.Definition: Higher risk is associated with greater probability of higher return and lower risk with a greater probability of smaller return. This trade off which an investor faces between risk and return while considering investment decisions is called the risk return trade off.Description: For example, Rohan faces a risk return trade off while making his decision to invest. If he deposits all his money in a saving bank account, he will earn a low return i.e. the interest rate paid by the bank, but all his money will be insured up to an amount of Rs 1 lakh (currently the Deposit Insurance and Credit Guarantee Corporation in India provides insurance up to Rs 1 lakh).

Case-1:Earlier average/expected return was 20% whereas the risk(standard deviation) was 6. Now the risk reduces to 3 from 6 (i.e. decline of 50% i.e. reduction of 3 for 6) whereas the return either remains as it is (i.e. 20% itself) Or reduces to 18% from 20% (i.e. decline of 10% i.e. reduction of 2 for 20).Above is an example of Divercification

DIVERSIFIED FUND tries to increase the return either with no change in the level of risk or with lesser level of increase in risk in comparison with the level of increase in return.

Case-2:If the earlier average/expected return was 20% whereas the risk(standard deviation) was 6. Now due to diversified portfolio the return increases to 30% from 20% (i.e. increase of 50% i.e. increase of 10 for 20) whereas the risk either remains as it is (i.e. 6 itself) Or increases to 6.6 from 6 (i.e. increase of 10% i.e. increase of 0.60 for 6). Return Increased 50%Risk increased 10%

Case-3:

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36.ANNUITY

An annuity is a series of equal payments made at fixed intervals of time. For example a Recurring Deposit account in a Bank accepting a monthly instalment of Rs.1000 for 5 years at 10% interest.While the payments in an annuity can be made as frequently as every week, in practice, ordinary annuity payments are made monthly, quarterly, semi-annually or annually. The opposite of an ordinary annuity is an annuity due, where payments are made at the beginning of each period.

• In SIP, an investor commits to pay an annuity amount regularly. Here investor needs to invest the same amount of money in a particular mutual fund at every stipulated time period.

37.What is Rule of 72?

When the number 72 has been divided by the interest (without /100) rate you assume to earn then that number gives you with the approximate number of years it will take for your investment to double. This is called rule of 72.

For example for an interest rate of 10% it takes 7.2 years to double your initial investment.

38. P/E (Price Earnings ratio)

P/E is short for the ratio of a company's share price to its per-share earnings. As the name implies, to calculate the P/E, the current stock price of a company is divided by its earnings per share (EPS):

P/E Ratio = Market Value per Share---------------------------------

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Ordinary Annuity (Payment at the end of the investment period)1.Future Value of Annuity FVAn=AMT[(1+r)^n-1)/r]2.Present Value of Annuity PVAn=AMT [(1+r)^n-1)/r*(1+r)^n] OR =AMT [1-(1+r)^-n)/r]3.Future Value Interest Factor of Annuity FVIFAn=[(1+r)^n-1)/r]4.Present Value Interest Factor of Annuity PVIFAn=[(1+r)^n-1)/r*(1+r)^n]

Annuity Due (Payment at the beginning of the investment period)1.Future Value of Annuity FVADue=AMT[(1+r)^n-1)/r]*(1+r)2.Present Value of Annuity PVADue=AMT [(1+r)^n-1)/r*(1+r)^n]*(1+r) OR =AMT [1-(1+r)^-n)/r]*(1+r)3.Future Value Interest Factor FVIFADue=[(1+r)^n-1)/r]*(1+r)4.Present Value Interest Factor PVIFADue[(1+r)^n-1)/r*(1+r)^n]*(1+r)

Earnings per Share (EPS)Most of the time, the P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E. However, occasionally the EPS figure comes from estimated earnings expected over the next four quarters. This is known as the leading or projected P/E. A third variation that is also sometimes seen uses the EPS of the past two quarters and estimates of the next two quarters.

39. NPV , IRR and Cost of Capital

The net present value (NPV) is the difference between the present value of the expected cash inflows and the present value of the expected cash outflows.If the present value of the expected cash outflows is greater than the present value of the expected cash inflows then NPV < 0.If the present value of the expected cash outflows is equal to the present value of the expected cash inflows then NPV = 0.

If the present value of the expected cash outflows is less than the present value of the expected cash inflows then NPV > 0.

The IRR is defined as the discount rate that makes the present value of the cash inflows equal to the present value of the cash outflows in an investment analysis, where all future cash flows are discounted to determine their present values.Application of IRR:

Comparison of cash flows Comparison of financial products Financial decision making

The cost of capital represents the minimum desired rate of return (i.e., a weighted average cost of debt and equity capital).

Relationship between NPV,IRR and Cost of capital:

40.Ponzi schemeA Ponzi scheme is a fraudulent investment operation where the operator, an individual or organization, pays returns to its investors from new capital paid to the operators by new investors, rather than from profit earned by

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Earnings per share (EPS) is the portion of a company’s profit that is allocated to each outstanding share of common stock, serving as an indicator of the company’s profitability. It is often considered to be one of the most important variables in determining a stock’s value, and it comprises the “E” part of the P/E (price-earnings) valuation ratio. EPS is calculated as:

EPS = net income / average outstanding common shares

EPS = (net income – dividends on preferred stock) / average

outstanding common shares

the operator. Operators of Ponzi schemes usually entice new investors by offering higher returns than other investments, in the form of short-term returns that are either abnormally high or unusually consistent.

Ponzi schemes occasionally begin as legitimate businesses, until the business fails to achieve the returns expected. The business becomes a Ponzi scheme if it then continues under fraudulent terms.

41.Tax Planning:

a) Important Terms: Assessment Year: The period of 12 months commencing on the first day of April every year. All the income earned by persons during the previous year is assessed in the assessment year and the taxes on the same are paid during the assessment year itself. For instance, the period from April 1, 2011 to March 31, 2012 shall be the assessment year for the income earned during previous year i.e. from April 1,2010 to March 31,2011. Previous Year: It is defined as the financial year immediately preceding the Assessment year. The previous year can also be understood as the year in which the income is earned by a person. Gross Total Income: Is the aggregate of income under all heads of income. Taxable Income: Is the income arrived at, after allowing all deductions and exemptions. PAN: Permanent Account Number - a ten digit number which helps the IT department to identify any person liable to pay income tax. TAN: tax deduction and collection account number – a 10 digit alpha numeric number to be obtained by all persons/entities who are entrusted with the task of collecting or deducting tax. TDS: Income tax shall be deducted while effecting payments like salary, interest, contractors’ settlement, Consultants’ fee etc. and remitted to the Central Government through an authorized bank. Tax Structure:

Direct Tax(Paid by tax payer directly to Government)

Indirect Tax(Paid to the Government by a third party and collected from tax payer)

1.Income Tax 1.Custom Duty2.Wealth Tax 2.Excise Duty3.Gift Tax 3.Service Tax4.Security Transaction Tax 4.Value Added Tax5.Capital Gains Tax

Collected by :Central Board of Direct Taxes Collected by: Central Board of Excise and Customs

Who is a person?Under Section 2(31) Income Tax Act1.Individual 4.Firm 7.Any other artificial

person2.HUF (Hindu Undivided Family) 5.Association of Persons (Incorporated or Not)3.Company 6.Local Authority

Who is a Resident Indian?

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1.Basic Conditions: Assessee has been in India for a period of 182 days or more in the previous year OR assessee has been in India for a period of at least 60 days in the previous year and 365 days or more in 4 years immediately preceding the previous year 2.Additional conditions: Assessee has been resident in India at least 2 out of 10 years immediately preceding the previous years AND assessee has been in India for a period of 730 days or more during the 7 years immediately preceding the previous year 3.Residential Status for Individuals is divided into three categories

• Resident and Ordinarily Resident (R&OR)• Resident and Not Ordinarily Resident (R&NOR)• Non-Resident (NR)

4.Resident and Ordinarily Resident: a person who fulfils any of the basic conditions and satisfies both the additional conditions 5.Non-resident: a person who fails to satisfy any of the basic conditions.

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What is INCOME, Salary Income and allowances as per Section 2(24) of Income Tax?Income Salary Income Allowances1.Income from Salary 1.Wages 1.Rent2.Income from House Property 2.Annuity/pension 2.Childern Education3.Income from Business and Profession

3.Retirement benefits 3.Entertainment

4.Income from Capital Gains 4.Other income in lieu of salary 4.Transport5.Income from other sources e.g. rental income, interest income etc.

5.Advance Salary 5.Medical

6.Allowances 6.Dearness7.Overtime8.Special Allowance

b) Basic Exemptions in the Income Tax (2015-2016):

For Men/Women below 60 years of age

For Senior Citizens (Age 60 years or more but less than 80 years)

For Senior Citizens (Age 80 years or more)

Income Level Tax Rate Income Level Tax Rate Income Level Tax Rate

Rs. 2,50,000 Nil Upto Rs. 3,00,000 Nil Upto Rs. 5,00,000 Nil

Rs. 2,50,001 - Rs. 500,000 10% Rs. 3,00,001 - Rs.

500,000 10% Rs. 5,00,001 - Rs. 10,00,000 20%

Rs. 500,001 - Rs. 10,00,000 20% Rs. 500,001 - Rs.

10,00,000 20% Above Rs. 10,00,000 30%

Above Rs. 10,00,000 30% Above Rs.

10,00,000 30%

Exemptions under Sec 80C:

Income Tax on Income Maturity

Life Insurance Policies Section 80C Varies from year to

year

Varies from scheme to scheme

Varies from scheme to scheme

Unit Linked Insurance Plan (ULIP) Section 80C Varies from year to

year

Varies from scheme to scheme

Varies from scheme to scheme (15 to 20 years)

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Infrastructure Bonds (NO LONGER AVAILABLE FOR FRESH INVESTMENT)

Section 80C

Varies from issue to issue. These were around 8%+ in Dec 2011. These have lost their charm as Additional Tax rebate of Rs 20,000 is NOT given now from FY 2012-13 onwards.

Taxable 3 to 5 years

Contribution to EPF / GPF / Voluntary PF Section 80C

8.75% on EPF for 2013-14 (announced in August 2013)

Interest earned is tax free

Till retirement (loans are permitted only after 5 years)

Insurance Policies Section 80C 6 to 7% onlyEarnings are tax free in most of the cases

Locked till maturity

ULIPS Section 80C Market linked Earnings are tax free Partial withdrawal allowed

Public Provident Fund (PPF) Section 80C 8.70% for FY 2015-

16Interest earned is tax free

15 years and extendable. Withdrawals allowed after 7 years. Yield on PPF will vary and will be fixed at 25 basis point above the 10 year government bonds.

NPS Section 80C Market Linked Interest earned is tax free

Withdrawal not permitted before maturity

Tuition Fees including admission fees or college fees paid for full time education of any two children of the assessee.

Section 80C Not applicable Not applicable Not applicable

Repayment of Housing Loan (Principal)

Section 80C Not applicable Not applicable Not applicable

Bank Tax Saving Fixed Deposits Schemes - 5 Years

Section 80CVaries from bank to bank (around 7.50% - 8.75%)

Taxable 5 Years

Senior Citizens Savings Scheme 2004 (from financial year 2007-08)

Section 80C 9.30% for FY 2015-16 Taxable

As per the guidelines issued in December 2011, there will be spread of 100 basis points above the 5 year bonds yields for this scheme.

Post Office Time Deposit Account (from financial 2007-08)

Section 80C 8.50% for five year Time Deposit Taxable

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d)Exemptions under Section 80CCC(1)

• Under this section, the contributions by individuals towards "Pension" schemes of LIC or any other Insurance company, is allowed as deduction of Rs.10,000/-. However, as provided under section 80CCE, the aggregate deduction u/s 80C, and u/s 80CCC and 80CCD can not exceed Rs.1,50,000/-. Thus effectively, now these are covered under the maximum limit of Rs.1,50,000/- under section 80C.

e) Deductions Under Section 80 D :

• Basic Deduction under Section 80D, Mediclaim premium paid for Self, Spouse or dependant children has now been raised to Rs 25,000 wef FY 2015-16.

• The deduction for senior citizens is raised from Rs 20,000 to Rs 30,000. For uninsured super senior citizens (more than 80 years old) medical expenditure incurred up to Rs 30,000 shall be allowed as a deduction under section 80D. However, total deduction for health insurance premium and medical expenses for parents shall be limited to Rs 30,000.

f) Deductions Under Section 80 E :

i) Under this section, deduction is available for payment of interest on a loan taken for higher education from any financial institution or an approved charitable institution. The loan should be taken for either pursuing a full-time graduate or post-graduate course in engineering, medicine or management, or a post-graduate course in applied science or pure science.

g) Deductions Under Section 24B :

Under this section, interest on borrowed capital for the purpose of house purchase or construction is deductible from taxable income upto Rs.2,00,000/- . (certain conditions are to be fulfilled)

We have seen that the principal amount in the repayment of a home loan can be added to the 80C limit of Rs1.5 lakh for tax savings. However, the interest component of home loans is allowed as deduction under Section 24 B for up to Rs2 lakh in case of a self-occupied house. In case the house is in the joint name of your spouse and you (joint loan), each one can avail of Rs2 lakh interest component deduction. This limit is only for self-occupied house. If you have property which is rented out, you can deduct the full interest paid on the home loan. The rent on the property does become part of your income. If the rent is lesser than the loan interest, it will lower your overall tax liability.

h) Deductions Under Section 10(10) (d) :

Section 10(10) (d) is one of the initiative taken by the government to promote the Insurance Product, It says that the maturity benefit/death benefit/surrender value in an insurance policy would be tax free in the hand of the recipient provided the sum assured should be equal to 10 times of the first year annualised premium and should not be below than that throughout the term of the policy.

For Example:

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Suppose, you bought a single premium life insurance policy where you had paid an annual premium of Rs 25000 and choose a sum assured of Rs 2.5 lakhs, then in this scenario your policy would be eligible for Sec 10 (10)(d) of the Income Tax Act and will have tax-free maturity benefit/death benefit/surrender value.

i) TAX FREE INCOMES

Some of the incomes are completely exempted from income tax and that too without any upper limit. The following incomes are tax free :-(1) Interest on EPF / GPF / PPF(2) Interest on GOI Tax Free Bonds / Tax Free Bonds issued with specific stipulation to this effect(3) Dividends on Shares and Mutual Funds. Dividend income from companies / Equity Oriented Mutual funds is completely exempt in the hands of investors. Dividend is also tax free in the hands of investors in case of debt-oriented Mutual Fund schemes. (However, the Asset Management Company is liable to deduct 22.44% distribution tax in case of non individuals / non HUF investors and 14.025% in case of individuals or HUF investors.)(4) Capital receipts from Life Insurance policies i.e. sums received either on death of the insured or on maturity of Life insurance plans. However, in case of life insurance policies issued after March 31, 2004, exemption on maturity payment u/s 10(10D) is available only if premium paid in any year does not exceed 20% of the sum asssured;(5) Interest on Saving Bank accounts in banks upto Rs10,000/- per year (from FY 2012-13 onwards)(6) Long term capial gains on sale of shares and equity mutual funds after 01/10/2004, if security transaction is paid / imposed on such transactions.

j) Assessment Year 2016-17

a) Surcharge: The amount of income-tax shall be increased by a surcharge at the rate of 12% of such tax, where total income exceeds one crore rupees. However, the surcharge shall be subject to marginal relief (where income exceeds one crore rupees, the total amount payable as income-tax and surcharge shall not exceed total amount payable as income-tax on total income of one crore rupees by more than the amount of income that exceeds one crore rupees).b) Education Cess: The amount of income-tax and the applicable surcharge, shall be further increased by education cess calculated at the rate of two per cent of such income-tax and surcharge.c) Secondary and Higher Education Cess: The amount of income-tax and the applicable surcharge, shall be further increased by secondary and higher education cess calculated at the rate of one per cent of such income-tax and surcharge.d) Rebate under Section 87A: The rebate is available to a resident individual if his total income does not exceed Rs. 5,00,000. The amount of rebate shall be 100% of income-tax or Rs. 2,000, whichever is less.

k) Case Study 1:

Calculate the income tax payable (Tax Liability) by Satish aged 36 years for the financial year 2014-15(Assessment year 2015-16). Gross Annual Income for 2014-15 - Rs.9.5 lacs.

• His investments are as under:• PPF. Rs.55000.• NSC. Rs.45000.• Life Insurance Rs.20000.• ELSS Rs.20000.

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• ULIP Rs.15000.• His has taken medical insurance are as under:• Mediclaim (Self/Spouse) Rs.20000.• Mediclaim (Parents-age 61Yrs) Rs.25000.

Step 1:Annual Income Rs.9.5 lacs.Step 2Exemptions Under Amount actually invested Eligible Amount as per exemptions80C : PPF 55000 NSC 45000 Life Insurance 20000 ELSS 20000 ULIP 15000Sub-Total 155000 150000Sec 80D - Health Insurance 20000 (self & family)

25000 (parents) 20000 25000

Total eligible exemptions 195000

Step 3:

• Total Income: Rs. 9, 50,000 Less Eligible Exemptions (i.e. 1.5 Lakh+15K+20K): Rs. 1, 95,000 Taxable Income: Rs. 7, 55,000 Step 4 Taxable Income Tax Rate Tax Payable Up to 2.50 lakhs 250000 Nil Nil 250001 to 5 lakhs 250000 10% 25000 500001 to 7.55 lakhs 255000 20% 51000 Total 765000 76000 Add 3% Education Cess on Tax Payable-76000x3/100 2280 Total Provisional Income Tax Payable 78280

42.Financial Planning

A process that enables better management of the personal financial situation of a household. It works primarily through the identification of key goals and putting in place an action plan to realign the finances to meet those goals.

A holistic approach that considers the existing financial position, evaluates the future needs, puts a process to fund the needs and reviews the progress.

43. Need For Financial Advisory Services

The primary task of the financial adviser is to link the large range of financial products and services to the specific needs and situations of the client. Not

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A tax rebate of Rs 2,000 from tax calculated will be available for people having an annual income upto Rs 5 lakh. However, this benefit of Rs2,000 tax credit will not be available if you cross the income range of Rs 5 lakh. Thus we can say that tax payable in 10% slab will be maximum Rs23,000 (taking into account Rs 2000 tax credit), but for people who fall in income range of Rs5 lakh and above, the tax will be Rs25,000 + 20% tax on income above Rs 5 lakh;

The education cess to continue at 3 percent.

every product may be suitable to every client; nor would a client be able to identify how to choose and use products and services from a very large range. A financial advisor, who possesses the expertise to understand the dynamics of the products on the one hand and the needs of the client on the other, is best suited to enable using such products and services in the interest of the client.

The following are the primary reasons why financial advisers are needed: 1.Personal financial management requires time and attention to recognize income and expense patterns, estimates of future goals, management of assets and liabilities, and review of the finances of the household. Many clients may not find time from their professional tasks to focus on these key issues. 2.Estimating financial goals, finding suitable products and arriving at suitable allocations to various assets require specific expertise and skills which may not be available in most households.

Selecting the right investment products, choosing the right service providers and managers, selecting insurance products, evaluating borrowing options and such other financial decisions may require extensive research. A professional adviser with capabilities to compare, evaluate and analyse various products enables making efficient choices from competing products. Asset allocation is a technical approach to managing money that requires evaluating asset classes and products for their risk and return features, aligning them to the investor’s financial goals, monitoring the current and expected performance of asset classes and modifying the weights to each asset in the investor’s portfolio periodically to reflect this. Advisers with technical expertise enable professional management of assets. Financial planning is a dynamic process that requires consistent attention to changing market and product performances, dynamic changes in the needs and status of the client and the ability to tune the process to these changes. It needs full-time professional attention and the efficiencies of a disciplined and systematic process.

44. Elements of Financial advisory and planning services

The following are elements of financial advisory and planning services:1.Personal financial analysis: An adviser assesses the financial position of a household by bringing together its income, expenses, assets and liabilities. 2.Debt counselling: Financial advisers help households plan their liabilities efficiently. It is common for households to borrow in order to fund their homes, cars and durables.3. Insurance Planning: Several unexpected expenses that can cause an imbalance in the income and expenses of a household can be managed with insurance. Insurance is a risk transfer mechanism where a small premium payment can result in payments from the insurance company to tide over risks from unexpected events.4.Investment Planning and Asset Allocation: A crucial component in financial planning and advisory is the funding of financial goals of a household. Investment planning involves estimating the ability of the household to save, and choosing the right assets in which such saving should be invested. 5.Tax Planning: Income is subject to tax and the amount a household can save, the return they earn on their investment and therefore the corpus they are able to build for their future goals, are all impacted by the tax regime they fall under. 6.Estate Planning: Wealth is passed on across generations. This process of inter-generational transfer not only involves legal aspects with respect to entitlements under personal law, but also documentation and processes that will enable a smooth transition of wealth in a tax-efficient way.

45.Financial Planning Delivery ProcessFinancial planning requires financial advisors to follow a process that enables acquiring client data and working with the client to arrive at appropriate financial decisions and plans, within the context of the defined relationship

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between the planner and the client. The following is the six-step process that is used in the practice of financial planning. 1.Establish and define the client-planner relationship: The planning process begins when the client engages a financial planner and describes the scope of work to be done and the terms on which it would be done. 2.Gather client data, including goals: The future needs of a client require clear definition in terms of how much money will be needed and when. This is the process of defining a financial goal. 3.Analyse and evaluate financial status: The current financial position of a client needs to be understood to make an assessment of income, expenses, assets and liabilities. The ability to save for a goal and choose appropriate investment vehicles depends on the current financial status. 4.Develop and present financial planning recommendations: The planner makes an assessment of what is already there, and what is needed in the future and recommends a plan of action. This may include augmenting income, controlling expenses, reallocating assets, managing liabilities and following a saving and investment plan for the future. 5.Implement the financial planning recommendations: This involves executing the plan and completing the necessary procedure and paperwork for implementing the decisions taken with the client. 6.Monitor the financial planning recommendations: The financial situation of a client can change over time and the performance of the chosen investments may require review. A planner monitors the plan to ensure it remains aligned to the goals and is working as planned and makes revisions as may be required.

46. Goal ValueThe goal value that is relevant to a financial plan is not the current cost of the goal but the amount of money required for the goal at the time when it has to be met. The current cost of the goal has to be converted to the value in future. The amount of money required is a function of

• Current value of the goal or expense• Time period after which the goal will be achieved• Rate of inflation at which the cost of the expense is expected to go up

47. Risk Profiling of a Client

Risk Profiling of a Client is Clients' financial risk tolerance . Risk tolerance is the assumed level of risk that a client is willing to accept.Financial risk tolerance can be split into two parts: 1.Risk capacity: the ability to take risk

• This relates to their financial circumstances and their investment goals. Generally speaking, a client with a higher level of wealth and income (relative to any liabilities they have) and a longer investment term will be able to take more risk, giving them a higher risk capacity.

2.Risk attitude: the willingness to take risk • Risk attitude has more to do with the individual's psychology than

with their financial circumstances. Some clients will find the prospect of volatility in their investments and the chance of losses distressing to think about. Others will be more relaxed about those issues.

Risk tolerance is typically measured using questionnaires that estimate the ability and willingness to take risks. The responses of investors are converted into a score that may classify them under categories that characterize their risk preferences.Consider the following classification: Conservative Investors

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Case Study on Goal ValueThe current cost of a college admission may be Rs. two lakhs. But after 5 years, the cost would typically be higher. This increase in the cost of goods and services is called inflation. While saving for a goal, therefore, it is important to estimate the future value of the goal because that is the amount that has to be accumulated.The future value of a goal = Current Value x (1+ Rate of Inflation) ^ (Years to Goal)Rs.200000 x (1+10%) ^ 5= Rs.322102.

• Do not like to take risk with their investments. Typically new to risky instruments. Prefer to keep their money in the bank or in safe income yielding instruments.

• May be willing to invest a small portion in risky assets if it is likely to be better for the longer term. Moderate Investors

• May have some experience of investment, including investing in risky assets such as equities• Understand that they have to take investment risk in order to meet their long-term goals are likely to be

willing to take risk with a part of their available assets. Aggressive Investors

• Are experienced investors, who have used a range of investment products in the past, and who may take an active approach to managing their investments?

• Willing to take on investment risk and understand that this is crucial to generating long term return.• Willing to take risk with a significant portion of their assets. • The risk preferences of the investor are taken into account while constructing an investment portfolio.

48. Portfolio Construction Portfolio Construction is Asset Allocation Linked to Financial Goals

When a need can be expressed in terms of the sum of money required and the time frame in which it would be needed, we call it a financial goal. When a financial goal is set, its monetary value and the future date on which the money will be required is first defined. This goal definition indicates the amount of investment value that needs to be generated on a future date. It is normal to include assumptions for expected inflation rate while defining a future goal. Then the return that the portfolio should generate to achieve the targeted sum can be ascertained, after understanding how much the investor can save for the goal.

49. Life Insurance Needs Analysis or Human Life Value Assessment

1.This is the value that insurance needs to compensate for if there is a loss to the life, or disability which results in a reduction in the ability to generate income. 2.HLV is the present value of the expected income over the working life of the individual that is available for the dependents. Human Life Value is the amount of insurance required after considering the

future value.1.Income Replacement Method2. Need Based Approach

1.Income Replacement Method

Human life value (HLV) is calculated as the present value of the person’s future earnings. This is a method of calculating the amount of life insurance a family will need based on the income that they would have to forego if the insured were to pass away today. It is usually calculated by taking into account a number of factors including but not limited to the Insured Individual’s :1.Age, 2.Gender, 3.Planned Retirement Age, 4.Occupation, 5.Annual Wage, 6.Employment Benefits, as well as the 7.Personal and Financial Information of the Spouse and/ or Dependent Children.

Information Required :

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Portfolio ConstructionAn individual creates a portfolio of investments to meet their various goals. The investments selected have to balance the required return with an appropriate level of risk. Assets and investments differ on their features of risk, return, liquidity and others.An investor will have multiple, differing requirements from their portfolio depending upon the goals they are saving for. They may need growth for long-term goals, liquidity for immediate needs and regular payouts to meet recurring expense. No one investment can meet all the requirements for growth, liquidity, regular income, capital protection and adequate return. The investor will have to create a portfolio of securities that has exposure to different assets which will cater to these diverse needs.

The information required to calculate HLV based on this method is as follows:1.The number of years the individual is likely to earn (Retirement age less present age) .Average annual earnings during the earning years.2.Amount of personal expenses like taxes, personal costs, insurance premium which is deducted from annual income.3.The rate at which the income is expected to grow over the earning years .The rate of return expected to be earned on the corpus.

2.Need Based Approach

This is a method of calculating the human life value, and therefore the amount of life insurance required by an individual or family, based on the amount required to cover their needs and goals in the event of the demise of the earning member. These include things living expenses, mortgage expenses, rent, debt and loans, medical expenses, college, child care, schooling and maintenance costs, emergency funds.The need based approach considers what is already available in the form of investments, assets, and dues such as EPF, gratuity that will contribute to the corpus. Insurance will be taken for the remaining value.Information RequiredThe needs and goals that have to be met and their current value.Inflation rate applicable.The current value of the available investments.The rate at which the investments are expected to grow.

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Case Study: Income Replacement Method

Siddhartha earns Rs.8 lakhs p.a. He is 28 years old and would like to retire at age 55. Calculate the insurance he needs as per the income replacement method if we assume that his income would have gone up each year by 5% and investment would have earned a return of 8%.

The amount of insurance required is that sum of money which if invested today at a return of 8% would replace the income that Siddhartha would have earned each year, taking into consideration the annual increment. The amount required has to take into account two rates that work here: the rate at which the income is expected to rise each year and the rate of return which the corpus will earn during the given period. The rate used in the calculation will be adjusted to reflect the effect of both these rates on the corpus required. Then the PV function can be used to calculate the present value of the corpus required. This will be the amount of insurance taken.

Calculate the adjusted rate to be used in the calculation of the corpus.

– ((1+Investment rate)/(1+Increment rate))-1 is the formula to be used

– Investment rate given is 8% and increment

Case Study: Need based approach

Anil currently has a monthly income of Rs. 1,50,000. He pays an insurance premium of Rs. 25,000 per month and an EMI of Rs. 32,000 on a loan of Rs. 40 lakhs that he has taken for this house. His personal expenses are Rs. 10,000. He wants to provide insurance protection for his wife who is currently 49 years old and is expected to live till 80. If the expected inflation is 6% and return on investment is 8%, what is the insurance cover he should take? His current insurance cover is for Rs.1 Cr and he has other

Sample Questions asked by Insurance Companies in India

to calculate HLV

1.How much annual income your dependants need if you die today?

2.How much annual income does your family get from other sources (other than your earnings)?

3.What is your expected inflation rate? (%):

4.What is your expected return on investemnt? (%):

50. Retirement Planning

Retirement planning involves making an estimate of the expenses in retirement and the income required to meet it, calculating the corpus required to generate the income, assessing the current financial situation to determine the savings that can be made for retirement and identifying the products in which the savings made will be invested so that required corpus is created and the products in which the corpus will be invested to generate the required income in retirement.

There are two distinct stages in retirement: the accumulation stage and the distribution stage. The accumulation stage is the stage at which the saving and investment for the retirement corpus is made. Ideally, the retirement savings should start as early as possible so that smaller contributions made can also contribute to the corpus significantly with the benefit of compounding.

Retirement planning involves the following steps:• Compute the retirement corpus required based on the estimation of expenses in retirement or income at

retirement.• Determine the periodic savings required to accumulate the retirement corpus. Analyse the current

financial situation to determine the savings possible.• Set in place a long-term savings plan based on the expected income Identify the investment products in

which the savings will be invested.• Monitor the performance of the investment and the growth of the retirement corpus periodically.• Review the adequacy of the retirement corpus whenever there is a change in personal situation that has

an impact on income or expenses.• Make mid-course corrections, if required.• Rebalance the portfolio to reflect the current stage in the retirement plan.•

There are different methods used to estimate the amount of income required in retirement.1. The Income Replacement method and the 2. Expense Protection Method

Income Replacement MethodThe income replacement ratio is the percentage of the income just before retirement that will be required by an individual to maintain the same standard of living in retirement. While estimating this ratio, the current income has to be adjusted for a few heads of expenses that may no longer be relevant in retirement. At the same time, there may be a larger outlay on other heads of expense such as medical and healthcare. Some people may like to have a higher discretionary income for travel or entertainment. Some of the expenses that have to be reduced from the income include:

1.The portion of the income that is being used towards paying taxes.2.The mandatory deduction from income being made, such as provident fund The portion of income going to savings for goals.3.Employment related expenses, such as those related to transportation.

The steps for estimating the income required in retirement under this method are:1.Calculate the current income2.Estimate the rate at which the income is expected to grow over the years to retirement3.Calculate the years to retirement4.Calculate the income at the time of retirement as Current value x(1+ rate of growth)^(Years to retirement)5.Apply the income replacement ratio to this income to arrive at the income required in retirement.

Case Study: Income Replacement Method

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Case Study: Income Replacement Method

Siddhartha earns Rs.8 lakhs p.a. He is 28 years old and would like to retire at age 55. Calculate the insurance he needs as per the income replacement method if we assume that his income would have gone up each year by 5% and investment would have earned a return of 8%.

The amount of insurance required is that sum of money which if invested today at a return of 8% would replace the income that Siddhartha would have earned each year, taking into consideration the annual increment. The amount required has to take into account two rates that work here: the rate at which the income is expected to rise each year and the rate of return which the corpus will earn during the given period. The rate used in the calculation will be adjusted to reflect the effect of both these rates on the corpus required. Then the PV function can be used to calculate the present value of the corpus required. This will be the amount of insurance taken.

Calculate the adjusted rate to be used in the calculation of the corpus.

– ((1+Investment rate)/(1+Increment rate))-1 is the formula to be used

– Investment rate given is 8% and increment

Case Study: Need based approach

Anil currently has a monthly income of Rs. 1,50,000. He pays an insurance premium of Rs. 25,000 per month and an EMI of Rs. 32,000 on a loan of Rs. 40 lakhs that he has taken for this house. His personal expenses are Rs. 10,000. He wants to provide insurance protection for his wife who is currently 49 years old and is expected to live till 80. If the expected inflation is 6% and return on investment is 8%, what is the insurance cover he should take? His current insurance cover is for Rs.1 Cr and he has other

Sample Questions asked by Insurance Companies in India

to calculate HLV

1.How much annual income your dependants need if you die today?

2.How much annual income does your family get from other sources (other than your earnings)?

3.What is your expected inflation rate? (%):

4.What is your expected return on investemnt? (%):

Pradeep has a current annual income of Rs. 10,00,000. He is 30 years of age and expects to retire at the age of 55. He also expects his income to grow at a rate of 10% and estimates that he will require an income replacement of 75%. What is the income required by Pradeep in retirement?

Current Annual Income (Rs.) 1000000

Age 30

Retirement age 55

Years to Retirement 25 55-30

Annual Rate of Growth in Income 10%Income at the time of Retirement 10834706 1000000*(1+10%)^25

Income Replacement Ratio 75%

Annual Income required in Retirement 8126029 10834706*75%

Expense Protection Method

In the expense protection method, the focus is on identifying and estimating the expenses likely to be incurred in the retirement years and providing for it. Typically, the expenses required by the person in retirement is taken as a percentage of the expenses of that person just before retirement – the assumption being that one’s post retirement expenses will not include certain expenses such as transport, home loan EMI. On the other hand the expenses incurred on other heads such as health, is likely to be higher.

Expense Protection is a slightly cumbersome method due to the detailed listing out of expenses incurred for the things / services required post-retirement. Estimating this wrongly may make the determination of retirement corpus inaccurate. The process involves preparing a list of pre and post-retirement expenses, and arriving at the total expense list. The expense so calculated has to be adjusted for inflation over the period of time left to retirement to arrive at the expense in retirement.

Case Study: Expense Protection Method

Pradeep has a monthly expense of Rs. 50,000 of which 60% is for household expenses. He is 30 years old and expects to retire at the age of 55. He expects to incur additional expenses of Rs. 10,000 pm at current prices for discretionary expenses in retirement. If inflation is seen at 6%, what is the expense that has to be met by retirement income?

Formula

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Current monthly expense (Rs.) 50000

Proportion of household expenses 60%

Current household expenses (Rs.) 30000 60% of Rs.50000

Additional discretionary expense in retirement 10000

Total retirement expenses at current prices 40000

Time to retirement (years) 25 Retirement age(55) – Current

age(30)

Expected rate of inflation 6%

Expense at the time of retirement (Rs.) 178600 40000 x (1+6%)^25

Determining the Retirement Corpus

The next step in retirement planning is to calculate the corpus that will generate the income required in retirement. The variables in this calculation are

• The periodic income required • The expected rate of inflation• The rate of return expected to be generated by the corpus• The period of retirement, i.e. the period for which income has to be provided by the corpus.

Case Study

Rani requires a monthly income of Rs.35000 by today’s value for her retirement 25 years away at the age of 60. She expects to live up to 80 years. What is the retirement corpus required if the banks deposit into which she will invest her retirement savings is likely to yield 8% and the rate of inflation is 6%?

There are two stages to calculating the retirement corpus: in first step the income required to meet expenses at retirement should be calculated and in the next step the corpus that will generate this income has to be computed.

Step 1: Calculation of income at retirement

Income required at current value Rs.35,000Time to retirement (Years) 25

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Expected inflation 6%

Income required at retirement (Rs) 150215 35000 x (1+6%)^25

Step 2: Calculation of retirement corpus

Formula

Income required at retirement (Rs.) 150215

Retirement Period 20 (80-60)

Rate of return on corpus 8%

Inflation rate 6%

Inflation adjusted rate of return 1.89% {((1+8%)/(1+6%))-1}X100

The retirement corpus can be calculated using the PV formula .The corpus required to generate a monthly income of Rs. 1,50,215 for 20 years is Rs. 3,00,48,832.PV=AMT{(1+r)^n-1/r(1+r)^n}In the previous example, what is the monthly saving that Rani must make to create the retirement corpus if she expects a return of 12% per annum on her investments?The amount of monthly savings required can be calculated using the PMT function is excel. The inputs required are:

Rate (return on investment expected) : 12%/12

period in months available to create the corpus

: 300 months (25 x12) which is the period between now and retirement date)

Future Value (retirement corpus required) : Rs. 30,048,832

Type (0 for investment at end of year and 1 for beginning) : 1

The monthly savings required is Rs. 15,835. If this sum is invested at an annual rate of 12% for 25 years, then the savings will compound to a value of Rs. 30,048,832, which is the retirement corpus required.

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What will be the effect if Rani had 30 years to save for the same amount? The amount of monthly savings will come down to Rs. 8512 since there is a longer period over which Rani can make contributions, and the money can be invested and grow to the corpus required.

51. Derivatives

A derivative refers to a financial product whose value is derived from another. A derivative is always created with reference to the other product, also called the underlying.

A derivative is a risk management tool used commonly in transactions where there is risk due to an unknown future value.

For example, a buyer of gold faces the risk that gold prices may not be stable. When one needs to buy gold on a day far into the future, the price may be higher than today. The fluctuating price of gold represents risk. Gold represents the ‘underlying’ asset in this case. A derivative market deals with the financial value of such risky outcomes. A derivative product can be structured to enable a pay-off and make good some or all of the losses if gold prices go up as feared.

Derivatives are typically used for three purposes: hedging, speculation and arbitrage.

a. Hedging

When an investor has an open position in the underlying, he can use the derivative markets to protect that position from the risks of future price movements.

b. Speculation

A speculative trade in a derivative is not supported by an underlying position in cash, but simply implements a view on the future prices of the underlying, at a lower cost.

c.Arbitrage

If the price of the underlying is Rs.100 and the futures price is Rs.110, anyone can buy in the cash market and sell in the futures market and make the riskless profit of Rs.10. This is called arbitrage.

Arbitrageurs are specialist traders who evaluate whether the Rs.10 difference in price is higher than the cost of borrowing. If yes, they would exploit the difference by borrowing and buying in the cash market, and selling in the futures market at the same time (simultaneous trades in both markets). If they settle both trades on the expiry date, they will make the gain of Rs.10 less the interest cost, irrespective of the settlement price on the contract expiry date, as long as both legs settle at the same price.

52.FUTURES

A futures is a contract for buying or selling a specific underlying, on a future date, at a price specified today, and entered into through a formal mechanism on an exchange. The terms of the contract (such as order size, contract date, delivery value and expiry date) are specified by the exchange. Example:

• FUTIDX NIFTY 26 Feb 2014 is a futures contract on the Nifty index that expires on 26th February 2014.

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• The value is 6235, which means a buyer or seller agrees to buy or sell Nifty for a delivery value of 6235 on a future date.

• It is available to trade from the date it is introduced by the exchange to its expiry date on 26th February 2014.

• On expiry, the settlement price at which this future contract will be settled may be higher or lower than 6235. If it is higher, any investor who had bought the future contract at a price of 6235 would have made profits and a seller at that price would have made losses. If the settlement price is lower, then the situation is reversed for the buyer and seller.

53.OPTIONS Options are derivative contracts, which splice up the rights and obligations in a futures contract. The buyer of an option has the right to buy (in case of “call”) or sell (in case of “put”) an underling on a specific date, at a specific price, on a future date. The seller of an option has the obligation to sell (in case of “call”) or buy (in case of “put”) an underlying on a specific date, at a specific price, on a future date. An option is a derivative contract that enables buyers and sellers to pick up just that portion of the right or obligation, on a future date.

54. Absolute Return

The absolute return on an investment is computed as:((End Value – Beginning Value)/Beginning Value) x 100 OR(Return on Investment/Original Investment) x 100 The rate of return is converted into percent terms by multiplying by 100.

Example:There are two investment opportunities as under:

Period of Investment Beginning Value End Value

Investment A one year 23000 28000

Investment B Three years 2500 3100

Which one of the above investment is better? Absolute Return on Investment A: (28000-23000)/23000 = 21.74% Absolute Return on Investment B: (3100-2500)/2500 = 24.0% Investment A has a higher amount of return in terms of rupees, but earns a lower rate of return as compared to investment B.

55. Annualized return

Annualized return is a standardized measure of return on investments in which the return is computed as percent per annum (% p.a.). It is calculated as:(End value - Beginning value)/Beginning value) x 100 x (1/ holding period of investment in years)

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Measuring returns as percent per annum is the accepted way to measure investment return. In the example given in section 54, the annualized return on the two investments is computed as: Annualized return = ( (30 lakh-20 lakhs)/20 lakhs) x100 x(1/1)= 50% Annualized return = ( (30 lakh-20 lakhs)/20 lakhs) x100 x(1/3)= 16.3% As expected, investment B has a much lower annualized return, because the same absolute return is earned over a longer holding period.

56.TOTAL RETURN

The returns from an investment can be in different forms such as interest income (debentures, bank deposits), dividend (mutual funds, equity shares) and profits on sale (capital gain on selling a house). An investment could provide more than one type of return. For example, equity shares can give dividend income, as well as profits on sale. A house property can yield rentals, and also capital gains on sale. A complete measure of return should take all benefits from an investment into consideration.Total return can be positive as well as negative. The sign of total return depends on its components and whether they are positive or negative.

57. HOLDING PERIOD RETURN

Holding period return is the return earned on an investment during a specific period when it was bought and held by the investor. Such return computations use the portfolio value at two chosen points. A simple formula for holding period return is:

HPR = Cash Inflows during the period + Capital gains during the period

Beginning Value of investment

OR

HPR = Cash inflows + (Ending value – Beginning value) Beginning value of investment

58. TAX ADJUSTED RETURNTax-adjusted return is the return earned after taxes have been paid by the investor. Since taxes actually reduce the money in the hands for an investor, it is necessary to adjust for them to get a realistic view of returns earned. Tax adjusted returns are lower than nominal returns because tax payments lower the nominal value of returns.

Suppose an investor earns an interest of 10% on an investment of Rs.1000. If this interest is taxed at 20%, then we calculate tax adjusted return as follows:

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Example-1consider an equity share of face value Rs.10, which yields a dividend of 30%. The share is purchased for Rs. 200, but sold for Rs.190 after one year.In this example the loss component is greater than the positive dividend earned so the total return becomes negative.1.Loss on Sale: Rs.200-Rs.190=Rs.10.00 2.Income as dividend Rs.3 (30% of face value of Rs.10)3.Net Loss is Rs.7.00

Example-2An investor bought a house for Rs.10 lakh. He earned a monthly rental income of Rs.3000 for 2 years. He then sold off the house for Rs.12 lakh. What is his total return? Rental Income = Rs.3000 x 24 = Rs.72000 Profit from selling after 2 years = Rs.12 lakhs - Rs.10 lakhs = Rs.200000 Total return = 200,000+72000 = Rs.272000 on an investment of Rs.10,00,000 The rate of return per cent p.a.= (272000/10,00,000) x (1/2) x 100 = 13.6%

• Nominal interest rate = 10% • Interest received = 10% of 1000 = 100 • Tax payable = 20% of 100 = 20 • Net interest received= 100- 20 = 80 • Post tax return = 80/1000 = 8%• In general, post tax or tax adjusted return TR = NR * (1-tax rate) • TR: tax adjusted return • NR: nominal return

59.RISK ADJUSTED RETURN

The relationship between the risk and return from an investment is a direct one implying that the investor who invests in a high risk investment will expect to be compensated by higher returns. Risk adjusted return relates the return from an investment to the risk taken to generate it. A high risk adjusted return indicates that the investment

was able to generate a higher return for a unit of risk taken.

60. Practice Questions:

Questions on Investment Planning

1.Financial Planning is:A.Investing in assets to receive the highest return possibleB.Keeping Taxes as low as possibleC.Planning to retire with maximum income possibleD.A process of solving financial problems and reaching financial goals.

2.Financial Planning is necessary:A.To achieve financial goalsB.To retire successfullyC.Only for people with lot of moneyD.If there is financial crisis in the family

3.Investment Planning is a process by which:A. Risk is totally avoidedB.Huge risk is taken to achieve financial goalsC.Risk return tradeoff is studied and incorporated in plans to achieve goalsD.None of the above

4.Market risk can be reduced by diversification:A.TrueB.False

5.Bond prices will rise:A. If interest rate fallsB. If interest rate risesC. If interest remains staticD.No impact of interest rates on Bonds prices

6.In case of treasury bills the interest rate is paid:A. QuarterlyB. Half yearlyC. Yearly

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ExampleAn investment earns a return of 11% p.a., but the income is taxable in the hands of the investor. The investor’s marginal tax rate is 30%. What is his after tax rate of return? In this investment, 30% of the income will be paid as tax, and only 70% will be available to the investor. Pre-tax rate of return = 11% Tax rate applicable = 30%

D. Issued at a discount

7.In case of dated securities of GOI the interest rate is paid:A. QuarterlyB. Half yearlyC. DailyD. Issued at a discount

8.Diversification can be achieved by all the following methods except:A. Investing in different securitiesB. Investing in different maturitiesC. Investing in various asset classesD. Purchasing Futures of Index.

9.The shares of Alpha were bought on Jan 1 ,2003 for Rs.45.The year end prices were as under:2003 Rs.502004 Rs.552005 Rs.48What is the total return percentage.A. 4.36%B. 2.22%C. 7%D. 8.42%

10.What is the yield of a Bond bearing a coupan rate of 8% payable annually and currently priced at Rs.950 with a face value of Rs.1000?

A. 4.36%B. 2.22%C. 8.42%D. 8.42%

11.Interest rate has following relation with share valuation:A. Directly proportional to the stock price riseB. Inversely proportional to the stock price riseC. No ImpactD. None of the above

12.In respect of investing in Index Funds, which one of the following statement is true?A. Suitable to investors who seek returns much in excess of market returns.B. Aggressive investment strategyC. Active investment strategyD. Suitable to investors who expect index returns on the investment.

13.A retired couple should ideally prefer which of the following asset allocation plan?Equity Debt cash

A. 60% 35% 5%B. 50% 40% 10%C. 80% 20% NilD. 20% 70% 10%

14.A young man of 25 years,who has just joined an IT company as a programmer should prefer which kind of investment planning.A. Systematic Investment plans that take care of capital growth and life insuranceB. All money in life insurance plansC. He should not invest now as he is too young. Should enjoy life.D. Make lump sum investment in index funds.

15.Mutual fund distributors are regulated by:A. AMFI

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B. RBIC. FPSBD. IRDA

16.As a financial planner, if you expect the interest rate to rise, you should recommend:A. Long Term bonds to clientsB. Government SecuritiesC. Short Term instrumentsD. Stock Market

17.If the expected return of two stocks are the same then the investor should prefer that stock where theA. Risk is higherB. Risk is lowerC. Risk is sameD. No Risk involved

18. Mr. Samant has invested in 10% GOI Tax Free Relief Bonds.If he is paying income tax at the rate of 30%,the tax effective yield on these bonds to Mr.Samant would work out to:A. 10%B. 12.5%C. 14.28%D. 16.23%

19.The rate of return on a stock in a particular year was 19.5%.The rate of inflation during that year was 5%.What is the real raturn on the stock?A. 14.5%B. 13.33%C. 15.8%D. 16.2% Hint: Real rate =[{(1+nominal rate/100)/(1+Inflation Rate/100)}-1] *100 20.

A. Rs.75B. Rs.100C. Rs.50D. Rs.120Hint: 3/(1+.12)^1+3.24/(1+.12)^2+{3.50+94.48/(1+.12)^3}

21.Which of the following strategies is not related to Managing Risk:A. Avoiding RiskB. Transferring RiskC. Controlling RiskD. Accepting RiskE. Dividing Risk

22. “The premium paid is used to purchase units in investment assets chosen by the policyholder after deducting for all the charges and premium for risk cover under policy.” Identify the investment option which matches above style of payments:1.Mutual Fund2.Equity3.Commodity4.ULIP

23.In a whole life plan with limited payments,the sum assured becomes payable :1.At the end of premium paying term2.Only on death of the policy holder

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3.At the end of the premium term or on the death whichever is earlier4.The sum assured is not payable at all if the policy holder survives the premium paying term.

24. In an Endowment Insurance Plan ,the sum assured becomes payable :1.At the end of premium paying term2.Only on death of the policy holder3.At the end of the term of the policy or on the death whichever is earlier4.The sum assured is not payable at all if the policy holder survives the premium paying term.

26.Unit linked insurance plans are basically:A.Short term and low cost Insurance plansB.Low cost investment plan with no risk.C.Market related plans with emphasis on investmentD.Market related plans with emphasis on insurance

27.An investor who wants to invest in immediate pension plan seeks your advice on what option to choose.He is 50 years of age and he expects to live for another 30 years at least.Which of the following option is best for him?A.Guaranteed pension for 5 years offering 7% p.a.B. Guaranteed pension for 25 years offering 6.5% p.a.C.Guaranteed pension for life and thereafter to his spouse offering 7% p.a.D.Invest in Mutual Fund rather than pension offering min 10% offering.

28.Which of the following funds is suitable for an investor who is happy with the equity market returns:A.Balanced FundB.Money Market FundC.Gilt FundD.Index Fund

29.A Pharma Fund can be categorized as:A.Thematic FundB.Offshore FundC.Real Estate FundD.Sectoral Fund

30.NAV minus Repurchase Price isA. Sale PriceB. Exit LoadC. Entry LoadD. Redeem Price

ANS:1.D,2.A,3.C,4.True,5.A,6.D,7.B,8.D,9.B,9.B,10.C,11.B,12.D,13.D,14.A,15.A,16.C,17.B,18.C ,19.B,20.A,21.E22.4,23.2,24.3,25.C,26.C,27.D,28.D,29.D,30.B,

61.Problems on future value

1. Mr. A deposits Rs. 50000 for 6 years with a finance company which pays interest of 15% p.a. Compute the future value. 115655

2. Mrs.B invests Rs. 37,000 for 2 years at 10.5% per annum compounded annually. Calculate the redemption value. 45177.93. Mr.B invests Rs. 44,000 in FD for 2 years at 3% per annum compounded quarterly. Calculate the maturity value of the FD.

46,7104. Mr.X deposits Rs. 94,000 for 3 years at 4.25% per annum compounded semi-annually. Calculate the maturity value. 1066405. Mr. Prasad lends Rs. 125000 to Mr. Yaswanth for 3 years at the rate of 18% p.a. Compute the amount payable by Mr. Ramrasad after 3

years. 2053796. Mr. ABC deposits Rs. 10000, Rs.20000, Rs.30000, Rs.20000 and Rs.15000 respectively in the year 1, 2, 3, 4 and 5 respectively. His deposit

earns an interest of 12% p.a. Calculate the amount he gets after 5 years. 1188657. Mr. XYZ is a Lawyer and deposits his savings every year in a deposit which gives him an interest of 10% p.a. Calculate the Future value if

he deposits the money yearly as below. 284014.5

Year Cash Flow1 450002 300003 20000

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4 500005 63000

8. Six annual payments of Rs. 5000 are made into a deposit account that pays 14% interest per year. What is the future value of this annuity at the end of 6 years? 42,677.6

9. Mr. Pradeep deposits Rs. 10000 every year for 4 years and deposit earns an interest of 10% p.a. Determine how much money he will have at the end of 4 years. 46,410

10. Ms. Smitha deposits Rs. 8000 each year for 6 years and the deposit earns a compound interest @ 14% p.a., how much amount will she receive after 6 years? 68,284

62.Problems on present value

1. What is the present value of Rs.800 to be received at the end of 8 years, assuming an annual interest rate of 8 percent? 4322. Mr. Venkatesh wants to have Rs. 20,00,000 lakhs after 6 years for his daughter’s marriage. How much he has to deposit today if the

rate of interest is 14% p.a. 9,11,2003. Mr. Lakshman is expecting Rs. 8,00,000 as retirement benefit after 5 years from now. How much loan he can take so today if the

interest rate is 11% p.a. 4748004. Find the present value of 1,000 to be received at the end of 2 years at a 12% nominal annual interest rate compounded quarterly.

789.45. What is the present value of the following cash stream

Year Cash Flow0 50001 60002 80003 90004 8000

Assume a discount rate of 10%. 26,629.14

6. An investor wants to have Rs.10000, Rs.15000, Rs.8000, Rs.11000 and Rs.4000 respectively 1,2,3,4 and 5 years. Find out the amount he has to deposit today if discount rate is 10%? 37,494.96

7. A person wants to get Rs. 20,000 for the next 5 years. If his investment earns an interest 12%p.a., how much he has to deposit today? 72096

8. A Company borrows Rs.500000 at an interest rate of 15% and the loan is to be repaid in 5 equal installments payable at the end of each of the next 5 years. What shall be the size of installment? 1676100

9. You buy a house for Rs.5 lakh and immediately make cash payment of Rs.1 lakh. You finance the balance amount at 12% for 6 years with equal annual installments. How much are the annual installment? 1644560

10. A 10,000 car loan has payments of 361.52 due at the end of each month for three years. What is the nominal interest rate? 18%

63.Questions on CAGR

QUESTION No.

Face Value Date of Purchase

NAV at purchase Date of Sale

NAV at Sale Date

1. Rs.10 15.01.2015 Rs.250.00 28.02.2016 Rs.280.00

2. Rs.10 10.04.2015 Rs.9.00 20.05.2016 Rs.11.50

3. Rs.10 12.03.2014 Rs.6.00 22.11.2016 Rs.25.00

4. Rs.100 01.01.2015 Rs.120.00 28.02.2017 Rs.189.00

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Example: An investor purchased mutual fund units at an NAV of Rs.11. After 450 days, she redeemed it at Rs.13.50. What is her compounded rate of return?

64. Calculate Actual Return and Tax Adjusted Return:

Question No. Investment Rate of Intt on Investment Tax BracketOf the Invstor

Period of Investment

1. Rs.1,00,000 8% 30% 2 years

2. Rs.2,00,000 12% 20% 3 years

3. Rs.3,00,000 10% 50% 4 years

4. Rs.1,00,000 9% 30% 5 years

65.Multiple Choice Questions on Financial Planning (Involving Calculations):

1.Raj bought an equity share whose face value is Rs.10 for Rs.250 and earned 50% dividend in year 1, 60% dividend in year 2, and sold it off after three years for Rs.300. What is the return on his investment?

a.8.13%b.61%c.11%d.10.13%

2.An investor bought a shop for Rs.10 lakh. He earned a monthly rental income of Rs.3000 for 2 years. He then sold off the shop for Rs.12 lakh. What is his total return?

a.13.6%b.6.13%c.61.10%d.20.13%

3. Nominal rate of return is 10% and inflation rate is 5%.What is the Real Rate of Return? a.4.76% b.4.13% c.4.10% d.4.53%

Hint:{(1+NR/1+IR)-1}*100

4. An investment earns a return of 11% p.a., but the income is taxable in the hands of the investor. The investor’s marginal tax rate is 30%. What is his after tax rate of return?

a.7.70%b.7.13%c.7.10%d.7.53%

5.An investor is considering a tax-free bond that pays 8% p.a. and a taxable bank deposit that pays 9% p.a. The tax bracket of the investor is 20%.What is the nominal return on Tax Free Bond?

a.10.00%b.7.02%c.8.12%d.15.53%

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6. Which of the following amount is the maturity amount of an investment of Rs.25000 for 25 years in a Bank Fixed Deposit @10% p.a.?

a.Rs.2,70,868b.Rs.87,500c.Rs.1,70,868d.Rs.1,87,500

7. Which of the following amount is the maturity amount of an SIP of Rs.2500 per month for 25 years in Mutual Fund @10% p.a.?

a. Rs.33,17,083b.Rs.87,33,500c.Rs.11,70,868d.Rs.31,87,500

8. Which of the following factor is the PVIF for 25 years at an interest rate of 10% p.a.?

a. Rs.9.0770b.Rs.8.0980c.Rs.11.9807d.Rs.3.9879

9. Which of the following factor is the FVIF (Annuity)for 25 years at an interest rate of 10% p.a.?

a. Rs.98.347b.Rs.80.980c.Rs.119.807d.Rs.39.879

10.Mrs. Kapoor has been accumulating mutual funds over the past two years. She decides to sell her holdings on January 31, 2014, on which date the value of her investments is as shown below. What is the annualized rate of return on her investments?

Purchase Date Purchase Cost (Rs.) Market Value on Jan 31, 2014 (Rs.)Dec 10, 2011 10000 13000May 15, 2012 15000 16000

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