investment options (final)
DESCRIPTION
jqwebjhbTRANSCRIPT
A PROJECT REPORT ON
INVESTMENT OPTIONS IN INDIA
SUBMITTED BY:-
BHUMI VAGHANI
T.Y.B.M.S. [Semester V]
MITHIBAI COLLEGE OF MANAGEMENT
VILE PARLE (W), MUMBAI - 400 056.
SUBMITTED TO:-
UNIVERSITY OF MUMBAI
ACADEMIC YEAR
2012-2013
PROJECT GUIDE
PROF. NAVEEN ROHATGI
DATE OF SUBMISSION
10 TH DECEMBER, 2012
DECLARATION
I, Ms. BHUMI VAGHANI, of MITHIBAI COLLEGE OF MANAGEMENT of TYBMS
[Semester V] hereby declare that I have completed my project, titled ‘INVESTMENT
OPTIONS IN INDIA’ in the Academic Year 2012-2013. The information submitted herein
is true and original to the best of my knowledge.
__________________________
Signature of Student
[Bhumi G. Vaghani]
2
CERTIFICATE
I, Mr. NAVEEN ROHATGI, hereby certify that Ms. BHUMI VAGHANI of Mithibai
College of TYBMS [Semester V] has completed his project, titled ‘Investment Options in
India’ in the academic year 2012-2013. The information submitted herein is true and original
to the best of my knowledge.
_______________________ ___________________
Signature of the Principal Signature of the Project Guide
[DR. KIRAN V. MANGAONKAR] [Mr. NAVEEN ROHATGI]
______________________
Signature of External Examiner
3
ACKNOWLEDGEMENT
Preservation, inspiration and motivation have always played a key role in the success of any
venture. In the present world of cutthroat competition project is likely a bridge between
theoretical and practical working. I feel highly delighted with the way project on topic
Investment Options In India has been completed. Any accomplishment requires the efforts of
many people and this work is not difficult.
This project would not have been a success without the guidance and motivation of my
mentor. I am thankful to all the persons behind this project.
I would like to express my gratefulness to my Prof. Naveen Rohatgi, who acted as a mentor
throughout my project for providing me valuable information and guidance.
Last but not the least; I would like to thank my parents and friends for motivating me all the
time throughout this project.
4
EXECUTIVE SUMMARY
Investment refers to the concept of deferred consumption which may involve purchasing an
asset, giving a loan or keeping funds in a bank account with the aim of generating future
returns. Today the spectrum of investment is indeed wide. An investment is confronted with
array of investment avenues. Various investment options available in india are cash
investment, debt securities, stocks, mutual funds, derivatives, commodities, real estate etc.
Considering the importance of investment at each and every stage of life, I have therefore,
selected the topic ‘Investment Options in India’ to be placed before the esteemed educational
institution. My deep interest in indian financial markets, insurance, etc. has encouraged me to
choose this project.
Here I have made my best possible efforts to place the several investments options available
in india in a easy and most understandable manner. The study has been undertaken to analyze
investors’ preferences and as well as the different factors that affect investors decision on the
different investment avenues.
5
Table of Content
sINTRODUCTION....................................................................................................................11
Definition of Investment.......................................................................................................11
What is investing?................................................................................................................12
Need for Investment.............................................................................................................12
Investment v/s Speculation...................................................................................................14
Investment v/s Gambling......................................................................................................14
Types of Investment.............................................................................................................15
SMALL SAVING SCHEMES & FIXED INCOME INSTRUMENTS..................................16
CAPITAL MARKET...............................................................................................................25
Definition of a Stock................................................................................................................25
Investment in equities...........................................................................................................28
Types of Investors in Equity Market....................................................................................29
Investment Approach............................................................................................................31
Tools for Equity Analysis.....................................................................................................31
Taxation................................................................................................................................32
DERIVATIVES.......................................................................................................................33
Types of Derivatives.............................................................................................................34
Types of Derivative Contracts..............................................................................................35
Participants in a Derivative Market......................................................................................38
Introduction to Futures.........................................................................................................40
Options Contracts.................................................................................................................43
Taxation of Derivative Transaction in Securities.................................................................48
MUTUAL FUNDS...................................................................................................................49
Concept of Mutual Fund.......................................................................................................49
How do Mutual Fund Schemes Operate?.............................................................................50
Advantages of Mutual Funds................................................................................................52
6
Limitations of a Mutual Fund...............................................................................................55
Open-Ended Funds, Close-Ended Funds and Interval Funds...............................................56
Actively Managed Funds and Passive Funds.......................................................................57
Debt, Equity and Hybrid Funds............................................................................................57
Dividend Payout, Growth and Dividend Re-Investment Options........................................63
Taxability of Mutual Fund....................................................................................................66
INSURANCE...........................................................................................................................69
What is Insurance?...............................................................................................................70
Types of Insurance...............................................................................................................70
Types of life insurance.........................................................................................................74
Taxation................................................................................................................................77
ALTERNATIVE INVESTMENTS.........................................................................................79
Art.........................................................................................................................................80
Investing In Gold..................................................................................................................82
Real Estate............................................................................................................................83
PRIMARY RESEARCH..........................................................................................................88
Introduction..........................................................................................................................88
Objective of the study...........................................................................................................89
Limitations of the study........................................................................................................90
RESEARCH METHODOLOGY.............................................................................................91
DATA ANALYSIS AND INTERPRETATION.....................................................................93
ANNEXURE 1.......................................................................................................................112
BIBLIOGRAPHY..................................................................................................................115
7
INTRODUCTION
Definition of Investment
Investment is the commitment of money or capital to purchase financial instruments or other
assets in order to gain profitable returns in the form of interest, income, or appreciation of the
value of the instrument. Investment is related to saving or deferring consumption.
An investment involves the choice by an individual or an organization such as a pension
fund, after some analysis or thought, to place or lend money in a vehicle, instrument or asset,
such as property, commodity, stock, bond, financial derivatives (e.g. futures or options), or
the foreign asset denominated in foreign currency, that has certain level of risk and provides
the possibility of generating returns over a period of time. When an asset is bought or a given
amount of money is invested in the bank, there is anticipation that some return will be
received from the investment in the future.
Investment is a term frequently used in the fields of economics, business management and
finance.
Investment in terms of Economics:
According to economic theories, investment is defined as the per-unit production of goods,
which have not been consumed, but will however, be used for the purpose of future
production. Examples of this type of investments are tangible goods like construction of a
factory or bridge and intangible goods like 6 months of on-the-job training. In terms of
national production and income, Gross Domestic Product (GDP) has an essential constituent,
known as gross investment.
Investment in Terms of Business Management:
According to business management theories, investment refers to tangible assets like
machinery and equipments and buildings and intangible assets like copyrights or patents and
goodwill. The decision for investment is also known as capital budgeting decision, which is
regarded as one of the key decisions.
8
Investment in Terms of Finance:
In finance, investment refers to the purchasing of securities or other financial assets from the
capital market. It also means buying money market or real properties with high market
liquidity. Some examples are gold, silver, real properties, and precious items.
What is investing?
By making an investment, an individual uses the money that would otherwise have been
consumed by spending on buying groceries, car, taking a vacations or building a house. An
individual is sacrificing these pleasures by making an investment. There ought to be some
reward for this sacrifice. The reward is that he expects to get back more than what he has put
in. He can then consume the increased amount at a later date. In economic terms, in making
investments an individual trades current consumption with future consumption.
Thus the basic theory driving investment as acceptable is that an individual believes that the
pleasure derived from future consumption will be more than pleasure foregone today. It refers
to commitment of funds to one or more assets that will be held over a certain time period.
Anything not consumed today and saved for future use with some risk can be considered as
an investment.
Thus all three: - investment, wealth and consumption are interrelated. This is an investment
consumption cycle.
Need for Investment
1. Protecting from inflation Inflation decreases the value of money. If you have Rs.1000 today and the rate of inflation is
8% then Rs.1000 will Rs.926 next year and if inflation continues at the rate of 9% every year
Rs.1000 will be Rs.501 after 9 years. This will be happened to your money if you are not
investing your money in any investment scheme. Investing your money in any investment
schemes can help you to save your money from inflation.
9
InvestmentCreates wealthLeads to consumtion
2. Good return from your ideal money
When you keep your money ideally in a savings account, you won’t get much benefit. If you
invest your money in risky instruments you can save your money as well as enjoy the growth
of money and money value. Higher the risk taken higher can be return. Thus risk and return
are directly related.
3. To satisfy your future financial goals
One has to accomplish many financial goals such as marriage of self or children, education,
buying a residential accommodation, good retirement income, good medical facility, etc. To
satisfy these financial goals one has to invest money regularly from existing source of
income.
4. Provide enough money for meeting uncertainties
Some financial needs cannot be predicted early such as medical treatment of any critical
illness or accident, death of the bread earner of one’s family, etc. So you have to make
enough provision for meeting such uncertain needs. Insurance and retirement schemes will
help in this case.
So it is necessary to invest your money and make a habit of saving and investment to get a
good stern stand in your financial needs and emergences.
Saving is different from investment
Investment is an activity that results from savings of an individual. Investments are made
from savings or it can be said people invest their savings. But all savers are not investors.
Saving is something, which an individual puts into piggybank, bank account, fixed deposits
or any other interest bearing securities, while investment is the saving with the desire to earn
better return with some risk.
10
Investment v/s Speculation
Investment and speculation, both are an activity of purchasing assets with an expectation of
return. The difference between the two is basically the risk taking capacity. Investment
differs with speculation because of certain characteristics. Some of them can be listed as:
Investment Speculation
Risk Risk is low with as anticipation of
average or over the average market
returns
Higher risk in order to achieve
high returns
Leverage No component of leverage i.e.
investment is carried with one owns
fund
It is based on borrowed capital or
leveraged activity
Capital Gain Price appreciation from an asset is a
consideration along with periodic
income
Fast price changes are basis for
getting capital appreciation
Basis Investment decisions are based on
some fundamental analysis and on
the strength of the investment
instrument
Decisions are mostly based on
tips, technical analysis and
sentiment prevailing in the market
Time Period Investments are time defined and
usually for a longer term
Speculation is seeking a short
term advantage
Investment v/s Gambling
Investment Gambling
Risk Funds committed to an asset,
wherein risk is low with an
anticipation of average market or
Funds put on bet taking higher risk
in order to achieve high returns
11
above average market return
Element of
excitement
Generally not present and certainly
is not the driver of investment
decision
Element of excitement is a major
driver for indulgence in gambling
Basis of
decision
Investment decisions are generally
based on some fundamental analysis
and on the strength of the investment
instrument
Decisions are mostly based on
unscientific and unfounded idea of
making super abnormal gains in
very short time.
Examples Funds invested in shares, bonds and
financial securities
Horse race, lotteries, card games,
etc.
It becomes clear that speculating and gambling are not similar things and can be
differentiated on simple fact that the speculation tries to take advantage of short term
anomalies that can exist in market for speculators to exploit, while gambling is purely betting
on odds without any reasoning and scientific law.
Types of Investment
12
INVESTMENTFinancial InvestmentEquitiesMutual FundsDerivativesBondsInsuranceNon-financial InvestmentReal estatePrecious metalsArt & AntiquesCollectibles
SMALL SAVINGS SCHEMES & FIXED INCOME INSTRUMENTS
Saving Schemes
These are basically savings avenues, where an individual puts his/her savings. These can be
classified in two parts:
a) Small saving schemes: They are designed to provide safe and attractive investment
options to the public and at the same time to mobilize resources for development of
economy.
b) Other saving scheme: These are all other schemes, which are not covered by small saving
schemes like bank fixed deposit, company fixed deposits, etc.
Small Saving Schemes
Traditionally schemes like public provident fund and national saving certificate have been
associated with attractive returns and tax benefits. Most importantly these schemes offer
assured returns thereby appealing to a large section of investor community. National Savings
Organization (NSO) is responsible for national level promotion of small saving schemes.
These schemes are primarily meant for small urban and rural investors. Institutions and NRI’s
are not eligible to invest in small savings schemes. The following schemes come under small
saving schemes:
1. Post Office Savings Account
2. Post Office Time Deposit Account
3. Post Office Recurring Deposit Account
4. National Saving Certificate (NSC)
5. Post Office Monthly Income Scheme (POMIS)
6. Public Provident Fund (PPF)
7. Senior Citizen Saving Scheme.
13
Post Office Savings Account
Account can be opened by A single adult or two/three adults jointly
A minor who has attained 10 years of age or guardian on behalf
of minor
Group accounts by provident fund , superannuating fund,
gratuity fund
A cooperative society or a cooperative bank
Public account by a local authority/body, etc
Deposits Account can be opened with minimum of Rs.20
Maturity period There is no lock-in/maturity period prescribed
Withdrawal Any amount subject to keeping minimum balance of Rs.50 in
simple and Rs.500 for cheque facility account
Interest Current interest rate is 4% pa
Nomination Nomination facility is available
Pass Book Depositor is provided with a pass book
Silent Account An account not operated during 3 completed years, shall be
treated as Silent Account. A service charge of Rs.20 per year is
charged on the last day of each year until it is reactivated
Income Tax Benefit Exempted u/s 10 of IT Act
Post Office Time Deposit Account
Types of Accounts 1,2,3 & 5 year maturity
Account can be opened by A single adult or two/three adults jointly
A minor who has attained 10 years of age or guardian on behalf
of minor
Group accounts by provident fund , superannuating fund,
gratuity fund
A cooperative society or a cooperative bank
Public account by a local authority/body, etc
Mode of account holding A depositor can hold more than 1 account in his name or jointly
with another, either in same post office or in different post
14
offices.
Deposits Minimum of Rs. 200. Maximum no limit
Transferability Transferable from one person to another
Maturity period The deposited amount is repayable after expiry of the period
Interest 1year- 8.2%
2year- 8.3%
3year- 8.4%
5year- 8.5%
Nomination Nomination facility is available
Pass book Depositor is provided with a pass book
Income Tax benefit Tax exemption u/s 80C for 5 year term deposit
Premature withdrawal Withdrawn within 6 months- No interest
After 6 months- 4%
After 1 year- 1% less rate specified for the period
Post Office Recurring Deposit Account
Account can be opened by A single adult or two adults jointly
A guardian on behalf of a minor or a person of unsound mind
A minor who has attained the age of 10 years in his own
name
Maturity Period of maturity of an account is 5 years
Deposits 60 equal monthly deposits in multiple of Rs.5 subject to
minimum of Rs.10
Defaults in deposit Accounts with not more than 4 defaults can be regularized
within a period of two months on payment of default fee.
Account becomes discontinued after more than 4 defaults
Rate of interest 8.4% pa
Repayment on maturity The deposited amount is repayable after expiry of the period
Nomination Nomination facility is available
Pass book Depositor is provided with a pass book
Loan facility Loan up to half of the deposit may be taken after 1 year and
before maturity. This must be repaid together with the
15
interest in one or more installments. Loan not repaid is
deducted together with interest from the amount payable at
the time of closure of the account.
Premature closure Premature closure is permissible after expiry of 3 years
provided that interest rate applicable to post office savings
account shall be payable on such premature closure of
account.
Continuation after maturity Permissible for a maximum period of 5 years
Income Tax benefit No TDS is deducted. Interest received is taxable.
National Saving Certificate
Who can purchase An adult, A minor, A trust, Hindu Undivided Family
Where available Available at Post Offices
Maturity 5 years and 10 years
Nomination Nomination facility is available
Transferability Certificates can be transferred from one post office to another
and also from one person to another.
Deposit limits Certificates are available in denominations of Rs.100,
Rs.500, Rs.1000, Rs.5000, Rs.10000. There is no maximum
limit for purchase of the certificates.
Interest rate 5 years - 8.6% pa
10 years - 8.9% pa
Maturity value Interest accrued on the certificates every year is liable to
income tax but deemed to have been reinvested.
Premature encashment Not permissible except in case of death of the holder,
forfeiture by pledgee and when ordered by a court of law.
Place of encashment Can be enchased at the place of post office where it is
registered or any other post office.
Income Tax benefit Deduction for amount invested u/s 80C of IT Act. This
deduction can be claimed by the person who has contributed
the money out of his chargeable Income Tax. It can be
claimed by the first name person in joint holding if first name
16
of the person has contributed the amount.
Post Office Monthly Income Scheme
Who can open A single adult or two adults jointly
A minor who has attained age of 10 years or a guardian on
behalf of minor
More than one account can be opened subject to maximum
deposit limits
Where can be opened At any post office
Maturity 5 years
Deposits Only one deposit
Deposit limit Minimum Rs.1500 and maximum Rs.450000 in case of
single and Rs.900000 in case of joint account.
Interest 8.5% pa
Bonus Discontinued
Premature closure After 1 year but before 3 years – deduction of 2% deposit
amount
After 3 years – deduction of 1% deposit
amount
Nomination Nomination facility is available
Closure of account Account shall be closed after expiry of 5 years
Income tax benefit No TDS is deducted. Interest received is taxable.
Public Provident Fund Scheme
Account can be opened by An individual in his/her own name or on behalf of a minor
Accounts can be opened At post offices and at branches of public sector banks
Maturity period 15 years
Extension after maturity Account can be continued with or without subscriptions after
maturity for block periods of 5 years.
With subscription- Withdrawal allowed up to 60% of balance
at the beginning of each extended period. The money can be
17
withdrawn in a lump sum or in installments but not more
than one withdrawal in a year.
Without subscription- One can withdraw the entire sum in
lump sum or in installments but not more than one
withdrawal a year.
Nomination Nomination facility is available
Deposit limits Minimum Rs.1000 and maximum Rs.100000
Maximum number of deposits is 12 in a financial year
Loans Loan from the amount at credit in PPF account can be taken
after completion of one year from the end of financial year of
opening of the account and before completion of fifth year.
The amount of loan that can be availed is 25% of amount that
stood to his credit to at the end of the second year
immediately preceding the year in which the loan is applied
for.
Interest on loan shall be 2% pa from 1.12.2011
Withdrawal Premature withdrawal is permissible every year after
completion of five years from the end of the year of opening
the account.
One withdrawal per year after 6 years i.e. from 7th year
The amount of withdrawal is limited to 50% of the balance at
credit at the end of 4th year immediately preceding the year in
which the amount is withdrawn or at the end of preceding
year, whichever is lower.
Transferability Account can be transferred from one post office to another,
from one bank to another and from bank to post office and
vice verse.
Interest 8.8% pa
Bankruptcy Courts in case of bankruptcy or default on any loan payment
cannot attach the amount in PPF account
Income tax benefit Deductions for deposit made u/s 80C of IT Act. Interest
credited every year is tax free.
Wealth tax Exempt
18
Senior Citizen Savings Scheme
Account can be opened by
individual
Who has attained age of 60 years
Who has attained 55 years of age or more but less than 60
years and has retired under VRS
No age limit for retired personnel of Defense service
NRI’s and HUF are not eligible.
Point of sale 24 nationalized banks, 1 private sector bank and post offices
Deposit limit Maximum Rs.15 lakhs and in multiple of Rs.1000
Maturity Maturity 5years and depositor may extend the account for
further period of 3 years. No withdrawal shall be permitted
Premature closure After 1 year but before 2 years – deduction of 1.5% of the
deposit
After 2 years but before maturity – deduction of 1% of the
deposit
In case of death before maturity, the account shall be closed
and deposit is refunded without any deduction along with
interest.
Interest 9.3% pa
Nomination Nomination facility is available
Income tax benefit Investment eligible for deduction u/s 80C. Interest earned is
liable for TDS.
Wealth tax No wealth tax exemption
Fixed Income Instruments
Government of India Savings Bonds
Eligibility An individual, not being an NRI
A Hindu Undivided Family
Charitable Institution and University
Point of sale Bonds are sold by RBI through designated banks and stock
holding corporation of India ltd on behalf of government of
19
India
Interest 8% pa
Issue price Bonds are issued at par and have face value of Rs.1000. No
upper limit on investment.
Maturity 6 years
Nomination Nomination facility is available
TDS Tax is deducted at source from interest amount if interest
exceeds Rs.10000 in a year.
Wealth tax Exempt
Bank Fixed Deposits
Eligibility Resident Individuals
Non Resident Indians
Minor through guardians
Hindu Undivided Family
Sole Proprietorship firm
Partnership firm
Limited Companies
Trust
Interest rate Interest rate differs from bank to bank
Maturity From 7 days to 5 years
TDS TDS is deducted if interest exceeds Rs.10000 in any financial
year. Individuals can file form 15H or 15G to claim
exemption from TDS deduction
Income tax benefit Fixed deposit of term 5 years or more are eligible for
deduction u/s 80C.
Company Fixed Deposits
Who can accept deposit? Manufacturing Companies
20
Housing Finance Companies
Non-Banking Finance Companies
Financial Institutions
Government Companies
Eligibility Resident Individuals
Non Resident Indians
Minor through guardians
Hindu Undivided Family
Sole Proprietorship firm
Partnership firm
Limited Companies
Trust
Nomination Nomination facility is available
Maturity Manufacturing Company - 6 months to 3 years
Housing Finance Company - 1 to 7 years
Non-Banking Finance Company - 1 to 5years
Interest rate It differs from company to company
Premature withdrawal Is allowed after completion of 3 months from date of deposit
Loan Is available after 3 months of placing deposit
TDS Tax is deducted at source from interest amount if interest
exceeds Rs.5000 in a year. Individuals can file form 15H or
15G to claim exemption from TDS deduction
KYC Compliance Latest photograph, proof of identity and proof of address
Income tax benefit Investments up to Rs.100000 qualify for deduction u/s 80C of
IT Act.
CAPITAL MARKET
Definition of a Stock
21
Stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater. Whether you say shares, equity, or stock, it all means the same thing. Over the last few decades, the average person's interest in the stock market has grown exponentially. What was once a toy of the rich has now turned into the vehicle of choice for growing wealth? This demand coupled with advances in trading technology has opened up the markets so that nowadays nearly anybody can own stocks.
Being an owner
Holding a company's stock means that you are one of the many owners (shareholders) of a
company and, as such, you have a claim to everything the company owns. As an owner, you
are entitled to your share of the company's earnings as well as any voting rights attached to
the stock.
A stock is represented by a share certificate. This is a fancy piece of paper that is proof of
your ownership. In today's computer age, you won't actually get to see this document because
your broker or DP keeps these records electronically, which is also known as holding shares
"in street name".
The importance of being a shareholder is that you are entitled to a portion of the company’s
profits and have a claim on assets. Profits are sometimes paid out in the form of dividends.
The more shares you own, the larger the portion of the profits you get. Your claim on assets
is only relevant if a company goes bankrupt. In case of liquidation, you'll receive what's left
after all the creditors have been paid.
Another extremely important feature of stock is its limited liability, which means that, as an
owner of a stock, you are not personally liable if the company is not able to pay its debts.
Owning stock means that, no matter what, the maximum value you can lose is the value of
your investment. Even if a company of which you are a shareholder goes bankrupt, you can
never lose your personal assets.
Debt vs. Equity
It is important that you understand the distinction between a company financing through debt
and financing through equity. When you buy a debt investment such as a bond, you are
22
guaranteed the return of your money (the principal) along with promised interest payments.
This isn't the case with an equity investment. By becoming an owner, you assume the risk of
the company not being successful - just as a small business owner isn't guaranteed a return,
neither is a shareholder. As an owner, your claim on assets is less than that of creditors. This
means that if a company goes bankrupt and liquidates, you, as a shareholder, don't get any
money until the banks, bondholders and other creditors have been paid out; we call this
absolute priority. Shareholders earn a lot if a company is successful, but they also stand to
lose their entire investment if the company isn't successful.
Risk and Return
Returns on equity are affected by risks like Business Risk, Financial Risk, Industry Risk,
Management Risk, Political, Economical and Exchange Rate Risk, Market Risk, etc. It must
be emphasized that there are no guarantees when it comes to individual stocks. Some
companies pay out dividends, but many others do not. And there is no obligation to pay out
dividends even for those firms that have traditionally given them. Without dividends, an
investor can make money on a stock only through its appreciation in the open market. On the
downside, any stock may go bankrupt, in which case your investment is worth nothing.
Although risk might sound all negative, there is also a bright side. Taking greater risk
demands a greater return on your investment. This is the reason why stocks have historically
outperformed other investments such as bonds or savings accounts. Over the long term, an
investment in stocks has historically had an average return of around 10-12% annually.
Different types of stock
a. Common Stock (Equity Shares)
When people talk about stocks they are usually referring to this type. In fact, the majority of
stock is issued is in this form. Common shares represent ownership in a company and a claim
(dividends) on a portion of profits. Investors get one vote per share to elect the board
members, who oversee the major decisions made by management. The holder of common
stock has limited liability up to amount of share capital contributed.
Over the long term, common stock, by means of capital growth, yields higher returns than
23
almost every other investment. This higher return comes at a cost since common stocks entail
the most risk. If a company goes bankrupt and liquidates, the common shareholders will not
receive money until the creditors, bondholders and preferred shareholders are paid.
b. Preferred stock (Preference Share)
Preferred stock represents some degree of ownership in a company but usually doesn't come
with the same voting rights. (This may vary depending on the company.) With preferred
shares, investors are usually guaranteed a fixed dividend forever. This is different than
common stock, which has variable dividends that are never guaranteed.
Another advantage is that in the event of liquidation, preferred shareholders are paid off
before the common shareholder (but still after debt holders). Preferred stock may also be
callable, meaning that the company has the option to purchase the shares from shareholders at
anytime for any reason (usually for a premium).
Investment in equities
1. Through the primary market
2. Through the secondary market
Primary market
Primary market provides an opportunity to the issuers of securities, both Government and
corporations, to raise resources to meet their requirements of investment. It's in this market
that firms sell new stocks to the public for the first time. For our purposes, you can think of
the primary market as being synonymous with an initial public offering (IPO). An IPO occurs
when a private company sells stocks to the public for the first time.
Securities, in the form of equity can be issued in domestic /international markets at face value
with discount or premium. The primary market issuance is done either through public issues
or private placement. Under Companies Act, 1956, an issue is referred as public if it results in
allotment of securities to 50 investors or more. However, when the issuer makes an issue of
securities to a select group of persons not exceeding 49 and which is neither a right issue nor
a public issue, it is called a private placement.
24
The important thing to understand about the primary market is that securities are purchased
directly from an issuing company.
Secondary Market
Secondary market refers to a market where securities are traded after being offered to the
public in the primary market or listed on the Stock Exchange. Secondary market comprises of
equity, derivatives and the debt markets. The secondary market is operated through two
mediums, namely, the Over-the-Counter (OTC) market and the Exchange-Traded Market.
OTC markets are informal markets where trades are negotiated.
The secondary market is what people are talking about when they refer to the "stock market".
This includes the National Stock Exchange (NSE), Bombay Stock Exchange (BSE) and other
major exchanges around the world. That is, in the secondary market, investors trade
previously issued securities without the involvement of the issuing companies.
Types of Investors in Equity Market
a. The Bull Market
A bull market is when everything in the economy is great, people are finding jobs, gross
domestic product (GDP) is growing, and stocks are rising. Picking stocks during a bull
market is easier because everything is going up. Bull markets cannot last forever though, and
sometimes they can lead to dangerous situations if stocks become overvalued. If a person is
optimistic and believes that stocks will go up, he or she is called a "bull" and is said to have a
"bullish outlook".
b. The Bear Market
A bear market is when the economy is bad, recession is looming and stock prices are falling.
Bear markets make it tough for investors to pick profitable stocks. One solution to this is to
25
make money when stocks are falling using a technique called short selling. Another strategy
is to wait on the sidelines until you feel that the bear market is nearing its end, only starting to
buy in anticipation of a bull market. If a person is pessimistic, believing that stocks are going
to drop, he or she is called a "bear" and said to have a "bearish outlook".
c. The Other Animals on the Farm - Chickens and Pigs
Chickens are afraid to lose anything. Their fear overrides their need to make profits and so
they turn only to money-market securities or get out of the markets entirely. While it's true
that you should never invest in something over which you lose sleep, you are also guaranteed
never to see any return if you avoid the market completely and never take any risk,
Pigs are high-risk investors looking for the one big score in a short period of time. Pigs buy
on hot tips and invest in companies without doing their due diligence. They get impatient,
greedy, and emotional about their investments, and they are drawn to high-risk securities
without putting in the proper time or money to learn about these investment vehicles.
Professional traders love the pigs, as it's often from their losses that the bulls and bears reap
their profits.
Investment StylesDifferent investor invests differently. Two most common ways of investment style in equity
are-
a. Value Investing - Value investing is wherein fund managers or investors tend to look
for companies trading below their intrinsic value, but whose true worth they believe will
eventually be recognized. These securities typically have low prices relative to earnings
or book value and a higher dividend yield.
b. Growth Investing - Growth investing is wherein fun managers or investors look for
companies with above average earnings growth and profits, which they believe will be
even more valuable in the future. They also look for companies that are well position to
capitalize on long term growth trends that may drive earnings higher. Because these
26
companies tend to grow earnings at a fast pace, they typically have higher prices relative
to earnings.
Investment Approach
a. Top down approach - Under this investment approach, fund managers or investors start
from big horizon in the economy and the financial world and then go on breaking these
into smaller parts to find a good company to invest in. After looking at the bigger horizon,
the different industrial sectors are analyzed and indentified in order to select those that are
expected to outperform market. After deciding on the industry and sector, the stock of
specific companies within the sector or industry is further analyzed and those that are
believed to be worth investing are chosen as investments.
b. Bottom up approach - This is opposite of top down approach, instead of looking at big
horizon and then at industry and then at companies with the industry, this approach
focuses on identifying the stock directly and believes that an individual company in any
industry can do well even if the sector is not performing.
Tools for Equity Analysis
a. Technical Analysis
Technical analysis is a method of evaluating securities by analyzing the statistics generated
by market activity, such as past prices and volume. Technical analysts do not attempt to
measure a security's intrinsic value, but instead use charts and other tools to identify patterns
that can suggest future activity.
The behavior of price movement of a stock is studied to predict its future movement. The
theory being that by plotting the price movements over the time, they can discern certain
patterns which will help them to predict the future price movement of the stocks. Technical
studies are based on prices and do not include balance sheets, profit and loss accounts.
b. Fundamental Analysis
A method of evaluating a security that entails attempting to measure its intrinsic value by
examining related economic, financial and other qualitative and quantitative factors.
27
Fundamental analysts attempt to study everything that can affect the security's value,
including macroeconomic factors (like the overall economy and industry
conditions) and company-specific factors (like financial condition and management).
The end goal of performing fundamental analysis is to produce a value that an investor can
compare with the security's current price, with the aim of figuring out what sort of position to
take with that security (underpriced = buy, overpriced = sell or short).
This method of security analysis is considered to be the opposite of technical analysis.
One of the most famous and successful fundamental analysts is the Oracle of Omaha, Warren
Buffett, who is well known for successfully employing fundamental analysis to pick
securities. His abilities have turned him into a billionaire.
TaxationTransactions in recognized stock exchange in India.
Purchase of
equity shares,
units of
equity
oriented MF
(delivery
based)
Sale of equity
shares
Sale of equity
shares (Day
Trading)
Sale of
derivative
Sale of unit of
an equity
oriented fund
to the mutual
fund
Whether
Securities
Transaction
Tax (STT) is
applicable?
Yes Yes Yes Yes Yes
Who has to
pay STT?
Purchases Seller Seller Seller Seller
Rate of STT 0.10% 0.10% 0.025% 0.017% 0.25%
Tax treatment
of long term
capital gain in
hands of
NA Exempt from
tax u/s 10(38)
Income is
generally
treated as
business
Income is
generally
treated as
business
Exempt from
tax u/s 10(38)
28
seller income income
Tax treatment
of short term
capital gain in
hands of
seller
NA Taxable at the
rate of 15%
plus
surcharge
plus
education
cess.
Income is
generally
treated as
business
income
Income is
generally
treated as
business
income
Taxable at the
rate of 15%
plus
surcharge
plus
education
cess.
Who will
collect STT?
Stock
exchange
Stock
exchange
Stock
exchange
Stock
exchange
Mutual fund
DERIVATIVES
Derivatives Defined as
29
The term ‘Derivative’ stands for a contract whose price is derived from or is dependent upon
an underlying asset. The underlying asset could be a financial asset such as currency, stock
and market index, an interest bearing security or a physical commodity. Today, around the
world, derivative contracts are traded on electricity, weather, temperature and even volatility.
According to the Securities Contract Regulation Act, (1956) the term “derivative” includes:
i. A security derived from a debt instrument, share, loan, whether secured or unsecured,
risk instrument or contract for differences or any other form of security;
ii. A contract which derives its value from the prices, or index of prices, of underlying
securities.
Derivatives Markets
Derivatives markets can broadly be classified as commodity derivatives market and financial
derivatives markets. As the name suggest, commodity derivatives markets trade contracts are
those for which the underlying asset is a commodity. It can be an agricultural commodity like
wheat, soybeans, rapeseed, cotton, etc or precious metals like gold, silver, etc. or energy
products like crude oil, natural gas, coal, electricity etc. Financial derivatives markets trade
contracts have a financial asset or variable as the underlying. The more popular financial
derivatives are those which have equity, interest rates and exchange rates as the underlying.
Types of Derivatives
30
Commodity Derivatives
A commodity derivative is defined as derivatives whose value derives from the price of an
underlying commodity. The underlying asset includes Precious metals (gold, silver, platinum
etc.), other metals (tin, copper, lead, steel, nickel, etc), Argo products (coffee, wheat, rice
pepper, cotton, etc) and Energy products (crude oil, heating oil, natural gas, etc)
Equity derivatives
A derivative instrument with underlying assets based on equity securities. An equity
derivative's value will fluctuate with changes in its underlying asset's equity, which is usually
measured by share price.
Investors can use equity derivatives to hedge the risk associated with taking a position in
stock by setting limits to the losses incurred by either a short or long position in a company's
shares. If an investor purchases a stock, he or she can protect against a loss in share value by
purchasing a put option. On the other hand, if the investor has shorted shares, he or she can
hedge against a gain in share price by purchasing a call option.
Interest rate derivatives
31
Types of DerivativesExchange TradedCommoditiesAgricultural commoditiesNon-agricultural commoditiesFinancialsEquity Interest rateCurrencyOver the Counter
A financial instrument based on an underlying financial security whose value is affected by
changes in interest rates. Interest-rate derivatives are hedges used by institutional investors
such as banks to combat the changes in market interest rates. Individual investors are more
likely to use interest-rate derivatives as a speculative tool - they hope to profit from their
guesses about which direction market interest rates will move.
Currency derivatives
Currency derivatives can be described as contracts between the sellers and the buyers whose
value are derived from the underlying exchange rate. They are mostly designed for hedging
purposes, although they are also used as instruments for speculation.
Types of Derivative Contracts
Derivatives comprise four basic contracts namely Forwards, Futures, Options and Swaps.
Over the past couple of decades several exotic contracts have also emerged but these are
largely the variants of these basic contracts. Let us briefly define some of the contracts.
1. Forward Contracts
These are promises to deliver an asset at a pre- determined date in future at a predetermined
price. Forwards are highly popular on currencies and interest rates. The contracts are traded
over the counter (i.e. outside the stock exchanges, directly between the two parties) and are
customized according to the needs of the parties. Since these contracts do not fall under the
purview of rules and regulations of an exchange, they generally suffer from counterparty risk
i.e. the risk that one of the parties to the contract may not fulfill his or her obligation.
2. Futures Contracts
A futures contract is an agreement between two parties to buy or sell an asset at a certain
time in future at a certain price. These are basically exchange traded, standardized contracts.
The exchange stands guarantee to all transactions and counterparty risk is largely eliminated.
The buyers of futures contracts are considered having a long position whereas the sellers are
32
considered to be having a short position. It should be noted that this is similar to any asset
market where anybody who buys is long and the one who sells in short.
Futures contracts are available on variety of commodities, currencies, interest rates, stocks
and other tradable assets. They are highly popular on stock indices, interest rates and foreign
exchange.
3. Options Contracts
Options give the buyer (holder) a right but not an obligation to buy or sell an asset in future.
Options are of two types - calls and puts. Calls give the buyer the right but not the obligation
to buy a given quantity of the underlying asset, at a given price on or before a given future
date. Puts give the buyer the right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date. One can buy and sell each of the
contracts. When one buys an option he is said to be having a long position and when one sells
he is said to be having a short position.
It should be noted that, in the first two types of derivative contracts (forwards and futures)
both the parties (buyer and seller) have an obligation; i.e. the buyer needs to pay for the asset
to the seller and the seller needs to deliver the asset to the buyer on the settlement date. In
case of options only the seller (also called option writer) is under an obligation and not the
buyer (also called option purchaser). The buyer has a right to buy (call options) or sell (put
options) the asset from / to the seller of the option but he may or may not exercise this right.
In case the buyer of the option does exercise his right, the seller of the option must fulfill
whatever is his obligation (for a call option the seller has to deliver the asset to the buyer of
the option and for a put option the seller has to receive the asset from the buyer of the option).
An option can be exercised at the expiry of the contract period (which is known as European
option contract) or anytime up to the expiry of the contract period (termed as American
option contract).
4. Swaps Swaps are private agreements between two parties to exchange cash flows in
33
the future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
a. Interest rate swaps : These entail swapping only the interest related cash flows between
the parties in the same currency.
b. Currency swaps : These entail swapping both principal and interest between the parties,
with the cash flows in one direction being in a different currency than those in the
opposite direction.
5. WarrantsOptions generally have lives of up to one year; the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer-dated options are called
warrants and are generally traded over-the-counter.
6. LEAPSThe acronym LEAPS means Long-Term Equity Anticipation Securities. These are options
having a maturity of up to three years.
7. BasketsBasket options are options on portfolios of underlying assets. The underlying asset is usually
a moving average or a basket of assets. Equity index options are a form of basket options.
8. SwaptionsSwaptions are options to buy or sell a swap that will become operative at the expiry of the
options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the
swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an
option to receive fixed and pay floating. A payer swaption is an option to pay fixed and
receive floating.
Participants in a Derivative Market
34
The derivatives market is similar to any other financial market and has following three broad
Categories of participants:
1. Hedgers These are investors with a present or anticipated exposure to the underlying asset which is
subject to price risks. Hedgers use the derivatives markets primarily for price risk
management of assets and portfolios.
2. Speculators These are individuals who take a view on the future direction of the markets. They take a
view whether prices would rise or fall in future and accordingly buy or sell futures and
options to try and make a profit from the future price movements of the underlying asset.
3. Arbitrageurs They take positions in financial markets to earn riskless profits. The arbitrageurs take short
and long positions in the same or different contracts at the same time to create a position
which can generate a riskless profit.
Forward Contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified
price. One of the parties to the contract assumes a long position and agrees to buy the
underlying asset on a certain specified future date for a certain specified price. The other
party assumes a short position and agrees to sell the asset on the same date for the same price.
Other contract details like delivery date, price and quantity are negotiated bilaterally by the
parties to the contract. The forward contracts are normally traded outside the exchanges.
The salient features of forward contracts are as given below:
• They are bilateral contracts and hence exposed to counter-party risk.
• Each contract is custom designed, and hence is unique in terms of contract size, expiration
date and the asset type and quality.
• The contract price is generally not available in public domain.
35
• On the expiration date, the contract has to be settled by delivery of the asset.
• If the party wishes to reverse the contract, it has to compulsorily go to the same counter-
party, which often results in high prices being charged.
Limitations of forward markets
• Lack of centralization of trading
• Illiquidity and
• Counterparty risk
In the first two of these, the basic problem is that of too much flexibility and generality. The
forward market is like a real estate market, in which any two consenting adults can form
contracts against each other. This often makes them design the terms of the deal which are
convenient in that specific situation, but makes the contracts non-tradable.
Counterparty risk arises from the possibility of default by any one party to the transaction.
When one of the two sides to the transaction declares bankruptcy, the other suffers. When
forward markets trade standardized contracts, though it avoids the problem of illiquidity, still
the counterparty risk remains a very serious issue.
Introduction to Futures
A futures contract is an agreement between two parties to buy or sell an asset at a certain time
in the future at a certain price. But unlike forward contracts, the futures contracts are
standardized and exchange traded. To facilitate liquidity in the futures contracts, the
exchange specifies certain standard features of the contract. It is a standardized contract with
standard underlying instrument, a standard quantity and quality of the underlying instrument
that can be delivered, (or which can be used for reference purposes in settlement) and a
standard timing of such settlement. A futures contract may be offset prior to maturity by
entering into an equal and opposite transaction. The standardized items in a futures contract
are:
• Quantity of the underlying
36
• Quality of the underlying
• The date and the month of delivery
• The units of price quotation and minimum price change
• Location of settlement
Distinction between Futures and Forwards Contracts
Forward contracts are often confused with futures contracts. The confusion is primarily
because both serve essentially the same economic functions of allocating risk in the presence
of future price uncertainty. However futures are a significant improvement over the forward
contracts as they eliminate counterparty risk and offer more liquidity.
FUTURES FORWARDS
Trade on an organized exchange OTC in nature
Standardized contract terms Customized contract terms
More liquid Less liquid
Requires margin payments No margin payment
Follows daily settlement Settlement happens at end of period
The exchange, on which these are traded
becomes counter party and guarantees
settlement.
There is a risk of counter party default
Contract can be reversed on Stock
Exchange.
Contract can be reversed with the same
counter party.
Futures Payoffs
Futures contracts have linear or symmetrical payoffs. It implies that the losses as well as
profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are
fascinating as they can be combined with options and the underlying to generate various
complex payoffs.
Payoff for buyer of futures: Long futures
37
The payoff for a person who buys a futures contract is similar to the payoff for a person who
holds an asset. He has a potentially unlimited upside as well as a potentially unlimited
downside. Take the case of a speculator who buys a two-month Nifty index futures contract
when the Nifty stands at 2220.
The underlying asset in this case is the Nifty portfolio. When the index moves up, the long
futures position starts making profits, and when the index moves down it starts making
losses.
Payoff for a buyer of Nifty futures
The above figure shows the profits/losses for a long futures position. The investor bought
futures when the index was at 2220. If the index goes up, his futures position starts making
profit. If the index falls, his futures position starts showing losses.
Payoff for seller of futures: Short futuresThe payoff for a person who sells a futures contract is similar to the payoff for a person who
shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited
downside. Take the case of a speculator who sells a two-month Nifty index futures contract
when the Nifty stands at 2220. The underlying asset in this case is the Nifty portfolio. When
the index moves down, the short futures position starts making profits, and when the index
moves up, it starts making losses.
38
Payoff for a seller of Nifty futures
The above figure shows the
profits/losses for a short futures position. The investor sold futures when the index was at
2220. If the index goes down, his futures position starts making profit. If the index rises, his
futures position starts showing losses.
Options Contracts
Options are the most recent and evolved derivative contracts. They have non linear or
asymmetrical profit profiles making them fundamentally very different from futures and
forward contracts. Option contracts help a hedger reduce his risk with a much wider variety
of strategies.
An option gives the holder of the option the right to do something in future. The holder does
not have to exercise this right. In contrast, in a forward or futures contract, the two parties
have committed themselves or are obligated to meet their commitments as specified in the
contract. Whereas it costs nothing (except margin requirements) to enter into a futures
contract, the purchase of an option requires an up-front payment. This chapter first introduces
key terms which will enable the reader understand option terminology. Afterwards futures
have been compared with options and then payoff profiles of option contracts have been
defined diagrammatically.
Options are different from futures in several interesting senses. At a practical level, the option
buyer faces an interesting situation. He pays for the option in full at the time it is purchased.
After this, he only has an upside. There is no possibility of the options position generating
39
any further losses to him (other than the funds already paid for the option). This is different
from futures, which is free to enter into, but can generate very large losses. This characteristic
makes options attractive to many occasional market participants, who cannot put in the time
to closely monitor their futures positions.
Comparison between Futures and Options
FUTURES OPTIONS
Exchange traded Same as futures.
Exchange defines the product Same as futures.
Price is zero, strike price moves Strike price is fixed, price moves.
Price is zero Price is always positive.
Linear payoff Nonlinear payoff.
Both long and short at risk Only short at risk.
Options Payoffs
The optionality characteristic of options results in a non-linear payoff for options. It means
that the losses for the buyer of an option are limited; however the profits are potentially
unlimited. For a writer, the payoff is exactly the opposite. Profits are limited to the option
premium; and losses are potentially unlimited. These non-linear payoffs are fascinating as
they lend themselves to be used to generate various payoffs by using combinations of options
and the underlying.
Payoff profile for buyer of call options: Long call
A call option gives the buyer the right to buy the underlying asset at the strike price specified
in the option. The profit/loss that the buyer makes on the option depends on the spot price of
the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit.
Higher the spot price more is the profit. If the spot price of the underlying is less than the
strike price, the option expires un-exercised. The loss in this case is the premium paid for
buying the option. Figure below gives the payoff for the buyer of a three month call option
(often referred to as long call) with a strike of 2250 bought at a premium of 86.60.
40
Payoff for buyer of call option
The figure above shows the profits/losses for the buyer of a three-month Nifty 2250 call
option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon
expiration, Nifty closes above the strike of 2250, the buyer would exercise his option and
profit to the extent of the difference between the Nifty-close and the strike price. The profits
possible on this option are potentially unlimited. However if Nifty falls below the strike of
2250, he lets the option expire. The losses are limited to the extent of the premium paid for
buying the option.
Payoff profile for writer of call options: Short call
A call option gives the buyer the right to buy the underlying asset at the strike price specified
in the option. For selling the option, the writer of the option charges a premium. The
profit/loss that the buyer makes on the option depends on the spot price of the underlying.
Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot price exceeds
the strike price, the buyer will exercise the option on the writer. Hence as the spot price
increases the writer of the option starts making losses. Higher the spot price, more are the
losses. If upon expiration the spot price of the underlying is less than the strike price, the
buyer lets his option expire unexercised and the writer gets to keep the premium. Figure
below gives the payoff for the writer of a three month call option (often referred to as short
call) with a strike of 2250 sold at a premium of 86.60.
41
Payoff for writer of call option
The figure above shows the profits/losses for the seller of a three-month Nifty 2250 call
option. As the spot Nifty rises, the call option is in-the-money and the writer starts making
losses. If upon expiration, Nifty closes above the strike of 2250, the buyer would exercise his
option on the writer who would suffer a loss to the extent of the difference between the Nifty-
close and the strike price. The loss that can be incurred by the writer of the option is
potentially unlimited, whereas the maximum profit is limited to the extent of the up-front
option premium of Rs.86.60 charged by him.
Payoff profile for buyer of put options: Long put
A put option gives the buyer the right to sell the underlying asset at the strike price specified
in the option. The profit/loss that the buyer makes on the option depends on the spot price of
the underlying. If upon expiration, the spot price is below the strike price, there is a profit.
Lower the spot price more is the profit. If the spot price of the underlying is higher than the
strike price, the option expires un-exercised. His loss in this case is the premium he paid for
buying the option. Figure below gives the payoff for the buyer of a three month put option
(often referred to as long put) with a strike of 2250 bought at a premium of 61.70.
42
Payoff for buyer of put option
The above figure shows the profits/losses for the buyer of a three-month Nifty 2250 put
option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon
expiration, Nifty closes below the strike of 2250, the buyer would exercise his option and
profit to the extent of the difference between the strike price and Nifty-close. The profits
possible on this option can be as high as the strike price. However if Nifty rises above the
strike of 2250, the option expires worthless. The losses are limited to the extent of the
premium paid for buying the option.
Payoff profile for writer of put options: Short put
A put option gives the buyer the right to sell the underlying asset at the strike price specified
in the option. For selling the option, the writer of the option charges a premium. The
profit/loss that the buyer makes on the option depends on the spot price of the underlying.
Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot price happens to
be below the strike price, the buyer will exercise the option on the writer. If upon expiration
the spot price of the underlying is more than the strike price, the buyer lets his option go un-
exercised and the writer gets to keep the premium. Figure below gives the payoff for the
writer of a three month put option (often referred to as short put) with a strike of 2250 sold at
a premium of 61.70.
43
Payoff for writer of put option
The above figure shows the profits/losses for the seller of a three-month Nifty 2250 put
option. As the spot Nifty falls, the put option is in-the-money and the writer starts making
losses. If upon expiration, Nifty closes below the strike of 2250, the buyer would exercise his
option on the writer who would suffer a loss to the extent of the difference between the strike
price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum
extent of the strike price (Since the worst that can happen is that the asset price can fall to
zero) whereas the maximum profit is limited to the extent of the up-front option premium of
Rs.61.70 charged by him.
Taxation of Derivative Transaction in Securities
Prior to Financial Year 2005–06, transaction in derivatives were considered as speculative
transactions for the purpose of determination of tax liability under the Income-tax Act. This is
in view of section 43(5) of the Income-tax Act which defined speculative transaction as a
transaction in which a contract for purchase or sale of any commodity, including stocks and
shares, is periodically or ultimately settled otherwise than by the actual delivery or transfer of
the commodity or scripts.
Finance Act, 2005 has amended section 43(5) so as to exclude transactions in derivatives
carried out in a “recognized stock exchange” for this purpose. This implies that income or
loss on derivative transactions which are carried out in a “recognized stock exchange” is not
taxed as speculative income or loss. Thus, loss on derivative transactions can be set off
44
against any other income during the year. In case the same cannot be set off, it can be carried
forward to subsequent assessment year and set off against any other income of the subsequent
year. Such losses can be carried forward for a period of 8 assessment years.
Securities transaction tax on derivatives transactions
As per Chapter VII of the Finance (No. 2) Act, 2004, Securities Transaction Tax (STT) is
levied on all transactions of sale and/or purchase of equity shares and units of equity oriented
fund and sale of derivatives entered into in a recognized stock exchange. As per Finance Act
2008, the following STT rates are applicable w.e.f. 1st June, 2008 in relation to sale of a
derivative, where the transaction of such sale in entered into in a recognized stock exchange.
Sl. No. Taxable securities transaction Rate Payable by
1. Sale of options in securities 0.017% Seller
2. Sale of options in securities,
Where option is exercised. 0.125%
Purchaser
3. Sale of futures in securities 0.017% Seller
45
MUTUAL FUNDS
Concept of Mutual FundMutual funds are a vehicle to mobilize moneys from investors, to invest in different markets
and securities, in line with the investment objectives agreed upon, between the mutual fund
and the investors.
Role of Mutual FundsMutual funds perform different roles for different constituencies:
Their primary role is to assist investors in earning an income or building their wealth, by
participating in the opportunities available in various securities and markets. It is possible for
mutual funds to structure a scheme for any kind of investment objective. Thus, the mutual
fund structure, through its various schemes, makes it possible to tap a large corpus of money
from diverse investors. The money that is raised from investors, ultimately benefits
governments, companies and other entities, directly or indirectly, to raise moneys to invest in
various projects or pay for various expenses.
As a large investor, the mutual funds can keep a check on the operations of the investee
company, their corporate governance and ethical standards.
The projects that are facilitated through such financing, offer employment to people; the
income they earn helps the employees to buy goods and services offered by other companies,
thus supporting projects of these goods and services companies. Thus, overall economic
development is promoted.
The mutual fund industry itself, offers livelihood to a large number of employees of mutual
funds, distributors, registrars and various other service providers. Higher employment,
income and output in the economy boost the revenue collection of the government through
taxes and other means. When these are spent prudently, it promotes further economic
development and nation building.
46
Mutual funds can also act as a market stabilizer, in countering large inflows or outflows from
foreign investors. Mutual funds are therefore viewed as a key participant in the capital market
of any economy.
How do Mutual Fund Schemes Operate?
Mutual fund schemes announce their investment objective and seek investments from the
public. Depending on how the scheme is structured, it may be open to accept money from
investors, either during a limited period only or at any time.
The investment that an investor makes in a scheme is translated into a certain number of
‘Units’ in the scheme. Thus, an investor in a scheme is issued units of the scheme.
Under the law, every unit has a face value of Rs10. The face value is relevant from an
accounting perspective. The number of units multiplied by its face value (Rs10) is the
capital of the scheme – its Unit Capital.
Running the scheme leads to its share of operating expenses
When the investment activity is profitable, the true worth of a unit goes up; when there
are losses, the true worth of a unit goes down. The true worth of a unit of the scheme is
otherwise called Net Asset Value (NAV) of the scheme.
When 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.
The money mobilized from investors is invested by the scheme as per the investment
objective committed. Profits or losses, as the case might be, belong to the investors. The
investor does not however bear a loss higher than the amount invested by them.
Various investors subscribing to an investment objective might have different
expectations on how the profits are to be handled. Some may like it to be paid off
47
regularly as dividends. Others might like the money to grow in the scheme. Mutual funds
address such differential expectations between investors within a scheme, by offering
various options, such as dividend payout option, dividend re-investment option and
growth option.
The relative size of mutual fund companies is assessed by their assets under management
(AUM). When a scheme is first launched, assets under management would be the amount
mobilized from investors. Thereafter, if the scheme has a positive profitability metric, its
AUM goes up; a negative profitability metric will pull it down.
Further, if the scheme is open to receiving money from investors even post-NFO, then
such contributions from investors boost the AUM. Conversely, if the scheme pays any
money to the investors, either as dividend or as consideration for buying back the units of
investors, the AUM falls.
The AUM thus captures the impact of the profitability metric and the flow of unit-holder
money to or from the scheme.
Advantages of Mutual Funds for Investors
1. Professional Management
Mutual funds offer investors the opportunity to earn an income or build their wealth through
professional management of their investible funds. There are several aspects to such
professional management viz. investing in line with the investment objective, investing based
on adequate research, and ensuring that prudent investment processes are followed.
2. Affordable Portfolio Diversification
Units of a scheme give investors exposure to a range of securities held in the investment
portfolio of the scheme. Thus, even a small investment of Rs 5,000 in a mutual fund scheme
can give investors a diversified investment portfolio.
48
With diversification, an investor ensures that all the eggs are not in the same basket.
Consequently, the investor is less likely to lose money on all the investments at the same
time. Thus, diversification helps reduce the risk in investment. In order to achieve the same
diversification as a mutual fund scheme, investors will need to set apart several lakh of
rupees. Instead, they can achieve the diversification through an investment of a few thousand
rupees in a mutual fund scheme.
3. Economies of Scale
The pooling of large sums of money from so many investors makes it possible for the mutual
fund to engage professional managers to manage the investment. Individual investors with
small amounts to invest, cannot, by themselves afford to engage such professional
management.
Large investment corpus leads to various other economies of scale. For instance, costs related
to investment research and office space get spread across investors. Further, the higher
transaction volume makes it possible to negotiate better terms with brokers, bankers and other
service providers.
4. Liquidity
At times, investors in financial markets are stuck with a security for which they can’t find a
buyer –worse; at times they can’t find the company they invested in! Such investments,
whose value the investor cannot easily realise in the market, are technically called illiquid
investments and may result in losses for the investors.
Investors in a mutual fund scheme can recover the value of the moneys invested, from the
mutual fund itself. Depending on the structure of the mutual fund scheme, this would be
possible, either at any time, or during specific intervals, or only on closure of the scheme.
Schemes where the money can be recovered from the mutual fund only on closure of the
scheme are listed in a stock exchange. In such schemes, the investor can sell the units in the
stock exchange to recover the prevailing value of the investment.
49
5. Tax Deferral
Mutual funds are not liable to pay tax on the income they earn. If the same income were to be
earned by the investor directly, then tax may have to be paid for the same financial year.
Mutual funds offer options, whereby the investor can let the moneys grow in the scheme for
several years. By selecting such options, it is possible for the investor to defer the tax
liability. This helps investors to legally build their wealth faster than would have been the
case, if they were to pay tax on the income each year.
6. Tax benefits
Specific schemes of mutual funds (Equity Linked Savings Schemes) gives investors the
benefit of deduction of the amount invested, from their income that is liable to tax. This
reduces their taxable income, and therefore the tax liability. Further, the dividend that the
investor receives from the scheme is tax-free in their hands.
7. Convenient Options
The options offered under a scheme allow investors to structure their investments in line with
their liquidity preference and tax position.
8. Investment Comfort
Once an investment is made with a mutual fund, they make it convenient for the investor to
make further purchases with very little documentation. This simplifies subsequent investment
activity.
9. Regulatory Comfort
The regulator, Securities & Exchange Board of India (SEBI) has mandated strict checks and
balances in the structure of mutual funds and their activities. Mutual fund investors benefits
from such protection.
50
10.Systematic Approach to Investments
Mutual funds also offer facilities that help investor to invest amounts regularly through a
Systematic Investment Plan (SIP); or withdraw amounts regularly through a Systematic
Withdrawal Plan (SWP); or move moneys between different kinds of schemes through a
Systematic Transfer Plan (STP). Such systematic approaches promote an investment
discipline, which is useful in long term wealth creation and protection.
Limitations of a Mutual Fund
1. Lack of Portfolio Customization
Some securities houses offer Portfolio Management Schemes (PMS) to large investors. In a
PMS, the investor has better control over what securities are bought and sold on his behalf.
On the other hand, a unit-holder is just one of several thousand investors in a scheme. Once a
unit-holder has bought into the scheme, investment management is left to the fund manager
(within the broad parameters of the investment objective). Thus, the unit-holder cannot
influence what securities or investments the scheme would buy.
Large sections of investors lack the time or the knowledge to be able to make portfolio
choices. Therefore, lack of portfolio customization is not a serious limitation in most cases.
2. Choice overload
Over 800 mutual fund schemes offered by 38 mutual funds – and multiple options within
those schemes – make it difficult for investors to choose between them. Greater
dissemination of industry information through various media and availability of professional
advisors in the market should help investors handle this overload.
51
3. No control over costs
All the investor's moneys are pooled together in a scheme. Costs incurred for managing the
scheme are shared by all the Unit-holders in proportion to their holding of Units in the
scheme. Therefore, an individual investor has no control over the costs in a scheme.
SEBI has however imposed certain limits on the expenses that can be charged to any scheme.
These limits vary with the size of assets and the nature of the scheme.
Open-Ended Funds, Close-Ended Funds and Interval Funds
Open-ended funds are open for investors to enter or exit at any time, even after the NFO.
When existing investors buy additional units or new investors buy units of the open ended
scheme, it is called a sale transaction. It happens at a sale price, which is equal to the NAV.
When investors choose to return any of their units to the scheme and get back their equivalent
value, it is called a re-purchase transaction. This happens at a re-purchase price that is linked
to the NAV.
Although some unit-holders may exit from the scheme, wholly or partly, the scheme
continues operations with the remaining investors. The scheme does not have any kind of
time frame in which it is to be closed. The ongoing entry and exit of investors implies that the
unit capital in an open-ended fund would keep changing on a regular basis.
Close-ended funds have a fixed maturity. Investors can buy units of a close-ended scheme,
from the fund, only during its NFO. The fund makes arrangements for the units to be traded,
post-NFO in a stock exchange. This is done through a listing of the scheme in a stock
exchange. Such listing is compulsory for close-ended schemes. Therefore, after the NFO,
investors who want to buy Units will have to find a seller for those units in the Stock
Exchange. Similarly, investors who want to sell Units will have to find a buyer for those units
in the stock exchange.
52
Interval funds combine features of both open-ended and close ended schemes. They are
largely close-ended, but become open ended at pre-specified intervals. For instance, an
interval scheme might become open-ended between January 1 to 15, and July 1 to 15, each
year. The benefit for investors is that, unlike in a purely close-ended scheme, they are not
completely dependent on the stock exchange to be able to buy or sell units of the interval
fund.
Minimum duration of an interval period in an interval scheme/plan is 15 days. No
redemption/repurchase of units is allowed except during the specified transaction period (the
period during which both subscription and redemption may be made to and from the scheme).
The specified transaction period will be of minimum 2 working days, as per revised SEBI
Regulations.
Actively Managed Funds and Passive Funds
Actively managed funds are 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.
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.
Since the portfolio is determined by the index itself, the fund manager has no role in deciding
on investments. Therefore, these schemes have low running costs.
Debt, Equity and Hybrid Funds
Schemes with an investment objective that limits them to investments in debt securities like
Treasury Bills, Government Securities, Bonds and Debentures are called debt funds.
53
A scheme might have an investment objective to invest largely in equity shares and equity-
related investments. Such schemes are called equity funds.
Hybrid funds have an investment charter that provides for a reasonable level of investment in
both debt and equity.
Types of Debt Funds
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).
Diversified debt funds on the other hand, invest in a mix of government and non-
government debt securities.
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 the
investee companies makes up for the losses arising out of a few companies defaulting.
Fixed maturity plans are a kind of debt fund where the investment portfolio is closely
aligned to the maturity of the scheme. AMCs tend to structure the scheme around pre-
identified investments. Further, like close-ended schemes, they do not accept moneys post-
NFO. Thanks to these characteristics, the fund manager has little ongoing role in deciding on
the investment options. Such a portfolio construction gives more clarity to investors on the
likely returns if they stay invested in the scheme until its maturity. This helps them compare
the returns with alternative investments like bank deposits.
Floating rate funds invest largely in floating rate debt securities i.e. debt securities where
the interest rate payable by the issuer changes in line with the market. For example, a debt
security where interest payable is described as ‘5-year Government Security yield plus 1%’,
will pay interest rate of 7%, when the 5- year Government Security yield is 6%; if 5-year
Government Security yield goes down to 3%, then only 4% interest will be payable on that
54
debt security. The NAVs of such schemes fluctuate lesser than debt funds that invest more in
debt securities offering a fixed rate of interest.
Liquid schemes or money market schemes are a variant of debt schemes that invest only in
debt securities where the moneys will be repaid within 91-days. These are widely recognized
to be the lowest in risk among all kinds of mutual fund schemes.
Types of 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), 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.
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. Most arbitrage funds take
contrary positions between the equity market and the futures and options market.
55
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.
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. The investment is structured, such that the principal amount invested in
the zero-coupon security together with the interest that accumulates during the period of the
scheme would grow to the amount that the investor invested at the start.
Suppose an investor invested Rs 10,000 in a capital protected scheme of 5 years. If 5-year
government securities yield 7% at that time, then an amount of Rs 7,129.86 invested in 5-year
zero coupon government securities would mature to Rs 10,000 in 5 years. Thus, by investing
Rs. 7,129.86 in the 5-year zero-coupon government security, the scheme ensures that it will
have Rs 10,000 to repay to the investor in 5 years. After investing in the government security,
Rs 2,870.14 is left over (Rs 10,000 invested by the investor, less Rs 7129.86 invested in
government securities). This amount is invested in riskier securities like equities. Even if the
risky investment becomes completely worthless (a rare possibility), the investor is assured of
getting back the principal invested, out of the maturity moneys received on the government
security.
Gold FundsThese funds invest in gold and gold-related securities in either of the following formats:
Gold Exchange Traded Fund, which is like an index fund that invests in gold. 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
56
closely linked to the profitability and gold reserves of the companies. Therefore, NAV of
these funds do not closely mirror gold prices.
Real Estate FundsThey 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.
Commodity FundsCommodities, as an asset class, include:
• Food crops like wheat and chana
• Spices like pepper and turmeric
• Precious metals (bullion) like gold and silver
The investment objective of commodity funds would specify which of these commodities it
proposes to invest in. 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.
International Funds
These are funds that invest outside the country. For instance, a mutual fund may offer a
scheme to investors in India, with an investment objective to invest abroad.
One way for the fund to manage the investment is to hire the requisite people who will
manage the fund. Since their salaries would add to the fixed costs of managing the fund, it
can be justified only if a large corpus of funds is available for such investment.
An alternative route would be to tie up with a foreign fund (called the host fund). If an Indian
mutual fund sees potential in China, it will tie up with a Chinese fund. In India, it will launch
57
what is called a feeder fund. Investors in India will invest in the feeder fund. The moneys
collected in the feeder fund would be invested in the Chinese host fund. Thus, when the
Chinese market does well, the Chinese host fund would do well, and the feeder fund in India
will follow suit.
Such feeder funds can be used for any kind of international investment. The investment could
be specific to a country (like the China fund) or diversified across countries. A feeder fund
can be aligned to any host fund with any investment objective in any part of the world,
subject to legal restrictions of India and the other country.
In such schemes, the local investors invest in rupees for buying the Units. The rupees are
converted into foreign currency for investing abroad. They need to be re-converted into
rupees when the moneys are to be paid back to the local investors. Since the future foreign
currency rates cannot be predicted today, there is an element of foreign currency risk.
Investor's total return in such schemes will depend on how the international investment
performs, as well as how the foreign currency performs. Weakness in the foreign currency
can pull down the investors' overall return.
Fund of Funds
The feeder fund was an example of a fund that invests in another fund. Similarly, 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.
Thus, an investor invests in a fund of funds, which in turn will manage the investments in
various schemes and options in the market.
Exchange Traded Funds
58
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.
Other investors will have to buy and sell units of the ETF in the stock exchange. In order to
facilitate such transactions in the stock market, the mutual fund appoints some intermediaries
as market makers, whose job is to offer a price quote for buying and selling units at all times.
If more investors in the stock exchange want to buy units of the ETF, then their moneys
would be due to the market maker. The market maker would use the moneys to buy a basket
of securities that is in line with the investment objective of the scheme, and exchange the
same for chapters of the scheme from the mutual fund. Thus, the market maker can offer the
units to the investors.
If there is more selling interest in the stock exchange, then the market maker will end up with
units, against which he needs to make payment to the investors. When these units are offered
to the mutual fund for extinguishment, corresponding securities will be released from the
investment portfolio of the scheme. Sale of the released securities will generate the liquidity
to pay the unit holders for the units sold by them.
In a regular open-ended mutual fund, all the purchases of units by investors on a day happen
at a single price. Similarly, all the sales of units by investors on a day happen at a single
price. The market however keeps fluctuating during the day. A key benefit of an ETF is that
investors can buy and sell their units in the stock exchange, at various prices during the day
that closely track the market at that time. Further, the unique structure of ETFs, make them
more cost-effective than normal index funds, although the investor would bear a brokerage
cost when he transacts with the market maker
Dividend Payout, Growth and Dividend Re-Investment Options
59
Most mutual fund schemes offer two options – Dividend and Growth. A third option which is
possible is the Dividend reinvestment Option. These are different options within a scheme;
they share the same portfolio. Therefore the portfolio returns are the same for all three
options. However, they differ in the structure of cash flows and income accruals for the unit-
holder, and therefore, the Unit-holder’s taxability, number of units held and value of those
units.
In a dividend payout option, the fund declares a dividend from time to time. When a dividend
is paid, the NAV of the units falls to that extent. Debt schemes need to pay an income
distribution tax on the dividend distributed. This tax payment too reduces the NAV. The
reduced NAV, after a dividend payout is called ex-Dividend NAV. After a dividend is
announced, and until it is paid out, it is referred to as cum-Dividend NAV. In a dividend
payout option, the investor receives the dividend in his bank account. However, the dividend
payout does not change the number of units held by the investor. The dividend received in the
hands of the investor does not bear any tax.
In a dividend re-investment option, as in the case of dividend payout option, NAV declines to
the extent of dividend and income distribution tax. The resulting NAV is called ex-dividend
NAV. However, the investor does not receive the dividend in his bank account; the amount is
re-invested in the same scheme.
Dividend is not declared in a growth option. Therefore, nothing is received in the bank
account (unlike dividend payout option) and there is nothing to re-invest (unlike dividend re-
investment option). In the absence of dividend, there is no question of income distribution
tax. The NAV would therefore capture the full value of portfolio gains.
Systematic Investment Plan (SIP)
It is considered a good practice to invest regularly. SIP is an approach where the investor
invests constant amounts at regular intervals. A benefit of such an approach, particularly in
equity schemes, is that it averages the unit-holder’s cost of acquisition.
60
Suppose an investor were to invest Rs 1,000 per month for 6 months. If, in the first month,
the NAV is Rs 10, the investor will be allotted Rs 1,000 ÷ Rs 10 i.e. 100 units. In the second
month, if the NAV has gone up to Rs 12, the allotment of units will go down to Rs 1,000 ÷
Rs 12 i.e.83.333 units. If the NAV goes down to Rs 9 in the following month, the unit-holder
will be allotted a higher number of Rs 1,000 ÷ Rs 9 i.e. 111.111 units.
Thus, the investor acquires his Units closer to the average of the NAV on the 6 transaction
dates during the 6 month period – a reason why this approach is also called Rupee Cost
Averaging.
Through an SIP, the investor does not end up in the unfortunate position of acquiring all the
units in a market peak. Mutual funds make it convenient for investors to lock into SIPs by
investing through Post-Dated Cheques (PDCs), ECS or standing instructions.
Systematic Withdrawal Plan
Just as investors do not want to buy all their units at a market peak, they do not want all their
units redeemed in a market trough. Investors can therefore opt for the safer route of offering
for repurchase, a constant value of units.
Suppose an investor were to offer for re-purchase Rs 1,000 per month for 6 months. If, in the
first month, the NAV is Rs 10, the investor’s unit-holding will be reduced by Rs 1,000 ÷ Rs
10 i.e. 100 units. In the second month, if the NAV has gone up to Rs 12, the unit-holding will
go down by fewer units viz. Rs 1,000 ÷ Rs 12 i.e. 83.333 units. If the NAV goes down to Rs
9 in the following month, the unit-holder will be offering for re-purchase a higher number of
units viz. Rs 1,000 ÷ Rs 9 i.e. 111.111 units. Thus, the investor repurchases his Units at an
average NAV during the 6 month period. The investor does not end up in the unfortunate
position of exiting all the units in a market trough.
Mutual funds make it convenient for investors to manage their SWPs by indicating the
amount, periodicity (generally, monthly) and period for their SWP. Some schemes even offer
the facility of transferring only the appreciation or the dividend. Accordingly, the mutual
61
fund will re-purchase the appropriate number of units of the unit-holder, without the
formality of having to give a re-purchase instruction for each transaction.
Systematic Transfer Plan
This is a variation of SWP. While in a SWP the constant amount is paid to the investor at the
pre-specified frequency, in a STP, the amount which is withdrawn from a scheme is re-
invested in some other scheme of the same mutual fund. Thus, it operates as a SWP from the
first scheme, and a SIP into the second scheme.
Since the investor is effectively switching between schemes, it is also called “switch”. If the
unit-holder were to do this SWP and SIP as separate transactions
• The Unit-holder ends up waiting for funds during the time period that it takes to receive the
re-purchase proceeds, and has idle funds, during the time it takes to re-invest in the second
scheme. During this period, the market movements can be adverse for the unit-holder.
• The Unit-holder has do two sets of paper work (Sale and Repurchase) for every period.
Taxability of Mutual Fund
The mutual fund trust is exempt from tax. The trustee company will however pay tax in the
normal course on its profits. For example, SBI Mutual Fund is exempt from tax; SBI Mutual
Fund Trustee Company however is liable to tax.
Some aspects of taxation of schemes are dependent on the nature of the scheme. The
definitions under the Income Tax Act, for the purpose are as follows:
Equity-oriented scheme is a mutual fund scheme where at least 65% of the assets are invested
in equity shares of domestic companies. For calculating this percentage, first the average of
opening and closing percentage is calculated for each month. Then the average of such value
is taken for the 12 months in the financial year.
For Money market mutual funds / Liquid schemes, income tax goes by the SEBI definition,
which says that such schemes are set up with the objective of investing exclusively in money
market instruments (i.e. short term debt securities).
62
Securities Transaction Tax (STT)
This is a tax on the value of transactions in equity shares, derivatives and equity mutual fund
units. Applicability is as follows:
On equity-oriented schemes of mutual funds
Rate
On purchase of equity shares in stock exchange 0.125%
On sale of equity shares in stock exchange 0.125%
On sale of futures & options in stock exchange 0.017%
On investors in equity oriented schemes of mutual fund
Rate
On purchase of the units in stock exchange 0.125%
On sale of the units in stock exchange 0.125%
On re-purchase of units (by AMC) 0.250%
STT is not payable on transactions in debt or debt-oriented mutual fund units.
Additional Tax on Income DistributedThis is a tax on dividend distributed by debt-oriented mutual fund schemes. Applicability is
as follows:
Money Market Mutual Funds / Liquid Schemes:
25% + Surcharge + Education Cess
63
Other debt funds (investors who are individual / HUF):
12.5% + Surcharge + Education Cess
Other debt funds (other investors):
20% + Surcharge + Education Cess
This additional tax on income distributed (referred to in the market as dividend distribution
tax) is not payable on dividend distributed by equity-oriented mutual fund schemes. Dividend
Distribution Tax (DDT) on dividends distributed to corporate investors by all categories of
debt funds have been increased to 30%, w.e.f. June 1, 2011.
Capital Gains Tax
Capital Gain is the difference between sale price and acquisition cost of the investment. Since
mutual funds are exempt from tax, the schemes do not pay a tax on the capital gains they
earn. Investors in mutual fund schemes however need to pay a tax on their capital gains as
follows:
Equity-oriented schemes
• Nil – on Long Term Capital Gains (i.e. if investment was held for more than a year) arising
out of transactions, where STT has been paid
• 15% plus surcharge plus Education Cess – on Short Term Capital Gains (i.e. if investment
was held for 1 year or less) arising out of transactions, where STT has been paid
• Where STT is not paid, the taxation is similar to debt-oriented schemes
Debt-oriented schemes
• Short Term Capital Gains (i.e. if investment was held for 1 year or less) are added to the
income of the investor. Thus, they get taxed as per the tax slabs applicable. An investor
whose income is above that prescribed for 20% taxation would end up bearing tax at 30%.
64
Investors in lower tax slabs would bear tax at lower rates. Thus, what is applicable is the
marginal rate of tax of the investor.
• In the case of Long Term Capital Gain (i.e. if investment was held for more than 1 year),
investor pays tax at the lower of the following:
10% plus surcharge plus Education Cess, without indexation
20% plus surcharge plus Education Cess, with indexation
Indexation means that the cost of acquisition is adjusted upwards to reflect the impact of
inflation. The government comes out with an index number for every financial year to
facilitate this calculation.
For example, if the investor bought units of a debt-oriented mutual fund scheme at Rs 10 and
sold them at Rs 15, after a period of over a year. Assume the government’s inflation index
number was 400 for the year in which the units were bought; and 440 for the year in which
the units were sold. The investor would need to pay tax on the lower of the following:
• 10%, without indexation viz. 10% X (Rs 15 minus Rs 10) i.e. Rs 0.50 per unit
• 20%, with indexation.
Indexed cost of acquisition is Rs 10 X 440 ÷ 400 i.e. Rs11. The capital gains post indexation
is Rs 15 minus Rs 11 i.e. Rs 4 per unit. 20% tax on this would mean a tax of Rs 0.80 per unit.
The investor would pay the lower of the two taxes i.e. Rs0.50 per unit.
Wealth TaxInvestments in mutual fund units are exempt from Wealth Tax.
65
INSURANCE
Introduction
It is the wish of most individuals to have enough assets, so that one can meet life’s necessities
and luxuries. Individual save to provide for these necessities and luxuries. The earning power
of an individual is reduced in retirement or by unforeseen disability or for any unexpected
happening. Many individuals also love to leave enough assets to assure continuation of these
necessities and luxuries to their dependents. Insurance takes care of these risks. Insurance
allows a person to join a large group of people to share losses. The group guarantees to pay a
sum of money to the person, to his family or to other beneficiaries as intended by the insured
upon the happening of an uncertain specified event like death, fire, etc. In return, the person
pays an agreed risk premium, also called premium to the insurance company. Japanese ranks
first in life insurance ownership in the world, while USA and Canada are second and third.
What is Insurance?Insurance is risk transfer mechanism wherein insured transfers the risk of unexpected
financial loss to insurers by paying premium.
66
An individual buys an insurance policyIndividual pays a premium to the insurance companyThe insurer agrees to pay a specifies amount of money in case of a loss.
Types of Insurance
Insurance can be broadly classified into two categories:
Life Insurance
Life insurance is a contract between an insurance policy holder and an insurer, where the
insurer promises to pay a designated beneficiary sum of money upon the death of the insured
person.
Life insurance deals with two risks that an individual faces
a) Dying prematurely, leaving a dependent family and
b) Living long without adequate means of support.
It enables the head or earning member of the family to discharge the sense of responsibility
that he feels for those dependent on him.
Life insurance includes Term insurance, Whole life insurance, Endowment plan, Money back
plan, Annuities and pension and Unit linked insurance plans.
67
Types on InsuranceLife InsuranceGeneral InsuranceMotor InsuranceFire InsuranceHealth InsuranceMarine Insurance
Advantages
1. Mental peace
The most important benefit of life insurance is that it assures mental peace. When a person
goes for life insurance, he and his family are relieved from worries of future. Thus, it ensures
mental peace.
2. Financial Security
The policy of life insurance provides economical security to the family of the policy holder in
case of death of the breadwinner. On occurrence of this unfortunate event, the family is
forced with a cash crunch. But by availing a life insurance policy, this problem of cash
crunch is solved by a lump sum amount paid by the insurer.
3. Loan in case of need
There are circumstances in life when the individual needs funds but is unable to get from
various sources. The life insurance policy also provides a solution to this problem as loan can
be taken against the policy and need not be repaid as the loan amount is deducted from the
police value on maturity.
4. Cover for whole life
The life insurance policy provides coverage for the whole life of the policyholder. It also
provides protection in cases of serious illness.
5. Tax-free source of savings
In addition it is a source of savings which is completely tax-free
6. Source of mitigating certain liabilities
The life insurance policy provides a great source to satisfy certain needs and liabilities like
loans and mortgages.
68
7. Maintenance of living standard
The life insurance policy helps in maintaining the living standard of the family even after the
death of the breadwinner by providing financial benefits to the family.
8. Enhanced coverage
The policy provides enhanced coverage by providing for medical benefits.
Disadvantages
1. Expensive
The life insurance can prove to be a costly affair, particularly when suffering from illness and
regarded by insurers as High Risk due to some reasons like old age etc.
2. Irrelevant in case of no-family person
The life insurance policy is irrelevant for an individual who is not having any family or
dependents
3. Increasing premiums
The premium payable increases with the increase in age. But the income gradually decreases
which makes it difficult to strike a balance.
4. No benefit in case of long life
Some policies do not provide any cash benefit on the policy holder surviving the policy term.
In that case, amount paid for premiums is wasted.
General Insurance
Any insurance other than ‘Life Insurance’ falls under the classification of General Insurance.
It comprises of:-
69
• Insurance of property against fire, theft, burglary, terrorism, natural disasters etc
• Personal insurance such as Accident Policy, Health Insurance and liability insurance which
covers legal liabilities.
• Errors and Omissions Insurance for professionals, credit insurance etc.
• Policy covers such as coverage of machinery against breakdown or loss or damage during
the transit.
• Policies that provide marine insurance covering goods in transit by sea, air, railways,
waterways and road and cover the hull of ships.
• Insurance of motor vehicles against damages or accidents and theft.
Types of life insurance
Depending on their objectives, there are at least three types of life insurance policy
classifications.
A life insurance policy could offer pure protection (insurance), another variant could offer
protection as well as investment while some others could offer only investment. In India, life
insurance has been used more for investment purposes than for protection in one’s overall
financial planning.
1. Pure Insurance Products
Term Plans
In the pure insurance category, there is only one product available which is called term
insurance. Term insurance policy covers only the risk of your dying and provides temporary
protection. Insured pays premium year on year to the insurance company and if he dies, the
insurance amount, called the Sum Assured, is paid out to the nominees. If he survives, he
won’t get anything and lose the yearly premiums paid.
Since everything insured pays goes towards covering the risk on life, term insurance is the
cheapest. There is no investment clubbed with a pure term insurance plan.
70
There is a variant of term insurance called level term insurance, decreasing term insurance,
increasing term insurance, renewable term insurance, convertible term insurance and term-
insurance-with-return-of-premium.
2. Insurance-cum-Investment Products
As the name goes, these are plans that provide insurance and along with it return on
investments.
Endowment Plans
Endowment plans are policies wherein premium is paid by policyholder for defined term and
benefits are either payable on claim or maturity. In most endowment plans, premium payment
term is equal to term of the policy. A bonus is added to the base policy every year depending
upon the investment and mortality experience of Life Insurance Company. The policy owner
has no control over the investment pattern of the premiums paid by him. Majority of
investments are made in government securities and other debt products. This result is
conservative returns derived from such investments.
Policyholder on survival receives sum assured with total bonus declared under the policy
during the term of the policy. On death Nominees receive the sum assured along with
accumulated bonus up to date of the claim.
There are two types endowment policies are without-profit endowment plans and with-profit
endowment plans.
Money-back plans
Money-back plans are variants of endowment plans with one difference – the payout can be
staggered through the policy term. Some part of the sum assured is returned to the
policyholder at periodic intervals through the policy tenure. In case of death, the full sum
assured is paid out irrespective of the payouts already made.
Bonus is also calculated on the full sum assured and not the balance money left. Because of
these two reasons, premiums on money-back plans are higher than endowment plans.
71
Whole-life plans
Term plans, endowment plans and money back plans offer insurance cover till a specified
age, generally 70 years. Whole-life plans provide cover throughout your life. Usually, the
policyholder is given an option to pay premiums till a certain age or a specified period (called
maturity age).
The primary advantages of whole life are guaranteed death benefit, guaranteed cash values,
fixed and known annual premiums, access to cash values and the fact that mortality and
expense charges will not reduce the cash value shown in the policy. The primary
disadvantage is premium inflexibility and internal rate of return in the policy may not be
competitive with other savings alternatives.
On reaching the maturity age, the policyholder has the option to continue the cover till death
without paying any premium or encashing the sum assured and bonuses.
Unit-linked insurance plans (ULIP)
In all the above mentioned insurance-cum-investment products, you have no say on where
your money is invested. To keep your money safe, most of these products will invest in debt.
Unit-linked insurance plans give you greater control on where your premium can be invested.
Think of them like mutual funds. The annual premium that policyholder pays can be invested
in various types of funds that invests in debt and equity in a proportion that suits all types of
investors. One can also switch from one fund plan to another freely and can also monitor the
performance of your plan easily.
3. Investment Products
Pension Plans
Pension plans are investment options that let you set up an income stream in your post
retirement years by giving away your savings to an insurance company who invests it on your
behalf for a fee. The returns you get depends on a host of factors like how much you
contributed and when is it that you started, the number of years when you want the money to
come to you and at what age that starts.
72
When you buy the pension plan contract, if the payment to you (called annuity) starts
immediately it is called an immediate annuity contract. However, if the payout starts after
some years of deferment, it is called a deferred annuity.
Taxation
Income Tax
Sections
Benefit
U/S 80C Premium paid up to maximum of Rs.100000 subject to maximum 20%
of Capital sum assured under traditional & unit linked plans in life
insurance. Sec 80CCC is now part of Sec80C.
a) Insurance policies which provide benefit u/s 80C attracts no
tax at the time of maturity payment, subject to sum assured
being in excess of 5 times of annual premium paid.
b) Insurance policies which provide u/s 80CCC attracts taxation
at the time of maturity or withdrawal as per following
1. Annuity received is taxable
2. 1/3rd of the maturity amount if commuted on maturity is tax
free.
U/S 80CCC The premium paid towards pension plans qualifies for tax benefits u/s
80CCC. The maximum amount that can be invested under this section
is Rs.100000.
a) Surrender value received is taxable in the year of receipt in the
hands of the assessee or nominee.
b) If deduction is claimed under 80CCC, pension received will be
taxable in the hands of assessee of the nominee in the year of
receipt.
U/S 80D The qualifying amounts under section 80D up to Rs.15000. However,
a higher amount up to Rs.20000 is permitted if the person is aged 65
years or more at any time during the financial year in which the
premium was paid. Such amounts of premium paid would be allowed
73
as deduction from total income of the assessee. This benefit is
available for standalone health insurance policy and health insurance
riders taken with life insurance policies.
U/S 80DD Premiums paid under plans exclusively for physically handicapped
persons up to Rs.50000. In case of severe disability as certified &
issued by medical authority up to Rs.100000
U/S 10(10D) a) Maturity benefits are tax-free. However in cases where
premium exceeds 20% of capital sum assured within a year,
benefits paid in excess of premium paid will be taxable.
b) Death benefits are tax free.
ALTERNATIVE INVESTMENTS
74
Alternative investments can be defined as investments, which are not from the universe of
traditional investments. Traditional investments, are investments availed by masses for a long
period of time. For example: direct equity investment, bank savings, small savings scheme,
real estate, etc. Alternative investments are complex in nature and extremely difficult to
analyze.
The primary benefit that alternative investing offers to an otherwise traditional portfolio of
financial assets is diversification. Many alternative investment strategies have extremely low
correlations to price movements as compared to traditional financial securities. Maintaining a
portion of a portfolio in assets whose returns are somewhat independent of the financial
markets can be enticing from a risk control standpoint, especially when financial markets
become overvalued. While opportunity for high returns might exist within the alternative
investment arena, the primary reason to consider alternatives is for diversification and risk
control.
Real estate, Coins, Stamps & Books, Fine Art, Wine, Antiques, Precious Metals, Vehicles,
Private equity, etc are all example of alternative investments. However alternative investment
comes with some warranties:-
a) Alternative investment segment mainly comprises the products, which are unregulated
without any set of investment, buying selling module and thus is subject to risk in the
manner of fraud and theft.
b) Being an unregulated market, these investments suffer from transparency in disclosing the
style and the methodology of investment and in publishing the portfolio. They also lack in
legal reporting requirements.
c) Deciding and finding alternative investment is complicated and equally difficult is to
arrive at allocation, which can be marked for these investments. This is because historical
data, investment strategies and more details about them are not available and thus a
thorough research and understanding of investment is required to decide on these.
d) Being unregulated and the absence of historical data, it becomes very difficult to analyze
performance as also there can a widening gap of investment performance compared to
75
investment avenues which are regulated. Transparency bridges the gap between
performances.
e) Liquidity is a big issue in alternative investments. It may not be suitable for a retail
investor to get into these investments because of the fact of limited liquidity.
f) Being unregulated, issues like legal, tax and operational issues must be sorted out before
investment.
Art
Although the concept of investing in art is relatively new in India, art has always been a
viable investment option in the west. Art investment in India is gaining momentum with the
works of M.F Husain, Tyeb Mehta and F.N Souza being lapped up by international
collectors. FN Souza’s work ‘the Birth’ sold for $2.3 million, setting records in valuing
Indian art. MF Husain and SH Raza are currently valued anywhere from $200,000 to $1
million. The growth in Indian contemporary art also reflects the same trend. The prices of
works of several famous artists like CF John, TM Azis, Yusuf Arakkal, Atul Dodiya have
increased considerably since Indian art reached the international stage.
Art and antiques are extremely vulnerable to fluctuations in public tastes and other factors, so
they are considered high-risk, speculative investments. Most investment consultants feel that
one should invest in art and antiques primarily because one likes them, and only secondarily
because they may return a profit. Also not more than 10-15 percent of the value of the
investment portfolio should not be kept into art and antiques.
Advantages
i. It survives economic downturn. However, lower priced categories react quickly to
worsening economic environment. An economic slowdown causes drop in demand and an
increase in supply, leading to forced selling. This, however, does not apply at all or only
rarely to artworks in the top price category. Consequently, top-quality art tends to be
more stable than most financial investments in difficult times.
76
ii. The long term trend for art prices would tend to be upward simply because art is a scarce
product and not reproducible at will. Rising incomes over the long-term ensure a steady
rise in demand for works of art against falling supply.
iii. Art and antiques popularity as an investment option arises due to its low correlation with
other financial assets.
Limitations
i. Successful investment in art requires not only extensive know-how about the artistic
quality and authenticity but also the peculiar nuances of the art market. As each work of
art is different, the markets are everything but transparent. Evaluating quality and price
requires knowledge of the market inside out.
ii. Investment horizons typically run for years or even decades, and the market is generally
illiquid, which significantly limits an investors' ability to convert a holding to cash.
iii. Transaction costs (auction fees, appraisal fees, insurance, handling costs etc.) are by far
larger than in other markets. Though there has been increase in availability of and access
to data from art-research firms, websites dedicated to prices of art, indices of the art
market and art auctions, it is far from adequate.
iv. The main trouble with investing in art is that it is almost impossible to identify an
intrinsic value. When evaluating individual purchases, there are few risks that may not
arise when investing in securities.
For example, there is no official registration office or certification authority that can
authenticate the ownership of individual artworks. Other transaction risks include absence
of clear title, forgery, mislabeling, and auction fraud.
v. The increase in the market rate of an art piece is also quite subjective and unpredictable –
two contemporary paintings of different style or similar style paintings done in different
periods by the same artist and of identical size and subject fetch drastically different
77
prices. Market price is not entirely a function of demand and supply, but is considerably
determined by what the critics and curators have to say about the value of the piece. And
until the piece is sold, there is no income the investor receives like dividend in equity or
interest in bonds. It is in the end an unregulated market.
vi. The minimum investment needed to begin investing in art is quite high and therefore this
route is available to only very high net worth individuals.
Investing In Gold
Gold was in use as a form of money, in one form or another, at least from 100% BC until the
end of the Bretton Woods system in 1971. It was used as a store of value both by individuals
and countries for much of that period. However in recent times it is still considered as a store
of value, a safe haven, anti inflationary and as an insurance in crisis situations.
Considering its high density and high value per unit mass, storing and transporting gold is
very easy. Gold also does not corrode. Gold has the potential for appreciation (or
depreciation), but lacks the two other components of total return: interest and compound
interest. Besides physical gold now gold can be purchased through a gold exchange traded
fund or in the form of gold certificate.
Why own Gold?
There are six primary reasons why investors own gold:
a. As a hedge against inflation.
b. As a hedge against a declining dollar.
c. As a safe haven in times of geopolitical and financial market instability.
d. As a commodity, based on gold’s supply and demand fundamentals.
e. As a store of value.
f. As a portfolio diversifier.
Gold is a monetary metal whose price is determined by inflation, by fluctuations in the dollar
and U.S. stocks, by currency-related crises, interest rate volatility and international tensions,
and by increases or decreases in the prices of other commodities.
78
The price of gold reacts to supply and demand changes and can be influenced by consumer
spending and overall levels of affluence. Gold is different from other precious metals such as
platinum, palladium and silver because the demand for these precious metals arises
principally from their industrial applications.
Gold is produced primarily for accumulation; other commodities are produced primarily for
consumption. Gold’s value does not arise from its usefulness in industrial or consumable
applications. It arises from its use and worldwide acceptance as a store of value. Gold is
money. In contrast to other commodities, gold does not perish, tarnish or corrode, nor does
gold have quality grades. Gold mined thousands of years ago is no different from gold mined
today.
Real Estate
The most basic definition real estate is "an interest in land". Broadening that definition
somewhat, the word "interest" can mean either an ownership interest leasehold interest. In an
ownership interest, the investor is entitled to the full rights of ownership of the land and must
also assume the risks and responsibilities of a landowner. On the other side of the
relationship, a leasehold interest only exists when a landowner agrees to pass some of his
rights on to a tenant in exchange for a payment of rent. If you rent an apartment, you have a
leasehold interest in real estate. If you own a home, you have an ownership interest in that
home.
As a real estate investor, you will most likely be purchasing ownership interests and then
earning a return on that investment by issuing leasehold interests to tenants, who will in turn
pay rent.
Real estate that generates income or is otherwise intended for investment purposes rather than
as a primary residence. It is common for investors to own multiple pieces of real estate, one
of which serves as a primary residence, while the others are used to generate rental income
and profits through price appreciation. The tax implications for investment real estate are
often different than those for residential real estate.
Characteristics of Real Estate Investments
79
One of the beneficial features of real estate is that it produces relatively consistent total
returns that are a hybrid of income and capital growth. In that sense, real estate has a coupon-
paying bond-like component in that it pays a regular, steady income stream, and it has a
stock-like component in that its value has a propensity to fluctuate.
The income return from real estate is directly linked to the rent payments received from
tenants, minus the costs of operating the property and outgoing mortgage/financing
payments. Your ability to keep the building full depends on the strength of the leasing market
- that is, the supply and demand for space similar to the space you are trying to lease. In
weaker markets with oversupply of vacancies or poor demand, you would have to charge less
rent to keep your building full than in a strong leasing market. And unfortunately, if your
rents are lower, your income returns are lower.
Capital appreciation of a property is determined by having the property appraised. If the
appraiser thinks your property would sell for more than you bought it for, then you've
achieved a positive capital return. Because the appraiser uses past transactions in judging
values, capital returns are directly linked to the performance of the investment sales market
Other Characteristics
Some of the other characteristics that make real estate unique as compared to other
investment alternatives are as follows:
1. No fixed maturity
Unlike a bond which has a fixed maturity date, an equity real estate investment does not
normally mature. This attribute of real estate allows an owner to buy a property, execute a
business plan, then dispose of the property whenever appropriate. An exception to this
characteristic is an investment in fixed-term debt; by definition a mortgage would have a
fixed maturity.
2. Tangible
Real estate is tangible. You can visit your investment, speak with your tenants, and show it
off to your family and friends. You can see it and touch it. A result of this attribute is that you
80
have a certain degree of physical control over the investment - if something is wrong with it,
you can try fixing it. You can't do that with a stock or bond.
3. Requires Management
Because real estate is tangible, it needs to be managed in a hands-on manner. Tenant
complaints must be addressed. Landscaping must be handled. And, when the building starts
to age, it needs to be renovated.
4. Inefficient Markets
An inefficient market is not necessarily a bad thing. It just means that information asymmetry
exists among participants in the market, allowing greater profits to be made by those with
special information, expertise or resources. In contrast, public stock markets are much more
efficient - information is efficiently disseminated among market participants, and those with
material non-public information are not permitted to trade upon the information. In the real
estate markets, information is king, and can allow an investor to see profit opportunities that
might otherwise not have presented themselves.
5. High Transaction Costs
Private market real estate has high purchase costs and sale costs. On purchases, there are real-
estate-agent-related commissions, lawyers' fees, engineers' fees and many other costs that can
raise the effective purchase price well beyond the price the seller will actually receive. On
sales, a substantial brokerage fee is usually required for the property to be properly exposed
to the market. Because of the high costs of “trading” real estate, longer holding periods are
common and speculative trading is rarer than for stocks.
6. Lower Liquidity
With the exception of real estate securities, no public exchange exists for the trading of real
estate. This makes real estate more difficult to sell because deals must be privately brokered.
There can be a substantial lag between the time you decide to sell a property and when it
actually is sold - usually a couple months at least.
7. Underlying Tenant Quality
81
When assessing an income-producing property, an important consideration is the quality of
the underlying tenancy. This is important because when you purchase the property, you're
buying two things: the physical real estate, and the income stream from the tenants. If the
tenants are likely to default on their monthly obligation, the risk of the investment is greater.
8. Variability among Regions
While it sounds cliché, location is one of the important aspects of real estate investments; a
piece of real estate can perform very differently among countries, regions, cities and even
within the same city. These regional differences need to be considered when making an
investment, because your selection of which market to invest in has as large an impact on
your eventual returns as your choice of property within the market.
Benefits of Investing in Real Estate
a) Diversification Value
The positive aspects of diversifying your portfolio in terms of asset allocation are well
documented. Real estate returns have relatively low correlations with other asset classes
(traditional investment vehicles such as stocks and bonds), which adds to the diversification
of your portfolio.
b) Yield Enhancement
As part of a portfolio, real estate allows you to achieve higher returns for a given level of
portfolio risk. Similarly, by adding real estate to a portfolio you could maintain your portfolio
returns while decreasing risk.
c) Inflation Hedge
Real estate returns are directly linked to the rents that are received from tenants. Some leases
contain provisions for rent increases to be indexed to inflation. In other cases, rental rates are
increased whenever a lease term expires and the tenant is renewed. Either way, real estate
income tends to increase faster in inflationary environments, allowing an investor to maintain
its real returns.
82
d) Ability to Influence Performance
Real estate is a tangible asset. As a result, an investor can do things to a property to increase
its value or improve its performance. Examples of such activities include: replacing a leaky
roof, improving the exterior and re-tenanting the building with higher quality tenants. An
investor has a greater degree of control over the performance of a real estate investment than
other types of investments.
Taxation
House can be classified as a capital asset and as such any gains or loss on dealing of house
property is called as capital gains. Capital gains on sale of house property may be long term
or short term. Exemptions are available only in case of long term capital gains.
Asset Short term Long term
Equity shares, mutual fund
units, zero coupon bond.
Held for 12 months or less Held for more than 12
months
Other assets like jewellery,
land, property.
Held for 36 months or less Held for more than 36
months
Exemption under section 54
Conditions for exemption u/s 54
Only individuals and HUF assesses are eligible for this exemption.
The residential house property which is transferred should be held by the owner for more
than three years.
The assessee should purchase a new residential house property within one year before or
within two years after from the date of transfer of previous residential property or
construct a new residential house property within three years from the date of transfer of
previous residential property.
The amount of exemption is cost of new residential house or capital gains whichever is
less. In other words for availing total exemption at least the capital gains have to be
invested in purchase/construction of new house.
Conditions for exemption u/s 54EC
83
If capital gains made on the sale of house property is invested in notifies bonds of
companies within six months from date of realization of capital gains, then the capital
gains tax is exempted to the extend investment made in bonds. I.e. Rural Electrification
Corporation, National Highway Authority of India (NHAI), etc.
PRIMARY RESEARCH
Introduction
Savings form an important part of the economy of any nation. With the savings invested in
various options available to the people, the money acts as the driver for growth of the
country. Indian financial scene too presents a plethora of avenues to the investors. Though
84
certainly not the best or deepest of markets in the world, it has reasonable options for an
ordinary man to invest his savings.
One needs to invest and earn return on their idle resources and generate a specified sum of
money for a specific goal in life and make a provision for an uncertain future. One of the
important reasons why one needs to invest wisely is to meet the cost of inflation. Inflation is
the rate at which the cost of living increases.
The cost of living is simply what it cost to buy the goods and services you need to live.
Inflation causes money to lose value because it will not buy the same amount of a good or
service in the future as it does now or did in the past. The sooner one starts investing the
better. By investing early you allow your investments more time to grow, whereby the
concept of compounding increases your income, by accumulating the principal and the
interest or dividend earned on it, year after year.
The three golden rules for all investors are
i. Invest early
ii. Invest regularly
iii. Invest for long term and not for short term
Objective of the study The purpose of the analysis is to determine the investment behavior of investors and
investment preferences for the same. Investor’s perception will provide a way to accurately
measure how the investors think about the products and services provided by the company.
The main objective of the project is to find out the needs and preferences of investors.
For this analysis, customer perception and awareness level will be measured in important
areas such as:
i. To understand in depth about different investment avenues available in India.
ii. To find out how investors get information about the various financial instruments.
iii. The type of financial instruments, they would prefer to invest.
iv. The duration for which they would prefer to keep their money invested.
v. What are the factors that they consider before investing?
vi. To know the risk tolerance level of the individual investor.
85
vii. To study the dependence/independences of the demographic factors (Age) of the
investor and his/her risk tolerance level.
viii. To find priority for investment like Return, Risk, Safety, Liquidity, Maturity of
investment, etc.
Need of the Study
Indentify Customers Preferences: with the survey on Investors Behavior, we can identify
investor’s preference towards different investment avenues.
Scope of the study
i. This study is limited to Mumbai city only.
ii. This study not includes other avenues such as retail textile, agricultural
business, etc.
iii. The scope of the study is limited to different selecting investment avenues
Limitations of the studyIn every research there are chances of errors and constraints. We have following limitations
in our study.
i. Sample size, which we have taken, is very small, on the basis of which efficient decision
can’t be taken
ii. Respondents were biased in their responses because they were more in favor of the brand
they were using.
iii. Co-operations from respondents, this was a major problem
iv. Most of the people were at their work. So they did not have enough time to give all
replies.
v. The population surveyed was not open to questions related to their personal income i.e.
either they fell hesitant in disclosing the facts about their incomes or they were simply not
interested.
vi. Time factor
vii. Cost factor
86
RESEARCH METHODOLOGY
Sampling technique initially, a rough draft will be prepared keeping in mind the objective of
the research. The final questionnaire will be arrived at only after certain important changes
are incorporated. Convenience sampling technique will be used for collecting the data from
different investors. The investors are selected by the convenience sampling method. The
selection of units from the population based on their easy availability and accessibility to the
researcher is known as convenience sampling. Convenience sampling is at its best in surveys
dealing with an exploratory purpose for generating ideas and hypothesis.
87
Sampling unit: The respondents who will be asked to fill out the questionnaires are the
sampling units. These comprise of employees of MNC͛s, government employees, housewives,
self employed, professionals and other investors.
Sampling size: The sample size will be restricted to only 100, which comprised of mainly
people from different regions of Mumbai.
Sampling area: The area of the research is Mumbai.
Research designThis section carry out the topic such as research sector, research population and instrument
used for the research.
i. Research Sector
Researcher is going to carry out the research on Investment Avenue available to
investor because the aim of the research is to study Investment pattern of the Investor.
ii. Research Population
Research population comprises of the survey are Salaried, Professional, Business owner,
Retired & Pensioner, trader, share broker and others. This survey will be analyzed in terms of
factors like Safety, Liquidity, Diversification, Simplicity, Tax saving and Affordability.
iii. Research instrument
The questionnaire is been carefully prepared to get the most of the required information from
the investors. A research design is simply the framework or plan for a study used as a guide
in collecting and analyzing data. It is the blue print that is followed in completing the study.
Research would be conducted in the context of this project report. I have utilized descriptive
research design.
Sources of information
Primary Data
Information is collected by conducting a survey by distributing a questionnaire to 100
investors in Mumbai. These 100 investors are of different age group, different occupation,
88
different income levels, and different qualifications. (A copy of the questionnaire is given in
the last as ANNEXURE 1).
Secondary Data
This data is collected by using the following means.
1. Articles in Financial Newspapers (Economic times͛ and Business Standard)
2. Investment Magazines, Business Magazines, Financial chronicles.
3. Expert’s opinion published in various print media.
4. Books written by various authors on Investments.
5. Data available on internet through various websites.
Method of analysis
The analysis of data collection is completed and presented systematically with the used of
Microsoft Excel and MS- Word. The various tools used for presentation are:
i. Bar graph
ii. Pie chart
iii. Column graph
iv. Doughnut chart
DATA ANALYSIS AND INTERPRETATION
Analysis of the report: An analysis is made on the responses received from 100 sample
investors. The objective of the report is to find out the investors behavior on various
investment avenues, to find out the needs of the current and future investors.
The questionnaire contains various questions on the investor’s financial experience, based on
these experiences an analysis is made to find out a pattern in their investments.
89
Based on these investment experiences of the 100 sample investors an analysis is made and
interpretations are drawn. Interpretations are made on a rational basis, these interpretations
may be correct or may not be correct but care is taken to draw a valid and approvable
interpretation.
Analysis is made only from the information collected through questionnaires no other data or
information is taken in to consideration for purpose of the analysis.
Independent Variables and Dependent VariablesThere are total four independent variables
1. Age group. 2. Occupation. 3. Qualification. 4. Annual income
There can be many dependent variables like
1. Level of risk tolerance
2. Percentage of income that can be invested
3. Time period that can be taken for investments
4. Savings objectives
5. Investment preference.
These independent variables can be compared with any dependent variables for finding the
relations between the parameters. In my analysis I have taken Age and Income category for
comparison with dependent variable investment preference and Occupation, Gender, Marital
Status and Age group comparing with the dependent variable level of risk tolerance.
Investment Preferences Among Various Age Groups
INVESTM
ENT
AVENUES
AGE GROUP ( IN YEARS)
LESS THAN
25
25-35 35-45 45-60 GREATER
THAN 60
Respo % Respo % Respo % Respo % Respo %
90
ndents ndents ndents ndents ndents
Equity 8 32 6 27 5 25 4 22 2 13
Debentures
/ Bonds
3 12 2 09 2 10 3 17 5 33
Bank
Deposits
6 24 4 18 4 20 3 17 3 20
Insurance 5 20 5 23 3 15 4 22 2 13
Mutual
Fund
3 12 3 14 3 15 2 11 1 7
Gold &
Real Estate
0 0 2 09 3 15 2 11 2 13
Total 25 100 22 100 20 100 18 100 15 100
Less than 25 25-35 35-45 45-60 Above 600
5
10
15
20
25
30
35
EquityDebentures/ bondsBank DepositsInsuranceMutual FundGold & Real Estate
Interpretation
91
From above table we can conclude that, all the age groups are giving more preference on
investing in equity, except those who are more than sixty years. The age group, which is
more than sixty years, gives more preference to Debentures/ Bonds and Bank Deposits.
We conclude that as the age of individual increases, the risk tolerance decreases.
Investment Preference Among Various Income Levels
INVESTME
NT
AVENUES
ANNUAL INCOME (IN LAKHS)
LESS THAN
200000
200001-500000 500001-800000 GREATER
THAN 800000
Respond
ents
% Respond
ents
% Respond
ents
% Respond
ents
%
Equity 5 16 6 21 7 29 5 31
Debentures/
Bonds
3 9 3 11 2 8 1 6
92
Bank
Deposits
12 37 8 29 4 17 2 13
Insurance 6 19 5 18 5 21 4 25
Mutual Fund 5 16 4 14 4 17 3 19
Gold & Real
Estate
1 3 2 7 2 8 1 6
Total 32 100 28 100 24 100 16 100
Less than 200000 200001-500000 500001-800000 Above 8000010
5
10
15
20
25
30
35
40
EquityDebentures/ BondsBank DepositsInsuranceMutual FundGold & Real estate
Interpretation
The above table reveals that higher income group gives more preference to investment in
equity where as lower income group gives more preference to investment in bank deposit. It
implies that the higher income levels can take more risk in investment rather than lower
income levels because the saving ratio of the higher income individuals is very high so that
they can afford to take higher risk by investing in equity and vice versa.
Risk Tolerance
93
27
46
18
9
Risk Tolerance
Less than 15%15% to 30%30% to 45%Above 45%
Interpretation
Table and Chart clearly shows that 46% i.e. majority of investor expect 15% to 30% risk on
annual basis, 27% investor expect less than 15%, 18% investor expect 30% to 45% and 9%
investor expect more than 45% risk.
Risk Tolerance Based on Occupation
RISK OCCUPATION (%)
EMPLOYED SELF- EMPLOYED OTHERS TOTA
L
Respondents % Respondents % Respondents % Respon
dents
94
Less than
15%
15 55.50 5 18.50 7 26 27
15% to
30%
22 48 14 30 10 22 46
30% to
45%
4 22 11 61 3 17 18
Above
45%
3 33 5 56 1 11 9
Less than 15%
15% to 30%
30% to 45%
Above 45%
0 10 20 30 40 50 60 70
OthersSelf- EmployedEmployed
95
Interpretation
Above graph shows that self employed individuals take more risk as compared to employed,
retired, housewife, etc. Self-employment status automatically leads to higher levels of risk
taking, and that, other things being equal, self-employed individuals will typically choose
riskier investments and accept increased investment volatility as compared to people who
work for others on a straight salary for higher returns.
Risk Tolerance Based on Gender
Interpretation
Above graph shows that male takes more risk than female. Women tend to be less risk
tolerant than men. We can conclude that gender is also an important investor risk tolerance
classification factor.
56% of the investors are men and the rest 44% are females. Generally males bear the
financial responsibility in Indian Society and therefore they have to make investment decision
to fulfill financial obligations.
Risk Tolerance Based on Marital Status
96
Less than 15% 15% to 30% 30% to 45% Above 45%0
10
20
30
40
50
60
70
80
90
41
57
67
78
59
43
33
22
MaleFemale
Less than 15% 15% to 30% 30% to 45% Above 45%0
10
20
30
40
50
60
70
80
2635
6167
7465
3933 Single
Married
Interpretation
Above graph shows that single individuals take more risk than married individuals. Marital
status is another important factor for risk tolerance. It is assumed that single individuals have
less to lose by accepting greater risk compared to married individuals who often have higher
social responsibility for themselves and dependents.
Risk Tolerance Based on Age
RISK AGE TOTAL
Less than 25 25-35 35-45 45-60 Above 60
No. % No. % No. % No. % No. %
Less
than
15%
2 7 5 19 7 26 6 22 7 26 27
15% to
30%
15 33 11 24 7 15 7 15 6 13 46
30% to
45%
6 33 5 28 3 17 2 11 2 11 18
Above
45%
4 45 3 33 1 11 1 11 0 0 9
97
Interpretation
From the above graph we can conclude that as age increases risk tolerance of individual
decreases. Older individuals have less time to recover losses than younger individuals and
thus older individuals have lower risk tolerance.
We can see a decreasing trend in the behavior of investors towards risk as their age increased.
We can conclude that there is a strong inverse or negative relationship between risk tolerance
and age group.
Qualification
Interpretation
98
7
33
39
21
Qualification
Under GraduatesGraduatesPost GraduatesOthers
Less than 15% 15% to 30% 30% to 45% Above 45%0
5
10
15
20
25
30
35
40
45
Less than 2525-3535-4545-60Above 60
39% of the individual investors covered in the study are postgraduates; 33%investors are
graduates and 7%of the investors are under-graduates, and 21% investors are categorized as
others who are more qualified than post graduates. It is interesting to note that most investors
(covered in the study) can be said to possess higher education (Bachelor Degree and above).
Objective of Investment
Interpretation
From the above table and chart, majority investor’s objective is future welfare and then
comes inflation protection, child career, high income and retirement protection. So we can
conclude that majority of investors are saving their future through long term objective.
99
High Income Inflation Protection
For Future Welfare
Retirement Protection
Child Career Others0
5
10
15
20
25
30
35
40
14
21
36
1215
2
Objective of Investment
Percentage
Factors Taken Into Consideration While Selecting an Investment Option
Safety
Tax Saving
Simplicity
Liquidity
Diversification
Affordability
0 5 10 15 20 25 30 35 40 45 50
50
24
5
11
3
7
Factors of Investment
Percentage
Interpretation
Safety has got the highest rank so we can conclude now a day investors focus more on safety.
At present considering last several years inflation position in India, investors are preferring to
cover themselves against the rise in inflation by investing large portion of their investment in
a safely mode e.g. Bank Fixed Deposit, Insurance, etc.
Investors are also focusing on tax planning factor which is also more important now a days.
Simplicity, Diversification, Liquidity and Affordability are few other factors.
Investment: Income Ratio
19
38
32
11
Investment Based on Income
Less than 20%20% to 35%35% to 50%Above 50%
100
Interpretation
The above chart shows that 11% of investors invest above 50% of their income, 19% less
than 20%, 32% invest between 35-50% and majority of investors i.e. 38% invest between 20-
35%.
It was found that irrespective of annual income they earn all investors are interested in
investment since today’s inflated cost of living is forcing everyone to save for their future
needs and invest those resources efficiently.
Do You Make Research Before Investment?
Types of Research
101
6
16
21
25
32
Types of Research
Studying annual reports of companyMonitoring share marketGathering information through brokerAllOthers
84
16
Research
YesNo
Interpretation
i. According to above first graph we can see 84% investor doing Research work and 16% of
investor are not doing research work
ii. In the second graph, we also can see 6% studying annual reports of Company, 16%
investor monitoring share market, 21% investor getting information through broker while
majority does all the above research before investment.
iii. The highest % category of investor does research work like reading newspapers,
magazine, etc before investment.
Types of Investment
Interpretation
Among the total sample size highest % of investors prefer long term investment and 22%
prefer short term investment. Whereas 34% of investors prefer to invest in both long term and
short term avenues.
102
22
44
34
Types of Investment
Short Term InvestmentLong Term InvestmentBoth
Frequency of Investment
6
36
26
20
12
Frequency of Investment
WeeklyMonthlyQuarterlyHalf YearlyYearly
Interpretation
This graph reveals that 36% of investors are investing monthly. 26% of investors are
investing quarterly. 12% of investors are investing in a yearly basis where as 6% and 20% of
investors are investing in weekly (preferably in equities) and half yearly basis respectively.
Due to busy life schedule many of investors are not able to spend time in monitoring their
investment.
Return Expectation
Less than 11%
11%-20%
21%-30%
More than 30%
0 10 20 30 40 50 60
15
48
21
16
Return Expectation
Percentage
103
Interpretation
Graph clearly shows that 40% investor expect 11-20% return on annual basis, 21% investor
expect 21-30%, 16% expect more than 30% and 15% investor expect less than 11% return on
annual basis. Majority of investor expect 11-20% return on annual basis on an average on
different alternatives of investment.
Basis Of Investment
49
33
18
Basis of Investment
Self AnalysisFinancial/ Broker/ CA AdviceFamily/ Friends/ Rel-atives
Interpretation
From this we can conclude that most of the investors invest on the basis of self analysis and
remaining investors take advice from broker, friends, relatives or charted accountant for
investment decision.
Most of the investors investing on the basis on self analysis save the cost of investment or
payment of professional fees. Whereas those investors who do not have much knowledge
about investment strategy or time to study the investment strategy are opting for professionals
advice for their investment decision.
104
Knowledge about Investment
18
3235
15
Knowledge about Investment
Very LimitedBasic KnowledgeConsiderable KnowledgeExtensive Knowledge
Interpretation
Apart from 18% of the investors having very limited knowledge, some of the investors
having considerable and extensive knowledge may opt for professional advice for deciding
their investment strategy due to lack of time required to be spent behind investment related
research.
105
CONCLUSION
As we now know various investment options are available in india i.e. small savings
schemes, insurance, mutual funds, equity, real estate, precious metals etc, but its selection
depends upon various factors. The investment decisions are driven by factors like Risk,
Reward, Age, Occupation, Gender, Marital status, Tax benefit, Income, Investment objective,
Period of investment etc.
The analysis and interpretations very clearly shows that the investors have different views
like investment pattern by market movement, factors influencing their decision, frequency of
investment, alternatives available and investment preferences truly influence their perception
towards different products and services of the company.
Thus, the study says that the Indian investment community have shown much interest in
investing in different financial products available in the market due to the spiraling growth of
Indian GDP, better performance by the companies, liberal rules and regulations by the
authority like SEBI to protect the investors interest and this process will grow much more
quicker in the future. There might be a chance that the perceptions of the investors’ of
different nature are varied due to diversity in social life, living pattern, income level etc that
needs to be studied further
The facts with regard to the several factors such as relationship between age and risk
tolerance level of individual investors etc. It has important implications for investment
managers as it came out with certain interesting facets of an individual investor. The
individual investor still prefers to invest in financial products which give risk free returns.
Hence it concludes that indian investors even if they are of high income, well educated,
salaried, independent are conservative investors & prefer to play safe.
106
ANNEXURE 1
Questionnaire
1. Name:-
2. Age:-
3. Occupation:-
o Self Employed
o Employed
o Other
4. Gender:-
o Male
o Female
5. Marital status:-
6. Your annual income:-
o Below 200000
o 200000-500000
o 500000-800000
o 800000 onwards
7. Education qualification:-
8. Your investment objective:-
o High Income
o Inflation Protection
o For Future Welfare
o Retirement Protection
o Child Career
o Others
107
9. Factors taken into consideration while selecting an investment option
o Safety
o Tax Saving
o Simplicity
o Liquidity
o Diversification
o Affordability
10. Investment portion of your income (in percentage):-
11. Do you make research before investment?
12. If yes what type of research do you make?
o Studying annual reports of company
o Monitoring share market
o Gathering information through broker
o All of the above
o Others
13. Your risk taking capacity:-
o Less than 15%
o 15% to 30%
o 30% to 45%
o Above 45%
14. What type of investment you prefer?
o Short term investment
o Long term investment
o Both
15. Frequency of investment
108
o Weekly
o Monthly
o Quarterly
o Half yearly
o Yearly
16. How much return do you expect?
o Less than 11%
o 11-20%
o 21-30%
o More than 30%
17. From whom do you get your investment advice?
o Self Analysis
o Financial/ Broker/ CA Advice
o Family/ Friends/ Relatives
18. When it comes to understanding your investment, how would you rate your
knowledge?
o Very limited
o Basic knowledge
o Considerable knowledge
o Extensive knowledge
19. Your preference to various investment avenues:-
o Equity
o Debentures / Bonds
o Mutual fund
o Real Estate & Gold
o Bank Deposit & Post office
o Insurance
109
BIBLIOGRAPHY
GENERAL WEBSITES AND SEARCH ENGINES
www.investopedia.com
www.moneycontrol.com
www.wikipedia.com
www.google.com
www.irdaindia.org
www.rediffmail-money-derivatives.htm
www.amfiindia.com
BOOKS & PUBLICATIONS
NCFM Course Publications
NISM Mutual Fund Publication
Economic Times
Business Standards
Capital Market Magazine
110
Dalal Street Magazine
111
112
113