Unit 1 The Investment Environment Q.1. “Investments involve Jon, Ans. Investment means emp sacrifice of present consumption invested funds ey & the rate which is at least so that at the end of the period, enough funds. are avai services Which were sacrificed entlier st the-time of a ae et some extra income. The word investment has been differently interpreted by different set of persons. For an economist, the term investment implies net addition to the capital stock of the nation that consists of goods and services required for the production Process, Financial investment refers to chi The financial and economic meanings of investment are related to each other because investment is a part of the savings of the individuals which flow into the “pital market. The expectation of return is an essential characteristic of fvestment. An investor expects to earn additional return on its Present money ffom the mode of investment that could be in the form of physical/financial assets. Investment requires the following elements: ( Purchase of an asset, and oS (®) Expectation to earn an additional return or an appreciation in value. From the above, it is crystal clear that investments involve long-term “imnitments of the investor. Bits : a 2 “Investment is carefully planned speculation.” Comment Tn fement, Ans. There are certain non-manageable risks which are eke ree Pasonal power. These are (i) the purchasing power risk ie, the fa 12 SHIV DAS DELHI UNIVERSITY SERIES value of interest and principal, and (ii) the money, rate risk or the fall in “ market value when interest rate rises. Thus, no investments are entirely risk free Such risks affect both the speculator and the investor. High tisk and low Tisk are general indicators to differentiate between speculation and investment. In speculation, the primary motive is to achieve Profits through price changes Purchase of securities preceded by proper investigation, analysis and Teview tp receive a stable return over a period of time is termed as ‘investment’, A longer. term fund allocation is termed as investment. A short-term holding is associated with trading for ‘quick return’ and is called speculation. : The investor constantly: evaluates the worth of a security whereas the speculator is interested in market action and price movement. There are no established rules and laws, which identify securities meant for permanent investment. There has to be a constant review of securities to find out whether it is a suitable investment. It will be appropriate to conclude that investment is a well grounded and carefully planned speculation. Q. 3. Define Investment. Distinguish between Investment and Speculation, (2014 June) Or, “Investment is 'a well-grounded and carefully planned speculation”, Explain the statement, clearly distinguishing - between investment and speculation. (2016 June) Ans. Investment and Speculation. Investment refers to channelisation of funds to the assets which are likely to yield some return in future either by way of their capital appreciation or due to accrual of income on them. The uncertainty factor ‘makes Investment a well-grounded and carefully planned speculation. Investment means employment of funds to earn'return. It requires sacrifice of Present consumption to get return in future. One must ensure that the invested funds grow at the rate which is at least greater than the rate of inflation so that at the end of the period, enough funds are available to purchase goods/services which were sacrificed earlier at the time of investing money along with some extra income. The word investment has been differently interpreted by different sets of Persons. For an economist, the term investment implies net addition to the capital stock of the nation that consists of goods and services required for the production Process, _ Financial investment refers to channelisation of funds to the assets which are likely to yield some return in future either by way of their capital appreciation or due to accrual of income on them. These assets are generally stocks, debentures, bonds etc. Thus, investment is an activity which requires commitment of funds in any financial/ physical form in the present with an expectation of receiving additional returns in the future. Distinction between Investment and Speculation Basis Investment Speculation Time Horizon| Long-term time framework | Shortterm planning— usually beyond twelve holding ‘assets even for a months. day.UNIT 1: THE INVESTMENT ENVIRONMENT 3 Risk Limited risk. Very high risk. Returns Consistent returns over long | High returns even though period even though it is | risk of loss may be high. moderate. Source of Fundamentals of the Hearsay, inside information, Information | company are given due | market rumors, etc. are consideration. relied upon. Use of funds | Own funds through savings. | Own and may use borrowed funds. Decision Safety, liquidity, profitability | Market behaviour infor- Criteria and stability considerations, | mation, judgment on move- performance of companies. ment in the stock market, gi hunches and beliefs. Investment vs. Gambling. Commitment of funds in horse races, card games, lotteries are some of the examples of gambling. In case of gambling, an individual makes commitment of funds not only to éarn high returns but also for his own excitement. Investment is done in’a planned manner. Gambling is unplanned and done without knowledge of the nature of risk involved in the given activity. Gambling has a very high element of uncertainty. It is done totally on the basis of market tips and rumours. It can either lead to generation of very high income or complete loss of funds including the principal amount. Gambling is also illegal. Q.4. Briefly explain the different kinds of investment outlets available to an investor. (2008) Ans. The following is the list.of investment outlets available to an investor: I. Ownership Securities: (a) Equity Shares, (b) Preference Shares I. Debt Securities: (a), Debentures (non-convertible) (b) Debentures (convertible) (c) Deep Discount Bonds IIL. Mutual Fund Securities i.e., Unit Schemes consisting of: (a) Income Scheme (b) Growth Scheme (0) Equity Scheme (@ Money Market Scheme IV. Financial Engineering Securities (Hybrid Security): ICICI, IFCI and IDBI had issued deep discount bonds with varying maturity periods. These are redeemable at’ full value but issued at a discount in the nominal value of the security. Interest is not paid in such a bond. The total redeemable value of the security is paid at the end of the stipulated period. The investor has the option to invest in the New Issue market or operate in the existing security market. He also has the option to invest in post office savings schemes. a Q.5. Distinguish between Direct investing and Indirect investing. (2015 0) Ans, Direct Investing. Direct investing involves the buying and selling of securities by the investors themselves. The securities may be capital market securities such as shares, debentures, or derivative products, or money marketSHIV DAS DELHI UNIVERSITY SERIES ry Bills, Commercial Bills, Commercial Papers, 4 instruments such as Treasu! Certificates of Deposit, etc. 7 ; f ae Indirect Investing. Investors may not directly investing and manage the i he units of funds that hold various types of antl cathe an ini nds are known as mutual funds or etna 3 aes & foun ceeds known as unit holders. In a of tooled ny eating the investors let the investment company do all the work and galt: deco (for a fee). The unit-holders have ownership interest in the = of the fund or the investment company and are entitled to a pro-rata share of interest, dividend and capital gains generated. een Direct Investing and Indirect Investing, Difference betw Direct Investing - Indirect Investing 1. Choice of Investment Wide range of direct invest- ments such as various forms of property, shares, listed investment companies, in-| frastructure trusts, options, warrants, futures and many fixed interest investments. Managed investments offer access to markets and investments that are not readily available to an individual retail investor. e.g, international or regional markets such as emerging markets of China, India or Eastern Europe, alternative asset classes such as infras- tructure or derivatives. 2, Link 3. Dependability of Return In direct investing, there is a direct link between the saver (investor) & the user. (investee). Return in case of direct investing depends upon the performance and profitabil- ity of the investee. In indirect investing, there is no such link. | In case of indirect investing, the return depends upon the efficiency of the investment company in managing the portfolio. 4. Decision The ultimate decision is made by investors in direct investing. In indirect investing deci- sion is made by investment company i.e, Mutual Fund company. 5. Costs The costs of direct invest- ment include brokerage, fees for financial planning advice and your own time. You may Pay an entry fee as well as an annual management fee, trustee fee and fees for financial planning advice. 6. Flexibility Regular small investments, switching in and out: of cash, and teinvestment of income are difficult and ex. Pensive, The flexibility of ongoing investment, the ability to Teinvest income and ease of switching investments make them very attractive. “Sty attractive.UNIT 1: THE INVESTMENT ENVIRONMENT 5 Q. 6. What are the objectives of investment? (Model Test Paper) ‘Ans. The basic objective of any investor while making an investment is to minimise risk and maximise the expected returns besides ensuring safety and liquidity of his investment. The main objectives while making an investment are explained below: : (i) Return. The most important objective of an investor is to earn highest possible return for a given level of risk. A return may be in the form of dividend, interest or through capital appreciation. The formula to calculate rate of return is as under: __ (Maturity Value— Value at which investment is made) + Dividend Value at which investment is made _ (Capital appreciation + Dividend) Value at which investment is made Return may vary in different types of Investments. (i) Risk. It is the variability in return. One tries to minimise the difference between the. expected and the actual return. The risk in case of investment in ‘securities can be reduced by forming a portfolio i.e, a group of securities. An investor chooses securities of different industries, different companies and ‘securities with both positive and negative correlation with the market index so as to minimise risk. (iif) Liquidity. Securities, which are frequently traded, provide enough liquidity to the investor. So the investment in securities providing optimum return commensurate with the level of risk must be convertible into liquid amount at the time of need of the investor. (jv) Hedge against inflation. It must be ensured that the return earned on the investment shall be greater than the rate of inflation. In case the investor fails to earn a return higher than the inflation rate, he would lose in real terms; this defeats the purpose of the investment. (0) Safety of the principal. The investor is also interested in the safety of his principal amount of investment. Bank deposits are more secure than debentures in this regard. Investment in debentures is more secure than investment in preference shares which in turn is more secure than investment in equity shares. (vi) Tax benefits. Investor would like to avail the available tax benefits. He plans his investment according to his tax status as well as the tax incentives provided by the Government. | Conclusion. The main objective of investment is growth in current wealth of the | investor, He tries to earn highest possible return from available investment with minimum risk. He is ready to assume a higher risk only if the opportunities | expected return is proportionately higher. | INVESTMENT DECISION PROCESS | Q@. 7. Define investment. ss briefly the steps involved in the + (2007) investment decision process. Or6 SHIV DAS DELHI UNIVERSITY SERIES What factors should an investor consider while making investment decision? (2008) Or, Define Investment. How does inflation affect investment decisions? Give examples. (2011) Ans. Investment means employment of funds to earn return. It requires sacrifice of present consumption to get return in future. One must ensure that the invested funds grow at the rate which is at least greater than the rate of inflation so that at the end of the period, enough funds are available to purchase goods/ services which were sacrificed earlier at the time of investing money along with some extra income. The word investment has been differently interpreted by different sets of persons. For an economist, the term investment implies net addition to the capital stock of the nation that consists of goods and services required for the production process. . Financial investment refers to channelisation of funds to the assets which are likely to yield some return in future either by way of their capital appreciation or due to accrual of income on them. These assets are generally stocks, debentures, bonds etc. Thus, investment is an activity which requires commitment of funds in any financial/physical form in present with an expectation of receiving additional return in future. Investment Decision Process: While making an investment decision, ‘the investor needs to undertake certain activities in the sequential order: (1) Designing a proper investment policy; (2) E-I-C Analysis; (3) Valuation of Securities; (4) Portfolio construction, and (6) Portfolio Appraisal and Revision. 1, Investment Policy. The investor decides the amount of funds to be invested -and its objective. The funds to be invested may either be generated out of savings of the investor or they may have been borrowed funds. The objective of investment may include different required rates of return by investors. Further, the investor refers to various investment alternatives and their risk-reward ratio and accordingly decides for investment of funds in these alternatives, 2. Analysis of Economy-Industry and Company. To assess the state of the economy, various macro factors such as growth rate in GDP, inflation and interest rates are referred to. Thereafter, the investor studies the Prospects of various industries and tries to Prospects are good. Next, he chooses the best companies among the shortlisted industries by referring to various qualitative and quantitative factors determining the growth prospects of the company. Valuation of Securities. The investor is to es 4 5 assess the value of the Securities in which funds are proposed to be i §. of the security (i., IVS). If IVS exceeds the current market Price, it is not a worthwhile investment,UNIT 1: THE INVESTMENT ENVIRONMENT 7 4, Investment Basket. Keeping in vi : available investment funds ‘are allootce erate ot the testor, the investor who is willing to bear high risk will put ree An securities having higher risk and less amount in the ln sgn the Appraisal and Revision of Investment, Performence ok eames. investment vis-a-vis market performance is evaluated, The jon satisfied if he has earned more than other capital ance ee eS level of risk which the investor decided to assur °°'® Raving same ‘The basic objective of any investor while making an investment isto minim risk and maximise the expected returns in addition to ene nme tiquidity of his investment. An investor tries to overcome purchaver ead by investing in areas which offer a rate of return which is higher than era eo inflation. The rate of return evaluated after incorporating the effect of intl a . known as Real rate of return or Inflation adjusted return. It is computed SS ante ow r=@-I/(0+) S p-mainesee i= Rate of inflation Example: If nominal return R = 12% and rate of inflation i = 8% then the rate of return would be given as “= (0.12 -.0.08)/(1 + 0.08) 0.04/1.08 = 0.037 = 3.7% Implication: The investment opportunity provides return of 12% but when it is adjusted in the light of inflation, the real rate of return is just 3.7% which is less than 1/3” of the original return. We can understand this further by looking at the following example. Example: Mr. X purchased a share of a standard company for %250 in the year 2008-09. He received dividend of %40 and finally sold it for %270 in 2009-2010. Rate of inflation was 5%. What would his return be? Sol. Stage I. Normal rate of return: = [(270 - 250) + 40]/250 = (20 + 40)/250 = 24% Stage II. Real rate of return = (0.24 - 0.05)/(1 + 0.05) = 0.19/1.05 = 18.09% Q.8. What do you mean by investment help an investor in making a sound investment Ans. An investor while making an investment d activities in the sequential order. These activities, known as Investment Decision Process. The activities following sequence: () Framing investment policy (ii) E-1-C Analysis [i.e., Economy, (ii) Valuation of securities e Portfolio construction, and _ () Portfolio appraisal and revision. income. Makin; vestment is Cente of funds for future incom decision process? How is-it going to t decision? (2009, 2012) lecision has to carry out certain when grouped together, are are to be carried out in the Industry and Company] g soundSHIV DAS DELHI UNIVERSITY SERIES investment decision requires both knowledge and skill. Skill is required to evaluate risk and returns associated with an investment decision. It is essential to have a complete knowledge regarding the complex investment alternatives available in the economic environment. Investment value is taken to be the present worth to the owners of future fate set of weights have to be applied benefits from the investments. An appropri i with the use of forecasted benefits to estimate the value of the investment assets. The investment process helps in the (i) determination of investible wealth, (if) determination of portfolio objectives, | (iii) identification of potential investment assets, and (iv) the allocation of wealth to asset categories. Concept Or Risk-RETURN Q. 9. Define Risk. Explain the various sources of risk. (2011) ‘Ans. Risk is defined as a variation of actual return from the expected return. Any individual while investing his funds tries to estimate the risk associated with his investment and make final decisions of investment only if it falls within the level of risk which he can afford to take. The individual is. to estimate the quantum of risk being undertaken by him while making investment decisions. Sources of Risk. The factors causing risk are broadly divided into two parts: 1. Systematic risk, and 2. Unsystematic risk. 1. Systematic Risk is non diversifiable and it arises due to (factors like) economic, sociological and political factors etc. which have a bearing on the entire market. Market risk, Interest rate risk and Purchasing power risk are encompassed by this systematic risk. . Market risk is referred to as variability in stock prices due to change in investor's attitude and expectations. If there is a war like situation, or there is political instability, the entire market would be affected ‘and all the securities listed in the market would suffer decline in their respective prices. Interest Rate Risk arises due to change in value of security price due to change in interest rate of the market. The increase in interest rate would make debt instruments more lucrative than equity. shares. Purchasing Power risk arises due to inflation. It arises when the change in price index for a given period is more than the change in return earned on investment by the investor. 2. Unsystematic Risk, It arises due to factors peculiar to any given firm such as labour strike, change in management, change in product line, change in demand of product etc. Business Risk and Financial Risk are two categories of such risk. The change in actual performance may vary from the expected performance due to a number of reasons which can either be internal to the firm or external to the firm. Financial risk arises due to presence of debt in the capital structure of the firm. Q. 10. “No investment is risk-free”. In view of this statement, write a note on the meaning and types of investment risk. (2014 June) ‘Ans. No Investment is risk-free. Most investors are risk averse but they expect maximum returns from their investment. Every investment must be analysedUNIT 1: THE INVESTMENT ENVIRONMENT 9 use there is definitely some tisk involved in it. A vast range of inv: epporturitis are Sere in the Government sector. These pian ak fee ut low return yielding. everal Incentives are attached to these. The private sector investments consist iy equity and preference shares, debentures and public ae posits with companies. These have features of high risk. An investor is to make i investment decisions keeping in view his requirements of profitability, iguidity and tsk of investments Government securities are risk-free’ and the investor is secured. However, Government securities give low returns, and do not fulfill his objective of appreciation in his capital base. The main concern while making an investment in any area is Risk. Risk is defined as variation of actual return from the expected return. It is for an individual to estimate the amount of risk being undertaken by him while makin, snvestment decisions. 8 "The factors which can lead to deviation of actual returns from expected returns an be divided into Systematic Risk and Unsystematic Risk. The Systematic risk is non-diversifiable and it arises due to factors like—economic, sociological and political, etc. which have a bearing on the entire market. The risks, which are normally covered under this category, are (i) Market risk, (ii) Interest Rate risk, and (iii) Purchasing power risk. The Unsystematic risk arises due toa peculiar reason to any firm such as: (a) labour strike, (b) change in management, (c) change in product line, and (@ change in the demand of a product, etc. There are two kinds of risks which are normally covered under this category: (i) Business risk, and (ii) Financial risk. Q.11. Explain ‘Risk-return trade-off’. (2007, 2016 June) Ans. Risk-Return trade-off. Risk and Return are two very important concepts in finance since they are used in almost all financial decisions. An individual may eam any amount of return but his efficiency can only be measured when the teturn is assessed with reference to the level of risk undertaken by him. Risk is a variation of actual return from the expected return. An individual while investing his funds tries to estimate the risk associated with his investment. He makes a final decision of investment only if it falls within the level of risk which he can afford. He always attempts to-have a trade off between ‘Risk involved’ and ‘Return desired’, An investor should make investment only when the expected return is higher than the risk ascertained percentage. PANTS & INSTRUMENTS ig? Explain some innovative instruments in the past few decades. (2015 June) _Ans, Financial Engineering. It is the use of mathematical techniques in solving cial problems. It uses tools and knowledge from the fields of Computer Science, Statistics, Economics and Applied Mathematics to address current ancial issues as well as to devise new and innovative Financia) prot ‘nancial engineering i i eferred to as quantital : ie by Sune Cael Series Investment Banks, Insurance Agencies and edge Funds, ' ' Financial Engineering has led to the explosion of derivative trading tia we in 4y. It is a process that utilises existing financial instruments to crea Financia, Markets, PAR’ Q. 12. What is Financial Engineer’ created using financial engineering10 SHIV DAS DELHI UNIVERSITY SERIES and enhanced product of some type. The process may involve a simple union between two products or make use of several different products to create a new product that provides benefits that none of the other instruments could manage on their own, | Following are some examples of innovative instruments created usin financial engineering in the past few decades: a (i) Secured Premium Notes (SPN) are financial instruments which are issued with detachable warrants and are redeemable after a certain period. SPN holders get the principal amount with interest on instalment basis after lock-in period of said period. However, during the lock-in. period no interest is paid. During 1992, TISCO Ltd. issued a special instrument called Secured Premium Notes (SPN) having a face value of %300. Each SPN was to be redeemed in four equal instalments of 3159 each (totalling %600) at the end of 4" to 7" year from the date of issue, No periodic interest was payable to SPN holders. (i) Optionally Convertible Debentures are debt securities which allow an issuer to raise capital and in return the issuer pays interest to the investor till the maturity. Reliance Petroleum Ltd. and DLF Cement Ltd. issued i Optionally Convertible Debentures under which the investors were given different options with respect to interest, redemption, right shares, etc. (iii) Indian Rayon and Industries Ltd., now Aditya Birla Nuvo, had issued Zero-Interest Fully Convertible Debentures (ZIFCD) on which no interest was payable but each ZIFCD was convertible into equity shares at a pre-determined price. (iv) A Zero Coupon Bond (also discount bond or deep discount bond) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity. Financial institutions such as ICICI Ltd., IFCI Ltd., IDBI Ltd. have issued Deep Discount Bonds of different maturity value and maturity period. DDBs are issued at a price which is at discount to the face value and the DDBs are redeemable at full face value. There is no interest payable for the intervening period. (2) In the year 2007, Tata Sons Ltd. proposed to issue ‘Exchangeable Bonds’. In case of exchangeable bonds, a company can raise resources by offering the investors an option of converting these bonds into shares of one of its group companies after a specified period. The exchangeable, bonds are different from convertible bonds, as in case of latter, the bonds are converted into shares of the company that has issued the bonds. In case of exchangeable bonds, the conversion gives the investors access to the shares of another group company. - Q.13. Explain in short the components of a financial system. (2009) Ans. The financial system of a country consists of a network of financial markets, institutions, investors, services and regulators. A financial system helps in effective collection of savings of the individuals and institutions 2” transforming these funds into investment. The financial system deals with the finances of the people of the country and other countries as well. Its main product is‘money and'credit and these two variables facilitate financial activity and in turn brings about economic development of the country.UNIT 1: THE INVESTMENT ENVIRONMI A inancial system consists of the followin, “ (i) Financial Markets also called Capltal M, Market and Stock Exchange arket which includes New Issue (i) Financial Institutions, Development 5 inks, Li Companies, Mutual Funds, Leasing ¢ mpanieg (General Insurance example, SBI, ICICI Bank. ‘Ompanies, Post Offices etc. For (ii) Banks. The Central Bank of the country woul there to regulate the monetary policy of a Suga aPe% bank. Ii commercial banks engaged in money and creation SUPPOrt the Reserve Bank of India (RB. creation of credit. For example, (iv) Financial Instruments, Long-term and : shares, debentures, treasury bills, papers, post office schemes, 4 (v) Market Regulators. They are m ue grees by making cettain law, rales ae to Pring in discipline in the market good example of the market regulates in a Piscetince TEL in (i) Market Participants. Which include individuals, government intermediaries and regulators ‘ Q. 14. Distinguish between capital and : is i fanctions performed by financial markets. et OOm NER a Or, What is a Money Market? How is it different from Capital Market?(2009 ees ym C: Ans. Distinction Between Capital Market and Money Redd bere Financial Market is an integral part ‘of the financial system of a country. Financial Market consists of Capital Market and Money Market. Capital Market * helps in the channelisation of funds from the surplus sector to deficit sector and thereby helps in the process of capital formation. It also helps in providing liquidity to the financial instruments. Basis of Distinction: : () Financial Instruments. Capital Market is a market for long term financial instruments such as shares, debentures and mutual fund investments. Money market is a marke maturity. It is a market for immediately at a small Treasury Bonds, Commercial Papers and Bills instruments tradeable in this money market. / (ii) Category of Market. Capital market is grouped as (a) Primary Market or New Issue Market meant for first time issue of securities; (b) a lary Market or Stock Exchange meant for sale of seco ba Lo es = There is no separate category for Money Market like a y ae Secondary Market. All short term transactions are executed in erie instituti rate in the (iii) Participants. Individual investors and institutions both ope Capital Market. institut The participants of the Money Market are large who deal in short term instruments. 11 short-term in nature. The mutual fund schemes, commercial corporate organisations, et for financial assets of less than one year those assets which can be converted into cash transaction cost. Inter-Corporate Deposits, are some of the financial onal investors a12 SHIV DAS DELHI UNIVERSITY SERIES Financial market Capital market Money market Primary market Secondary market Q. 15. Name the important participants of security market. Explain any two of them in brief. (2011) Ans. The security market consists of different players which includes regulators and facilitators besides buyer and seller in the market. The important market Participants are—(i) Regulators; (ii). Depositories and Custodians; (iif) Stock exchanges; (iv) Brokers including sub-brokers; (2) Foreign institutional investors; (vi) Portfolio managers; (vii) Merchant bankers; (viti) Underwriters; (ix) Mutual Funds, etc. and (x) Securities Appellate Tribunals. Regulators. There is a necessity to have proper regulatory mechanism which should monitor the.market. In the securities market, the regulator has to ensure timely settlement of transactions between the buyers and the sellers. It also ensures that the investors should not become victim of any manipulation by any operator or a cartel of players. The principal regulators in the securities market include: (@) SEBI. The Securities and Exchange Board of India keeps a watchful eye on the activities taking place within the securities market. () RBI. The Reserve Bank of India keeps a watch over the activities relating to financing of players in the market through banks." Brokers and Sub-Brokers. An investor intending to purchase or sell his securities through stock exchange cannot directly execute his transaction on his own. He has to take the help of registered members of the stock exchange. These registered members are known as brokers. Only’a broker is permitted to transact business in the stock exchange. Thus, a broker acts as a legal agent of his client while transacting shares on his behalf. A stock broker is expected to maintain high standard of fairness and integrity while conducting business for his clients. Q. 16. Briefly state the procedure of trading in securities in the stock market in India. (2008) Ans. Procedure of Trading in Securities in the Stock Market in India. In the Process of trading in stock exchanges there is the basic need for a Demat Account and ‘transaction’ between an individual and a broker. A transaction to buy and sell securities is also called ‘trades’. This is to be done through selection of a broker. A broker needs to be a member of the stock exchange. The member can either be'an individual or a partnership firm. The broker can trade only on listed securities, These members execute customer's orders to buy and sell on the stock exchange and their firms Teceive negotiated commission on these transactions. The procedure of trading in securities is as under: 1, Placement of an order and execution of transaction. There has to be two seperate investors. One who wants to sell and the other who wants to buy. Both the investors would first contact their Tespective brokers. The transaction would take place only if the price of the two investors would match. The respective brokers will have to issue contract notes to their clients. The contract note is an evidence of the fact that the broker has executed a transaction in a given security for his client. This.contract note also contains the time at which the transactionUNIT 1: THE INVESTMENT ENVIRONMENT 13 has occurred in the stock exchange and the Price at which the transaction has been executed. 2. Payment of delivery. The seller client after Teceiving the contract note will have to transfer shares in the broker's account and the buyer client will have to deposit money in the broker’s account for the shares purchased by him. 3, Settlement of Transaction on the Stock Exchange. For each trading day, there is pay-in and pay-out of securities and funds, There will be a schedule issued by stock exchanges for settling all the trades which take place on a particular day. The settlement schedule consists of the following activities: (a) Pay-in of securities (b) Pay-in of funds (c) Pay-out of securities, and (@) Pay-out of funds. The respective brokers after having received funds and shares for their respective clients would transfer them in their account. Finally, the seller would get funds for the shares sold by him and the buyer would get shares purchased by him. The brokers would get the brokerage fees from their clients for services provided to them. Q. 17. Compare the following investments in terms of return, tisk, liquidity and tax shelter: . (2010) () Equity shares (i) Non-convertible debentures (i#) Residential house (iv) Gold. : Comparison Basis Equity Shares | Non-convertible Residential Gold Debentures. house Return It is not fixed. It is assured or |House Rent can| It is quite high if Usually. in a | fixed. It is usually |be saved/earned kept for a longer growing company | less than the Pref- | on regular basis. | period of time. it is higher than | erence and Equity Preference Shares | Shares. and Debentures. Risk —_| Risk is high, this | Risk is least. No risk of loss of | No risk provided is why return is property if fire,| if it is kept in a relatively high. general insurance | safe place. ‘ is done. Liquidity|No redemption. | Usually these are | It is least. It takes It has liquidity el- a “ eowever it can redeemable after | time to dispose of a| ement. It can be be sold in the | a fixed period. But | residential property.| sold in the mar- stock market at any | if required, these | However, money | ket. time during the | can be sold in Debt | can be borrowed business hours. _| Trading Market. | by’ mortgaging it. it in | Interest income is | There is tax shield|'There is no tax tlie Ser on taxable. if the Capital Gain | shield available. Short-term or and the proceeds long-term gain is are invested in taxable. a oe ential) or depos: ited in a. special a/c (Bonds) for a specified period.14 SHIV DAS DELHI UNIVERSITY SERIES Q. 18. Discuss briefly the following: (2013, 2015 June) (a) NIFTY () Sensex. ' Ans. (a) NIFTY. Nifty is the leading index in the Indian Stock Market thay keeps the record of the large companies on the National Stock Exchange, q represents top 50 stocks that belong to 23 different economical sectors. Nifty may be used for differertt purposes such as index funds, index based derivatives an, bench-marking fund portfolios: The India Index Services and Products Ltd. owns and manages NIFTY index. } NIFTY has emerged as the only financial product in India which has the largest ecosystem. This ecosystem comprises of onshore and offshore exchange traded funds, exchange traded futures and options that are linked to NSE in India. NIFTY is free floating market that is weighted on capitalization from the day: NIFTY was introduced, it used capitalization as weight, assigning it to different constituents of the share market. (b) Sensex. The Bombay Stock Exchange sensitive index, popularly known as Sensex was first compiled in 1986 and it is the most widely followed stock market index in India. It is market capitalisation-weighted index of the equity of 30 companies from both specified and non-specified groups selected on the basis of market activity and representation of major industries. Several global equity benchmarks are based on their method. The base year chosen for Sensex was 1978-79 and the Exchanges covered are Mumbai, Delhi, Kolkata, Ahemdabad, Madras and Bangalore. The base value of sensex was taken as 100 on 1% April 1979. Being a sensitive index it covers all the market leaders. BSE considers factors such as listing history, trading frequency, market capitalisation, and industry importance for including a stock in the Sensex. The composition of the stocks in the Sensex is reviewed and modified by BSE to ensure that Sensex remains representative of stock market conditions, Sensex is a value-weighted index. The Sensex is regarded as the pulse of the domestic stock markets in India. If the Sensex goes up, it means that the Prices of the stocks of most of the major companies on the BSE has gone up and vice versa. The S&P BSE sensex also called BSE 30 or simply sensex is a free float market capitalisation weighted stock market index of 30 well established and financially sound companies listed on BSE Ltd. The 30 component companies which are some of the largest and most actively traded stocks, are representative of various industrial sections of Indian Economy. The BSE constantly raises and modifies its composition to be sure that it reflects current market conditions. The index is ‘calculated based on free float capitalisation method, a variation of market capitalisation method. Instead of using a company’s outstanding shares it uses its float or shares that are readily available for trading. The index has increased by almost ten times from June 1980 to the present date. gaq0Qunit 2 i Fixed Income Securities ; xep INcoME SEcuRI Q. 1. What are the merits and demerits of having fixed income securities in your portfolio? (2013) Ans. Fixed Income securities represent a claim ona periodic stream of income over a given period of tite. The holder of fixed income security gets a fixed periodic income during the holding period from the company issuing these securities. From the point of borrower, these are fixed charge Securities or debt which represent an obligation to pay’a fixed periodic charge and to repay the loan. A fixed charged security is a tradeable form of loan. Merits: Having fixed income securities in the portfolio— * ensures steady, income in the portfolio which is assured after regular intervals. - * helps keeping a gauge on returns so that future expenditures and investments can be planned. + Fixed securities attract lesser risk of default. 7 * Fixed securities offer marketability by trading in markets and hence are liquid in nature though it may take some time to convert them in cash. * In the terminal year, one gets the pre-declared amount apart from regular interest received. ‘-¢ Fixed income securities may attract premium on redemption. Demerits: * Lesser risk invites lesser return on fixed income securities. Equities may give higher returns for the same holding period. - * Equities are much more marketable and liquid than fixed income securities. * Higher interest payments may lead a company to file for bankruptcy. Bonp Features Q.2. State the basic characteristic features of bonds. Ans. Features of bonds: (i) Set Maturity Dates—bonds have set maturity dates that can range from one to 30 years—short-term bonds (mature in three years or less), intermediate bonds (mature in three to ten years) and long-term bonds (mature in ten years or more). : : (i Interest Payments —bonds typically offer some from of interest payment; however, this depends on their structure: “Fixed Rate Bonds’ provide fixed interest payments on a regular schedule for the life of the bond; 1516 SHIV DAS DELHI UNIVERSITY SERIES “Floating Rate Bonds” have variable interest rates that are periodical] adjusted; and, “Zero Coupon Bonds” do not pay periodic interest at al], but offer an advantage in that they are can be bought at a discounteq price of the face value and can be redeemed at the face value at maturity, (iif) Principal Investment Repayment —bonds issuers are obligated to repay the full principal amount of a bond in a lump sum when the bond reaches maturity. (iv) Credit Ratings—You can evaluate the “default risk” (the risk that the issuers won't be able to make interest or principal payments) of a bond by. checking the rating it has been given by a bond rating agency such as Moddy’s Investors Service or Standard and Poor's. (v) Callable Borids —If the bonds has a “call' feature”, the issuer is allowed to redeem the bond before its maturity date, repay the loan and thus, stop paying interest on it. Q. 3. Explain the following: (2007) (i) Zero-interest fully convertible debenture; (ii) Deep discount bonds; (ii) Bond Indenture. Ans. (i) Zero-Interest Fully Convertible Debenture. It does not carry any — coupon rate. It is compulsorily converted into equity shares: According to SEBI guidelines, the time gap between the date of issue and the time of conversion shall not exceed more than three years. The debenture holder in this case benefits from the difference in price at which equity shares are generated out-of the debentures and their prevailing market price at the time of conversion. (i) Deep Discount Bonds. They are like Zero Coupon Bonds (Debentures) but they do not have compulsory conversion requirement as in the case of Zero Coupon Bonds. They are issued at a discount to their. face value and the bond- holder gets the face value at the end of the maturity period. The difference in the issue price and face value represents the return to the bond-holder The bond- holders find present value of the face value by discounting it with their own required rate of return and compare it with the issue price. If the discounted value of the face value exceeds: the issue price, the investment proposal is accepted. (iii) Bond Indenture. Bond Indenture is a legal instrument incorporating an agreement between the issuing authority, the bondholder who lends money, and the trustee which is either the Commercial Bank or a Trust Company and represents the bondholder. Thus, three parties—the Company, Bondholders and the Trustee are involved. The bondholders acquire their bonds and automatically accept the indenture. The role of the trustee is mainly coordination between the Company and the Bondholder. The Company does not directly enter into an agreement with each of the Bondholders. The indenture consists of: : (a) Coupon Rate; (b) Authorisation of Issue; (c) Specimen copy of the Bond; (d) Trustee's certificate; () Pledged property as security; (f) Endorsement; (g) Registration; (i) Restrictions;UNIT 2: FIXED INCOME SECURITIES 7 a) Agreements; . Remedies when problems occur between the trustee and the bondholder; q all legal terminologies for purposes of clarity; )) in case of conversion, the rights of the bondholders, and (m) in case of redemption, the rights of the bondholders, a4. Explain the Floating Rate Bonds, Ans. Floating Rate Bonds. Floating rate is also called variable rate, on the rate of interest on a financial asset, whi (2014 June) Q. 5. Differentiate between Callable and Puttable Bond, (2011, 2015 June) Ans, Callable and Puttable Bond. Both these bonds are similar to other bonds except in terms of right of redeeming the bond before the maturity period. A bond ensures fixed payment of interest to its investors at a predetermined period of time. The companies issuing bonds must ensure that they generate enough funds over the period of time to Pay the interest timely to their bondholders. Incase of Callable bonds, the issuing companies have right to redeem the bond before the maturity period whereas in case of Puttable bonds, the bondholders have the right to redeem the bond before the maturity. The company usually exercises its right of redemption when market rate of interest is less than the coupon rate and the bondholder exercises his tight of seeking redemption when the market rate of interest is more than the coupon rate of the bond. Note: Callable and Puttable debentures are same as Callable & Puttable Bond, Q.6. Write a short note on callable bonds and junk bonds. (2014) Ans. Callable bonds. The companies have the right to redeem the bonds before their maturity period.The company generally exercises this right when market rate of interest is less than the coupon rate, Junk bonds. These are the bonds which have very high coupon rate but they are Rot secured by an asset of the company. These bonds, therefore, are subject to high default and credit risk. These are mainly subscribed by the speculators. Q 7. What is a convertible bond? Why do investors prefer a convertible ond over a non-convertible one? (2008) Ans. A bond ensures fixed payment of interest to its investors at pre-determi: Petiod of time. The company issuing bonds has to ensure that it generates enough funds over the period of time to pay the interest timely to its bond holders. i Convertible Bond is a hybrid security between stocks and bonds. It remains as pond for sometime and thereafter it is converted inthe form of shares, The bond js is Bets a fixed rate of interest for a certain number on years and thereafter his nds are converted int a specified number of equity shares. : n-convertible eae cenlinse with the features of ee rough thet ,utity period, holders in this case get interest payment on their isin during tha io of investment or maturity period whichever is >18 SHIV DAS DELHI UNIVERSITY SERIES Investors prefer convertible bonds over non-convertible ones as the equity shares received in lieu of convertible bonds can be retained for a longer period a, ‘investment’. The holder of such equity .shares has the unqualified right to dispose of part or entire lot of shares in the open market at the market price. If he retains such shares, he enjoys all the benefits of being a shareholder of a compan, ie, he can attend all meetings of the shareholders (AGM, EGM etc.). He has, right to receive dividend, bonus shares, right shares etc. The investor of the convertible bond can sell the equity shares, in case he so desires in the secondary market to realize his principal value. Q. 8. State various properties of bond value described by Malkiel. (2013) Ans. Malkiel’s properties of Bond values: There is relationship. between the — market interest rates, time to maturity and the bond values. The relation is summarized as below: ( Required rate of return and bond value are inversely related. As the : required rate increases, the bond prices fall and vice versa. (i) Prices of long-term bonds are more sensitive to interest rate changes than prices of short-term bonds. (iii) The sensitivity of bond prices to change in required rate of return increases at a decreasing rate as the time to maturity increases. (iv) Prices of high coupon rate bonds are less sensitive to changes in interest rates than prices of low coupon bond rates. (0) The sensitivity of a bond’s price to a:change in required rate of return is inversely related to the yield to maturity at which the bond is traded at present. Q. 9. “Market interest rate and debenture prices are inversely related.” Comment. (2010, 2016 June) ‘Ans. When the market price of the bond increases, the yield on the bonds decreases because there is inverse relationship between the price of the bond and the market price. It becomes clear from the following table: Consider a bond having face value of %1,000 and coupon rate 15%. The yield of the bond at different market prices is shown below: 1,200 {1,300 | 1,400 | 1,500 Current Market Price (CMP) (%) | 1,100 Rate of Interest (I) 150 150 150 150 150 . I Yield = ogp 13.64 | 12.50 | 11.54 | 10.71 | 10.00 It is observed that as the market price increases from 71,100 to 71,500, the yield on the bond decreases from 13.64% to 10%. This is due to the fact that higher return is available to an investor when he gets 150 on an investment of 1,100 than when he gets 7150 on an investment of 71,500, i.e,, 10%. The value of the bond will decrease as the interest rate starts increasing. If the rate of interest is 8% and the amount of interest is %80, the value of the bond is 21,000. If the rate is raised to 10%, the value of the bond shall become %800. Conversely if the rate is. 7%, the bond value will be 1,143 (80/0.07). Thus, it is obvious that there is inverse relationship between the value of the bond and the market price. |UNIT 2: FIXED INCOME SECURITIES 19 40. Examine the relationship between time to maturity and bond valuation, with the help of a diagram. (2012) The amount of discount or premium declines as the life of the bond reaches its maturity period provided its yield remains constant through its maturity nea, The rate of decline increases as the life of the bond moves near its maturity Perot The rate of discount decreases at an increasing rate as the life of the bond Popes its maturity period. A When coupon rate is greater than yield to maturity When coupon rate is equal to yield to maturity ‘When coupon rate is less than yield to maturity Maturity Rate The rate of premium decreases at an increasing rate as the life of the bond reaches its maturity period. If the yield to maturity remains equivalent to the coupon rate of the bond throughout its life, the bond will remain at its par value throughout its life and no change will be observed. The above relations are shown in the given diagram. Q. 11. Discuss various kinds of risks involved in bond investment. (2015) Ans. Risks involved in Bond Investment: : (i Inflation Risk. When the rate of return on investments is less than the market price inflation, it is known as Inflation Risk. Example, Mr. R invested 7100 having return of 12% p.a. So, after 1 year he will get %112 but the market inflation is 15%, it means the commodity which could be purchased for %100 one year ago is worth 2115 now. (i Interest Rate Risk. This risk is related with the rate of interest or coupon rate. If a company is giving interest rate which is higher than the market rate, the price of bond of the company will increase. On the other hand, if the company is paying interest rate which is lower than the market rate, it may decrease the bond price of the company. ; h (ii) Call Risk. Call risk arises if a company redeems its bond prior to the specified time. This may occur when the market interest rate secreasee Example, Company X is paying 15% interest but the market rate is 107. So, Company X will redeem its bonds and issue them to other invest at the market rate which is 10%. | . (i) Default Risk. The inefficiency of company to pay intetest &° eer amount on the due date is known as peta erat 6 y when a company is under peony os aes ae Sail aa (0) Liquidity Risk. Most of the debts ane ar sllng the investment because of which an investor faces problems when he requires to.a 20 SHIV DAS DELHI UNIVERSITY SERIES Q. 12. What do you mean by credit rating? Discuss its relevance for investors and the issuing companies. (2016, 2015 jun Ans. Credit Rating. It is the method of assigning some standard scores fo particular debt instrument. Rating is essentially an opinion which is expressed through standard symbols by the credit rating agencies. In India with th inception of CRISIL (Credit Rating Information Services of India) credit rating was first started in 1987. Credit rating depends on many factors which are dependent on the judgement of the rating agency. Credit rating is meant to: (a) provide credence to financial commitments made by a company. (b) provide information to the investor in selecting debt securities, (0) help in providing the company with marketability. Thus, credit rating facilitates trading in debt securities, It helps the participants to arrive at a quick estimate and opinion about various instruments. Benefits of Credit rating to Investors are: 1, Safeguards against bankruptcy. Credit rating of an instrument done by a credit rating agency gives an idea to the investors about the degree of financial strength of the issuer company which enables them to decide about the investment. Highly rated instrument of'a company gives an assurance to the investors of safety of the instrument and minimum risk of bankruptcy. 2. Recognition of risk. Credit rating provides investors with rating symbols which carry information in easily recognisable manner for the benefit of investors to perceive risk involved in investment. It becomes easier for the investors by looking at the symbol to understand the worth . of the issuer company. a = Credibility of issuer. Rating gives a clue to the credibility of the issuer company. The rating agency is quite independent of the issuer company and has no business connections or otherwise any relationship with it or its Board of Directors, etc. which provides a ground for credibility. Easy understandability of investment proposal. Rating symbols can be understood by an investor which needs no analytical knowledge on his part. Investor can take quick decisions about the investment to be made in any particular rated security of a company. Safety of resources. Investors rely upon credit rating. This relieves investors from the botheration of knowing about the fundamentals of 2 company, its actual strength, financial standing, management details, etc. because of quality of credit rating done by professional experts. Independence of investment decisions. For making investment decisions, investors have to seek advice of financial intermediaries, the stock brokers, merchant bankers, the portfolio managers etc. about the good investment proposals. But for rated instruments, investors need not depend upon their advice as the rating symbols suggest the credit worthiness of the instruments. 7. Choice of investments. Several alternative credit rating instruments 7° > a »UNIT 2: FIXED INCOME SECURITIES 21 vailable at a particular point of ti faa Se era ile investors can ei A for making pee in the capital risk profile and diversification plans, In addition to above upon their own _ other advantages like quick understanding of the eerie investors have eteoance for the Issuing companies: ee _ Improves Corporate image. Hi Feat 2 frst in the minds of te inven too sn eee ee company enjoys a good corporate image in the ae Therefore, the Lowers Cost of Borrowing, Companies that have high credit rat their debt instruments will get funds at lower cost from the ff te igh rating will enable the company ‘to offer low. interest eis o1 Fi et deposits, debentures and other debt securities. The investi i acee Jow interest rates because they prefer low risk instrum a shania Wider Audience for Borrowing. A company with high ‘atin, fori anes ane oe audience for borrowing. It can woah ancial institutions, investin; i é : This is because the credit ratings are Say waded peel Cee Good for Non-popular companies. Credit rating is beveficial for the non-popular companies, such as closely-held companies. If the credit rating is good, the public will invest in these companies, even if these companies are not well-known in the market. : ‘Act as a Marketing Tool. Credit rating not only presents a good image of the company among the investors, but also among the customers, dealers, suppliers, ete. High credit rating can act as a marketing tool to develop confidence in the minds of customers, dealer, suppliers etc. Helps in Growth and Expansion. Credit rating enables a company to grow and expand. This is because better credit rating will enable a company to get finance easily for growth and expansion. Q. 13. Explain the process of credit rating of debt instruments adopted by credit rating agencies. (2010, 2016 June) ‘Ans. Process of credit rating. The process of credit rating is as under: () A formal request is made by the company intending to come out with the security issue. It defines terms of rating assignment, which requires the Credit Rating Agency to maintain confidentiality. It also states that the issuer would provide information required by it for rating subsequent revision. , (i) A Rating Team is cons 2 > a oo tituted keeping in view the expertise and skills required for evaluating the business of the client company. thers information from secondary source of (ii) The rating agency also ga information using its own Research Division. The secondary sources of information are necessary to study policies about the industry. (iv) It interacts with the management to assess the future outlook of the company. Plant visits are conducted to understand the Produation Process and to assess the state of equipment and the quality of Personnel, etc. ; () Having completed the analysis, the rating team makes presentation before22 SHIV DAS DELHI UNIVERSITY SERIES the senior officer where the findings of the team are di: in mi details. Consequently, the rating symbol is decided. Dense’ in te (vi) The assigned rating is communicated to the top management f acceptance. The management is also provided with an opportunity e furnish additional information. The rejected ratings are not disclosed aa they are kept confidential. (vii) The additional information is placed before the rating committee, which has powers to revise the rating symbol in the light of additional information. The credit rating agency is required to monitor the accepted ratings over the tenure of the rated instruments. Though there is a compulsory requirement to review the rating on annual basis but the same can be done earlier also if the situation warrants so. On review, the initial rating could be retained or changed, Q. 14. What do you mean by Credit Rating Agency? Explain the role played by these agencies in making an investment decision. (2014) ‘Ans. Credit rating agency. A credit rating agency provides information and guidance to institutional and individual investors and creditors. It helps in increasing the ability of borrowers to raise funds from money market and the also helps the regulators in promoting transparency in the capital market. It financial markets. It provides an opinion regarding the ability of borrowers to pay.off their debt obligations on time. king an investment decision. Following services are provided by a Role in mai good Credit Rating Agency: . () The credit rating of all types of debt instruments—both short term and long term is undertaken. : Service under which it makes available (ii) It provides Information information on any company, local body, business enterprise. It enables the users of the service to mal decisions regarding investments. (iii) It prepares credit reports on companies which are used by the banks and financial institutions while granting loans to companies. (iv) It undertakes the study of equities by conducting an extensive study of the shares listed on the major stock exchanges. It attempts to identify the equity having good prospects in future on the basis of various fundamentals. industry or sector required by a ike informed gaagunit 3 “Approaches to Equity Analysis FUNDAMENTAL & TECHNICAL ANaLys; Q.1. What is Technical Analy, help of suitable example. Or, Explain the Technical Anal analysis? Or, “Fundamental analysis is a more technical analysis.” Do you agree? Comment. (2011) Ans. Technical analysis. An investor would always like to purchase the shares priate time. Technical analysis helps in estimating the sis? Explain line chart and bar chart with the , : (2007) ysis. How is it different from fundamental (2009) important tool for investor than the find appropriate time of purchase and sale of the stock. Various kinds of tools such as relationship between price and volume of trading, bars and line charts, head and Stoulder patterns, triangles etc. are used by the technical analysts, Line charts. Charts used by technical analysts are usually in the form of line charts. These charts are drawn to predict the future price of stocks. They are Prepared in a method that it connects the successive days’ closing prices. Bar charts, They are prepared in vertical lines and made to show the closing Price of each day and the closing price movements. Line charts and bar charts are simple projections of prices. They show the amount of shares which are traded at tach time when the price changes. These charts represent the volume of trading ofshares. They do not represent the security prices but only show trading volumes, Fundamental analysis is a method of finding out the future price of a stock Which an investor wishes to buy. The method for forecasting the future behaviour of investments and the rate of return on them i8‘clearly through an ‘nalysis of the broad economic forces in which they operate, the kind of industry ‘which they belong and the analysis of the company’s internal working through ‘ months. The Short-term Trends are the movements which occur within a day. They are also called oscillations. The Primary Trend, When the market reflects a rising trend, it is called bull harket; it consists of three peaks. The three peaks are formed in such a manner thateach peak is higher than the preceding peak and the bottoms are also higher the preceding bottoms. first peak shows building of good rT fi *ntiment and confidence among the security Loss of confidences nwket investors about the development in Poor financial results seeqegetomy and corporate results. The g — nd set of investors make an entry while & nec tPorate results are being announced. © the cory I jounced, = > rf Porate results are anni L — - hey selloff their holdings and make an exit. Days ‘Bear-Market Dp