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    STOCK MARKET:

    Stock market is a term used to describe the physical location where the buying and selling of

    stocks take place as well as the overall activity of the market within a particular country. The

    correct term to be used in pertaining to the physical location for trading stocks is stock

    exchange. Every country may have a couple of different stock exchanges that are usually traded

    on only one exchange although a lot of large corporations may be listed in several different

    locations.

    Stock markets perform the following functions:

    y Connecting those who seek money with those who can provide it.y Create an auction mechanism in which prices can be decided for investments.y Distributing the future risk of investments across many millions of individuals.y Connecting financial institutions together to create money.

    HOW A TRADE ACTUALLY TAKES PLACE ON A STOCK EXCHANGE?

    If you are the owner of a restaurant and you want t0o sell your stock of goods lying in the

    restaurant, you might do it by word-of-mouth, or by placing an ad in the newspaper. This would

    certainly make the whole process a lot easier.

    However, it creates a problem down the line for investors who want to sell their shares in the

    restaurant. The seller has to go out and find a buyer, which can be hard. A "stock market" solves

    this problem. Stocks/Shares of publicly traded companies are bought and sold at a stock market

    (also known as a stock exchange). Bombay Stock Exchange (BSE) is an example of such a

    market.

    In your neighborhood, you have a "supermarket" (like Big Bazaar) that sells food. The reason

    you go to Big Bazaar is because you can go to one place and buy all of the different types of

    food that you need in one stop -- it's a lot more convenient than driving around to the vegetable

    vendor, the dairy farmer, the baker, etc. The BSE is a supermarket for shares. The BSE can be

    thought of as a big room where everyone who wants to buy and sell shares of stocks can go to, to

    do their buying and selling.

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    The exchange makes buying and selling easy. You don't have to actually travel to Mumbai to

    visit BSE -- you can call a stock broker who does business with the BSE, and he or she will deal

    with the BSE on your behalf to buy or sell your shares. If the exchange did not exist, buying or

    selling shares would be a lot harder. You would have to place a classified ad in the newspaper,

    wait for a call and haggle on a price whenever you wanted to sell stock. With an exchange in

    place, you can buy and sell shares instantly.

    INDIAN STOCK MARKET:

    The Bombay Stock Exchange (BSE) and the National Stock Exchange of India Ltd (NSE) are

    the two primary exchanges in India. In addition, there are about 22* Regional Stock Exchanges.

    However, the BSE and NSE that have established themselves as the two leading exchanges and

    account for about eighty per cent of the equity volume traded in India.

    The Indian stock markets operate five days a week from 9.55 am to 3.30 pm. They are closed on

    Saturdays, Sundays and other declared Public Holidays.

    The key regulator governing Stock Exchanges, Brokers, Depositories, Depository participants,

    Mutual Funds, FIIs and other participants in Indian secondary and primary market is the

    Securities and Exchange Board ofIndia (SEBI) Ltd.

    EQUITY BASICS:

    Wouldn't you love to be the owner of a prosperous business without actually working for the

    company? Imagine having the ownership in companies, seeing those companies grow, and

    collecting the dividend cheques year after year, without involving yourself in the workings of the

    business. This situation might sound like a fancy dream, but it's closer to reality than you might

    think.

    Materializing this flight of imagination could be possible only by holding one of the greatest

    tools ever invented for building wealth, undoubtedly, the stocks or equities!!!

    A share of stock (also referred to as equity shares) represents a share of ownership in a company.

    For growth of the business, a company can raise money from the public by offering them

    ownership in return for their money. Once the money is raised, the company lists on the stock

    exchange where the shares of the company can be openly bought and/or sold by the investors. So

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    basically if you want to invest in a company, you will have to buy the shares of that particular

    company from the stock exchange at the current share price, provided that company is listed on

    the stock exchange.

    Equities are a part, if not the cornerstone, of nearly every investment portfolio. When you start

    on your road to financial freedom, you need to have a solid understanding of equities and how

    they trade on the stock market.

    In an accounting context, Shareholders' equity (or stockholders' equity, shareholders' funds,

    shareholders' capital or similar terms) represents the remaining interest in assets of a company,

    spread among individual shareholders of common or preferred stock.

    EQUITY INVESTMENTS:

    An equity investment generally refers to the buying and holding of shares of stock on a stock

    market by individuals and firms in anticipation of income from dividends and capital gains, as

    the value of the stock rises. It may also refer to the acquisition of equity (ownership)

    participation in a private (unlisted) company or a startup company. When the investment is in

    infant companies, it is referred to as venture capital investing and is generally understood to be

    higher risk than investment in listed going-concern situations.

    The equities held by private individuals are often held via mutual funds or other forms of

    collective investment scheme, many of which have quoted prices that are listed in financial

    newspapers or magazines; the mutual funds are typically managed by prominent fund

    management firms, such as Schroders, Fidelity Investments or The Vanguard Group. Such

    holdings allow individual investors to obtain the diversification of the fund(s) and to obtain the

    skill of the professional fund managers in charge of the fund(s). An alternative, which is usually

    employed by large private investors and pension funds, is to hold shares directly; in the

    institutional environment many clients who own portfolios have what are called segregated

    funds, as opposed to or in addition to the pooled mutual fund alternatives.

    A calculation can be made to assess whether an equity is over or underpriced, compared with a

    long-term government bond. This is called the Yield Gap or Yield Ratio. It is the ratio of the

    dividend yield of an equity and that of the long-term bond

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    Ownership equity includes both tangible and intangible items (such as brand names and

    reputation / goodwill).

    Accounts listed under ownership equity include (example):

    y Share capital (common stock)y Preferred stocky Capital surplusy Retained earningsy Treasury stocky Stock optionsy Reserve

    SHARE CAPITAL:

    Share capital or issued capital or capital stock refers to the portion of a company's equity that has

    been obtained (or will be obtained) by trading stock to a shareholder for cash or an equivalent

    item of capital value. For example, a company can set aside share capital, to exchange for

    computer servers instead of directly purchasing the servers from existing equity.

    Share capital usually comprises the nominal values of all shares issued, less those repurchased by

    the company. It includes both common stock (ordinary shares) and preferred stock (preference

    shares). If the market value of shares is greater than the their nominal value (value at par), the

    shares are said to be at a premium (called share premium, additional paid-in capital or paid-in

    capital in excess of par).

    PREFERRED STOCK:

    Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special

    equity security that has properties of both an equity and a debt instrument and is generally

    considered a hybrid instrument. Preferreds are senior (i.e., higher ranking) to common stock, but

    are subordinate to bonds.

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    Preferred stock usually carries no voting rights, but may carry a dividend and may have priority

    over common stock in the payment of dividends and upon liquidation. Preferred stock may have

    a convertibility feature into common stock. Terms of the preferred stock are stated in a

    "Certificate ofDesignation".

    Similar to bonds, preferred stocks are rated by the major credit rating companies. The rating for

    preferreds is generally lower since preferred dividends do not carry the same guarantees as

    interest payments from bonds and they are junior to all creditors.

    CAPITAL SURPLUS:

    Capital surplus (also referred to as additional paid in capital, paid in capital in excess of par or

    share premium), is an accounting term that frequently appears as a balance sheet item as a

    component of shareholders' equity. Capital surplus is used to account for the capital that a firm

    raises in excess of the par value (nominal value) of the shares (common stock).

    Taken together, common stock (and sometimes preferred stock) issued and paid plus capital

    surplus represent the total amount actually paid by investors for shares when issued (assuming no

    subsequent adjustments or changes).

    Shares, for which there is no par value, will generally not have any form of capital surplus on the

    balance sheet; all funds from issuing shares will be credited to common stock issued.

    RETAINED EARNINGS:

    In accounting, retained earnings refer to the portion of net income which is retained by the

    corporation rather than distributed to its owners as dividends. Similarly, if the corporation takes a

    loss, then that loss is retained and called variously retained losses, accumulated losses or

    accumulated deficit. Retained earnings and losses are cumulative from year to year with losses

    offsetting earnings.

    Retained earnings are reported in the shareholders' equity section of the balance sheet.

    Companies with net accumulated losses may refer to negative shareholders' equity as a

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    shareholders' deficit. A complete report of the retained earnings or retained losses is presented in

    the Statement of Retained Earnings or Statement of Retained Losses.

    TREASURY STOCK:

    A treasury stock or reacquired stock is stock which is bought back by the issuing company,

    reducing the amount of outstanding stock on the open market ("open market" including insiders'

    holdings).

    Stock repurchases are often used as a tax-efficient method to put cash into shareholders' hands,

    rather than paying dividends. Sometimes, companies do this when they feel that their stock is

    undervalued on the open market. Other times, companies do this to provide a "bonus" to

    incentive compensation plans for employees. Rather than receive cash, recipients receive an asset

    that might appreciate in value faster than cash saved in a bank account. Another motive for stock

    repurchase is to protect the company against a takeover threat.

    The United Kingdom equivalent of treasury stock as used in the United States is treasury share.

    Treasury stocks in the UK refer to government bonds or gilts.

    STOCK OPTION:

    In finance, an option is a derivative financial instrument that establishes a contract between two

    parties concerning the buying or selling of an asset at a reference price. The buyer of the option

    gains the right, but not the obligation, to engage in some specific transaction on the asset, while

    the seller incurs the obligation to fulfill the transaction if so requested by the buyer. The price of

    an option derives from the difference between the reference price and the value of the underlying

    asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the

    time remaining until the expiration of the option. Other types of options exist, and options can in

    principle be created for any type of valuable asset.

    An option which conveys the right to buy something is called a call; an option which conveys the

    right to sell is called a put. The reference price at which the underlying may be traded is called

    the strike price or exercise price. The process of activating an option and thereby trading the

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    underlying at the agreed-upon price is referred to as exercising it. Most options have an

    expiration date. If the option is not exercised by the expiration date, it becomes void and

    worthless.

    In return for granting the option, called writing the option, the originator of the option collects a

    payment, the premium, from the buyer. The writer of an option must make good on delivering

    (or receiving) the underlying asset or its cash equivalent, if the option is exercised.

    An option can usually be sold by its original buyer to another party. Many options are created in

    standardized form and traded on an anonymous options exchange among the general public,

    while other over-the-counter options are customized ad hoc to the desires of the buyer, usually

    by an investment bank.

    RESERVE

    In financial accounting, the term reserve is most commonly used to describe any part of

    shareholders' equity, except for basic share capital. Sometimes, the term is used instead of the

    term provision; such a use, however, is inconsistent with the terminology suggested by

    International Accounting Standards Board.

    Equity reserves are created from several possible sources:

    y Reserves created from shareholders' contributions, the most common examples of whichare:

    o Legal reserve fund - it is required in many legislations and it must be paid as apercentage of share capital

    o Share premium - amount paid by shareholders for shares in excess of theirnominal value

    y Reserves created from profit, especially retained earnings, i.e. accumulated accountingprofits. However, profits may be distributed also to other types of reserves, for example:

    o Legal reserve fund from profit - many legislations require creation of the fund as apercentage of profits

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    o Remuneration reserve - will be used later to pay bonuses to employees ormanagement.

    o Translation reserve - arises during consolidation of entities with differentreporting currencies

    Reserve is the profit achieved by a company where a certain amount of it is put back into the

    business which can help the business in their rainy days.

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    SECURITIES:

    This is an introduction to the different types of debt and equity instruments floated by a firm. The

    various types of securities and explanations as to the distinguishing characteristic and purpose

    are discussed here.

    1. Corporate securities

    A. Equity SharesB. Preference SharesC. BondsD. DebenturesE. Warrants

    2. Deposits in banks and non-banking companies.

    3. UTI and other mutual fund schemes.

    4. Post office deposits and certificates

    5. Life insurance policies

    6. Provident fund schemes.

    7. Government and semi-Government securities.

    1. CORPORATE SECURITIES:Corporate securities are the securities issued by joint stock companies in the private sector.

    These include equity shares, preference shares and debentures. Equity shares have variable

    dividend and hence belong to the high risk - high return category, while preference shares and

    debentures have fixed returns with lower risk.

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    A. EQUITY SHARES:Equity shares are commonly referred to as common stock or ordinary shares. Even though the

    words shares and stocks are interchangeably used, there is a difference between them. Share

    capital of a company is divided into a number of small units of equal value called shares. The

    term stock is the aggregate of a member's fully paid up shares of equal value merged into one

    fund. It is a set of shares put together in a bundle. The "stock" is expressed in terms of money

    and not as many shares. Stock can be divided into fractions of any amount and such fractions

    may be transferred like shares.

    Share certificate means a certificate under the common seal of the company specifying the

    number of shares held by any member. Share certificate provides the prima facie evidence of title

    of the members to such shares. This gives the shareholder the facility of dealing more easily with

    the shares in the market. It enables the sale of shares by showing marketable title.

    Equity shares have the following rights according to section 85 (2) of the Companies Act 1956 in

    India.

    1. Right to vote at the general body meetings of the company.2. Right to control the management of the company.3. Right to share in the profits in the form of dividends and bonus shares.4. Right to claim on the residual value after repayment of all the claims in the case of

    winding up of the company.

    5. Right of pre-emption in the matter of issue of new capital.6. Right to apply to court if there is any discrepancy in the rights set aside.7. Right to receive a copy of the statutory report, copies of annual accounts along with

    audited report.

    8. Right to appeal to the central government to call an annual meeting when a company failsto call such a meeting.

    9. Right to appeal to the Company Law Board for calling an extraordinary general meeting.

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    In a limited company the equity shareholders are liable to pay the company's debt only to the

    extent of their share in the paid up capital. The equity shares have certain advantages. The main

    advantages are :

    1. Capital appreciation2. Limited liability3. Free tradeability4. Tax advantages (in certain cases) and5. Hedge against inflation

    TYPES OF EQUITY SHARES

    y Non-voting Sharesy Rights Sharesy Bonus sharesy Sweat Equity

    NON-VOTING SHARES

    Non-voting shares carry no voting rights. They carry additional dividends instead of the voting

    rights. Even though the idea was widely discussed in 1987, it was only in the year 1994 that the

    Finance Ministry announced certain broad guidelines for the issue of non-voting shares.

    They have right to participate in the bonus issue. The non-voting shares also can be listed and

    traded in the stock exchanges. If non-voting shares are not paid dividend for two years, the

    shares would automatically get voting rights. The company can issue this to a maximum of 25

    per cent of the voting stock. The dividend on non-voting shares would have to be 20 percent

    higher than the dividend on the voting shares. All rights and bonus shares for the non-voting

    shares have to be issued in the form of non-voting shares only.

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    RIGHTS SHARES

    Shares offered to the existing shareholders at a price by the company are called rights shares.

    They are offered to the shareholders as a matter of legal right. If a public company wants to

    increase its subscribed capital by way of issuing shares after two years from its formation date or

    one year from the date of first allotment, whichever is earlier, such shares should be offered first

    to the existing shareholders in proportion to the capital paid up on the shares held by them at the

    date of such offer. This pre-emptive right can be forfeited by the shareholders through a special

    resolution. The shareholder can renounce the rights shares in favour of a nominee in part or fully.

    The rights shares may be partly paid. Minimum subscription limit is prescribed for rights issues.

    In the event of company failing to receive 90% subscription, the company shall have to return

    the entire money received. At present, SEBI has removed this limit. Rights issues are regulated

    under the provisions of the Companies Act and SEBI.

    BONUS SHARES

    Bonus share is the distribution of shares in addition to the cash dividends to the existing

    shareholders. Bonus shares are issued to the existing shareholders without any payment of cash.The aim of bonus share is to capitalise the free reserves. The bonus issue is made out of free

    reserves built out of genuine profit or share premium collected in cash only. The bonus issue

    could be made only when all the partly paid shares, if any, existing are made fully paid up.

    The declaration of the bonus issue used to have favourable impact on the psychology of the

    shareholders. They take it as an indication of higher future profits. Bonus shares are declared by

    the directors only when they expect a rise in the profitability of the concern. The issue of bonus

    shares enables the shareholders to sell the shares and get capital gains while retaining their

    original shares.

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    SWEAT EQUITY

    Sweat equity is a new equity instrument introduced in the Companies (Amendment) Ordinance,

    1998. Newly inserted Section 79A of the Companies Act, 1956 allows issue of sweat equity.

    However, it should be issued out of a class of equity shares already issued by the company. It

    cannot form a new class of equity shares. Section 79A (2) explains that all limitations,

    restrictions and provisions applicable to equity shares are applicable to sweat equity. Thus, sweat

    equity forms a part of equity share capital.

    The definition of sweat equity has two different dimensions:

    i. Shares issued at a discount to employees and directors.ii. Shares issued for consideration other than cash for providing know- how or making

    available rights in the nature of intellectual property rights or value additions.

    In its first form, issue of sweat equity may be priced at a discount to the preferential pricing or at

    a discount to face value. Issue of sweat equity falls in the category of preferential issue under

    Section 81 (lA) of the Companies Act,1956. Agreed upon price of shares of the company is

    derived in accordance with preferential pricing norm, which may be called as normal price.

    The level of discount to normal price may be decided on the basis of the valuation of the

    intangibles to be acquired. Discount is the difference between the normal price and price at

    which sweat equity is issued.

    Discount may also mean any issue of sweat equity below the par value. This eases the restriction

    on issue of shares at discount as stated in Section 79. This route can be used by a company

    whose share price is 10-20% above the par value. Issue of shares at discount under Section 79

    can be carried at 10% discount. In case of sweat equity, it becomes imperative to decide the

    maximum level of discount that can be offered to the employees and directors.

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    The second type of sweat equity can be issued at par or above par. In other words, the sweat

    equity can be issued against know-how, intellectual property rights or in recognition of value

    additions. Issue of sweat equity for consideration other than cash should be at the normal

    preferential price.

    Reasons for issuing sweat equityDirectors and employees contribute intellectual property rights

    to the company. This may be in the form of providing technical know-how captured by way of

    research, contributing to the company in the form of strategy, software developed for the

    company, or adding profit.

    Traditional way of recognizing the employees and directors in the form of monetary and non-

    monetary benefit is deficient. Even incentive bonus on the basis of performance fails to reward

    them adequately. Rather in the matter of intellectual property right, the contributing

    employees/directors are not well protected.

    In case a director/employee leaves the company or is asked to leave, the generatation of cash

    flows to the company for an unidentified future period is not stopped and the director/employee

    also gets adequate return.

    Sweat equity is especially for

    y Directors/employees who designed strategic alliance.y Directors/employees who worked for strategic market penetration and helped the

    company attain sustainable market share.

    In the service industry, sweat equity has a special relevance. The major industries where the

    directors and employees can be rewarded through sweat equity are:

    y Computer hardware and software development

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    y Management consultancy where a standard strategy is issued to earn a fee, likeEnterprise Resource Planning (ERP) solution

    y NBFCs where product design is crucialy Other non-traditional financial service industries like custodians, depositories and credit

    rating wherein basic service design is important

    y In the life insurance segment, commission-based business can be converted into sweatequity with development officers and branch managers (sales)

    B. PREFERENCE SHARESThe characters of the preferred share are hybrid in nature. Some of its features resemble the bond

    and others the equity shares. Like the bonds, their claims on the company's income are limited

    and they receive fixed dividend. In the event of liquidation of the company their claims on the

    assets of the firm are also fixed. At the same time like the equity, it is a perpetual liability of the

    corporate. The decision to pay dividend to the preferred stock is at the discretion of the Board of

    Directors. In the case of bonds, payment of interest rate is mandatory.

    The dividend received by the preferred share is treated on par with the dividend received from

    the equity share for tax purposes. These shareholders do not enjoy any of the voting powers

    except when any resolution affects their rights.

    Types of Preference Shares

    y Cumulative preference sharesy Non-cumulative preference sharesy Convertible preference sharesy Non-Convertible preference sharesy Redeemable preference sharesy Irredeemable preference sharesy Cumulative Convertible Preference shares

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    Cumulative preference shares Here, the cumulative total of all unpaid preferred dividends must

    be paid before dividends are paid on the common equity. The unpaid dividends are known as

    arrears. The arrears do not earn interest. The nonpayment of the dividend only continues to grow.

    The arrears occur only for a limited number of years and not indefinitely. Generally three years

    of arrears accrue and the accumulative feature ceases after three years. But the dividends in

    arrears continue if there is no provision in the Articles of Association. In the case of liquidation,

    no arrears of dividends are payable unless there is a provision for them in the Articles of

    Association.

    Non-cumulative shares As the name suggests, the dividend does not accumulate. If there is no

    profit or inadequate profit in the company in a particular year, the company does not pay it.When the company is wound up if the preference and equity shares are fully paid they have no

    further rights to have claims in the surplus. If there is a provision in the Articles of Association

    for such claims, then they have the rights to claim.

    Convertible preference shares The convertibility feature makes the preference share a more

    attractive investment security. The conversion feature is almost identical with that of the bonds.

    These preference shares are convertible as equity shares at the end of the specified period and are

    quasi-equity shares. This gives the additional privilege of sharing the potential increase in the

    equity value, along with the security and stability of income.

    Non-Convertible preference shares The non-convertibility feature implies that the preference

    shares retain their characteristics of a preference share document.

    Redeemable preference shares If there is a provision in the Articles of Association,

    redeemable preference shares can be issued. But redemption of the shares can be done only

    when:

    a) The partly paid up shares are made fully paid up.

    b) The fund for redemption is created from the profits, which would otherwise be available for

    distribution of dividends or out of the proceeds of a fresh issue of shares for the purpose.

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    c) If any premium has to be paid on redemption, it should be paid out of the profits or out of the

    company's share premium account.

    d) When redemption is made out of profits, a sum equal to the nominal value of the redeemed

    shares should be transferred to the capital redemption reserve account.

    Irredeemable preference shares This type of shares is not redeemable except on occasion like

    winding up of the business. In India, this type of shares were permitted till 15th June 1988. The

    introduction of section 80A in the Companies Act 1956 has put an end to it.

    Cumulative Convertible Preference Shares (CCPS) This CCPS was introduced by the

    Government in 1984 This preference share gives a regular return say 10% during the gestation

    period from three years to five years and then are converted into equity as per the agreement.

    According to the guidelines, CCPS can be issued for any of the following purposes (a) setting up

    of new projects (b) expansion or diversification of existing projects (c) normal capital

    expenditure for modernisation and (d) working capital requirements. CCP failed to attract the

    interest of the investors because the rate of interest is very low and the gain that could be

    received from the conversion into equity also depends on the profitable functioning of the

    company.

    C. BONDS:In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and,

    depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay

    the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed

    money with interest at fixed intervals.]

    Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor),

    and the coupon is the interest. Bonds provide the borrower with external funds to finance long-

    term investments, or, in the case of government bonds, to finance current expenditure.

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    Certificates of deposit (CDs) or commercial paper are considered to be money market

    instruments and not bonds.

    Bonds and stocks are both securities, but the major difference between the two is that (capital)

    stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders

    have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds

    usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may

    be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with

    no maturity).

    FEATURES OF BONDS:

    The most important features of a bond are:

    y Nominal, principal or face amount the amount on which the issuer pays interest, andwhich, most commonly, has to be repaid at the end of the term. Some structured bonds

    can have a redemption amount which is different from the face amount and can be linked

    to performance of particular assets such as a stock or commodity index, foreign exchange

    rate or a fund. This can result in an investor receiving less or more than his original

    investment at maturity.

    y Issue price the price at which investors buy the bonds when they are first issued,which will typically be approximately equal to the nominal amount. The net proceeds that

    the issuer receives are thus the issue price, less issuance fees.

    y Maturity date the date on which the issuer has to repay the nominal amount. As longas all payments have been made, the issuer has no more obligations to the bond holders

    after the maturity date. The length of time until the maturity date is often referred to as

    the term or tenor or maturity of a bond. The maturity can be any length of time, although

    debt securities with a term of less than one year are generally designated money market

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    instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds

    have been issued with maturities of up to one hundred years, and some even do not

    mature at all.

    In the market for U.S. Treasury securities, there are three groups of bond maturities:

    o Short term (bills): maturities between one to five year; (instruments withmaturities less than one year are called Money Market Instruments)

    o Medium term (notes): maturities between six to twelve years;o Long term (bonds): maturities greater than twelve years.

    y Coupon the interest rate that the issuer pays to the bond holders. Usually this rate isfixed throughout the life of the bond. It can also vary with a money market index, such as

    LIBOR, or it can be even more exotic. The name coupon originates from the fact that in

    the past, physical bonds were issued which had coupons attached to them. On coupon

    dates the bond holder would give the coupon to a bank in exchange for the interest

    payment.

    y The "quality" of the issue refers to the probability that the bondholders will receive theamounts promised at the due dates. This will depend on a wide range of factors:

    o Indentures and Covenants An indenture is a formal debt agreement thatestablishes the terms of a bond issue, while covenants are the clauses of such anagreement. Covenants specify the rights of bondholders and the duties of issuers,

    such as actions that the issuer is obligated to perform or is prohibited from

    performing. In the U.S., federal and state securities and commercial laws apply to

    the enforcement of these agreements, which are construed by courts as contracts

    between issuers and bondholders. The terms may be changed only with great

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    difficulty while the bonds are outstanding, with amendments to the governing

    document generally requiring approval by a majority (or super-majority) vote of

    the bondholders.

    o High yield bonds are bonds that are rated below investment grade by the creditrating agencies. As these bonds are more risky than investment grade bonds,

    investors expect to earn a higher yield. These bonds are also called junk bonds.

    y Coupon dates the dates on which the issuer pays the coupon to the bond holders. Inthe U.S. and also in the U.K. and Europe, most bonds are semi-annual, which means that

    they pay a coupon every six months.

    y Optionality: Occasionally a bond may contain an embedded option; that is, it grantsoption-like features to the holder or the issuer:

    o Callability Some bonds give the issuer the right to repay the bond before thematurity date on the call dates. These bonds are referred to as callable bonds.

    Most callable bonds allow the issuer to repay the bond at par. With some bonds,

    the issuer has to pay a premium, the so called call premium. This is mainly the

    case for high-yield bonds. These have very strict covenants, restricting the issuer

    in its operations. To be free from these covenants, the issuer can repay the bonds

    early, but only at a high cost.

    o Putability Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates. (Note: "Putable" denotes an

    embedded put option; "Puttable" denotes that it may be put.)

    o Call dates and put datesthe dates on which callable and putable bonds can beredeemed early. There are four main categories.

    A Bermudan callable has several call dates, usually coinciding withcoupon dates.

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    A European callable has only one call date. This is a special case of aBermudan callable.

    An American callable can be called at any time until the maturity date. A death put is an optional redemption feature on a debt instrument

    allowing the beneficiary of the estate of the deceased to put (sell) the bond

    (back to the issuer) in the event of the beneficiary's death or legal

    incapacitation. Also known as a "survivor's option".

    y Sinking fund provision of the corporate bond indenture requires a certain portion of theissue to be retired periodically. The entire bond issue can be liquidated by the maturity

    date. If that is not the case, then the remainder is called balloon maturity. Issuers may

    either pay to trustees, which in turn call randomly selected bonds in the issue, or,

    alternatively, purchase bonds in open market, then return them to trustees.

    y Convertible bond lets a bondholder exchange a bond to a number of shares of theissuer's common stock.

    y Exchangeable bond allows for exchange to shares of a corporation other than the issuer.

    Types of Bonds:

    y Secured bonds and unsecured bondsy Perpetual bonds and redeemable bondsy Fixed interest rate bonds and floating interest rate bondsy Zero coupon bondsy Deep discount bondsy Capital indexed bonds

    Secured bonds and unsecured bonds The secured bond is secured by the real assets of the

    issuer. In the case of the unsecured bond the name of issuer may be the only security.

    Perpetual bonds and redeemable bonds Bonds that do not mature or never mature are called

    perpetual bonds. The interest alone would be paid. In the redeemable bond the bond is redeemed

    after a specific period of time. The redemption value is specified by the issuer.

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    Fixed interest rate bondsand floating interest rate bondsIn the fixed interest rate bonds the

    interest rate is fixed at the time of the issue. Whereas in the floating interest rate bonds the

    interest rates change according to the prefixed norms. For example in Dec 1993 State Bank of

    India issued floating interest rate bonds worth Rs 500 Cr. pegging the interest rate with its own

    three and five years fixed deposit rates to provide built in yield flexibility to the investors.

    Zero coupon bonds These bonds sell at a discount and the face value is repaid at maturity. The

    origin of this type of bond can be traced in the U.S. Security Market. The high value of the

    U.S.Government security prevented the investors from investing their money in the Government

    security. Big brokerage companies like Merril Lynch, Pierce and others purchased theGovernment securities in large quantum and resold them in smaller denomination at a discounted

    rate. The difference between the purchase cost and face value of the bond is the gain for the

    investor. Since the investor does not receive any interest on the bond, the conversion price is

    suitably arranged to protect the interest loss to the investor.

    The merit of this bond is that the company does not have the burden of servicing the debt during

    the execution period of the project. The repayment could be adjusted to fall after the completion

    of the project. This could result in considerable cost savings for the company.

    Deep discount bondsDeep discount bond is another form of zero coupon bond. The bonds are

    sold at large discount on their nominal value; interest is not paid for them and they mature at par

    value. The difference between the maturity value, and the issue price serves as an interest return.

    The deep discount bonds' maturity period may range from 3 years to 25 years or more. IDBI was

    the first to issue deep discount bonds in India in 1992 with varying maturity period options.

    ICICI also issued deep discount bonds with four optional maturity periods in 1997. Early

    redemption option is provided at the end of the 6th,12th and 18th year.

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    Capital indexed bondsCapital indexed bonds were introduced in 1997. In the capital indexed

    bond, the principal amount of the bond is adjusted for inflation for every year. For example, an

    investment of Rs.l000 in the inflation indexed bonds earn the investor a semi annual interestincome for the five years' period. The reselling of the principal amount is done semi annually

    based on the Wholesale Price Index (WPI) movements. The principal amount of the bond is

    adjusted for inflation for each of the years. On the inflation-adjusted principal, the coupon rate of

    6 per cent is worked. The benefit of the bond is that it gives the investor an increase in return by

    taking inflation into account. The investor enjoys the benefit of a return on his principal, which is

    equal to the average inflation between the issue (purchase) and maturity period of the instrument.

    To avail the benefit of inflated principal, the investor needs to hold the instrument for the entire 5

    year period.

    If the investor wants to exit early, he can do it through the secondary market. The value of the

    principal repayment will be adjusted by the Index Rate (IR), which will be announced by the

    RBI two weeks prior to the repayment of the principal. The IR is worked out as follows

    IR = Reference WPI as in Aug 2002/Base WPI (as in August 1997).

    In the Indian situation indexed bonds offer more scope since the economy is highly sensitive to

    inflation. According to the study conducted by the Development Research Group (DRG) of the

    RBI, during the period 1972-93, the real rate of interest was negative for most of the years.

    Average value over the period is minus 1.84 per cent.

    This situation warrants an inflation hedge. The inflation protection provided by the bond

    guarantees real rate of return which means that with the rise in inflation, the return from the

    inflation protected bond will rise.

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    YIELD TO MATURITY

    The Yield to maturity (YTM) orredemption yield of a bond or other fixed-interest security,

    such as gilts, is the internal rate of return (IRR, overall interest rate) earned by an investor who

    buys the bond today at the market price, assuming that the bond will be held until maturity, and

    that all coupon and principal payments will be made on schedule. Yield to maturity is actually an

    estimation of future return, as the rate at which coupon payments can be reinvested when

    received is unknown.[1] It enables investors to compare the merits of different financial

    instruments. The YTM is often given in terms of Annual Percentage Rate (A.P.R.), but more

    usually market convention is followed: in a number of major markets the convention is to quote

    yields semi-annually (see compound interest: thus, for example, an annual effective yield of

    10.25% would be quoted as 5.00%, because 1.05 x 1.05 = 1.1025).

    The yield is usually quoted without making any allowance for tax paid by the investor on the

    return, and is then known as "gross redemption yield". It also does not make any allowance for

    the dealing costs incurred by the purchaser (or seller).

    y If the yield to maturity for a bond is less than the bond's coupon rate, then the (clean)market value of the bond is greater than the par value (and vice versa).

    y If a bond's coupon rate is less than its YTM, then the bond is selling at a discount.

    y If a bond's coupon rate is more than its YTM, then the bond is selling at a premium.y If a bond's coupon rate is equal to its YTM, then the bond is selling at par.

    YIELD CURVE

    In finance, the yield curve is the relation between the interest rate (or cost of borrowing) and

    the time to maturity of the debt for a given borrower in a given currency. For example, the

    U.S. dollar interest rates paid on U.S. Treasury securities for various maturities are closely

    watched by many traders, and are commonly plotted on a graph such as the one below which

    is informally called "the yield curve." More formal mathematical descriptions of this relation

    are often called the term structure of interest rates.

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    The yield of a debt instrument is the overall rate of return available on the investment. For

    instance, a bank account that pays an interest rate of 4% per year has a 4% yield, when the price

    of the bond equals its par value. In general the percentage per year that can be earned is

    dependent on the length of time that the money is invested. For example, a bank may offer a

    "savings rate" higher than the normal checking account rate if the customer is prepared to leave

    money untouched for five years. Investing for a period of time t gives a yield Y(t).

    This function Y is called the yield curve, and it is often, but not always, an increasing function oft. Yield curves are used by fixed income analysts, who analyze bonds and related securities, to

    understand conditions in financial markets and to seek trading opportunities. Economists use the

    curves to understand economic conditions.

    The yield curve function Y is actually only known with certainty for a few specific maturity

    dates, while the other maturities are calculated by interpolation

    D. DEBENTURESAccording to the Companies Act 1956, "Debenture includes debenture stock, bonds and any

    other securities of company, whether constituting a charge on the assets of the company or not".

    Debentures are generally issued by the private sector companies as a long-term promissory note

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    for raising loan capital. The company promises to pay interest and principal as stipulated. Bond

    is an alternative form of debenture in India. Public sector companies and financial institutions

    issue bonds.

    CHARACTERISTIC FEATURES OF DEBENTURES:

    Form;

    It is given in the form of certificate of indebtedness by the company specifying the date of

    redemption and interest rate.

    Interest:

    The rate of interest is fixed at the time of issue itself which is known as contractual or coupon

    rate of interest. Interest is paid as a percentage of the par value of the debenture and may be paid

    annually, semi annually or quarterly. The company has the legal binding to pay the interest rate.

    Redemption:

    As stated earlier the redemption date would be specified in the issue itself. The maturity period

    may range from 5 years to 10 years in India. They may be redeemed in installment. Redemption

    is done through a creation of sinking fund by the company. A trustee in charge of the fund buys

    the debentures either from the market or owners. Creation of the sinking fund eliminates the risk

    of facing financial difficulty at the time of redemption because redemption requires a huge sum.

    Buy back provisions help the company to redeem the debentures at a special price before the

    maturity date. Usually the special price is higher than the par value of the debenture.

    Indenture:

    Indenture is a trust deed between the company issuing debenture and the debenture trustee who

    represents the debenture holders. The trustee takes the responsibility of protecting the interest of

    the debenture holders and ensures that the company fulfills the contractual obligations. Financial

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    institutions, banks, insurance companies or firm attornies act as trustees to the investors. In the

    indenture the terms of the agreement, description of debentures, rights of the debenture holders,

    rights of the issuing company and the responsibilities of the company are specified clearly.

    TYPES OF DEBENTURES;

    Debentures are classified on the basis of the security and convertibility

    y Secured or unsecuredy Fully convertible debenturey Partly convertible debenturey Non-convertible debenture

    Secured or unsecured;

    A secured debenture is secured by a lien on the company's specific assets. In the case of default

    the trustee can take hold of the specific asset on behalf of the debenture holders. In the Indian

    market secured debentures have a charge on the present and future immovable assets of the

    company.

    When the debentures are not protected by any security they are known as unsecured or nakeddebentures. In the American capital market debenture means unsecured bonds while bonds could

    be secured or unsecured in the Indian market. Unsecured debentures find it difficult to attract

    investors because of the risk involved in them. Generally debentures are rated by the credit rating

    agencies.

    Fully convertible debenture;

    This type of debenture is converted into equity shares of the company on the expiry of specific period. The conversion is carried out according to the guidelines issued by SEBl. The FCD

    carries lower interest rate than other types of debentures because of the attractive feature of

    convertibility into equity shares.

    Partly convertible debenture;

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    This debenture consists of two parts namely convertible and non-convertible. The convertible

    portion can be converted into shares after a specific period. Here, the investor has the advantage

    of convertibe and non-convertible debentures blended into one debenture. Example: Procter and

    Gamble had issued PCD of Rs 200 each to its existing shareholders. The investor can get a share

    for Rs 65 with the face value of Rs 10 after 18 months from allotment.

    Non-convertible debenture;

    Non-convertible debentures do not confer any option on the holder to convert the debentures

    into equity shares and are redeemed at the expiry of the specified period.

    E. WARRANTSA warrant is a bearer document of title to buy specified number of equity shares at a specified

    price. Usually warrants can be exercised over a number of years. The life periods of warrants are

    long. Warrants are generally offered to make the bond or preferred stock offering more

    attractive. Bonds may bear low interest rate but the warrants offered along with them helps the

    investor to enjoy the equity appreciation value. Warrants are detachable. The investor can sell the

    warrants separately and they are traded in the market.

    The person who is holding the warrant cannot enjoy the benefits of the equity holder before the

    conversion of the warrant. The price at which the warrants are converted is called exercise price.

    The exercise price is always greater than the current market price of the respective equity at the

    time of issue of warrant. When warrants are issued along with host securities and are detachable,

    they are known as detachable warrants. In some cases the warrants can be sold back to the

    company before the expiry date and is known as puttable warrants. Naked warrants are issued

    separately and not with any host securities. The investor has the option to convert it into equity

    or bond.

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    ADVANTAGES OF WARRANTS:

    1) Warrants make the non-convertible debentures and other debentures more attractive and

    acceptable.

    2) The debentures along with the warrants are able to create their own market and reduce the

    company's dependence on financial institutions and mutual funds.

    3) Since the exercise of the warrants takes place at a future date, the cash flow and the capital

    structure of the company can be planned accordingly.

    4) The cost of debt is reduced if warrants are attached to it. Investors are willing to accept lower

    interest rate in the anticipation of enjoying the capital appreciation of equity value at a later date.

    5) Warrants provide high degree of leverage to the investors. They can sell the warrant in the

    market or convert it into stocks or allow it to lapse. But if the conversion is compulsory, even if

    there is a fall in the price of the shares, the investors have to shell out money from his pocket.

    6) Warrants are liquid and they are traded in the stock exchanges. Hence, the investor can sell the

    warrants before exercising them.

    Difference Between Share Warrants and Share Certificate

    Warrants Share Certificate

    1. Issued by public limited

    company

    Issued by public and private

    companies

    2. Need for provision in the

    Articles of Association

    No need for provision in the

    Articles of Association

    3. Should be approved by the

    central Government

    Central Government approval is

    not needed

    4. Transfer of share warrant

    requires no registration

    Transfer of share would be

    complete only if it registration is

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    complete

    5. Share warrants are issued to fully

    paid up shares

    Share certificates are issued to fully

    and partly paid shares

    6. It is considered as a negotiable

    instrument

    Share certificate is not considered

    like that

    2. Deposits:Among the non-corporate investments, the most popular are deposits with banks such as savings

    accounts and fixed deposits. Savings deposits have low interest rates whereas fixed deposits havehigher interest rates varying with the period of maturity. Interest is payable quarterly or half-

    yearly. Fixed deposits may also be recurring deposits wherein savings are deposited at regular

    intervals. Some banks have reinvestment plans wherein savings are deposited at regular intervals.

    Some banks have reinvestment plans wherein the interest is reinvested as it gets accrued. The

    principal and accumulated interests are paid on maturity. Joint stock companies also accept fixed

    deposits from the public. The maturity period varies from three to five years. Fixed deposits in

    companies have high risk since they are unsecured, but they promise higher returns than bank

    deposits. Fixed deposit in non-banking financial companies (NBFCs) is another investment

    avenue open to savers. NBFCs include leasing companies, hire purchase companies, investment

    companies, chit funds etc. Deposits in NBFCs carry higher returns with higher risk compared to

    bank deposits.

    3. UTI and other mutual fund schemes:UTI is the oldest and the largest Mutual Fund in the country. It has many investment schemes.

    Unit Scheme 1964, Unit Linked Insurance Plan 1971, Master share, Master Equity Plans,

    Mastergain etc. are some of the popular schemes of UTI. A number of commercial banks and

    financial institutions have set up Mutual Funds. Mutual Funds have been set up in the private

    sector also. These Mutual Funds offer various investment schemes to investors.

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    4. Post office deposits and certificates:

    The investment avenues provided by post offices are generally non-marketable. Moreover, themajor investments in post office enjoy tax concessions also. Post offices accept savings deposits

    as well as fixed deposits from the public. There is also a recurring deposit scheme which is an

    instrument of regular monthly savings.Six-year National Savings Certificates(NSC) are issued by

    post office to investors. The interest on the amount invested is compounded half-yearly and is

    payable along with the principal at the time of maturity which is six years from the date of

    issue.Indira Vikas Patra and Kissan Vikas Patra are savings certificates issued by post office.

    5. Life insurance Policies:The Life Insurance corporation offers many investment schemes to investors. These schemes

    have the additional facility of life insurance cover. Some of the schemes of L IC are whole Life

    Policies, Convertible Whole Life Assurance Policies, Endowment Assurance policies, Jeevan

    Saathi, Money Back Plan, Jeevan Dhara, Marriage Endowment Plan, etc.

    6. Provident fund Scheme:Provident fund schemes are compulsory deposit schemes applicable to employees in the public

    and private sectors. There are three kinds of provident funds applicable to different sectors of

    employment, namely, Statutory Provident Fund, Recognized Provident Fund and Unrecognized

    Provident Fund.I

    n addition to these, there is a voluntary provident fund scheme which is open toany investor whether employed or not. This is known as the Public Provident Fund (PPF). Any

    member of the public can join the scheme which is operated by the post office and the State

    Bank ofIndia.

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    7. Government and semi-Government securities:The government and semi-government bodies like the public sector undertakings borrow money

    from the public through the issue of Government securities and public sector bonds. These are

    less risky avenues of investment because of the credibility of the Government and Government

    undertakings.

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    earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion

    of their earnings and pay the remainder as a dividend.

    For a joint stock company, a dividend is allocated as a fixed amount per share. Therefore, a

    shareholder receives a dividend in proportion to their shareholding. For the joint stock company,

    paying dividends is not an expense; rather, it is the division of after tax profits among

    shareholders. Retained earnings (profits that have not been distributed as dividends) are shown in

    the shareholder equity section in the company's balance sheet - the same as its issued share

    capital. Public companies usually pay dividends on a fixed schedule, but may declare a dividend

    at any time, sometimes called a special dividend to distinguish it from the fixed schedule

    dividends.

    Cooperatives, on the other hand, allocate dividends according to members' activity, so their

    dividends are often considered to be a pre-tax expense.

    Dividends are usually paid in the form of cash, store credits (common among retail consumers'

    cooperatives) and shares in the company (either newly created shares or existing shares bought in

    the market.) Further, many public companies offer dividend reinvestment plans, which

    automatically use the cash dividend to purchase additional shares for the shareholder.

    The word "dividend" comes from the Latin word "dividendum" meaning "thing to be divided".

    ULIP:

    A unit-linked insurance plan (ULIP) is a type of life insurance where the cash value of a policy

    varies according to the current net asset value of the underlying investment assets. It allows

    protection and flexibility in investment, which are not present in other types of life insurance

    such as whole life policies. The premium paid is used to purchase units in investment assets

    chosen by the policyholder.

    In India investments in ULIP are covered under Section 80C ofIT Act. However, the concept of

    having an investment e governed by the Insurance Regulatory and Development Authority

    (IRDA).

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    INDEX FUNDS:

    An index fund or index tracker is a collective investment scheme (usually a mutual fund or

    exchange-traded fund) that aims to replicate the movements of an index of a specific financial

    market, or a set of rules of ownership that are held constant, regardless of market conditions.

    Tracking can be achieved by trying to hold all of the securities in the index, in the same

    proportions as the index. Other methods include statistically sampling the market and holding

    "representative" securities. Many index funds rely on a computer model with little or no humaninput in the decision as to which securities are purchased or sold and is therefore a form of

    passive management.

    ACTIVELY MANAGED FUNDS:

    Active management (also called active investing) refers to a portfolio management strategy

    where the manager makes specific investments with the goal of outperforming an investment

    benchmark index

    Ideally, the active manager exploits market inefficiencies by purchasing securities (stocks etc.)

    that are undervalued or by short selling securities that are overvalued. Either of these methods

    may be used alone or in combination. Depending on the goals of the specific investment

    portfolio, hedge fund or mutual fund, active management may also serve to create less volatility

    (or risk) than the benchmark index. The reduction of risk may be instead of, or in addition to, thegoal of creating an investment return greater than the benchmark.

    Active portfolio managers may use a variety of factors and strategies to construct their

    portfolio(s). These include quantitative measures such as price/earnings ratio P/E ratios and PEG

    ratios, sector investments that attempt to anticipate long-term macroeconomic trends (such as a

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    focus on energy or housing stocks), and purchasing stocks of companies that are temporarily out-

    of-favor or selling at a discount to their intrinsic value. Some actively managed funds also pursue

    strategies such as merger arbitrage, short positions, option writing, and asset allocation.

    PASSIVELY MANAGED FUNDS:

    Passive management (also called passive investing) is a financial strategy in which an investor

    (or a fund manager) invests in accordance with a pre-determined strategy that doesn't entail any

    forecasting (e.g., any use of market timing or stock picking would not qualify as passive

    management). The idea is to minimize investing fees and to avoid the adverse consequences of

    failing to correctly anticipate the future. The most popular method is to mimic the performance

    of an externally specified index. Retail investors typically do this by buying one or more 'index

    funds'. By tracking an index, an investment portfolio typically gets good diversification, low

    turnover (good for keeping down internal transaction costs), and extremely low management

    fees. With low management fees, an investor in such a fund would have higher returns than a

    similar fund with similar investments but higher management fees and/or turnover/transaction

    costs.

    Passive management is most common on the equity market, where index funds track a stock

    market index, but it is becoming more common in other investment types, including bonds,

    commodities and hedge funds. Today, there is a plethora of market indexes in the world, and

    thousands of different index funds tracking many of them.

    One of the largest equity mutual funds, the Vanguard 500, is a passive management fund. The

    two firms with the largest amounts of money under management, Barclays Global Investors and

    State Street Corp., primarily engage in passive management strategies

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    HEDGING:

    A hedge fund is a private investment fund that participates in a range of assets and a variety of

    investment strategies intended to protect the fund's investors from downturns in the market while

    maximizing returns on market upswings.

    Hedge funds are distinct from mutual funds, individual retirement and investment accounts, and

    other types of traditional investment portfolios in a number of ways. As a class, hedge funds

    undertake a wider range of investment and trading activities than traditional long-only

    investment funds, and invest in a broader range of assets, including equities, bonds and

    commodities. By taking a long position on a particular asset the manager is asserting that this

    position is likely to increase in value. When the manager takes a short position in another asset

    they would be asserting that the asset is likely to decrease in value. Most hedge fund investment

    strategies aim to secure positive return on investment regardless of overall market performance.

    Hedge fund managers typically invest their own money in the fund they manage, which serves to

    align their interests with investors in the fund. Investors in hedge funds typically pay a

    management fee that goes toward the operational costs of the fund, and a performance fee when

    the funds net asset value is higher than that of the previous year. The net asset value of a hedge

    fund can be billions of dollars, due to investments from large institutional investors including

    pension funds, university endowments and foundations. Worldwide, 61% of investment in hedge

    funds is from institutional sources as of February 2011[update].As of 2009[update], hedge funds

    represent 1.1% of the total funds and assets held by financial institutions. The estimated size of

    the global hedge fund industry is US$1.9 trillion.

    Hedge funds are only open for investment to a limited number of accredited or qualified

    investors who meet criteria set by regulators. Because hedge funds are not sold to the public or

    retail investors its advisers have historically not been subject to the same restrictions that govern

    other investment fund advisers, with regard to how the fund may be structured and how

    strategies are employed. However, hedge funds must comply with many of the same statutory

    and regulatory restrictions as other institutional market participants Regulations passed in the

    United States and Europe after the 2008 credit crisis are intended to increase government

    oversight of hedge funds and eliminate any regulatory gaps.

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    DERIVATIVES:

    In finance, a derivative is a contract whose payoff depends on the behavior of some benchmark,

    which is known as the "underlying". The underlying is typically a tradable asset, for example, a

    stock or commodity, but can be a non-tradable such as the weather (in the case of weather

    derivatives). The most common derivatives are futures, options, and swaps.

    The most common derivatives have a market value and are traded on exchanges. Among the

    oldest of these are rice futures, which have been traded on the Dojima Rice Exchange since the

    eighteenth century.

    Derivatives are usually broadly categorized by:

    y The relationship between the underlying asset and the derivative (e.g., forward, option,swap);

    y The type of underlying asset (e.g., equity derivatives, foreign exchange derivatives,interest rate derivatives, commodity derivatives or credit derivatives);

    y The market in which they trade (e.g., exchange-traded or over-the-counter); andy Their pay-off profile.

    Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For example,

    a speculator may sell deep in-the-money naked calls on a stock, expecting the stock price to

    plummet, but exposing him to potentially unlimited losses. Very commonly, companies buy

    currency forwards in order to limit losses due to fluctuations in the exchange rate of two

    currencies.

    COMMON DERIVATIVE CONTRACT TYPES

    There are three major classes of derivatives:

    1. Futures/Forwards :These are contracts to buy or sell an asset on or before a future date at a price specified

    today. A futures contract differs from a forward contract in that the futures contract is a

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    standardized contract written by a clearing house that operates an exchange where the

    contract can be bought and sold, whereas a forward contract is a non-standardized

    contract written by the parties themselves.

    2. Options :These are contracts that give the owner the right, but not the obligation, to buy (in the

    case of a call option) or sell (in the case of a put option) an asset. The price at which the

    sale takes place is known as the strike price, and is specified at the time the parties enter

    into the option. The option contract also specifies a maturity date. In the case of a

    European option, the owner has the right to require the sale to take place on (but not

    before) the maturity date; in the case of an American option, the owner can require the

    sale to take place at any time up to the maturity date. If the owner of the contract

    exercises this right, the counter-party has the obligation to carry out the transaction.

    3. Swaps:These are contracts to exchange cash (flows) on or before a specified future date based on

    the underlying value of currencies/exchange rates, bonds/interest rates, commodities,

    stocks or other assets.

    More complex derivatives can be created by combining the elements of these basic types. For

    example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or

    before a specified future date.

    TYPES OF DERIVATIVES:

    In broad terms, there are two groups of derivative contracts, which are distinguished by the way

    they are traded in the market:

    1. Over-the-counter (OTC)OTC derivatives are contracts that are traded (and privately negotiated) directly between two

    parties, without going through an exchange or other intermediary. Products such as swaps,

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    forward rate agreements, and exotic options are almost always traded in this way. The OTC

    derivative market is the largest market for derivatives, and is largely unregulated with respect to

    disclosure of information between the parties, since the OTC market is made up of banks and

    other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult

    because trades can occur in private, without activity being visible on any exchange. According to

    the Bank forInternational Settlements, the total outstanding notional amount is US$684 trillion

    (as of June 2008). Of this total notional amount, 67% are interest rate contracts, 8% are credit

    default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are

    equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange,

    there is no central counter-party. Therefore, they are subject to counter-party risk, like an

    ordinary contract, since each counter-party relies on the other to perform.

    2. Exchange-traded derivative contracts (ETD)ETD are those derivatives instruments that are traded via specialized derivatives exchanges or

    other exchanges. A derivatives exchange is a market where individuals trade standardized

    contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary

    to all related transactions, and takes Initial margin from both sides of the trade to act as a

    guarantee. The world's largest derivatives exchanges (by number of transactions) are the Korea

    Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of

    European products such as interest rate & index products), and CME Group (made up of the

    2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008

    acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in

    the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of

    derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments

    such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges.

    Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs

    and various other instruments that essentially consist of a complex set of options bundled into a

    simple package are routinely listed on equity exchanges. Like other derivatives, these publicly

    traded derivatives provide investors access to risk/reward and volatility characteristics that, while

    related to an underlying commodity, nonetheless are distinctive.