STUDY ON PORTFOLIO MANAGEMENT

A report submitted to IIMT, Greater Noida as a part fulfillment of

Fulltime Post graduate Diploma in management.

Under the guidance of

Mr. GAURAV KUMAR

SUBMITTED TO: SUBMITTED BY:

DR.D.K. GARG AVINASH KR. SINHA

CHAIRMAN ENR NO: FMR 4013

GREATER NOIDA SURAJ SINGH

ENR NO: FMR 4014

ISHAN INSTITUTE OF MANAGEMENT& TECHNOLOGY, 1KNOWLEDGE PARK-1,

GREATER NOIDA, DISTRICT: G.B.NAGAR, (UP),

Website: ishanfamily.com

E-mail: www.ishanfamily.com

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Acknowledgement

We express our hearty and sincere gratitude to our guide Mr. Gaurav Kumar for his

inspiring encouragement, effective guidance and supervision thus providing us an

opportunity to experience the practical aspects related to Finance, our field of study.

We are thankful for his immense co-operation and without his help this work would

have been impossible 

 

I am also grateful to Modex Group having allowed us to work in the organization to

complete my work. 

Our thanks are also due to Mr. D. K. Garg, Chairman Ishan Institute of Management

& Technology, Greater Noida for providing all the required facilities for completion

of our work. 

We are also grateful to our co-workers and friends for their unobliging help.

Last but not the least we are thankful to our Parents and all our friends and well

wishers for their inspiration and unconditional help they have extended during this

endeavor.

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PREFACE

The Final Project has an object to make management students familiar with the real

life business situation and give an opportunity to understand the concept of

management in a particular way. The project schedule for a period of three to four

months was my first exposure to real life situation in the dynamic corporate world.

The project entitled to us is “Study on Portfolio Management.”

As Capital market in India is growing at an increasing rate. The competition is getting

tough day by day.

The project includes the preference given by the Broking firm regarding the Stocks &

Mutual Fund. We have also analyzed the consumer behavior in the purchase of Stocks

& Mutual Funds

The project report also gives a glimpse of state licensing policy.

3

Modex International Securities Ltd.

Modex Commodity Trades Pvt.

Ltd.

MEMBER OF NSE, BSE, MCX-SX, NCDEX, MCX, DEPOSITORY – CDSL AND INTERNET TRADING

Connaught Place - EPBAX NO (Common) 47217000: FAX NO: 47217066/77

Rajendra Place No- 47210300: FAX NO: 47210355

WEBSITE: www.modexindia.com E-MAIL: contact@modexindia.com

CERTIFICATE

This is to certify that the project work done on “STUDY ON PORTFOLIO

MANAGEMENT” submitted to Ishan Institute of Management and technology,

Greater Noida by Mr. Avinash Kr. Sinha & Mr. Suraj Singh in partial fulfilment of

the requirement for the award of degree of PG Diploma in Financial Management is a

bonafide work carried out by them under my supervision and guidance. This project

report is the original one and has not been submitted anywhere else for any other

degree/diploma.

Date Seal/Stamp of the Guide Name of the guide

4

DECLARATION

We Avinash Kumar Sinha & Suraj Singh student of PGDFM 4th Semester Ishan

Institute of Management & Technology, Greater Noida hereby declare that, this

Project report on “Study on Portfolio Management” is the record of our original work

done under the invaluable guidance of Mr. Gaurav Kumar MODEX International

Securities Ltd.

Avinash Kumar Sinha

Suraj Singh

Date:-

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CONTENTS

Page no

CHAPTER-1 INTRODUCTION TO FINANCIAL MARKET (9-23)

Introduction

Types of financial market

Capital market

Importance

CHAPTER-2 INVESTMENT ALTERNATIVES (24-76)

Non-marketable financial assets

Money market instruments

Equity shares

Mutual funds

Financial derivatives

Insurance

CHAPTER-3 RISK AND RETURN (77-88)

Risk and return

Measuring historical risk and return

Measuring expected risk and return

CHAPTER-4 EQUITY EVALUATION (89-94)

CHAPTER-5 FINANCIAL STATEMENT ANALYSIS (95-99)

Financial statement

Financial ratios

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CHAPTER-6 BOND EVALUATION (100-109)

Bond Characteristics, price, yield risks

Interest rate risk

CHAPTER-7 FUNDAMENTAL ANALYSIS (110-166)

Economic analysis

Industry analysis

Company analysis

CHAPTER-8 TECHNICAL ANALYSIS (167-208)

What is technical analysis?

Charting techniques

Evaluation

CHAPTER-9 PORTFOLIO THEORY (209-217)

Diversification and portfolio risk

Portfolio risk and return

Riskless borrowing and lending

CHAPTER-10 PORTFOLIO MANAGEMENT FRAMEWORK (218-235)

Specification of investment objectives

Selection of assets

Formulation of portfolio strategies

Evaluation of portfolio revision

CHAPTER-11 GUIDELINES FOR INVESTMENT DECISIONS (236-254)

Basic guidelines

Guidelines for equity investments

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CHAPTER-12 MY PERSONAL EXPERIENCE (255-261)

Limitations and suggestions

My learning’s

Words of Thanks

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CHAPTER-1 (FINANCIAL MARKET)

(a) INTRODUCTION

A financial market is a mechanism that allows people to easily buy and sell (trade)

financial securities (such as stocks and bonds), commodities (such as precious metals

or agricultural goods), and other fungible items of value at low transaction costs and

at prices that reflect the efficient market hypothesis.

Financial markets have evolved significantly over several hundred years and are

undergoing constant innovation to improve liquidity.

Both general markets, where many commodities are traded and specialized markets

(where only one commodity is traded) exist. Markets work by placing many interested

sellers in one "place", thus making them easier to find for prospective buyers. An

economy which relies primarily on interactions between buyers and sellers to allocate

resources is known as a market economy in contrast either to a command economy or

to a non-market economy that is based, such as a gift economy.

In Finance, Financial markets facilitate:

The raising of capital (in the capital markets);

The transfer of risk (in the derivatives markets); and

International trade (In the currency markets).

They are used to match those who want capital to those who have it.

Typically a borrower issues a receipt to the lender promising to pay back the capital.

These receipts are securities which may be freely bought or sold. In return for lending

money to the borrower, the lender will expect some compensation in the form of

interest or dividends.

DEFINITION

The term financial markets can be a cause of much confusion. Financial markets

could mean:

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1. Organizations that facilitate the trade in financial products. I.e. Stock exchanges

facilitate the trade in stocks, bonds and warrants.

2. The coming together of buyers and sellers to trade financial products. I.e. stocks

and shares are traded between buyers and sellers in a number of ways including: the

use of stock exchanges; directly between buyers and sellers etc.

In academia, students of finance will use both meanings but students of economics

will only use the second meaning. Financial markets can be domestic or they can be

international.

(b) TYPES OF FINANCIAL MARKETS

The financial markets can be divided into different subtypes:

Within the financial sector, the term "financial markets" is often used to refer just to

the markets that are used to raise finance: for long term finance, the Capital markets;

for short term finance, the Money markets. Another common use of the term is as a

catchall for all the markets in the financial sector, as per examples in the breakdown

below.

Capital markets which consist of:

Stock markets, which provide financing through the issuance of shares

or common stock, and enable the subsequent trading thereof.

Bond markets, which provide financing through the issuance of bonds, and

enable the subsequent trading thereof.

Commodity markets, which facilitate the trading of commodities.

Money markets, which provide short term debt financing and investment.

Derivatives markets, which provide instruments for the management

of financial risk.

Futures markets, which provide standardized forward contracts for trading

products at some future date; see also forward market.

Insurance markets, which facilitate the redistribution of various risks.

Foreign exchange markets, which facilitate the trading of foreign exchange.

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The capital markets may also be divided into primary markets and secondary markets.

Newly formed (issued) securities are bought or sold in primary markets, such as

during initial public offerings. Secondary markets allow investors to buy and sell

existing securities. The transactions in primary markets exist between issuers and

investors, while in secondary market transactions exist among investors. Liquidity is a

crucial aspect of securities that are traded in secondary markets. Liquidity refers to the

ease with which a security can be sold without a loss of value. Securities with an

active secondary market mean that there are many buyers and sellers at a given point

in time.

(c) Capital markets which consist of:

Stock markets, which provide financing through the issuance of shares or common

stock, and enable the subsequent trading thereof. Bond markets, which provide

financing through the issuance of Bonds, and enable the subsequent trading thereof.

Commodity markets, which facilitate the trading of commodities. Money markets,

which provide short term debt financing and investment. Derivatives markets, which

provide instruments for the management of financial risk. Futures markets, which

provide standardized forward contracts for trading products at some future date; see

also forward market. Insurance markets, which facilitate the redistribution of various

risks. Foreign exchange markets, which facilitate the trading of foreign exchange. The

capital markets consist of primary markets and secondary markets. Newly formed

(issued) securities are bought or sold in primary markets. Secondary markets allow

investors to sell securities that they hold or buy existing securities.

Raising capital

To understand financial markets, let us look at what they are used for, i.e. what is their

purpose?

Without financial markets, borrowers would have difficulty finding lenders

themselves. Intermediaries such as banks help in this process. Banks take deposits

from those who have money to save. They can then lend money from this pool of

deposited money to those who seek to borrow. Banks popularly lend money in the

form of loans and mortgages.

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More complex transactions than a simple bank deposit require markets where lenders

and their agents can meet borrowers and their agents, and where existing borrowing or

lending commitments can be sold on to other parties. A good example of a financial

market is a stock exchange. A company can raise money by selling shares to investors

and its existing shares can be bought or sold.

The following table illustrates where financial markets fit in the relationship between

lenders and borrowers:

Relationship between lenders and borrowers

Lenders Financial Intermediaries Financial Markets Borrowers

Individuals

Companies

Banks

Insurance Companies

Pension Funds

Mutual Funds

Interbank

Stock Exchange

Money Market

Bond Market

Foreign Exchange

Individuals

Companies

Central Government

Municipalities

Public Corporations

Lenders

Many individuals are not aware that they are lenders, but almost everybody does lend

money in many ways. A person lends money when he or she:

Puts money in a savings account at a bank;

Contributes to a pension plan;

Pays premiums to an insurance company;

Invests in government bonds; or

Invests in company shares.

Companies tend to be borrowers of capital. When companies have surplus cash that is

not needed for a short period of time, they may seek to make money from their cash

surplus by lending it via short term markets called money markets.

There are a few companies that have very strong cash flows. These companies tend to

be lenders rather than borrowers. Such companies may decide to return cash to

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lenders (e.g. via a share buyback.) Alternatively, they may seek to make more money

on their cash by lending it (e.g. investing in bonds and stocks.)

Borrowers

Individuals borrow money via bankers' loans for short term needs or longer term

mortgages to help finance a house purchase.

Companies borrow money to aid short term or long term cash flows. They also

borrow to fund modernization or future business expansion.

Governments often find their spending requirements exceed their tax revenues. To

make up this difference, they need to borrow. Governments also borrow on behalf of

nationalized industries, municipalities, local authorities and other public sector bodies.

In the UK, the total borrowing requirement is often referred to as the public sector

borrowing requirement (PSBR).

Governments borrow by issuing bonds. In the UK, the government also borrows from

individuals by offering bank accounts and Premium Bonds. Government debt seems

to be permanent. Indeed the debt seemingly expands rather than being paid off. One

strategy used by governments to reduce the value of the debt is to influence inflation.

Municipalities and local authorities may borrow in their own name as well as

receiving funding from national governments. In the UK, this would cover an

authority like Hampshire County Council.

Public Corporations typically include nationalized industries. These may include the

postal services, railway companies and utility companies.

Many borrowers have difficulty raising money locally. They need to borrow

internationally with the aid of Foreign exchange markets.

Derivative products

During the 1980s and 1990s, a major growth sector in financial markets is the trade in

so called derivative products, or derivatives for short.

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In the financial markets, stock prices, bond prices, currency rates, interest rates and

dividends go up and down, creating risk. Derivative products are financial products

which are used to control risk or paradoxically exploit risk.

Currency markets

Main article: Foreign exchange market

Seemingly, the most obvious buyers and sellers of foreign exchange are

importers/exporters. While this may have been true in the distant past, whereby

importers/exporters created the initial demand for currency markets, importers and

exporters now represent only 1/32 of foreign exchange dealing, according to.

The picture of foreign currency transactions today shows:

Banks and Institutions -

Speculators -

Government spending (for example, military bases abroad) -

Importers/Exporters

Analysis of financial markets See Statistical analysis of financial markets, statistical

finance much effort has gone into the study of financial markets and how prices vary

with time. Charles Dow, one of the founders of Dow Jones & Company and The Wall

Street Journal, enunciated a set of ideas on the subject which are now called Dow

Theory. This is the basis of the so-called technical analysis method of attempting to

predict future changes. One of the tenets of "technical analysis" is that market trends

give an indication of the future, at least in the short term. The claims of the technical

analysts are disputed by many academics, who claim that the evidence points rather to

the random walk hypothesis, which states that the next change is not correlated to the

last change.

The scale of changes in price over some unit of time is called the volatility. It was

discovered by Benoît Mandelbrot that changes in prices do not follow a Gaussian

distribution, but are rather modeled better by Levy stable distributions. The scale of

change, or volatility, depends on the length of the time unit to a power a bit more than

1/2. Large changes up or down are more likely that what one would calculate using a

Gaussian distribution with an estimated standard deviation.

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Financial markets in popular culture

Gordon Gekko is a famous caricature of a rogue financial markets operator, famous

for saying "greed ... is good".

Only negative stories about financial markets tend to make the news. The general

perception, for those not involved in the world of financial markets is of a place full of

crooks and con artists. Big stories like the Enron scandal serve to enhance this view.

Stories that make the headlines involve the incompetent, the lucky and the downright

skillful. The Barings scandal is a classic story of incompetence mixed with greed

leading to dire consequences. Another story of note is that of Black Wednesday, when

sterling came under attack from hedge fund speculators. This led to major problems

for the United Kingdom and had a serious impact on its course in Europe. A

commonly recurring event is the stock market bubble, whereby market prices rise to

dizzying heights in a so called exaggerated bull market. This is not a new

phenomenon; indeed the story of Tulip mania in the Netherlands in the 17th century

illustrates an early recorded example.

Financial markets are merely tools. Like all tools they have both beneficial and

harmful uses. Overall, financial markets are used by honest people. Otherwise, people

would turn away from them en masse. As in other walks of life, the financial markets

have their fair share of rogue elements.

(d) IMPORTANCE OF STOCK MARKET

Function and purpose

The stock market is one of the most important sources for companies to raise money.

This allows businesses to be publicly traded, or raise additional capital for expansion

by selling shares of ownership of the company in a public market. The liquidity that

an exchange provides affords investors the ability to quickly and easily sell securities.

This is an attractive feature of investing in stocks, compared to other less liquid

investments such as real estate.

History has shown that the price of shares and other assets is an important part of the

dynamics of economic activity, and can influence or be an indicator of social mood.

An economy where the stock market is on the rise is considered to be an up-and-

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coming economy. In fact, the stock market is often considered the primary indicator

of a country's economic strength and development. Rising share prices, for instance,

tend to be associated with increased business investment and vice versa. Share prices

also affect the wealth of households and their consumption. Therefore, central banks

tend to keep an eye on the control and behavior of the stock market and, in general, on

the smooth operation of financial system functions. Financial stability is the raison

d'être of central banks. Exchanges also act as the clearinghouse for each transaction,

meaning that they collect and deliver the shares, and guarantee payment to the seller

of a security. This eliminates the risk to an individual buyer or seller that the

counterparty could default on the transaction. The smooth functioning of all these

activities facilitates economic growth in that lower costs and enterprise risks promote

the production of goods and services as well as employment. In this way the financial

system contributes to increased prosperity. An important aspect of modern financial

markets, however, including the stock markets, is absolute discretion. For example,

American stock markets see more unrestrained acceptance of any firm than in smaller

markets. For example, Chinese firms that possess little or no perceived value to

American society profit American bankers on Wall Street, as they reap large

commissions from the placement, as well as the Chinese company which yields funds

to invest in China. However, these companies accrue no intrinsic value to the long-

term stability of the American economy, but rather only short-term profits to

American business men and the Chinese; although, when the foreign company has a

presence in the new market, this can benefit the market's citizens. Conversely, there

are very few large foreign corporations listed on the Toronto Stock Exchange TSX,

Canada's largest stock exchange. This discretion has insulated Canada to some degree

to worldwide financial conditions. In order for the stock markets to truly facilitate

economic growth via lower costs and better employment, great attention must be

given to the foreign participants being allowed in.

Irrational behavior

Sometimes the market seems to react irrationally to economic or financial news, even

if that news is likely to have no real effect on the fundamental value of securities

itself. But this may be more apparent than real, since often such news has been

anticipated, and a counter reaction may occur if the news is better (or worse) than

expected. Therefore, the stock market may be swayed in either direction by press

16

releases, rumors, euphoria and mass panic; but generally only briefly, as more

experienced investors (especially the hedge funds) quickly rally to take advantage of

even the slightest, momentary hysteria.

Over the short-term, stocks and other securities can be battered or buoyed by any

number of fast market-changing events, making the stock market behavior difficult to

predict. Emotions can drive prices up and down, people are generally not as rational

as they think, and the reasons for buying and selling are generally obscure.

Behaviorists argue that investors often behave 'irrationally' when making investment

decisions thereby incorrectly pricing securities, which causes market inefficiencies,

which, in turn, are opportunities to make money.

Crashes

A stock market crash is often defined as a sharp dip in share prices of equities listed

on the stock exchanges. In parallel with various economic factors, a reason for stock

market crashes is also due to panic and investing public's loss of confidence. Often,

stock market crashes end speculative economic bubbles.

There have been famous stock market crashes that have ended in the loss of billions of

dollars and wealth destruction on a massive scale. An increasing number of people are

involved in the stock market, especially since the social security and retirement plans

are being increasingly privatized and linked to stocks and bonds and other elements of

the market. There have been a number of famous stock market crashes like the Wall

Street Crash of 1929, the stock market crash of 1973–4, the Black Monday of 1987,

the Dot-com bubble of 2000, and the Stock Market Crash of 2008.One of the most

famous stock market crashes started October 24, 1929 on Black Thursday. The Dow

Jones Industrial lost 50% during this stock market crash. It was the beginning of the

Great Depression. Another famous crash took place on October 19, 1987 Black

Monday. The crash began in Hong Kong and quickly spread around the world.

Stock market index

The movements of the prices in a market or section of a market are captured in price

indices called stock market indices, of which there are many, e.g., the S&P, the FTSE

and the Euronext indices. Such indices are usually market capitalization weighted,

with the weights reflecting the contribution of the stock to the index. The constituents

17

of the index are reviewed frequently to include/exclude stocks in order to reflect the

changing business environment.

Derivative instruments

Financial innovation has brought many new financial instruments whose pay-offs or

values depend on the prices of stocks. Some examples are exchange-traded funds

(ETFs), stock index and stock options, equity swaps, single-stock futures, and stock

index futures. These last two may be traded on futures exchanges (which are distinct

from stock exchanges their history traces back to commodities futures exchanges), or

traded over-the-counter. As all of these products are only derived from stocks, they

are sometimes considered to be traded in a (hypothetical) derivatives market, rather

than the (hypothetical) stock market.

Leveraged strategies

Stock that a trader does not actually own may be traded using short selling; margin

buying may be used to purchase stock with borrowed funds; or, derivatives may be

used to control large blocks of stocks for a much smaller amount of money than

would be required by outright purchase or sale.

Short selling

In short selling, the trader borrows stock (usually from his brokerage which holds its

clients' shares or its own shares on account to lend to short sellers) then sells it on the

market, hoping for the price to fall. The trader eventually buys back the stock, making

money if the price fell in the meantime or losing money if it rose. Exiting a short

position by buying back the stock is called "covering a short position." This strategy

may also be used by unscrupulous traders in illiquid or thinly traded markets to

artificially lower the price of a stock. Hence most markets either prevent short selling

or place restrictions on when and how a short sale can occur. The practice of naked

shorting is illegal in most (but not all) stock markets.

Margin buying

In margin buying, the trader borrows money (at interest) to buy a stock and hopes for

it to rise. Most industrialized countries have regulations that require that if the

borrowing is based on collateral from other stocks the trader owns outright, it can be a

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maximum of a certain percentage of those other stocks' value. A margin call is made

if the total value of the investor's account cannot support the loss of the trade. (Upon a

decline in the value of the margined securities additional funds may be required to

maintain the account's equity, and with or without notice the margined security or any

others within the account may be sold by the brokerage to protect its loan position.

The investor is responsible for any shortfall following such forced sales.)

New issuance

Global issuance of equity and equity-related instruments totaled $505 billion in 2004,

a 29.8% increase over the $389 billion raised in 2003. Initial public offerings (IPOs)

by US issuers increased 221% with 233 offerings that raised $45 billion, and IPOs in

Europe, Middle East and Africa (EMEA) increased by 333%, from $ 9 billion to $39

billion.

Investment strategies

One of the many things people always want to know about the stock market is, "How

do I make money investing?" There are many different approaches; two basic

methods are classified as either fundamental analysis or technical analysis.

Fundamental analysis refers to analyzing companies by their financial statements

found in SEC Filings, business trends, general economic conditions, etc. Technical

analysis studies price actions in markets through the use of charts and quantitative

techniques to attempt to forecast price trends regardless of the company's financial

prospects. Additionally, many choose to invest via the index method. In this method,

one holds a weighted or un weighted portfolio consisting of the entire stock market or

some segment of the stock market (such as the S&P 500). The principal aim of this

strategy is to maximize diversification, minimize taxes from too frequent trading, and

ride the general trend of the stock market. (which, in the U.S., has averaged nearly

10%/year, compounded annually, since World War II).

Taxation

According to much national or state legislation, a large array of fiscal obligations are

taxed for capital gains. Taxes are charged by the state over the transactions, dividends

and capital gains on the stock market, in particular in the stock exchanges. However,

these fiscal obligations may vary from jurisdiction to jurisdiction because, among

19

other reasons, it could be assumed that taxation is already incorporated into the stock

price through the different taxes companies pay to the state, or that tax free stock

market operations are useful to boost economic growth.

Bond market

The bond market (also known as the debt, credit, or fixed income market) is a

financial market where participants buy and sell debt securities, usually in the form of

bonds. As of 2009, the size of the worldwide bond market (total debt outstanding) is

an estimated $82.2 trillion. References to the "bond market" usually refer to the

government bond market, because of its size, liquidity, lack of credit risk and,

therefore, sensitivity to interest rates. Because of the inverse relationship between

bond valuation and interest rates, the bond market is often used to indicate changes in

interest rates or the shape of the yield curve.

Market Structure

Bond markets in most countries remain decentralized and lack common exchanges

like stock, future and commodity markets. This has occurred, in part, because no two

bond issues are exactly alike, and the variety of bond securities outstanding greatly

exceeds that of stocks. Besides other causes, the decentralized market structure of the

corporate and municipal bond markets, as distinguished from the stock market

structure, results in higher transaction costs and less liquidity. A study performed by

Profs Harris and Piwowar in 2004, Secondary Trading Costs in the Municipal Bond

Market, reached the following conclusions: "Municipal bond trades are also

substantially more expensive than similar sized equity trades. We attribute these

results to the lack of price transparency in the bond markets. Additional cross-

sectional analyses show that bond trading costs decrease with credit quality and

increase with instrument complexity, time to maturity, and time since issuance." "Our

results show that municipal bond trades are significantly more expensive than

equivalent sized equity trades.

Types of bond markets

The Securities Industry and Financial Markets Association (SIFMA) classify the

broader bond market into five specific bond markets.

20

Corporate

Government & agency

Municipal

Mortgage backed, asset backed, and collateralized debt obligation

Funding

Bond market participants

Bond market participants are similar to participants in most financial markets and are

essentially either buyers (debt issuer) of funds or sellers (institution) of funds and

often both.

Participants include:

Institutional investors

Governments

Traders

Individuals

Because of the specificity of individual bond issues, and the lack of liquidity in many

smaller issues, the majority of outstanding bonds are held by institutions like pension

funds, banks and mutual funds. In the United States, approximately 10% of the market

is currently held by private individuals.

Bond market size

Amounts outstanding on the global bond market increased 10% in 2009 to a record

$91 trillion. Domestic bonds accounted for 70% of the total and international bonds

for the remainder. The US was the largest market with 39% of the total followed by

Japan (18%). Mortgage-backed bonds accounted for around a quarter of outstanding

bonds in the US in 2009 or some $9.2 trillion. The sub-prime portion of this market is

variously estimated at between $500bn and $1.4 trillion. Treasury bonds and

corporate bonds each accounted for a fifth of US domestic bonds. In Europe, public

sector debt is substantial in Italy (93% of GDP), Belgium (63%) and France (63%).

21

Concerns about the ability of some countries to continue to finance their debt came to

the forefront in late 2009. This was partly a result of large debt taken on by some

governments to reverse the economic downturn and finance bank bailouts. The

outstanding value of international bonds increased by 13% in 2009 to $27 trillion. The

$2.3 trillion issued during the year was down 4% on the 2008 total, with activity

declining in the second half of the year.

Bond market volatility

For market participants who own a bond, collect the coupon and hold it to maturity,

market volatility is irrelevant; principal and interest are received according to a pre-

determined schedule. But participants who buy and sell bonds before maturity are

exposed to many risks, most importantly changes in interest rates. When interest rates

increase, the value of existing bonds falls, since new issues pay a higher yield.

Likewise, when interest rates decrease, the value of existing bonds rise, since new

issues pay a lower yield. This is the fundamental concept of bond market volatility:

changes in bond prices are inverse to changes in interest rates. Fluctuating interest

rates are part of a country's monetary policy and bond market volatility is a response

to expected monetary policy and economic changes. Economists' views of economic

indicators versus actual released data contribute to market volatility. A tight

consensus is generally reflected in bond prices and there is little price movement in

the market after the release of "in-line" data. If the economic release differs from the

consensus view the market usually undergoes rapid price movement as participants

interpret the data. Uncertainty (as measured by a wide consensus) generally brings

more volatility before and after an economic release. Bond market influence Bond

markets determine the price in terms of yield that a borrower must pay in able to

receive funding. In one notable instance, when President Clinton attempted to increase

the US budget deficit in the 1990s, it led to such a sell-off (decreasing prices;

increasing yields) that he was forced to abandon the strategy and instead balance the

budget.

Bond investments

Investment companies allow individual investors the ability to participate in the bond

markets through bond funds, closed-end funds and unit-investment trusts. In 2006

total bond fund net inflows increased 97% from $30.8 billion in 2005 to $60.8 billion

22

in 2006. Exchange-traded funds (ETFs) are another alternative to trading or investing

directly in a bond issue. These securities allow individual investors the ability to

overcome large initial and incremental trading sizes.

Bond indices

A number of bond indices exist for the purposes of managing portfolios and

measuring performance, similar to the S&P 500 or Russell Indexes for stocks. The

most common American benchmarks are the Barclays Aggregate, Citigroup BIG and

Merrill Lynch Domestic Master. Most indices are parts of families of broader indices

that can be used to measure global bond portfolios, or may be further subdivided by

maturity and/or sector for managing specialized portfolios.

23

CHAPTER-2 (INVESTMENT ALTERNATIVES)

(a) NON-MARKETABLE FINANCIAL ASSETS

I.INTRODUCTION

Wealth, in economics, an accumulation of goods having economic value. Economic

value has several characteristics. First, an object must have utility. It must have, or be

suspected of having, the capacity to satisfy some human want. Wealth can be

increased by discovering uses for things previously not regarded as useful. Thus, the

discovery of uses for petroleum in the 19th century added enormously to wealth.

Second, economic goods must be in scarce supply. Air does not normally have

economic value because it is freely available. Air that is artificially conditioned is

economically valuable, however, because it is relatively scarce. Third, economic

goods must be transferable; that is, it must be possible to buy and sell them at definite

market prices. Finally, an object must have measurable economic value. Because the

only common unit of value today is money, the worth of goods must be expressible in

monetary terms. Some economists also regard a definite skill in performing a job as

human wealth; as such skill has a determinable market value.

II.COMPONENTS OF WEALTH

In classifying wealth it is useful to distinguish between producers' goods and

consumers' goods and, in each of these categories, between durable and nondurable

goods. Among producers' durable goods are plants, machinery, and other fixed

installations. Inventories of goods to be sold or in process of production make up

producers' nondurable goods. Together, producers' durable and nondurable goods

constitute capital, as generally understood. Food, clothing, and similar items of

consumption are consumer nondurables; consumer durables are homes, furniture, and

the like. Services are not included in estimated wealth as they cannot be stored.

Services do, however, have economic value, whether as services to producers (for

example, business accounting and legal services) or as services to consumers (for

example, hairdressing, education, and health-related services).

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WEALTH AND INCOME

Wealth must be distinguished from income. Both involve utility, scarcity,

transferability, and measurability. Whereas wealth is an accumulation, a stock existing

at a certain instant of time, income is a flow of goods and services during a certain

period of time. Wealth may be regarded as a lake, and income as a stream flowing

into and out of it. Thus 20 hectares (50 acres) of farmland is wealth, whereas the crop

in any given year is income. By the same token an accumulation of grain in storage is

wealth. The difference between income received and income consumed, wasted, or

depreciated, as when grain deteriorates, is the measure of wealth accumulation.

A person's holdings of currency, bank balances, and other financial instruments

constitute personal wealth as distinct from national wealth. These holdings, moreover,

are not items of social wealth, but only claims on that wealth against the actual

material objects that compose social wealth, such as a house or an automobile.

Economists estimate wealth by measuring the actual physical stock of assets.

In a period of inflation, private wealth may rise while its social value falls; the

monetary value of a house, for instance, may rise in relation to other prices, although

the house is actually deteriorating physically. To reach a valid measurement of

wealth, monetary valuations must be deflated to real values, discounting the effects of

changes in the purchasing power of money. See Inflation and Deflation.

THEORY OF NATIONAL WEALTH

National wealth is the sum total of economic goods in the possession of the national,

state, and local governments; business and nonprofit institutions; and the individual

inhabitants of a country. Systematic study of what constitutes a nation's wealth was

begun in the 16th century by the mercantilists (see Mercantilism). They advanced the

thesis that a nation's stock of precious metals forms the most important part of its

wealth. This view was generally accepted until the 18th century, when a reaction

against the narrowness of mercantilist doctrine set in. It became evident that precious

metals, particularly in the form of currency, were claims on wealth rather than wealth

itself. Mercantilist doctrine was gradually replaced by the view of the physiocrats, a

group of French economists of the 18th century, which only farming, mining, fishing,

and other extractive industries could contribute to the real wealth of nations. The

Scottish economist Adam Smith broadened the physiocratic concept by stressing that

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wealth not only can be extracted but also can be created by manufacturing. This view

was systematically formulated in the 19th century by the British economist John

Stuart Mill. His formulation, with certain relatively minor modifications, is the one

generally accepted today.

ASSESSING VALUE

In addition to problems of deciding what categories of wealth to include in estimates

of national wealth, serious difficulties develop in assessing values. These difficulties

arise because only a small part of a nation's wealth is traded on the market in any

given year, and the market values of shares, real estate, and other assets may fluctuate

considerably from year to year. In evaluating national wealth economists have used

two approaches: subjective evaluation and objective evaluation.

A) Subjective Evaluation

In the subjective approach, a nation's wealth is measured by summing up individual

estimates of the worth of individual possessions, as reported on tax returns and other

required reports. The subjective approach depends a great deal on personal honesty

and on the completeness with which the various forms of wealth are covered by

official documents.

B) Objective Evaluation

The objective approach requires that disinterested and qualified outsiders estimate the

aggregate value of particular possessions. Values at market prices are difficult to

obtain for the reasons given above. Values shown in companies' books are invalid

because prices may fluctuate substantially after the asset is acquired and entered in the

books. Even when prices remain the same, allowances made by a company for

depreciation and obsolescence may be, for internal financial reasons, either higher or

lower than those that objectively should have been allowed. The best method open to

statisticians is to estimate, in prices of the present day or of some fixed base date, the

values of all existing assets and then to reduce these values by applying appropriate

rates of depreciation and obsolescence. Sometimes the subjective and objective bases

of evaluation can be used concurrently and the results checked against each other.

Such figures are approximate and must be used with caution.

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Calculations of national wealth fell into disfavor as national-income accounting

focused on use value as a basis of measurement of economic growth. The U.S.

government, which has developed the most detailed and accurate economic statistics

of any nation in the world, abandoned its efforts to evaluate the nation's wealth in

1922. Unofficial estimates for later years, however, have been made. The voluminous

data on wealth contained in Study of Savings in the United States (3 volumes, 1955),

by the American economist Raymond W. Goldsmith, helped to clarify the situation in

the U.S. and encouraged similar work in other countries.

(b) MONEY MARKET INSTRUMENTS

Money market

In finance, the money market is the global financial market for short-term borrowing

and lending. It provides short-term liquid funding for the global financial system. The

money market is where short-term obligations such as Treasury bills, commercial

paper and banker' acceptances are bought and sold.

The money market consists of financial institutions and dealers in money or credit

who wish to either borrow or lend. Participants borrow and lend for short periods of

time, typically up to thirteen months. Money market trades in short term financial

instruments commonly called "paper". This contrasts with the capital market for

longer-term funding, which is supplied by bonds and equity.

Participants

The core of the money market consists of banks borrowing and lending to each other,

using commercial paper, repurchase agreements and similar instruments. These

instruments are often benchmarked to LIBOR.

Finance companies such as GMAC typically fund themselves by issuing large

amounts of asset-backed commercial paper (ABCP) which is secured by the pledge of

eligible assets into an ABCP conduit. Examples of eligible assets include auto loans,

credit card receivables, residential/commercial mortgage loans, mortgage backed

securities and similar financial assets. Certain large corporations with strong credit

ratings, such as General Electric, issue commercial paper on their own credit. Other

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large corporations arrange for banks to issue commercial paper on their behalf via

commercial paper lines.

In the United States, federal, state and local governments all issue paper to meet

funding needs. States and local governments issue municipal paper, while the US

Treasury issues Treasury bills to fund the US public debt. Trading companies often

purchase bankers' acceptances to be tendered for payment to overseas suppliers.

Retail and Institutional Money Market Funds

Banks -

Central Banks -

Cash management programs -

Arbitrage ABCP conduits, which seek to buy higher yielding paper, while themselves

selling cheaper paper. Trading takes place between banks in the "money centers"

(London, New York, and Tokyo).

Common money market instruments

Bankers' acceptance - A draft issued by a bank that will be accepted for payment,

effectively the same as a cashier's check.

Certificate of deposit - A time deposit at a bank with a specific maturity date; large-

denomination certificates of deposits can be sold before maturity.

Repurchase agreements - Short-term loans—normally for less than two weeks and

frequently for one day—arranged by selling securities to an investor with an

agreement to repurchase them at a fixed price on a fixed date.

Commercial paper - An unsecured promissory notes with a fixed maturity of one to

270 days; usually sold at a discount from face value.

Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch located

outside the United States.

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Federal Agency Short-Term Securities - (in the US). Short-term securities issued by

government sponsored enterprises such as the Farm Credit System, the Federal Home

Loan Banks and the Federal National Mortgage Association.

Federal funds - (in the US). Interest-bearing deposits held by banks and other

depository institutions at the Federal Reserve; these are immediately available funds

that institutions borrow or lend, usually on an overnight basis. They are lent for the

federal funds rate.

Municipal notes - (in the US). Short-term notes issued by municipalities in

anticipation of tax receipts or other revenues.

Treasury bills - Short-term debt obligations of a national government that are issued

to mature in 3 to 12 months. For the U.S., see Treasury bills.

Money market mutual funds - Pooled short maturity, high quality investments which

buy money market securities on behalf of retail or institutional investors.

Types of bond markets

The Securities Industry and Financial Markets Association (SIFMA) classifies the

broader bond market into five specific bond markets.

Corporate

Government & agency

Municipal

Mortgage backed, asset backed, and collateralized debt obligation

Funding

Bond market participants

Bond market participants are similar to participants in most financial markets and are

essentially either buyers (debt issuer) of funds or sellers (institution) of funds and

often both.

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Participants include:

Institutional investors

Governments

Traders

Individuals

Because of the specificity of individual bond issues, and the lack of liquidity in many

smaller issues, the majority of outstanding bonds are held by institutions like pension

funds, banks and mutual funds. In the United States, approximately 10% of the market

is currently held by private individuals.

Bond investments

Investment companies allow individual investors the ability to participate in the bond

markets through bond funds, closed-end funds and unit-investment trusts. In 2006

total bond fund net inflows increased 97% from $30.8 billion in 2005 to $60.8 billion

in 2006. Exchange-traded funds (ETFs) are another alternative to trading or investing

directly in a bond issue. These securities allow individual investors the ability to

overcome large initial and incremental trading sizes.

Bond indices

A number of bond indices exist for the purposes of managing portfolios and

measuring performance, similar to the S&P 500 or Russell Indexes for stocks. The

most common American benchmarks are the Barclays Aggregate, Citigroup BIG and

Merrill Lynch Domestic Master. Most indices are parts of families of broader indices

that can be used to measure global bond portfolios, or may be further subdivided by

maturity and/or sector for managing specialized portfolios.

Income/Debt Oriented Schemes provide regular and steady income to investors. Such

schemes generally invest in fixed income securities such as bonds, corporate

debentures, government securities and money market instruments. Such funds are less

risky compared to equity schemes. Balanced Funds provide both growth and regular

income as such schemes invest both in equities and fixed income securities in the

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proportion indicated in their offer documents. These are appropriate for investors

looking for moderate growth.

ETFs have a number of advantages over traditional open-ended index funds:

a) They can be bought and sold on the exchange at prices that are usually close to the

actual intra-day NAV of the scheme.

b) They are an innovation to traditional MFs as they provide investors a fund that

closely tracks the performance of an index with the ability to buy/sell on an intra-day

basis.

c) Unlike listed closed-ended funds, which trade at substantial premia or more

frequently at discounts to NAV, ETFs are structured in a manner which allows to

create new units and redeem outstanding units directly with the fund, thereby ensuring

that ETFs trade close to their actual NAVs.

Like any other index fund, ETFs are usually passively managed funds wherein

subscription/redemption of units works on the concept of exchange with underlying

securities. Units can also be bought and sold directly on the exchange. The funds have

all the benefits of indexing such as diversification, low cost and transparency. As the

funds are listed on the exchange, costs of distribution are much lower and the reach is

wider. These savings in cost are passed on to the investors in the form of lower costs.

Further, exchange traded mechanism helps reduce to the minimal of the collection,

disbursement and other processing charges. The structure of ETFs is such that it

protects long term investors from inflows and outflows of short-term investor. This is

because the fund does not bear extra transaction cost when buying/selling due to

frequent subscriptions and redemptions. Tracking error, which is divergence between

the price behavior of a position or portfolio and the price behavior of a benchmark, of

an ETF is likely to be low as compared to a normal index fund. ETFs are highly

flexible and can be used as a tool for gaining instant exposure to the equity markets,

equalizing cash or for arbitraging between the cash and futures market.

ETFs launched on NSE:

(a) The first ETF in India, ‘Nifty BeES’ (Nifty Benchmark Exchange Traded Scheme)

based on S&P CNX Nifty, was launched in January 2002 by BENCHMARK Mutual

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Fund, an Asset Management Company. It is bought and sold like any other stock on

NSE and has all characteristics of an index fund. One can buy or sell Nifty BeES in

exactly the same way as one buys/sells any share. Nifty BeES are in dematerialised

form and is settled like any other share in rolling settlement.

(b) Junior BeES-The units of Nifty Junior Benchmark Exchange Traded Scheme

(Junior BeES) were admitted to dealings on the Exchange w.e.f March 6, 2003. These

units too are traded in rolling settlement in dematerialised form only.

(c) Liquid BeES (Liquid Benchmark Exchange Traded Scheme) is the first money

market ETF (Exchange Traded Fund) in the world. The investment objective of the

Scheme is to provide money market returns. Liquid BeES invests in a basket of call

money, short-term government securities and money market instruments of short and

medium maturities. It is listed and traded on the NSE’s Capital Market Segment and

is settled on a T+2 Rolling basis. The Fund endeavors to provide daily returns to the

investors, which accrue in the form of daily dividend, that are compulsorily reinvested

in the Fund daily. The units arising out of dividend reinvestment are be allotted and

credited to the Demat account of the investors at the end of every month. Such units

of Liquid BeES are allotted and credited daily, up to 3 decimal places.

NSDL and CDSL have waived all the charges (including Custodian charges) relating

to transactions in Liquid BeES in the NSDL and CDSL depository systems

respectively.

(c) EQUITY SHARES

In the long term, equities have been known to outperform every other asset class. It’s

a truism all right, but one that merits iteration, such are the wonders equities can work

into your personal finances. That is, when picked carefully and managed smartly. You

can build and maintain a portfolio by yourself—research stocks, buy and sell them

through a broker, and follow up regularly. Alternatively, if you don’t understand the

market, or don’t want to expend time and energy in this pursuit, you can let equity

funds go to work for you. They can be just as effective as direct investing and, in

many ways, a lot more convenient. Equity funds pool savings of many investors, and

invest this sum in a bunch of stocks—typically, 25-30 stocks, across various sectors.

So a portfolio of the average equity fund might look something like this: Infosys,

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Wipro, ITC, Reliance, Hindustan Lever, and then some. For an affordable amount,

starting from as little as Rs 1,000, you can pick up a stake in all these companies, and

their fortunes, through an equity fund. The fund house does everything for you for a

fee. Its fund managers and analysts track the market and sift through the universe of

stocks, and construct portfolios capable of delivering returns characteristic of equities.

If you are looking to maximize returns on your investment, and can bear the risk of it

eroding temporarily in that pursuit, consider equity funds. The universe of equity

funds comprises many kinds of schemes, each of which services a specific investment

objective. We have broken down equity funds into five categories, which collectively

cover the risk-return spectrum of equities. Your choice of scheme should match your

risk profile and investment objective.

Stock market

A stock market or equity market is a public market (a loose network of economic

transactions, not a physical facility or discrete entity) for the trading of company stock

and derivatives at an agreed price; these are securities listed on a stock exchange as

well as those only traded privately.

The size of the world stock market was estimated at about $36.6 trillion US at the

beginning of October 2008. The total world derivatives market has been estimated at

about $791 trillion face or nominal value, 11 times the size of the entire world

economy. The value of the derivatives market, because it is stated in terms of notional

values, cannot be directly compared to a stock or a fixed income security, which

traditionally refers to an actual value. Moreover, the vast majority of derivatives

'cancel' each other out. Many such relatively illiquid securities are valued as marked

to model, rather than an actual market price. The stocks are listed and traded on stock

exchanges which are entities of a corporation or mutual organization specialized in

the business of bringing buyers and sellers of the organizations to a listing of stocks

and securities together. Participants in the stock market range from small individual

stock investors to large hedge fund traders, who can be based anywhere. Their orders

usually end up with a professional at a stock exchange, who executes the order. Some

exchanges are physical locations where transactions are carried out on a trading floor,

by a method known as open outcry. This type of auction is used in stock exchanges

and commodity exchanges where traders may enter "verbal" bids and offers

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simultaneously. The other type of stock exchange is a virtual kind, composed of a

network of computers where trades are made electronically via traders. Actual trades

are based on an auction market model where a potential buyer bids a specific price for

a stock and a potential seller asks a specific price for the stock. (Buying or selling at

market means you will accept any ask price or bid price for the stock, respectively.)

When the bid and ask prices match, a sale takes place, on a first-come-first-served

basis if there are multiple bidders or askers at a given price. The purpose of a stock

exchange is to facilitate the exchange of securities between buyers and sellers, thus

providing a marketplace (virtual or real). The exchanges provide real-time trading

information on the listed securities, facilitating price discovery.

(d) MUTUAL FUNDS

‘Put your money in trust, not trust in money’ entices the small investors, who

generally lack expertise to invest on their own in the securities market and prefer

some kind of collective investment vehicles, which can pool their marginal resources,

invest in securities and distribute the returns there from among them on co-operative

principles. The investors benefit in terms of reduced risk, and higher returns arising

from professional expertise of fund managers employed by such investment vehicle.

This was the original appeal of mutual funds (MFs) which offer a path to stock market

far simpler and safer than the traditional call-a-broker-and-buy-securities route. This

caught the fancy of small investors leading to proliferation of MFs. In developed

financial markets, MFs have overtaken bank deposits and total assets of insurance

funds. In the USA, the number of MFs far exceeds the number of listed securities.

MFs, thus, operate as CIV that pools resources by issuing units to investors and

collectively invests those resources in a diversified portfolio comprising of stocks,

bonds or money market instruments in accordance with objectives disclosed in the

offer document issued for the purpose of pooling resources. The profits or losses are

shared by investors in proportion to their investments. The process gathered

momentum in view of regulatory protection, fiscal concession and change in

preference of investors. The first ever MF in India, the Unit Trust of India (UTI) was

set up in 1964. This was followed by entry of MFs promoted by public sector banks

and insurance companies in 1987. The industry was opened up to private sector in

1993 providing Indian investors a broader choice. Starting with an asset base of Rs.

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25 crore in 1964, the industry has grown exponentially to Rs. 5,05,152 crore with a

total number of 40 MFs at the end of March 2008.

Investments in Foreign Securities by Mutual Funds

As per SEBI circular in April 2008, the aggregate ceiling for overseas investments by

mutual funds has been enhanced to US $ 7 billion and a maximum of US$ 300 million

to each mutual fund irrespective of size of assets.

Code of Conduct

The MF regulations regulate conduct MFs and AMCs, their employees and

intermediaries in the following manner:

(i) Trustees and AMCs must maintain high standards of integrity and fairness in all

their dealings and in the conduct of their business. They must keep the interest of all

unit holders paramount in all matters.

(ii) The sponsor of the MF, the trustees or the AMC or any of their employees shall

not render, directly or indirectly any investment advice about any security in the

publicly accessible media, whether real-time or non real-time, unless a disclosure of

his interest including long or short position in the said security has been made, while

rendering such advice.

(iii) Each director of the AMC would file details of his transactions of dealing in

securities with the trustees on a quarterly basis.

(iv) The AMC shall file with the trustees the details of transactions in securities by its

key personnel. Also, the trustees shall furnish to SEBI a certificate stating that they

have satisfied themselves that there have been no instances of self dealing or front

running by any of the trustees, directors and key personnel of the asset management

company.

(v) The employees of AMCs and trust companies shall follow the procedure and code

of conduct laid down by SEBI for investments / trading in securities. Specified

categories of employees are required to obtain prior approval before making personal

transactions. The intermediaries are required to take necessary steps to protect the

interests of the clients, provide full and latest information of schemes to investors,

35

highlight risk factors of each scheme, avoid misinterpretation and exaggeration, avoid

any commission driven malpractices, not rebate commission back to investors, and

obtain AMFI certification.

Structure of Mutual Funds

A typical MF in India has the following constituents: Fund Sponsor: A ‘sponsor’ is

any person who, acting alone or in combination with another body corporate,

establishes a MF. It obtains the certificate of registration as a MF from SEBI. The

sponsor of a fund is similar to the promoter of a company. In accordance with SEBI

Regulations, the sponsor forms a trust and appoints a Board of Trustees, and also

generally appoints an AMC as fund manager. In addition, the sponsor also appoints a

custodian to hold the fund assets. The sponsor contributes at least 40% of the net

worth of the AMC. It must have a sound financial track record over five years to

registration and general reputation of fairness and integrity in all its business

transactions.

Mutual Fund: A MF is constituted in the form of a trust under the Indian Trusts Act,

1882. The instrument of trust is executed by the sponsor in favour of trustees and is

registered under the Indian Registration Act, 1908. The fund invites investors to

contribute their money in the common pool, by subscribing to ‘units’ issued by

various schemes established by the trust. The assets of the trust are held by the trustee

for the benefit of unit holders, who are the beneficiaries of the trust. Under the Indian

Trusts Act, the trust or the fund has no independent legal capacity, it is the trustee(s)

who have the legal capacity.

Gold Exchange Traded Fund

A gold exchange traded fund unit is like mutual fund units whose underlying asset is

Gold and is held in demat form. It is typically an Exchange traded Mutual Fund unit

which is listed and traded on a stock exchange. Every gold ETF unit is representative

of a definite quantum of pure gold and the traded price of the gold unit moves in

tandem with the price of the actual gold metal. The underlying asset in case of a gold

ETF is gold which is held by a mutual fund house issuing such units either in a

physical form or through gold receipt giving right of ownership. Authorized

participants can redeem the gold ETF units and can demand equivalent value of actual

36

pure gold at any time. By means of a Gold ETF (GETF), investors can participate in

the gold bullion market without taking any physical delivery of gold and buying and

selling through trading of a security on a stock exchange. The GETF aims at

providing returns which closely correspond to the returns provided by Gold. The Gold

ETFs listed on NSE are Gold BeEs (listed on March 19, 2007), Gold share (listed on

April 17, 2007), Kotak Gold ETF (Listed on August 8, 2007), Reliance Gold ETF

(November 26, 2007) and Quantum Gold Fund - Exchange Traded Fund (listed on

February 28, 2008).

Unit Trust of India

Experimentation with MFs in India, as mentioned earlier, began in 1964 with the Unit

Trust of India (UTI) set up by a special statute called the UTI Act, 1963. The

objective of the statutory corporation was to encourage saving and investment. UTI

was not required to be registered with SEBI. Till recently, all of UTI’s schemes and

its overall functioning were completely governed by the UTI Act. However, schemes

launched after July 1994 fell under SEBI purview (and among the major schemes of

UTI, only US-64 remained outside the purview of SEBI till December 2002). In

October 2002, Cabinet issued an ordinance for restructuring UTI, including repealing

the UTI Act. UTI was finally bifurcated into UTI-I and UTI-II in December 2002.

UTI-I comprised of US-64 and other assured return schemes, while UTI-II got all the

NAV based schemes. Further in February 2003, UTI-II was converted into UTI

Mutual Fund.

Management of MFs

SEBI amended (mutual fund) regulations, 1996 to provide that the meeting of the

trustees should be held at least once in two calendar months and at least six such

meetings should be held in every year. It provides that as a result of non-recording of

transactions, the NAV of a scheme should not be affected by more than 1%. If the

NAV of a scheme differs by more than 1% due to non recording of transactions, the

investors or the scheme as the case may be, shall be paid the difference in the amount.

If the investors are allotted units at a price higher than NAV or given a price lower

than NAV at the time of sale of their units, they shall be paid the difference in amount

by the scheme. If investors are charged lower NAV at the time of purchase of their

units or are given a higher NAV at the time of sale of their units, the AMC shall pay

37

the difference in amount to scheme. SEBI amended its Mutual Funds Regulations,

1996 also to provide nomination facility for the unit holders. The asset management

company would now provide an option to the unit holder to nominate a person in

whom the units held by him shall vest in the event of his death. Where the units are

held jointly, the joint unit holders may together nominate a person in whom all the

rights in the units shall vest in the event of death of all the joint unit holders.

Risk Management System for Mutual Funds

MFs should ensure a minimum standard of due diligence or risk management system

in various areas of their operations like fund management, operations, customer

service, marketing and distribution, disaster recovery and business contingency, etc.

For the purpose, AMFI has prepared an operating manual which covers risk

management practices in various areas of operations under three categories:

(i) Existing industry practices

(ii) Practices to be followed on mandatory basis and

(iii) Best Practices to be followed by all MFs.

AMFI has advised MFs to follow the following step-by-step approach to implement

the risk management system:

Identification of observance of each recommendation: The MFs shall identify areas of

current adherence as well as non-adherence of various risk management practices

under each of the aforesaid three categories. They shall examine the areas where

development or improvement of systems is required. After identifying the same, the

MFs shall review the progress made on implementation of the systems on a monthly

basis and shall ensure full compliance of all the risk management practices within a

period of six months. Review of progress of implementation: Boards of AMCs and

trustee companies shall review the progress made by their MFs with regard to risk

management practices and the same shall be reported to SEBI at the time of sending

quarterly compliance test reports and half-yearly trustee reports.

Sale and Repurchase Price of Units

To bring about uniformity in determination of sale and repurchase price of mutual

fund units applicable for investors, it has been decided by SEBI that a uniform

38

method should be used by all mutual funds. Applicable load as a percentage of NAV

would be added to NAV to calculate sale price and would be subtracted from NAV to

calculate repurchase price. The following formulae should be used:

Sale Price = Applicable NAV × (1+ Sales Load, if any)

Repurchase Price = Applicable NAV × (1- Exit Load, if any)

NAV would be rounded off up to four decimal places in case of liquid/money market

MF schemes and up to two decimal places in respect of all other schemes. The

disclosures relating to these shall be made in the new offer documents and while

updating existing offer documents.

Venture Capital Funds

‘Venture capital fund’ means a fund established in the form of a trust or a company

including a body corporate and registered under these regulations which has a

dedicated pool of capital raised in a manner specified in the regulations, and invests in

accordance with the regulations. `Venture capital undertaking’ means a domestic

company whose shares are not listed on a recognized stock exchange in India and

which is engaged in the business for providing services, production or manufacture of

article or things or does not include such activities or sectors which are specified in

the negative list by the Board with the approval of the Central Government by

notification in the Official Gazette in this behalf. SEBI is the single-point nodal

agency for registration and regulation of both domestic and overseas VCFs. No

approval of VCFs by tax authorities is required. VCFs enjoy a complete pass-through

status. There is no tax on distributed or undistributed income of such funds. The

income distributed by the funds is only taxed in the hands of investors at the rates

applicable to the nature of income. This liberalization is expected to give a strong

boost to NRIs in Silicon Valley and elsewhere to invest some of their capital,

knowledge and enterprise in ventures in their motherland.

History of Mutual Fund-

Although the Massachusetts investors Trust, formed on 21 March 1924 by three

Boston financial executives, is recognized as the first Mutual Fund, the idea of

pooling money for investment purposes is not a twentieth century phenomenon. By

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various historical accounts, investment entities that resembled what we now know as

mutual funds had been around in Europe since the eighteenth century.

Origin

In 1774, a Dutch merchant invited subscriptions from investors to set up an

investment trust by the name of Eendragt Maakt Magt(‘ unity creates strength’), with

the objective of providing diversification at low cost to small investors. Its success

caught on, and more investment trusts were launched, with verbose and quirky names

that, when translated, read, ‘profitable and prudent’ or ‘Small Matters Grow by

Consent’. The Foreign and Colonial Government Trust, formed in London in 1868,

promised “ the investor of modest means the same advantages as the large capitalist…

by spreading the investment over a number of stocks”.

Over a new investment vehicle, but much of this died with the onset of the Great

Depression in 1929. It took a series of confidence-building measures- the birth of a

powerful market regulator, laying down of rules for all industry participants,

enactment of legislation-for the mutual fund juggernaut to start rolling again. And,

once it did, it never stopped. The birth of the Massachusetts Investor Trust in the US,

in 1924, started a chain of events that would bring mutual funds to American homes

for good. There was an initial euphoria among American investors more and more

financial entities got into the act. The 80 schemes and $500 million in assets the US

mutual fund industry had in 1940 multiplied to 160 schemes and $17 billion in assets

by 1960.

New types of schemes were launched, new services were introduced. The industry

got another visible push in the 1970s, on all fronts, and really captured the fancy of

the small investor. Mutual funds were allowed access to retirement funds, schemes

offered new investment exposures and higher returns than banks, services like

cheque-writing made a debut. By the end of the 1970s, 524 schemes were managing

$95 billion in the US.

The Indian Timeline

1963 UTI, Indian’s first mutual fund, launched

1964 UTI launches US-64

1986 UTI Master share, India’s first true’ mutual fund’ scheme, launched

1987 PSU banks and insurers allowed to float mutual funds; State Bank of India(SBI)

first off the block

40

1992 Harshad Mehta-fuelled bull market arouses middle-class interest in shares and

mutual funds

1993 private sector and foreign players allowed; Kothari Pioneer first private fund

house to start operations; SEBI set up to regulate industry

1994 Morgan Stanley is the first foreign player

1996 SEBI’s mutual fund rules and regulations, which form the basis of most current

laws, come into force

1998 UTI Master Index Fund is India’s first index fund

1999 The takeover of 20th century AMC by Zurich Mutual Fund is the first

acquisition in the industry

2000 The industry’s assets under management cross (AUM) Rs 1, 00,000 crore

2001 US-64 scam leads to UTI overhaul

2002 UTI bifurcated, comes under SEBIi purview; mutual fund distributors banned

from giving commissions to investors; floating rate funds and foreign debt funds

debut

2003 AMFI certification made compulsory for new agents

2004 Long-term capital gains exempt from tax for equity funds. Securities transaction

tax introduced

2005 The industry’s AUM crosses Rs 2, 00,000 crore section 80C introduced, which

allows up to Rs 1 lakh in equity-linked savings schemes(ELSS) for deduction from

total taxable income.

2006 AUM crosses Rs 3, 00,000 crore in October

2007 Mutual funds launch Gold ETFs schemes that will invest in overseas securities

(e) FINANCIAL DERIVATIVES

Derivative instruments

Financial innovation has brought many new financial instruments whose pay-offs or

values depend on the prices of stocks. Some examples are exchange-traded funds

(ETFs), stock index and stock options, equity swaps, single-stock futures, and stock

index futures. These last two may be traded on futures exchanges (which are distinct

from stock exchanges—their history traces back to commodities futures exchanges),

or traded over-the-counter. As all of these products are only derived from stocks, they

are sometimes considered to be traded in a (hypothetical) derivatives market, rather

than the (hypothetical) stock market.

41

Derivatives traders at the Chicago Board of Trade.

Derivatives are financial instruments whose value is derived from the value of

something else. They generally take the form of contracts under which the parties

agree to payments between them based upon the value of an underlying asset or other

data at a particular point in time. The main types of derivatives are futures, forwards,

options, and swaps. The main use of derivatives is to reduce risk for one party while

offering the potential for a high return (at increased risk) to another. The diverse range

of potential underlying assets and payoff alternatives leads to a huge range of

derivatives contracts available to be traded in the market. Derivatives can be based on

different types of assets such as commodities, equities (stocks), bonds, interest rates,

exchange rates, or indexes (such as a stock market index, consumer price index (CPI)

see inflation derivatives — or even an index of weather conditions, or other

derivatives). Their performance can determine both the amount and the timing of the

payoffs. One use of derivatives is as a tool to transfer risk by taking an equal but

opposite position in the futures market against the underlying commodity. For

example, a farmer will buy/sell futures contracts on a crop from/to a speculator before

the harvest since the farmer intends to eventually sell his crop after the harvest. By

taking a position in the futures market, the farmer minimizes Speculation and

arbitrage

Types of derivatives

OTC and exchange-traded

Broadly speaking there are two distinct groups of derivative contracts, which are

distinguished by the way they are traded in market:

Over-the-counter (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, forward rate agreements, and exotic options are

almost always traded in this way. The OTC derivatives market is huge. According to

the Bank for International Settlements, the total outstanding notional amount is USD

298 trillion (as of 2005).

Exchange-traded derivatives are those derivatives products that are traded via

specialized Derivatives exchanges or other exchanges. 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 &

42

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). 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(tm)

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.

Other examples of underlying are:

Economic derivatives that pay off according to economic reports as measured and

reported by national statistical agencies Energy derivatives that pay off according to a

wide variety of indexed energy prices. Usually classified as either physical or

financial, where physical means the contract includes actual delivery of the

underlying energy commodity (oil, gas, power, etc)

Commodities

Freight derivatives

Inflation derivatives

Insurance derivatives

Weather derivatives

Credit derivatives

Sports derivatives

Property derivatives

Definitions

Bilateral Netting: A legally enforceable arrangement between a bank and a

counterparty that creates a single legal obligation covering all included individual

contracts. This means that a bank’s obligation, in the event of the default or

insolvency of one of the parties, would be the net sum of all positive and negative fair

values of contracts included in the bilateral netting arrangement.

43

Credit derivative: A contract that transfers credit risk from a protection buyer to a

credit protection seller. Credit derivative products can take many forms, such as credit

default options, credit limited notes and total return swaps.

Derivative: A financial contract whose value is derived from the performance of

assets, interest rates, currency exchange rates, or indexes. Derivative transactions

include a wide assortment of financial contracts including structured debt obligations

and deposits, swaps, futures, options, caps, floors, collars, forwards and various

combinations thereof.

Exchange-traded derivative contracts: Standardized derivative contracts (e.g. futures

contracts and options) that are transacted on an organized futures exchange.

Gross negative fair value: The sum of the fair values of contracts where the bank

owes money to its counterparties, without taking into account netting. This represents

the maximum losses the bank’s counterparties would incur if the bank defaults and

there is no netting of contracts, and no bank collateral was held by the counterparties.

Gross positive fair value: The sum total of the fair values of contracts where the

bank is owed money by its counterparties, without taking into account netting. This

represents the maximum losses a bank could incur if all its counterparties default and

there is no netting of contracts, and the bank holds no counterparty collateral.

High-risk mortgage securities: Securities where the price or expected average life is

highly sensitive to interest rate changes, as determined by the FFIEC policy statement

on high-risk mortgage securities.

Notional amount: The nominal or face amount that is used to calculate payments

made on swaps and other risk management products. This amount generally does not

change hands and is thus referred to as notional.

Over-the-counter (OTC) derivative contracts: Privately negotiated derivative

contracts that are transacted off organized futures exchanges.

Structured notes: Non-mortgage-backed debt securities, whose cash flow

characteristics depend on one or more indices and/or have embedded forwards or

options.

44

Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists

of common shareholders equity, perpetual preferred shareholders equity with

noncumulative dividends, retained earnings, and minority interests in the equity

accounts of consolidated subsidiaries. Tier 2 capitals consists of subordinated debt,

intermediate-term preferred stock, cumulative and long-term preferred stock, and a

portion of a bank’s allowance for loan and lease losses.

(f) INSURANCE

Although Indian markets were privatized and opened up to foreign companies in a

number of sectors in 1991, insurance remained out of bounds on both counts. The

government wanted to proceed with caution. With pressure from the opposition, the

government (at the time, dominated by the Congress Party) decided to set up a

committee headed by Mr. R. N. Malhotra (the then Governor of the Reserve Bank of

India). Malhotra Committee

Liberalization of the Indian insurance market was recommended in a report released

in 1994 by the Malhotra Committee, indicating that the market should be opened to

private-sector competition, and ultimately, foreign private-sector competition. It also

investigated the level of satisfaction of the customers of the LIC. Curiously, the level

of customer satisfaction seemed to be high. The union of the LIC made political

capital out of this finding. The following are the purposes of the committee.

(a) To suggest the structure of the insurance industry, to assess the strengths and

weaknesses of insurance companies in terms of the objectives of creating an efficient

and viable insurance industry, to have a wide coverage of insurance services, to have

a variety of insurance products with a high quality service, and to develop an effective

instrument for mobilization of financial resources for development.

(b) To make recommendations for changing the structure of the insurance industry,

for changing the general policy framework etc.

(c) To taken specific suggestions regarding LIC and GIC with a view to improve the

functioning of LIC and GIC.

(d) To make recommendations on regulation and supervision of theinsurance sector in

India.

45

(e) To make recommendations on the role and functioning of surveyors,

intermediaries like agents etc. in the insurance sector.

(f) To make recommendations on any other matter which are relevant for

development of the insurance industry in India? The committee made a number of

important and far-reaching recommendations. Mukherjee Committee Immediately

after the publication of the Malhotra Committee Report, a new committee (called the

Mukherjee Committee) was set up to make concrete plans for the requirements of the

newly formed insurance companies. Recommendations of the Mukherjee Committee

were never made public. But, from the information that filtered out it became clear

that the committee recommended the inclusion of certain ratios in insurance company

balance sheets to ensure transparency in accounting. But the Finance Minister

objected. He argued (probably on the advice of some of the potential entrants) that it

could affect the prospects of a developing insurance company.

Insurance Regulatory Act (1999)

After the report of the Malhotra Committee came out, changes in the insurance

industry appeared imminent. Unfortunately, instability in Central Government,

changes in insurance regulation could not pass through the parliament. The dramatic

climax came in 1999. On March 16, 1999, the Indian Cabinet approved an Insurance

Regulatory Authority (IRA) Bill that was designed to liberalize the insurance sector.

The bill was awaiting ratification by the Indian Parliament. However, the BJP

Government fell in April 1999. The deregulation was put on hold once again.

An election was held in late 1999. A new BJP-led government came to power. On

December 7, 1999, the new government passed the Insurance Regulatory and

Development Authority (IRDA) Act. This Act repealed the monopoly conferred to the

Life Insurance Corporation in 1956 and to the General Insurance Corporation in

1972.The authority created by the Act is now called IRDA. It has ten members. New

licenses are being given to private companies (see below).

IRDA has separated out life, non-life and reinsurance insurance businesses. Therefore,

a company has to have separate licenses for each line of business. Each license has its

own capital requirements (around USD24 million for life or non-life and USD48

million for reinsurance).

46

The bond market, also known as the debt, credit, or fixed income market, is a

financial market where participants buy and sell debt securities usually in the form of

bonds. The size of the international bond market is an estimated $45 trillion of which

the size of outstanding U.S. bond market debt is $25.2 trillion.

Nearly all of the $923 billion average daily trading volume in the U.S. Bond Market

takes place between broker-dealers and large institutions in a decentralized, over-the-

counter (OTC) market. However, a small number of bonds, mainly corporate, are

listed on exchanges.

Annual returns

An Annual Rate of Return is the return on an investment over a one-year period, such

as January 1st through December 31st, or June 3rd 2006 through June 2nd 2007. Each

ROI in the cash flow example above is an annual rate of return. An Annualized Rate

of Return is the return on an investment over a period other than one year (such as a

month, or two years) multiplied or divided to give a comparable one-year return. For

instance, a one-month ROI of 1% could be stated as an annualized rate of return of

12%. Or a two-year ROI of 10% could be stated as an annualized rate of return of 5%.

In the cash flow example above, the dollar returns for the four years add up to $265.

The annualized rate of return for the four years is $265 ÷ ($1,000 x 4 years) =

6.625%.

Arithmetic return

In mathematical terms, the arithmetic return is defined as the following:

Where

Vi is the initial investment value and

Vf is the final investment value

This return has the following characteristics:

ROIArith = + 1.00 = + 100% when the final value is twice the initial value

ROIArith > 0 when the investment is profitable

ROIArith < 0 when the investment is at a loss

ROIArith = − 1.00 = − 100% when investment can no longer be recovered

47

Yield

In financial economics, the term yield indicates a rate of return that is based on

compounding, reinvestment, and/or the changing market value of a security. Yield

indicates that the value of the investment increases or decreases during the investment

period. Effective annual rate (EAR) or Annual percentage yield (APY) indicates an

annual yield from compound interest. The yield depends on the frequency of

compounding. An Annual Rate of Return is the return on an investment over a one-

year period, such as January 1st through December 31st, or June 3rd 2006 through

June 2nd 2007. Each ROI in the cash flow example above is an annual rate of return.

An Annualized Rate of Return is the return on an investment over a period other than

one year (such as a month, or two years) multiplied or divided to give a comparable

one-year return.

FREQUENCY OF COMPOUNDING

Effective Annual Rate Based on Frequency of Compounding

Rate Semi-AnnualQuarterl

yMonthly Daily Continuous

1% 1.002% 1.004% 1.005% 1.005% 1.005%

5% 5.062% 5.095% 5.116% 5.127% 5.127%

10% 10.250% 10.381% 10.471% 10.516% 10.517%

15% 15.563% 15.865% 16.075% 16.180% 16.183%

20% 21.000% 21.551% 21.939% 22.134% 22.140%

30% 32.250% 33.547% 34.489% 34.969% 34.986%

40% 44.000% 46.410% 48.213% 49.150% 49.182%

50% 56.250% 60.181% 63.209% 64.816% 64.872%

48

After-tax returns

The after-tax rate of return is calculated by multiplying the rate of return by the tax

rate, then subtracting that percentage from the rate of return.

A return of 5% taxed at 15% gives an after-tax return of 4.25%

0.05 x 0.15 = 0.0075

0.05 - 0.0075 = 0.0425 = 4.25%

A return of 10% taxed at 25% gives an after-tax return of 7.5%

0.10 x 0.25 = 0.025

0.10 - 0.025 = 0.075 = 7.5%

Cash or potential cash returns

Time value of money

Investments generate cash flow to the investor to compensate the investor for the time

value of money. A dollar in cash is worth less today than it was yesterday, and worth

more today than it will be worth tomorrow. The main factors that are used by

investors to determine the rate of return at which they are willing to invest money

include: estimates of future inflation rates, estimates regarding the risk of the

investment (e.g. how likely it is that investors will receive regular interest/dividend

payments and the return of their full capital) Whether or not the investors want the

money available (“liquid”) for other uses. The time value of money is reflected in the

interest rates that banks offer for deposits, and also in the interest rates that banks

charge for loans such as home mortgages. The “risk-free” rate is the rate on U.S.

Treasury Bills, because this is the highest rate available without risking capital. The

rate of return which an investor expects from an investment is called the Discount

Rate. Each investment has a different discount rate, based on the cash flow expected

in future from the investment. The higher the risk, the higher the discount rate (rate of

return) the investor will demand from the investment. Any investment with a return

less than the annual inflation rate represents a loss of value, even though the return

might well be greater than 0%. When ROI is adjusted for inflation, the resulting return

is considered an increase or decrease in purchasing power. If an ROI value is adjusted

for inflation, it’s stated explicitly, such as “The return, adjusted for inflation, was

2%.” Compounding or reinvesting Compound interest or other reinvestment of cash

returns (such as interest and dividends) does not affect the discount rate of an

49

investment, but it does affect the Annual Percentage Yield, because

compounding/reinvestment increases the capital invested. For example, if an investor

put $1,000 in a 1-year Certificate of Deposit (CD) that paid an annual interest rate of

4%, compounded quarterly, the CD would earn 1% interest per quarter on the account

balance. The account balance includes interest previously credited to the account.

Compound Interest Example

1st

Quarter

2nd

Quarter

3rd

Quarter

4th

Quarter

Capital at the beginning

of the period$1,000 $1,010 $1,020.10 $1,030.30

Dollar return for the

period$10 $10.10 $10.20 $10.30

Account Balance at end

of the period$1,010.00 $1,020.10 $1,030.30 $1,040.60

Quarterly ROI 1% 1% 1% 1%

The concept of 'income stream' may express this more clearly. At the beginning of the

year, the investor took $1,000 out of his pocket (or checking account) to invest in a

CD at the bank. The money was still his, but it was no longer available for buying

groceries. The investment provided a cash flow of $10.00, $10.10, $10.20 and $10.30.

At the end of the year, the investor got $1,040.60 back from the bank. $1,000 was

return of capital.

Once interest is earned by an investor it becomes capital. Compound interest involves

reinvestment of capital; the interest earned during each quarter is reinvested. At the

end of the first quarter the investor had capital of $1,010.00, which then earned

$10.10 during the second quarter. The extra dime was interest on his additional $10

investment. The Annual Percentage Yield or Future value for compound interest is

higher than for simple interest because the interest is reinvested as capital and earns

interest. The yield on the above investment was 4.06%. Bank accounts offer

50

contractually

guaranteed returns, so

investors cannot lose

their capital.

Investors/Depositors

lend money to the

bank, and the bank is

obligated to give

investors back their

capital plus all earned

interest. Since

investors are not

risking losing their

capital on a bad

investment, they earn

a quite low rate of return. But their capital steadily increases

Returns when capital is at risk -Average returns

There are three common ways investment returns are calculated over multiple periods

of time

Arithmetic Average Rate of Return Arithmetic mean

Geometric Average Rate of Return (Time-Weighted Average Return)

Dollar-Weighted Average Return Internal rate of return

These calculations use averages of periodic percentage returns. None will accurately

translate to dollar gains or losses if percent losses are averaged with percent gains. A

10% loss on a $100 investment is a $10 loss, and a 10% gain on a $100 investment is

a $10 gain. When percentage returns on investments are calculated, they are

calculated for a period of time – not based on original investment dollars, but based

on the dollars in the investment at the beginning and end of the period. So if an

investment of $100 loses 10% in the first period, the investment amount is then $90.

If the investment then gains 10% in the next period, the investment amount is $99.

51

Example #1 Level Rates of Return

Year 1 Year 2 Year 3 Year 4

Rate of Return 5% 5% 5% 5%

Geometric Average 5% 5% 5% 5%

Capital at End of Year $105.00$110.2

5$115.76 $121.55

Dollar Profit/(Loss) $21.55

Compound Yield 5.4%

A 10% gain followed

by a 10% loss is a 1%

dollar loss. The order in

which the loss and gain

occurs does not affect

the result. A 50% gain

and a 50% loss is a

25% loss. An 80% gain

plus an 80% loss is a

64% loss. To recover

from a 50% loss, a

100% gain is required. The mathematics of this are beyond the scope of this article,

but since investment returns are published as "Average Returns", it’s important to

note that average returns do not always translate into dollar returns.

To the right and below are some examples of what can happen to a 4-year $100

investment with an Arithmetic Average Rate of Return of 5%.

Example #3 Highly Volatile Rates of Return, including losses

Year 1 Year 2 Year 3 Year 4

Rate of Return -95% 0% 0% 115%

Geometric Average -95% -77.6% -63.2% -42.7%

Capital at End of Year $5.00 $5.00 $5.00 $10.75

Dollar Profit/(Loss) ($89.25)

Compound Yield -22.3%

Mutual fund returns

Mutual Funds and exchange-traded funds (ETFs) hold portfolios of various

companies' stock shares. When the companies pay a dividend, and when the fund

52

Example #2 Volatile Rates of Return, including losses

Year 1 Year 2 Year 3 Year 4

Rate of Return 50% -20% 30% -40%

Geometric Average 50% 9.5% 16% -1.6%

Capital at End of Year$150.0

0$120.00 $156.00 $93.60

Dollar Profit/(Loss) ($6.40)

Compound Yield -1.6%

trades shares, dividends and capital gains are distributed to the mutual fund

shareholders. Mutual funds trade at the net asset value of the stock shares.

Total returns

Mutual funds report total returns based on reinvestment factors. Reinvestment factors

are based on total distributions (dividends plus capital gains) during each period.

.

.

.

Total Return = ((Final Price x Last Reinvestment Factor) - Beginning Price) /

Beginning Price

Average annual return (geometric)

Average Annual Return (geometric)

=

History

Massachusetts Investors Trust (now MFS Investment Management) was founded on

March 21, 1924, and, after one year, had 200 shareholders and $392,000 in assets.

53

The entire industry, which included a few closed-end funds, represented less than $10

million in 1924. The stock market crash of 1929 slowed the growth of mutual funds.

In response to the stock market crash, Congress passed the Securities Act of 1933 and

the Securities Exchange Act of 1934. These laws require that a fund be registered with

the Securities and Exchange Commission and provide prospective investors with a

prospectus that contains required disclosures about the fund, the securities themselves,

and fund manager. The SEC helped draft the Investment Company Act of 1940,

which sets forth the guidelines with which all SEC-registered funds today must

comply. With renewed confidence in the stock market, mutual funds began to

blossom. By the end of the 1960s, there were approximately 270 funds with $48

billion in assets. The first retail index fund, the First Index Investment Trust, was

formed in 1976 and headed by John Bogle, who conceptualized many of the key

tenets of the industry in his 1951 senior thesis at Princeton University. It is now called

the Vanguard 500 Index Fund and is one of the largest mutual funds ever with over

$100 billion in assets. One of the largest contributors of mutual fund growth was

individual retirement account (IRA) provisions added to the Internal Revenue Code in

1975, allowing individuals (including those already in corporate pension plans) to

contribute $2,000 a year. Mutual funds are now popular in employer-sponsored

defined contribution retirement plans (401(k), IRAs and Roth IRAs. As of April 2006,

there are 8,606 mutual funds that belong to the Investment Company Institute (ICI),

the national association of investment companies in the United States, with combined

assets of $9.207 trillion.

Usage

Mutual funds can invest in many different kinds of securities. The most common are

cash, stock, and bonds, but there are hundreds of sub-categories. Stock funds, for

instance, can invest primarily in the shares of a particular industry, such as technology

or utilities. These are known as sector funds. Bond funds can vary according to risk

(e.g., high-yield junk bonds or investment-grade corporate bonds), type of issuers

(e.g., government agencies, corporations, or municipalities), or maturity of the bonds

(short- or long-term). Both stock and bond funds can invest in primarily U.S.

securities (domestic funds), both U.S. and foreign securities (global funds), or

primarily foreign securities (international funds). Most mutual funds' investment

portfolios are continually adjusted under the supervision of a professional manager,

54

who forecasts the future performance of investments appropriate for the fund and

chooses those which he or she believes will most closely match the fund's stated

investment objective. A mutual fund is administered through a parent management

company, which may hire or fire fund managers. Mutual funds are liable to a special

set of regulatory, accounting, and tax rules. Unlike most other types of business

entities, they are not taxed on their income as long as they distribute substantially all

of it to their shareholders. Also, the type of income they earn is often unchanged as it

passes through to the shareholders. Mutual fund distributions of tax-free municipal

bond income are also tax-free to the shareholder. Taxable distributions can be either

ordinary income or capital gains, depending on how the fund earned those

distributions.

Net asset value

The net asset value, or NAV, is the current market value of a fund's holdings, less the

fund's liabilities, usually expressed as a per-share amount. For most funds, the NAV is

determined daily, after the close of trading on some specified financial exchange, but

some funds update their NAV multiple times during the trading day. The public

offering price, or POP, is the NAV plus a sales charge. Open-end funds sell shares at

the POP and redeem shares at the NAV, and so process orders only after the NAV is

determined. Closed-end funds (the shares of which are traded by investors) may trade

at a higher or lower price than their NAV; this is known as a premium or discount,

respectively. If a fund is divided into multiple classes of shares, each class will

typically have its own NAV, reflecting differences in fees and expenses paid by the

different classes. Some mutual funds own securities which are not regularly traded on

any formal exchange. These may be shares in very small or bankrupt companies; they

may be derivatives; or they may be private investments in unregistered financial

instruments (such as stock in a non-public company). In the absence of a public

market for these securities, it is the responsibility of the fund manager to form an

estimate of their value when computing the NAV. How much of a fund's assets may

be invested in such securities is stated in the fund's prospectus.

Turnover

Turnover is a measure of the fund's securities transactions, usually calculated over a

year's time, and usually expressed as a percentage of net asset value. This value is

55

usually calculated as the value of all transactions (buying, selling) divided by 2

divided by the fund's total holdings; i.e., the fund counts one security sold and another

one bought as one "turnover". Thus turnover measures the replacement of holdings. In

Canada, under NI 81-106 (required disclosure for investment funds) turnover ratio is

calculated based on the lesser of purchases or sales divided by the average size of the

portfolio (including cash). Turnover generally has tax consequences for a fund, which

are passed through to investors. In particular, when selling an investment from its

portfolio, a fund may realize a capital gain, which will ultimately be distributed to

investors as taxable income. The process of buying and selling securities also has its

own costs, such as brokerage commissions, which are borne by the fund's

shareholders.

Brokerage Commissions

An additional expense which does not pass through the statement of operations and

cannot be controlled by the investor is brokerage commissions. Brokerage

commissions are incorporated into the price of the fund and are reported usually 3

months after the fund's annual report in the statement of additional information.

Brokerage commissions are directly related to portfolio turnover (portfolio turnover

refers to the number of times the fund's assets are bought and sold over the course of a

year). Usually the higher the rate of the portfolio turnover, the higher the brokerage

commissions. The advisors of mutual fund companies are required to achieve "best

execution" through brokerage arrangements so that the commissions charged to the

fund will not be excessive.

Types of mutual funds

Open-end fund

The term mutual fund is the common name for an open-end investment company.

Being open-ended means that, at the end of every day, the fund issues new shares to

investors and buys back shares from investors wishing to leave the fund. Mutual funds

may be legally structured as corporations or business trusts but in either instance are

classed as open-end investment companies by the SEC. Other funds have a limited

number of shares; these are either closed-end funds or unit investment trusts, neither

of which a mutual fund is.

56

Exchange-traded funds

Main article: Exchange-traded fund

A relatively recent innovation, the exchange traded fund (ETF), is often formulated as

an open-end investment company. ETFs combine characteristics of both mutual funds

and closed-end funds. An ETF usually tracks a stock index (see Index funds). Shares

are issued or redeemed by institutional investors in large blocks (typically of 50,000).

Investors typically purchase shares in small quantities through brokers at a small

premium or discount to the net asset value; this is how the institutional investor makes

its profit. Because the institutional investors handle the majority of trades, ETFs are

more efficient than traditional mutual funds (which are continuously issuing new

securities and redeeming old ones, keeping detailed records of such issuance and

redemption transactions, and, to effect such transactions, continually buying and

selling securities and maintaining liquidity position) and therefore tend to have lower

expenses. ETFs are traded throughout the day on a stock exchange, just like closed-

end funds. Exchange traded funds are also valuable for foreign investors who are

often able to buy and sell securities traded on a stock market, but who, for regulatory

reasons, are unable to participate in traditional US mutual funds.

Equity funds

Equity funds, which consist mainly of stock investments, are the most common type

of mutual fund. Equity funds hold 50 percent of all amounts invested in mutual funds

in the United States. Often equity funds focus investments on particular strategies and

certain types of issuers.

Capitalization

Fund managers and other investment professionals have varying definitions of mid-

cap and large-cap ranges. The following ranges are used by Russell Indexes:

Russell Microcap Index - micro-cap ($54.8 - 539.5 million)

Russell 2000 Index - small-cap ($182.6 million - 1.8 billion)

Russell Midcap Index - mid-cap ($1.8 - 13.7 billion)

Russell 1000 Index - large-cap ($1.8 - 386.9 billion)

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Growth vs. value

Another distinction is made between growth funds, which invest in stocks of

companies that have the potential for large capital gains, and value funds, which

concentrate on stocks that are undervalued. Value stocks have historically produced

higher returns; however, financial theory states this is compensation for their greater

risk. Growth funds tend not to pay regular dividends. Income funds tend to be more

conservative investments, with a focus on stocks that pay dividends. A balanced fund

may use a combination of strategies, typically including some level of investment in

bonds, to stay more conservative when it comes to risk, yet aim for some growth.

Index funds versus active management

Main articles: Index fund and active management

An index fund maintains investments in companies that are part of major stock (or

bond) indices, such as the S&P 500, while an actively managed fund attempts to

outperform a relevant index through superior stock-picking techniques. The assets of

an index fund are managed to closely approximate the performance of a particular

published index. Since the composition of an index changes infrequently, an index

fund manager makes fewer trades, on average, than does an active fund manager. For

this reason, index funds generally have lower trading expenses than actively managed

funds, and typically incur fewer short-term capital gains which must be passed on to

shareholders. Additionally, index funds do not incur expenses to pay for selection of

individual stocks (proprietary selection techniques, research, etc.) and deciding when

to buy, hold or sell individual holdings. Instead, a fairly simple computer model can

identify whatever changes are needed to bring the fund back into agreement with its

target index. The performance of an actively managed fund largely depends on the

investment decisions of its manager. Statistically, for every investor who outperforms

the market, there is one who underperforms. Among those who outperform their index

before expenses, though, many end up underperforming after expenses. Before

expenses, a well-run index fund should have average performance. By minimizing the

impact of expenses, index funds should be able to perform better than average.

Certain empirical evidence seems to illustrate that mutual funds do not beat the

market and actively managed mutual funds under-perform other broad-based

portfolios with similar characteristics. One study found that nearly 1,500 U.S. mutual

58

funds under-performed the market in approximately half of the years between 1962

and 1992. Moreover, funds that performed well in the past are not able to beat the

market again in the future (shown by Jensen, 1968; Grimblatt and Sheridan Titman,

1989.

Bond funds

Bond funds account for 18% of mutual fund assets. Types of bond funds include term

funds, which have a fixed set of time (short-, medium-, or long-term) before they

mature. Municipal bond funds generally have lower returns, but have tax advantages

and lower risk. High-yield bond funds invest in corporate bonds, including high-yield

or junk bonds. With the potential for high yield, these bonds also come with greater

risk.

Money market funds

Money market funds hold 26% of mutual fund assets in the United States. Money

market funds entail the least risk, as well as lower rates of return. Unlike certificates

of deposit (CDs), money market shares are liquid and redeemable at any time. The

interest rate quoted by money market funds is known as the 7 Day SEC Yield.

Funds of funds

Funds of funds (FoF) are mutual funds which invest in other underlying mutual funds

(i.e., they are funds comprised of other funds). The funds at the underlying level are

typically funds which an investor can invest in individually. A fund of funds will

typically charge a management fee which is smaller than that of a normal fund

because it is considered a fee charged for asset allocation services. The fees charged at

the underlying fund level do not pass through the statement of operations, but are

usually disclosed in the fund's annual report, prospectus, or statement of additional

information. The fund should be evaluated on the combination of the fund-level

expenses and underlying fund expenses, as these both reduce the return to the

investor. Most FoFs invest in affiliated funds (i.e., mutual funds managed by the same

advisor), although some invest in funds managed by other (unaffiliated) advisors. The

cost associated with investing in an unaffiliated underlying fund is most often higher

than investing in an affiliated underlying because of the investment management

research involved in investing in fund advised by a different advisor. Recently, FoFs

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have been classified into those that are actively managed (in which the investment

advisor reallocates frequently among the underlying funds in order to adjust to

changing market conditions) and those that are passively managed (the investment

advisor allocates assets on the basis of on an allocation model which is rebalanced on

a regular basis). The design of FoFs is structured in such a way as to provide a ready

mix of mutual funds for investors who are unable to or unwilling to determine their

own asset allocation model. Fund companies such as TIAA-CREF, Vanguard, and

Fidelity have also entered this market to provide investors with these options and take

the "guess work" out of selecting funds. The allocation mixes usually vary by the time

the investor would like to retire: 2020, 2030, 2050, etc. The more distant the target

retirement date, the more aggressive the asset mix.

Hedge funds

Main article: Hedge fund

Hedge funds in the United States are pooled investment funds with loose SEC

regulation and should not be confused with mutual funds. Some hedge fund managers

are required to register with SEC as investment advisers under the Investment

Advisers Act. [11] The Act does not require an adviser to follow or avoid any

particular investment strategies, nor does it require or prohibit specific investments.

Hedge funds typically charge a management fee of 1% or more, plus a "performance

fee" of 20% of the hedge fund's profits. There may be a "lock-up" period, during

which an investor cannot cash in shares.

Mutual funds vs. other investments

Mutual funds offer several advantages over investing in individual stocks. For

example, the transaction costs are divided among all the mutual fund shareholders,

who also benefit by having a third party (professional fund managers) apply their

expertise, dedicate their time to manage and research investment options. However,

despite the professional management, mutual funds are not immune to risks. They

share the same risks associated with the investments made. If the fund invests

primarily in stocks, it is usually subject to the same ups and downs and risks as the

stock market.

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Share classes

Many mutual funds offer more than one class of shares. For example, you may have

seen a fund that offers "Class A" and "Class B" shares. Each class will invest in the

same pool (or investment portfolio) of securities and will have the same investment

objectives and policies. But each class will have different shareholder services and/or

distribution arrangements with different fees and expenses. These differences are

supposed to reflect different costs involved in servicing investors in various classes;

for example, one class may be sold through brokers with a front-end load, and another

class may be sold direct to the public with no load but a "12b-1 fee" included in the

class's expenses (sometimes referred to as "Class C" shares). Still a third class might

have a minimum investment of $10,000,000 and be available only to financial

institutions (a so-called "institutional" share class). In some cases, by aggregating

regular investments made by many individuals, a retirement plan (such as a 401(k)

plan) may qualify to purchase "institutional" shares (and gain the benefit of their

typically lower expense ratios) even though no members of the plan would qualify

individually. As a result, each class will likely have different performance results. A

multi-class structure offers investors the ability to select a fee and expense structure

that is most appropriate for their investment goals (including the length of time that

they expect to remain invested in the fund). [13]

Load and expenses

Main article: Mutual fund fees and expenses

A front-end load or sales charge is a commission paid to a broker by a mutual fund

when shares are purchased, taken as a percentage of funds invested. The value of the

investment is reduced by the amount of the load. Some funds have a deferred sales

charge or back-end load. In this type of fund an investor pays no sales charge when

purchasing shares, but will pay a commission out of the proceeds when shares are

redeemed depending on how long they are held. Another derivative structure is a

level-load fund, in which no sales charge is paid when buying the fund, but a back-

end load may be charged if the shares purchased are sold within a year.

Load funds are sold through financial intermediaries such as brokers, financial

planners, and other types of registered representatives who charge a commission for

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their services. Shares of front-end load funds are frequently eligible for breakpoints

(i.e., a reduction in the commission paid) based on a number of variables. These

include other accounts in the same fund family held by the investor or various family

members, or committing to buy more of the fund within a set period of time in return

for a lower commission "today". It is possible to buy many mutual funds without

paying a sales charge. These are called no-load funds. In addition to being available

from the fund company it, no-load funds may be sold by some discount brokers for a

flat transaction fee or even no fee at all. (This does not necessarily mean that the

broker is not compensated for the transaction; in such cases, the fund may pay

brokers' commissions out of "distribution and marketing" expenses rather than a

specific sales charge. The purchaser is therefore paying the fee indirectly through the

fund's expenses deducted from profits.) No-load funds include both index funds and

actively managed funds. The largest mutual fund families selling no-load index funds

are Vanguard and Fidelity, though there are a number of smaller mutual fund families

with no-load funds as well. Expense ratios in some no-load index funds are less than

0.2% per year versus the typical actively managed fund's expense ratio of about 1.5%

per year. Load funds usually have even higher expense ratios when the load is

considered. The expense ratio is the anticipated annual cost to the investor of holding

shares of the fund. For example, on a $100,000 investment, an expense ratio of 0.2%

means $200 of annual expense, while a 1.5% expense ratio would result in $1,500 of

annual expense. These expenses are before any sales commissions paid to purchase

the mutual fund. Many fee-only financial advisors strongly suggest no-load funds

such as index funds. If the advisor is not of the fee-only type but is instead

compensated by commissions, the advisor may have a conflict of interest in selling

high-commission load funds.

Criticism of managed mutual funds

Historically, only a small percentage of actively managed mutual funds, over long

periods of time, have returned as much, or more than comparable index mutual funds.

Another criticism concerns sales commissions on load funds, an upfront or deferred

fee as high as 8.5 percent of the amount invested in a fund (the average front-end load

is no more than 5% normally). In addition, no-load funds may charge a 12b-1 fee in

order to pay for "shelf space" with the company the investor uses for purchase of the

fund (when the fund is bought from outside the fund family), but they do not pay a

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load. Critics point out that high sales commissions can sometimes represent a conflict

of interest, as high commissions benefit the sales people but hurt the investors.

Although, "A shares", which have the highest front-end load, (around 5%) may be the

cheapest for the investor, if the investor is planning on 1) keeping the fund for more

than 5 years, 2) investing more than 100,000 in one fund family, which likely will

qualify them for breakpoints, which is a form of discount, or 3) staying with that fund

family for more than 5 years, but switching funds within the same fund company. In

this case, the front-end load may be best for the client, and at times outperform the no

load or B or C shares. High commissions can sometimes cause sales people to

recommend funds that maximize their income. This might be solved by working with

a fee-only advisor instead of a broker, where the investment advisor charges strictly

for advice, and may avoid load funds entirely. 12b-1 fees, which are found on 70% of

mutual funds, can motivate the fund company to focus on advertising to attract more

and more new investors, as new investors would also cause the fund assets to

increase, thus increasing the amount of money that the mutual fund managers make.

Conceding this point, Schott argues that these fees "overall fund fees (of which

distribution costs are a part) have declined by 50 percent" over the period 1980-2006.

He further states the reason for these fees: "Rule 12b-1 lets investors pay over time for

the bundle of valuable services they receive, rather than doing so through sales

charges at the time of purchase." Schott continues with the assertion that, according to

an ICI survey, 80% of investors consider these fees before purchasing an investment.

Fund managers may be encouraged to take more risks with investors' money than they

ought to: fund flows (and therefore compensation) towards successful, market beating

funds are much larger than outflows from funds that lose to the market. Fund

managers may have an incentive to purchase high risk investments in the hopes of

increasing their odds of beating the market and receiving the high inflows, with

relatively less fear of the consequences of losing to the market. Many analysts,

however, believe that the larger the pool of money one works with, the harder it is to

manage actively, and the harder it is to squeeze good performance out of it. This is

due to there being only so many companies that one can identify to put the money into

(buy shares of) that fit with the "style" of the mutual fund, due to what is disclosed in

the prospectus. Improper Thus some fund companies can be focused on attracting new

customers and not close the mutual fund to new investments when they get too big to

invest the assets properly, thereby hurting its existing investors' performance. A great

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deal of a fund's costs are flat and fixed costs, such as the salary for the manager. Thus

it can be more profitable for the fund to try to allow it to grow as large as possible,

instead of limiting its assets. Most fund companies have closed some funds to new

investors to maintain the integrity of the funds for existing investors.[] If the funds

reach more than 1 billion dollars, many times, these funds have gotten too large

before they are closed, and when this happens, the funds tend to not have a place to

put the money and can and tend to lose value. Some funds attribution needed illegal

are guilty of market timing (although many fund companies tightly control this).

Some fund managers accept extravagant gifts in exchange for trading stocks through

certain investment banks. Which presumably charge the fund more for transactions

than would non-gifting investment bank.[ This practice, although done, is completely

illegal. As a result, all fund companies strictly limit - or completely bar - such gifts.

Scandals

In September 2003, the United States mutual fund industry was beset by a scandal in

which several major fund companies permitted and facilitated late trading

Primary market provides opportunity to issuers of securities, Government as well as

corporate, to raise resources to meet their requirements of investment and/or discharge

some obligation. The issuers create and issue fresh securities in exchange of funds

through public issues and/or as private placement. They may issue the securities at

face value, or at a discount/premium and these securities may take a variety of forms

such as equity, debt or some hybrid instrument. They may issue the securities in

domestic market and/or international market through ADR/GDR/ECB route.

2 MARKET DESIGN

The market design for primary market is provided in the provision of the Companies

Act, 1956, which deals with issues, listing and allotment of securities. In addition,

DIP guidelines of SEBI prescribe a series of disclosures norms to be complied by

issuer, promoter, management, project, risk factors and eligibility norms for accessing

the market. In this section, the market design as provided in securities laws has been

discussed.

2.1 DIP Guidelines, 2000

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The issues of capital to public by Indian companies are governed by the Disclosure

and Investor Protection (DIP) Guidelines of SEBI, 2000. The guidelines provide

norms relating to eligibility for companies issuing securities, pricing of issues, listing

requirements, disclosure norms, lock-in period for promoters’ contribution, contents

of offer documents, pre-and post issue obligations, etc. The guidelines apply to all

public issues, offers for sale and rights issues by listed and unlisted companies.

Eligibility Norms

Any company issuing securities through the offer document has to satisfy the

following conditions:

A company making a public issue of securities has to file a draft prospectus with

SEBI, through an eligible merchant banker, at least 30 days prior to the filing of

prospectus with the Registrar of Companies (RoCs). The filing of offer document is

mandatory for a listed company issuing security through a rights issue where the

aggregate value of securities, including premium, if any, exceeds Rs.50 lakh. A

company cannot make a public issue unless it has made an application for listing of

those securities with stock exchange(s). The company must also have entered into an

agreement with the depository for dematerialization of its securities and also the

company should have given an option to subscribers/shareholders/investors to receive

the security certificates or securities in dematerialized form with the depository. A

company cannot make an issue if the company has been prohibited from accessing the

capital market under any order or discretion passed by SEBI. An unlisted company

can make an Initial Public Offering (IPO) of equity shares or any other security which

may be converted into or exchanged with equity shares at a later date, only if it meets

all the following conditions:

(a) The company has net tangible assets of at least Rs.3 crore in each of the preceding

3 full years (12 months each), of which not more than 50 % is held in monetary

assets, provided that if more than 50 % of the net tangible assets are held in monetary

assets, the company has made firm commitments to deploy such excess monetary

assets in its business/project.

(b) The company has a track record of distributable profits in terms of section 205 of

the Companies Act, 1956, for at least three (3) out of immediately preceding five (5)

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years. Provided further, that extraordinary items shall not be considered for

calculating distributable profits in terms of section 205 of Companies Act,1956/

(c) The company has a net worth of at least Rs.1 crore in each of the preceding 3 full

years (of 12 months each).

(d) In case the company has changed its name within the last one year, at least 50% of

the revenue for the preceding 1 full year is earned by the company from the activity

suggested by the new name.

Pricing of Issues

The companies eligible to make public issue can freely price their equity shares or any

security convertible into equity at a later date in cases of public/rights issues by listed

companies and public issue by unlisted companies. In addition, eligible infrastructure

companies can freely price their equity shares subject to compliance of disclosure

norms as specified by SEBI from time to time. The public and private sector banks

can also freely price their shares subject to approval by RBI. A company may issue

shares to applicants in the firm allotment category at higher price than the price at

which securities are offered to public. A listed company making a composite issue of

capital may issue securities at differential prices in its public and rights issue. Further,

an eligible company is free to make public/rights issue in any denomination

determined by it in accordance with the Companies Act, 1956 and SEBI norms.

Contribution of Promoters and lock-in

The promoters’ contribution in case of public issues by unlisted companies and

promoters’ shareholding in case of ‘offers for sale’ should not be less than 20% of the

post issue capital. In case of public issues by listed companies, promoters should

contribute to the extent of 20% of the proposed issue or should ensure post-issue

holding to the extent of 20% of the post-issue capital. For composite issues, the

promoters’ contribution should either be 20% of the proposed public issue or 20% of

the post-issue capital. The promoters should bring in the full amount of the promoters

contribution including premium at least one day prior to the issue opening date (which

shall be kept in an escrow account with a Scheduled Commercial Bank andthe said

contribution/amount should be released by the company along with the public issue

proceeds). The requirement of promoters contribution is not applicable in case of (i)

66

public issue of securities which has been listed on a stock exchange for at least 3

years and has a track record of dividend payment for at least 3 immediate preceding

years, (ii) companies where no identifiable promoter or promoter group exists, and

(iii) rights issues. For any issue of capital to the public, the minimum promoter’s

contribution is locked in for a period of 3 years. If the promoters contribution exceeds

the required minimum contribution, such excess is locked in for a period of one year.

Securities allotted in firm allotment basis are also locked in for a period of one year.

The locked-in securities held by promoters may be pledged only with banks or FIs as

collateral security for loans granted by such banks or FIs, provided the pledge of

shares is one of the terms of sanction of loan.

Issue of Sweat Equity

The SEBI (Issue of Sweat Equity) Regulations, 2002 have been framed and the main

provisions laid down therein for issue of sweat equity are (a) under the new

guidelines, the Sweat Equity shares can be issued by a company to its employees and

directors as well as promoters, (b) the pricing of the sweat equity shares should be as

per the formula prescribed for that of preferential allotment, (c) the sweat equity

shares should be locked in for a period of 3 years from the date of Allotment. In case

of a subsequent public issue being made, lock in shall be as per the SEBI (DIP)

Guidelines, 2000.

Issue Obligations

The lead merchant banker plays an important role in the pre-issue obligations of the

company. He exercises due diligence and satisfies himself about all aspects of

offering, veracity and adequacy of disclosures in the offer document. Each company

issuing securities has to enter into a Memorandum of Understanding with the lead

merchant banker, which specifies their mutual rights, liabilities and obligations

relating to the issue. In case of under subscription of an issue, the lead merchant

banker responsible for underwriting arrangements has to invoke underwriting

obligations and ensure that the underwriters pay the amount of devolvement. It should

ensure the minimum number of collection centers. It should also ensure that the issuer

company has entered into an agreement with all the depositories for dematerialization

of securities. All the other formalities related to post-issue obligations like, allotment,

refund and dispatch of certificates are also taken care by the lead merchant banker.

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Book Building

Book Building means a process undertaken by which a demand for the securities

proposed to be issued by a body corporate is elicited and built up and the price for

such securities is assessed for the determination of the quantum of such securities to

be issued by means of a notice, circular, advertisement, document or information

memoranda or offer document. Book building is a process of offering securities in

which bids at various prices from investors through syndicate members are collected.

Based on bids, demand for the security is assessed and its price discovered. In case of

normal public issue, the price is known in advance to investor and the demand is

known at the close of the issue. In case of public issue through book building, demand

can be known at the end of everyday but price is known at the close of issue. In case

of an issuer company makes an issue of 100% of the net offer to public through 100%

book building process) Not less than 35 % of the net offer to the public shall be

available for allocation to retail individual investors.

2.2 Merchant Banking

The merchant banking activity in India is governed by SEBI (Merchant Bankers)

Regulations, 1992. All merchant bankers have to be registered with SEBI. The person

applying for certificate of registration as merchant banker has to be a body corporate

other than a non-banking financial company, has necessary infrastructure, and has at

least two persons in his employment with experience to conduct the business of the

merchant banker. The applicant has to fulfill the capital adequacy requirements, with

prescribed minimum net worth. The regulations specify the code of conduct to be

followed by merchant bankers, responsibilities of lead managers, payments of fees

and disclosures to SEBI. They are required to appoint a Compliance Officer, who

monitors compliance requirements of the securities laws and is responsible for

redressal of investor grievance.

2.3 Credit Rating

Credit rating is governed by the SEBI (Credit Rating Agencies) Regulations, 1999.

The Regulations cover rating of securities only and not rating of fixed deposits,

foreign exchange, country ratings, real estate’s etc. CRAs can be promoted by public

financial institutions, scheduled commercial banks, foreign banks operating in India

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with the approval of RBI, foreign credit rating agencies recognized in the country of

their incorporation, having at least five years experience in rating, or any company or

a body corporate having continuous net worth of minimum Rs.100 crore for the

previous five years. CRAs would be required to have a minimum net worth of Rs. 5

crore. No Chairman, Director or Employee of the promoters shall be Chairman,

Director or Employee of CRA or its rating committee. A CRA cannot rate (i) a

security issued by its promoter, (ii) securities issued by any borrower, subsidiary, an

associate promoter of CRA, if there are common Chairman, Directors and Employees

between the CRA or its rating committee and these entities (iii) a security issued by its

associate or subsidiary if the CRA or its rating committee has a Chairman, Director or

Employee who is also a Chairman, Director or Employee of any such entity. For all

public and rights issues of debt securities, an obligation has been cast on the issuer to

disclose in the offer documents all the ratings it has got during the previous 3 years

for any of its listed securities. CRAs would have to carry out periodic reviews of the

ratings given during the lifetime of the rated instrument.

2.4 Demat Issues

As per SEBI mandate, all new IPOs are compulsorily traded in dematerialized form.

The admission to a depository for dematerialization of securities is a prerequisite for

making a public or rights issue or an offer for sale. The investors would however,

have the option of either subscribing to securities in physical form or dematerialized

form. The Companies Act, 1956 requires that every public listed company making

IPO of any security for Rs.10 crore or more shall issue the same only in

dematerialized form.

2.5 Private Placement

The private placement involves issue of securities, debt or equity, to a limited number

of subscribers, such as banks, FIs, MFs and high net worth individuals. It is arranged

through a merchant/investment banker, who acts as an agent of the issuer and brings

together the issuer and the investor(s). On the presumption that these are allotted to a

few sophisticated and experienced investors and the public at large does not have

much stake in it, the securities offered in a private placement are exempt from the

public disclosure regulations and registration requirements of the regulatory body.

What distinguishes private placement from public issues is while the latter invite

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application from as many subscribers, the subscriptions in the private placement are

normally restricted to a limited number. In terms of the Companies Act, 1956, offer of

securities to more than 50 persons is deemed to be public issue.

2.6 Virtual Debt Portal

The private placement of debt as well as transactions in debt securities are generally

affected through opaque negotiations. The result is inefficient price discovery,

fragmented market, low liquidity, poor disclosures and ineffective audit trails. B2B

portal, namely debt on net India provides a secure, anonymous, neutral and flexible

transactional platform for issue and trading of fixed income instruments. The debt on

net India is a B2B web-enabled market place for primary issuance of debt securities

and provides investors and brokers similar levels of efficiency and transparency on

the primary market segment as exchange system provides for secondary market in

debt.

2.7 ADRs/GDRs

Indian companies are permitted to raise foreign currency resources through two main

sources:(a) issue of Foreign Currency Convertible Bonds (FCCBs) –more commonly

known as ‘Euro Issues’ and (b) issue of ordinary equity shares through depository

receipts, namely, Global Depository Receipts (GDRs)/American Depository Receipts

(ADRs) to foreign investors i.e .institutional investors or individuals (including NRIs)

residing abroad. A depository receipt (DR) is any negotiable instrument in the form of

a certificate denominated in US dollars. The certificates are issued by an overseas

depository bank against certain underlying stock/shares. The shares are deposited by

the issuing company with the depository bank. The depository bank in turn tenders

DRs to the investors. A DR represents a particular bunch of shares on which the

receipt holder has the right to receive dividend, other payments and benefits which

company announces from time to time for the share holders. However, it is non-

voting equity holding. DRs facilitate cross border trading and settlement, minimize

transactions costs and broaden the potential base, especially among institutional

investors. An American Depository Receipt (ADR) is a negotiable U.S. certificate

representing ownership of shares in a non-U.S. corporation. ADRs are quoted and

traded in U.S. dollars in the U.S. securities market. Also, the dividends are paid to

investor in U.S. dollars. ADRs were specifically designed to facilitate the purchase,

70

holding and sale of non-U.S. securities by U.S. investor, and to provide a corporate

finance vehicle for non-U.S. companies. Any non-U.S. company seeking to raise

capital in the U.S. or increase their base of U.S. investor can issue ADRs. Advantages

of ADRs are:

ADRs allow you to diversify your portfolio with foreign securities easily.

ADRs trade, clear and settle in accordance with U.S. market regulations and permit

prompt dividend payments and corporate action notification.

3 COLLECTIVE INVESTMENT VEHICLES

Three distinct categories of collective investment vehicles (CIVs) namely, Mutual

Funds, venture capital funds and collective investment schemes, mobilize resources

from market for investment purposes.

3.1 Mutual Funds

‘Put your money in trust, not trust in money’ entices the small investors, who

generally lack expertise to invest on their own in the securities market and prefer

some kind of collective investment vehicles, which can pool their marginal resources,

invest in securities and distribute the returns there from among them on co-operative

principles. The investors benefit in terms of reduced risk, and higher returns arising

from professional expertise of fund managers employed by such investment vehicle.

This was the original appeal of mutual funds (MFs) which offer a path to stock market

far simpler and safer than the traditional call-a-broker-and-buy-securities route. This

caught the fancy of small investors leading to proliferation of MFs. In developed

financial markets, MFs have overtaken bank deposits and total assets of insurance

funds. In the USA, the number of MFs far exceeds the number of listed securities.

MFs, thus, operate as CIV that pools resources by issuing units to investors and

collectively invests those resources in a diversified portfolio comprising of stocks,

bonds or money market instruments in accordance with objectives disclosed in the

offer document issued for the purpose of pooling resources. The profits or losses are

shared by investors in proportion to their investments. The process gathered

momentum in view of regulatory protection, fiscal concession and change in

preference of investors. The first ever MF in India, the Unit Trust of India (UTI) was

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set up in 1964. This was followed by entry of MFs promoted by public sector banks

and insurance companies in 1987. The industry was opened up to private sector in

1993 providing Indian investors a broader choice. Starting with an asset base of Rs.

25 crore in 1964, the industry has grown exponentially to Rs. 5,05,152 crore with a

total number of 40 MFs at the end of March 2008.

Regulation of Mutual Funds

The MF industry in India is governed by SEBI (Mutual Fund) Regulations, 1996,

which lay the norms for the MF and its Asset Management Company (AMC). SEBI

requires all MFs to be registered with it. All MFs in India are constituted as trusts. A

MF is allowed to issue open-ended and closed-ended schemes under a common legal

structure. The SEBI (Mutual Fund) Regulations, 1996 lay down detailed procedure

for launching of schemes, disclosures in the offer document, advertisement material,

listing and repurchase of closed-ended schemes, offer period, transfer of units,

investments, etc. SEBI Regulations also specify the qualifications for being the

sponsor of a fund; the contents of Trust Deed; rights and obligations of Trustees;

appointment, eligibility criteria, and restrictions on business activities and obligations

of the AMC and its Directors. The AMCs, members of Board of trustees or directors

of Trustee Company and other associated company have to follow certain code of

conduct. They should ensure that the information disseminated to the unit holders is

adequate, accurate, and explicit. They should also avoid conflicts of interest in

managing the affairs of the schemes and keep the interest of all unit holders

paramount in all matters. In addition to SEBI, RBI also supervises the operations of

bank-owned MFs. While SEBI regulates all market related and investor related

activities of the bank/FI-owned funds, any issues concerning the ownership of the

AMCs by banks fall under the regulatory ambit of the RBI. Further, MFs, AMCs and

corporate trustees are companies registered under the Companies Act, 1956 and

therefore answerable to regulatory authorities empowered by the Companies Act. The

Registrar of Companies ensures that the AMC, or the Trustee Company complies with

the provisions of the Companies Act. Many closed-ended schemes of the MFs are

listed on one or more stock exchanges. Such schemes are subject to regulation by the

concerned stock exchange(s) through a listing agreement between the fund and the

stock exchange. MFs, being Public Trusts are governed by the Indian Trust Act, 1882.

The Board of Trustees or the Trustee Company is accountable to the office of the

72

Public Trustee, which in turn reports to the Charity Commissioner. These regulators

enforce provisions of the Indian Trusts Act.

Investment Restrictions Investment policies of each MF scheme are dictated by the

investment objective of the scheme as stated in the offer document. However, the

AMC and its fund managers have to comply with the restrictions imposed by SEBI.

Investments should be made only in transferable securities in the money market or in

the capital market or in privately placed debentures or securitized debts. Money

collected under money market schemes should be invested only in money market

instruments. Investment by a MF should be subject to following restrictions:

1. A mutual fund scheme should not invest more than 15% of its NAV in debt

instruments issued by a single issuer which are rated not below investment grade by a

credit rating agency authorized to carry out such activity under the Act. Such

investment limit may be extended to 20% of the NAV of the scheme with the prior

approval of the Board of Trustees and the Board of asset Management Company

provided that such limit should not be applicable for investments in Government

securities and money market instruments. Further, that investment within such limit

can be made in mortgaged backed securitized debt which is rated not below

investment grade by a credit rating agency registered with SEBI. A mutual fund

scheme should not invest more than 10% of its NAV in unrated debt instruments

issued by a single issuer and the total investment in such instruments should not

exceed 25% of the NAV of the scheme. All such investments should be made with the

prior approval of the Board of Trustees and the Board of asset Management

Company.

2. No mutual fund under all its schemes should own more than ten per cent of any

company’s paid up capital carrying voting rights.

3. Transfers of investments from one scheme to another scheme in the same mutual

fund should be allowed only if,

(a) Such transfers are done at the prevailing market price for quoted instruments on

spot basis. ‘Spot basis’ has the same meaning as specified by stock exchange for spot

transactions.

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(b) The securities so transferred should be in conformity with the investment objective

of the scheme to which such transfer has been made.

4. A scheme may invest in another scheme under the same asset management

company or any other mutual fund without charging any fees, provided that aggregate

inter scheme investment made by all schemes under the same management or in

schemes under the management of any other asset management company should not

exceed 5% of the net asset value of the mutual fund. However, this is not applicable to

any fund of funds scheme.

5. Every mutual fund should buy and sell securities on the basis of deliveries and shall

in all cases of purchases, take delivery of relative securities and in all cases of sale,

deliver the securities, provided that a mutual fund may engage in short selling of

securities in accordance with the framework relating to short selling and securities

lending and borrowing specified by SEBI, Provided further that a mutual fund may

enter into derivatives transactions in a recognized stock exchange, subject to the

framework specified by the SEBI. Further, the sale of government security already

contracted for purchase would be permitted in accordance with the guidelines issued

by the Reserve Bank of India in this regard.

6. Every mutual fund should get the securities purchased or transferred in the name of

the mutual fund on account of the concerned scheme, wherever investments are

intended to be of long-term nature.

7. Pending deployment of funds of a scheme in securities in terms of investment

objectives of the scheme , a mutual fund can invest the funds of the scheme in short

term deposits of scheduled commercial banks, subject to the guidelines as may be

specified by the board.

8. No mutual fund [scheme] should make any investment in,—

(a) Any unlisted security of an associate or group company of the sponsor; or

(b) Any security issued by way of private placement by an associate or group

company of the sponsor; or

(c) The listed securities of group companies of the sponsor which is in excess of 25

per cent of the net assets.

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9. No scheme of a mutual fund should make any investment in any fund of funds

scheme.

10. No mutual fund scheme should invest more than 10 per cent of its NAV in the

equity shares or equity related instruments of any company. Provided that, the limit of

10 per cent should not be applicable for investments in case of index fund or sector or

industry specific scheme.

11. A mutual fund scheme should not invest more than 5% of its NAV in the unlisted

equity shares or equity related instruments in case of open ended scheme and 10% of

its NAV in case of close ended scheme.

(D) S&P CNX NIFTY UTI NOTIONAL DEPOSITORY RECIEPTS

SCHEME (SUNDER) is a passively managed open-ended exchange traded fund, with

the objective to provide investment returns that, before expenses, closely correspond

to the performance and yield of the basket of securities underlying the S&P CNX

NIFTY Index. SUNDER has all benefits of index funds such as diversification, low

cost and a transparent portfolio and the flexibility of trading like a share. Thus it

provides the best features of both open-ended fund and a listed stock. SUNDER

commenced trading on NSE on July 16, 2003.

(a) Bank BeEs is an Open Ended Index Fund Listed on the NSE in form an ETF and

tracks the CNX Bank Index and was listed on June 4, 2004.

(b) PSU Bank Benchmark Exchange Traded Scheme (PSUBNKBEES) was listed on

NSE on November 1, 2007.

‘SPIcE’, the first Exchange Traded Fund (ETF) on SENSEX, was launched by

Prudential ICICI Mutual Fund. An ETF is a hybrid product having features of both an

open-ended mutual fund and an exchange listed security. The price will be equal to

approximately 1/100th of SENSEX value. It was listed on January 13, 2003.

Collective Investment Schemes

A Collective investment scheme (CIS) is any scheme or arrangement made or offered

by any company under which the contributions, or payments made by the investors,

are pooled and utilized with a view to receive profits, income, produce or property,

75

and is managed on behalf of the investors. CIS should satisfy the conditions, referred

to in sub-section (2) of section 11AA of the SEBI Act. Investors do not have day to

day control over the management and operation of such scheme or arrangement. As

per the provisions of SEBI (Collective Investment Schemes) Regulations, 1999,

which was notified on October 15, 1999, no existing CIS could launch any new

scheme or raise money from the investors even under the existing schemes, unless a

certificate of registration was granted to it by SEBI. SEBI continued with its efforts

aimed at protecting investors in Collective Investment Schemes (CISs) by asking

individual entities, which had failed to apply for grant of registration, to wind up their

schemes and repay investors, and by issuing public notices cautioning investors about

the risks associated with CIS. In terms of regulation, an existing CIS which has failed

to make an application for registration to SEBI; or has not been granted provisional

registration by SEBI; or have obtained provisional registration but failed to comply

with the provisions of regulations 71 is required to wind up its existing schemes,

make repayment to the investors and thereafter submit its winding up and repayment

report to SEBI.

CHAPTER-3 (RISK AND RETURN)

RISK AND RETURN

If someone had invested $1,000 in a portfolio of large-company stocks in 1925 and

then reinvested all dividends received, his or her investment would have grown to

$2,845,697 by 1999. Over the same time period, a portfolio of small-company stocks

76

would have grown even more, to $6,641,505. But if instead he or she had invested in

long-term government bonds, the $1,000 would have grown to only $40,219, and to a

measly $15,642 for short-term bonds. Given these numbers, why would anyone invest

in bonds? The answer is, “Because bonds are less risky.” While common stocks have

over the past 74 years produced considerably higher returns, (1) we cannot be sure

that the past is a prologue to the future, and (2) stock values are more likely to

experience sharp declines than bonds, so one has a greater chance of losing money on

a stock investment. For example, in 1990 the average small-company stock lost 21.6

percent of its value, and large-company stocks also suffered losses. Bonds, though,

provided positive returns that year, as they almost always do. Of course, some stocks

are riskier than others, and even in years when the overall stock market goes up, many

individual stocks go down. Therefore, putting all your money into one stock is

extremely risky. According to a Business Week article, the single best weapon against

risk is diversification: “By spreading your money around, you’re not tied to the

fickleness of a given market, stock, or duisntry.... Corerlation, in portfolio-manager

speak, helps you diversify properly because it describes how closely two investments

track each other. If they move in tandem, they’re likely to suffer from the same bad

news. So, you should combine assets with low correlations.” U.S. investors tend to

think of “the stock market” as the U.S. stock market. However, U.S. stocks amount to

only 35 percent of the value of all stocks. Foreign markets have been quite profitable,

and they are not perfectly correlated with U.S. markets. Therefore, global

diversification offers U.S. investors an opportunity to raise returns and at the same

time reduce risk. However, foreign investing brings some risks of its own, most

notably “exchange rate risk,” which is the danger that exchange rate shifts will

decrease the number of dollars a foreign currency will buy. Although the central

thrust of the Business Week article was on ways to measure and then reduce risk, it

did point out that some recently created instruments that are actually extremely risky

have been marketed as low-risk investments to naive investors. For example, several

mutual funds have advertised that their portfolios “contain only securities backed by

the U.S. government” but then failed to highlight that the funds themselves are using

financial leverage, are investing in

BASICS OF RISK AND RETURNS

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We start from the basic premise that investors like returns and dislike risk. Therefore,

people will invest in risky assets only if they expect to receive higher returns. We

define precisely what the term risk means as it relates to investments, we examine

procedures managers use to measure risk, and we discuss the relationship between

risk and return. Then, in Chapters 7, 8, and 9, we extend these relationships to show

how risk and return interact to determine security prices. Managers must understand

these concepts and think about them as they plan the actions that will shape their

firms’ futures. As you will see, risk can be measured in different ways, and different

conclusions about an asset’s riskiness can be reached depending on the measure used.

Risk analysis can be confusing, but it will help if you remember the following:

1. All financial assets are expected to produce cash flows, and the riskiness of an asset

is judged in terms of the riskiness of its cash flows.

2. The riskiness of an asset can be considered in two ways: (1) on a standalone basis,

where the asset’s cash flows are analyzed by themselves, or (2) in a portfolio context,

where the cash flows from a number of assets are combined, and then the consolidated

cash flows are analyzed.1 There is an important difference between stand-alone and

portfolio risk, and an asset that has a great deal of risk if held by itself may be much

less risky if it is held as part of a larger portfolio.

3. In a portfolio context, an asset’s risk can be divided into two components:

(a) diversifiable risk, which can be diversified away and thus is of little con-

1 A portfolio is a collection of investment securities. If you owned some General

Motors stock, some Exxon Mobil stock, and some IBM stock, you would be holding a

three-stock portfolio. Because diversification lowers risk, most stocks are held in

portfolios. “Derivatives,” or are taking some other action that boosts current yields

but exposes investors to huge risks. When you finish this chapter, you should

understand what risk is, how it is measured, and what actions can be taken to

minimize it, or at least to ensure that you are adequately compensated for bearing

it.cern to diversified investors, and (b) market risk, which reflects the risk of a general

stock market decline and which cannot be eliminated by diversification, hence does

concern investors. Only market risk is relevant diversifiable risk is irrelevant to

rational investors because it can be eliminated.

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4. An asset with a high degree of relevant (market) risk must provide a relatively high

expected rate of return to attract investors. Investors in general are averse to risk, so

they will not buy risky assets unless those assets have high expected returns.

INVESTMENT RETURNS

With most investments, an individual or business spends money today with the

expectation of earning even more money in the future. The concept of return provides

investors with a convenient way of expressing the financial performance of an

investment. To illustrate, suppose you buy 10 shares of a stock for $1,000. The stock

pays no dividends, but at the end of one year, you sell the stock for $1,100. What is

the return on your $1,000 investment? One way of expressing an investment return is

in dollar terms. The dollar return is simply the total dollars received from the

investment less the amount invested: Dollar return _ Amount received _ Amount

invested_ $1,100 _ $1,000_ $100.

If at the end of the year you had sold the stock for only $900, your dollar return would

have been _$100. Although expressing returns in dollars is easy, two problems arise:

(1) To make a meaningful judgment about the return, you need to know the scale

(size) of the investment; a $100 return on a $100 investment is a good return

(assuming the investment is held for one year), but a $100 return on a $10,000

investment would be a poor return. (2) You also need to know the timing of the

return; a $100 return on a $100 investment is a very good return if it occurs after one

year, but the same dollar return after 20 years would not be very good. The solution to

the scale and timing problems is to express investment results as rates of return, or

percentage returns. For example, the rate of return on the 1-year stock investment,

when $1,100 is received after one year, is 10 percent: The rate of return calculation

“standardizes” the return by considering the return per unit of investment. In this

example, the return of 0.10, or 10 percent, indicates that each dollar invested will earn

0.10($1.00) _ $0.10. If the rate of 0.10 _ 10%. Rate of return _ Amount received _

Amount invested Amount invested

STAND-ALONE RISK

Risk is defined in Webster’s as “a hazard; a peril; exposure to loss or injury.” Thus,

risk refers to the chance that some unfavorable event will occur. If you engage in

79

skydiving, you are taking a chance with your life—skydiving is risky. If you bet on

the horses, you are risking your money. If you invest in speculative stocks (or, really,

any stock), you are taking a risk in the hope of making an appreciable return.

An asset’s risk can be analyzed in two ways: (1) on a stand-alone basis, where the

asset is considered in isolation, and (2) on a portfolio basis, where the asset is held as

one of a number of assets in a portfolio. Thus, an asset’s stand-alone risk is the risk an

investor would face if he or she held only this one asset. Obviously, most assets are

held in portfolios, but it is necessary to understand stand-alone risk in order to

understand risk in a portfolio context. To illustrate the riskiness of financial assets,

suppose an investor buys $100,000 of short-term Treasury bills with an expected

return of 5 percent. In this case, the rate of return on the investment, 5 percent, can be

estimated quite precisely, and the investment is defined as being essentially risk free.

However, if the $100,000 were invested in the stock of a company just being

organized to prospect for oil in the mid-Atlantic, then the investment’s return could

not be

RISK

The chance that some unfavorable event will occur. The risk an investor would face if

he or she held only one asset. It is estimated precisely. One might analyze the

situation and conclude that the expected rate of return, in a statistical sense, is 20

percent, but the investor should also recognize that the actual rate of return could

range from, say, _1,000 percent to _100 percent. Because there is a significant danger

of actually earning much less than the expected return, the stock would be relatively

risky. No investment will be undertaken unless the expected rate of return is high

enough to compensate the investor for the perceived risk of the investment. In our

example, it is clear that few if any investors would be willing to buy the oil

company’s stock if its expected return were the same as that of the T-bill. Risky assets

rarely produce their expected rates of return—generally, risky assets earn either more

or less than was originally expected. Indeed, if assets always produced their expected

returns, they would not be risky. Investment risk, then, is related to the probability of

actually earning a low or negative return— the greater the chance of a low or negative

return, the riskier the investment. However, risk can be defined more precisely, and

we do so in the next section.

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PROBABILITY DISTRIBUTIONS

An event’s probability is defined as the chance that the event will occur. For example,

a weather forecaster might state, “There is a 40 percent chance of rain today and a 60

percent chance that it will not rain.” If all possible events, or outcomes, are listed, and

if a probability is assigned to each event, the listing is called a probability distribution.

The possible outcomes are listed in Column 1, while the probabilities of these

outcomes, expressed both as decimals and as percentages, are given in Column 2.

Notice that the probabilities must sum to 1.0, or 100 percent. Probabilities can also be

assigned to the possible outcomes (or returns) from an investment. If you buy a bond,

you expect to receive interest on the bond plus a return of your original investment,

and those payments will provide you with a rate of return on your investment. The

possible outcomes from this investment are (1) that the issuer will make the required

payments or (2) that the issuer will default on the payments. The higher the

probability of default, the riskier the bond, and the higher the risk, the higher the

required rate of return. If you invest in a stock instead of buying a bond, you will

again expect to earn a return on your money. A stock’s return will come from

dividends plus capital gains. Again, the riskier the stock—which means the higher the

probability that the firm will fail to perform as you expected—the higher the expected

return must be to induce you to invest in the stock. With this in mind, consider the

possible rates of return (dividend yield plus capital gain or loss) that you might earn

next year on a $10,000 investment in the stock of either Martin Products Inc. or U.S.

Water Company. Martin man-

EXPECTED RATE OF RETURN

If we multiply each possible outcome by its probability of occurrence and then sum

these products, as in Table 6-2, we have a weighted average of outcomes. The weights

are the probabilities, and the weighted average is the expected rate of return, kˆ ,

called “k-hat.”3 The expected rates of return for both Martin Products and U.S. Water

are shown in Table 6-2 to be 15 percent.

RATE OF RETURN ON STOCK

IF THIS DEMAND OCCURS

DEMAND FOR THE PROBABILITY OF THIS

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COMPANY’S PRODUCTS DEMAND OCCURRING MARTIN PRODUCTS

U.S. WATER

Strong0.3 100% 20%

Normal 0.4 15 15

Weak 0.3 (70) 10

Probability Distributions for Martin Products and U.S. Water

2 It is, of course, completely unrealistic to think that any stock has no chance of a

loss. Only in hypothetical examples could this occur. To illustrate, the price of

Columbia Gas’s stock dropped from $34.50 to $20.00 in just three hours a few years

ago. All investors were reminded that any stock is exposed to some risk of loss, and

those investors who bought Columbia Gas learned that lesson the hard way. 3 In

Chapters 8 and 9, we will use kd and ks to signify the returns on bonds and stocks,

respectively. However, this distinction is unnecessary in this chapter, so we just use

the general term, k, to signify the expected return on an investment.

Expected Rate of Return, kˆ

The rate of return expected to be realized from an investment; the weighted average of

the probability distribution of possible results. The expected rate of return calculation

can also be expressed as an equation that does the same thing as the payoff matrix

table:4 Expected rate of return. Here ki is the ith possible outcome, Pi is the

probability of the ith outcome, and n is the number of possible outcomes. Thus, kˆ is a

weighted average of the possible outcomes (the ki values), with each outcome’s

weight being its probability of occurrence. Using the data for Martin Products, we

obtain its expected rate of return. We can graph the rates of return to obtain a picture

of the variability of possible outcomes; this is shown in the Figure 6-1 bar charts. The

height of each bar signifies the probability that a given outcome will occur. The range

of probable returns for Martin Products is from _70 to _100 percent, with an expected

return of 15 percent. The expected return for U.S. Water is also 15 percent, but its

range is much narrower. Thus far, we have assumed that only three situations can

exist: strong, normal, and weak demand. Actually, of course, demand could range

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from a deep depression to a fantastic boom, and there are an unlimited number of

possibilities.

DIVERSIFIABLE RISK VERSUS MARKET RISK

As noted above, it is difficult if not impossible to find stocks whose expected returns

are negatively correlated—most stocks tend to do well when the national economy is

strong and badly when it is weak.7 Thus, even very large portfolios end up with a

substantial amount of risk, but not as much risk as if all the money were invested in

only one stock. To see more precisely how portfolio size affects portfolio risk,

consider Figure 6-8, which shows how portfolio risk is affected by forming larger and

larger portfolios of randomly selected New York Stock Exchange (NYSE) stocks.

(b)MEASURING HISTORICAL RISK AND RETURN

When you are evaluating alternative investments for inclusion in your portfolio, you

will often be comparing investments with widely different prices or lives. As an

example, you might want to compare a $10 stock that pays no dividends to a stock

selling for $150 that pays dividends of $5 a year. To properly evaluate these two

investments, you must accurately compare their historical rates of returns. A proper

measurement of the rates of return is the purpose of this section. When we invest, we

defer current consumption in order to add to our wealth so that we can consume more

in the future. Therefore, when we talk about a return on an investment, we are

concerned with the change in wealth resulting from this investment. This change in

wealth can be either due to cash inflows, such as interest or dividends, or caused by a

change in the price of the asset (positive or negative). If you commit $200 to an

investment at the beginning of the year and you get back $220 at the end of the year,

what is your return for the period? The period during which you own an investment is

called its holding period, and the return for that period is the holding period return

(HPR). In this example, the HPR is 1.10, calculated as follows:

HPR

Ending Value of Investment

Beginning Value of Investment

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This value will always be zero or greater—that is, it can never be a negative value. A

value greater than 1.0 reflects an increase in your wealth, which means that you

received a positive rate of return during the period. A value less than 1.0 means that

you suffered a decline in wealth, which indicates that you had a negative return during

the period. An HPR of zero indicates that you lost all your money. Although HPR

helps us express the change in value of an investment, investors generally evaluate

returns in percentage terms on an annual basis. This conversion to annual percentage

rates makes it easier to directly compare alternative investments that have markedly

different characteristics. The first step in converting an HPR to an annual percentage

rate is to derive a percentage return, referred to as the holding period yield (HPY).

The HPY is equal to the HPR minus 1. Note that we made some implicit assumptions

when converting the HPY to an annual basis. This annualized holding period yield

computation assumes a constant annual yield for each year. In the two-year

investment, we assumed an 18.32 percent rate of return each year, compounded. In the

partial year HPR that was annualized, we assumed that the return is compounded for

the whole year. That is, we assumed that the rate of return earned during the first part

of the year is likewise earned on the value at the end of the first six months. The 12

percent rate of return for the initial six months compounds to 25.44 percent for the full

year.2 Because of the uncertainty of being able to earn the same return in the future

six months, institutions will typically not compound partial year results. Remember

one final point: The ending value of the investment can be the result of a positive or

negative change in price for the investment alone (for example, a stock going from

$20 a share to $22 a share), income from the investment alone, or a combination of

price change and income. Ending value includes the value of everything related to the

investment. Now that we have calculated the HPY for a single investment for a single

year, we want to consider mean rates of return for a single investment and for a

portfolio of investments. Over a number of years, a single investment will likely give

high rates of return during some years and low rates of return, or possibly negative

rates of return, during others. Your analysis should consider each of these returns, but

you also want a summary figure that indicates this investment’s typical experience, or

the rate of return you should expect to receive if you owned this investment over an

extended period of time. You can derive such a summary figure by computing the

mean annual rate of return for this investment over some period of time. Alternatively,

you might want to evaluate a portfolio of investments that might include similar

84

investments (for example, all stocks or all bonds) or a combination of investments (for

example, stocks, bonds, and real estate). In this instance, you would calculate the

mean rate of return for this portfolio of investments for an individual year or for a

number of years. Single Investment Given a set of annual rates of return (HPYs) for

an individual investment, there are two summary measures of return performance. The

first is the arithmetic mean return, the second the geometric mean return. Investors are

typically concerned with long-term performance when comparing alternative

investments. GM is considered a superior measure of the long-term mean rate of

return because it indicates the compound annual rate of return based on the ending

value of the investment versus its beginning value.3 Specifically, using the prior

example, if we compounded 3.353 percent for three years, (1.03353)3, we would get

an ending wealth value of 1.104. Although the arithmetic average provides a good

indication of the expected rate of return for an investment during a future individual

year, it is biased upward if you are attempting to measure an asset’s long-term

performance. When rates of return are the same for all years, the GM will be equal to

the AM. If the rates of return vary over the years, the GM will always be lower than

the AM. The difference between the two mean values will depend on the year-to-year

changes in the rates of return. Larger annual changes in the rates of return—that is,

more volatility—will result in a greater difference between the alternative mean

values. An awareness of both methods of computing mean rates of return is important

because published accounts of investment performance or descriptions of financial

research will use both the AM and the GM as measures of average historical returns.

We will also use both throughout this book. Currently most studies dealing with long-

run historical rates of return include both AM and GM rates of return. A Portfolio of

Investments The mean historical rate of return (HPY) for a portfolio of investments is

measured as the weighted average of the HPYs for the individual investments in the

portfolio, or the overall change in value of the original portfolio. The weights used in

computing the averages are the relative beginning market values for each investment;

this is referred to as dollar-weighted or value-weighted mean rate of return. This

technique is demonstrated by the examples in Exhibit 1.1. As shown, the HPY is the

same (9.5 percent) whether you compute the weighted average return using the

beginning market value weights or if you compute the overall change in the total

value of the portfolio. Although the analysis of historical performance is useful,

selecting investments for your portfolio requires you to predict the rates of return you

85

expect to prevail. The next section discusses how you would derive such estimates of

expected rates of return. We recognize the great uncertainty regarding these future

expectations, and we will discuss how one measures this uncertainty, which is

referred to as the risk of an investment. Risk is the uncertainty that an investment will

earn its expected rate of return. In the examples in the prior section, we examined

realized historical rates of return. In contrast, an investor who is evaluating a future

investment alternative expects or anticipates a certain rate of return. The investor

might say that he or she expects the investment will provide a rate of return of 10

percent, but this is actually the investor’s most likely estimate, also referred to as a

point estimate. Pressed further, the investor would probably acknowledge the

uncertainty of this point estimate return and admit the possibility that, under certain

conditions, the annual rate of return on this investment might go as low as –10 percent

or as high as 25 percent. The point is, the specification of a larger range of possible

returns from an investment reflects the investor’s uncertainty regarding what the

actual return will be. Therefore, a larger range of expected returns makes the

investment riskier. The expected rate of return for this investment is the same as the

certain return discussed in the first example; but, in this case, the investor is highly

uncertain about the actual rate of return. This would be considered a risky investment

because of that uncertainty. We would anticipate that an investor faced with the

choice between this risky investment and the certain (risk-free) case would select the

certain alternative. This expectation is based on the belief that most investors are risk

averse, which means that if everything else is the same, they will select the investment

that offers greater certainty. We have shown that we can calculate the expected rate of

return and evaluate the uncertainty, or risk, of an investment by identifying the range

of possible returns from that investment and assigning each possible return a weight

based on the probability that it will occur. The real risk-free rate (RRFR) is the basic

interest rate, assuming no inflation and no uncertainty about future flows. An investor

in an inflation-free economy who knew with certainty what cash flows he or she

would receive at what time would demand the RRFR on an investment. Earlier, we

called this the pure time value of money, because the only sacrifice the investor made

was deferring the use of the money for a period of time. This RRFR of interest is the

price charged for the exchange between current goods and future goods. Two factors,

one subjective and one objective, influence this exchange price. The subjective factor

is the time preference of individuals for the consumption of income. When individuals

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give up $100 of consumption this year, how much consumption do they want a year

from now to compensate for that sacrifice? The strength of the human desire for

current consumption influences the rate of compensation required. Time preferences

vary among individuals, and the market creates a composite rate that includes the

preferences of all investors. This composite rate changes gradually over time because

it is influenced by all the investors in the economy, whose changes in preferences may

offset one another. The objective factor that influences the RRFR is the set of

investment opportunities available in the economy.

The investment opportunities are determined in turn by the long-run real growth rate

of the economy. A rapidly growing economy produces more and better opportunities

invest funds and experience positive rates of return. A change in the economy’s long-

run real growth rate causes a change in all investment opportunities and a change in

the required rates of return on all investments. Just as investors supplying capital

should demand a higher rate of return when growth is higher; those looking for funds

to invest should be willing and able to pay a higher rate of return to use the funds for

investment because of the higher growth rate. Thus, a positive relationship exists

between the real growth rate in the economy and the RRFR. Earlier, we observed that

an investor would be willing to forgo current consumption in order to increase future

consumption at a rate of exchange called the risk-free rate of interest. This rate of

exchange was measured in real terms because the investor wanted to increase the

consumption of actual goods and services rather than consuming the same amount

that had come to cost more money.

c) MEASURING EXPECTED RISK AND RETURN

ESTIMATING THE MARKET RISK PREMIUM

The Capital Asset Pricing Model (CAPM) is more than just a theory describing the

trade-off between risk and return. The CAPM is also widely used in practice. As we

will see in Chapter 9, investors use the CAPM to determine the discount rate for

valuing stocks. Later, in Chapter 10 we will also see that corporate managers use the

CAPM to estimate the cost of equity financing. The market risk premium is an

important component of the CAPM. In practice, what we would ideally like to use in

the CAPM is the expected market risk premium, which gives an indication of

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investors’ future returns. Unfortunately, we cannot directly observe investors’

expectations. Instead, academicians and practitioners often use an historical estimate

of the market risk premium as a proxy for the expected risk premium. Historical

premiums are found by taking the differences between actual returns of the overall

stock market and the risk free rate. Ibbotson Associates provide perhaps the most

comprehensive estimates of historical risk premiums. Their estimates indicate that the

equity risk premium has averaged about 8 percent a year over the past 75 years.

Analysts have pointed out some of the shortcomings of using an historical estimate as

a proxy for the expected risk premium. First, historical estimates may be very

misleading at times when the market risk premium is changing. As we mentioned. in

an earlier box entitled “Is the Dow Jones Heading to 36,000?,” many analysts believe

that the expected risk premium has fallen in recent years. It is important to recognize

that a sharp drop in the expected risk premium (perhaps because of lower perceived

risk and/or declining risk aversion) pushes up stock prices, and that ironically

increases the observed (history).

VOLATILITY VERSUS RISK

Before closing this chapter, we should note that volatility does not necessarily imply

risk. For example, suppose a company’s sales and earnings fluctuate widely from

month to month, from year to year, or in some other manner. Does this imply that the

company is risky in either the stand-alone or portfolio sense? If the fluctuations follow

seasonal or cyclical patterns, as for an ice cream distributor or a steel company, they

can be predicted, hence volatility would not signify much in the way of risk. If the ice

cream company’s earnings dropped about as much as they normally did in the winter,

this would not concern in Volatility versus Risk.

CHAPTER-4 (EQUITY EVALUATION)

COMMON STOCK VALUATION

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Common stock represents an ownership interest in a corporation, but to the typical

investor, a share of common stock is simply a piece of paper characterized by two

features:

1. It entitles its owner to dividends, but only if the company has earnings out of which

dividends can be paid, and only if management chooses to pay dividends rather than

retaining and reinvesting all the earnings. Whereas a bond contains a promise to pay

interest, common stock provides no such promise—if you own a stock, you may

expect a dividend, but your expectations may not in fact be met. To illustrate, Long

Island Lighting Company (LILCO) had paid dividends on its common stock for more

than 50 years, and people expected those dividends to continue. However, when the

company encountered severe problems a few years ago, it stopped paying dividends.

Note, though, that LILCO continued to pay interest on its bonds; if it had not, then it

would have been declared bankrupt, and the bondholders could potentially have taken

over the company. 2. Stock can be sold at some future date, hopefully at a price

greater than the purchase price. If the stock is actually sold at a price above its

purchase price, the investor will receive a capital gain. Generally, at the time people

buy common stocks, they do expect to receive capital gains; common stock valuation.

SELF-TEST QUESTIONS

What is an IPO? Red Hat’s stock closed just above $54 per share. Demand for the

stock continued to surge, and the stock’s price reached a high of just over $300 in

December 1999. Soon afterward, the company announced a two-forone stock split.

The split effectively cut the stock’s price in half but it doubled the number of shares

held by each shareholder. After adjusting for the split, the stock’s price stood at $132

per share in early January 2000. However, from that point forward, Red Hat’s stock

has tumbled. At year-end 2000, the stock was trading below $14 per share, which is

equivalent to $28 per share before the split. Finally, it is important to recognize that

firms can go public without raising any additional capital. For example, the Ford

Motor Company was once owned exclusively by the Ford family. When Henry Ford

died, he left a substantial part of his stock to the Ford Foundation. When the

Foundation later sold some of this stock to the general public, the Ford Motor

Company went public, even though the company raised no capital in the transaction.

STOCKS AND THEIR VALUATION

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Otherwise, they would not purchase the stocks. However, after the fact, one can end

up with capital losses rather than capital gains. LILCO’s stock price dropped from

$17.50 to $3.75 in one year, so the expected capital gain on that stock turned out to be

a huge actual capital loss.

DEFINITIONS OF TERMS USED

IN STOCK VALUATION MODELS

Common stocks provide an expected future cash flow stream, and a stock’s value is

found in the same manner as the values of other financial assets— namely, as the

present value of the expected future cash flow stream. The expected cash flows

consist of two elements: (1) the dividends expected in each year and (2) the price

investors expect to receive when they sell the stock. The expected final stock price

includes the return of the original investment plus an expected capital gain. We saw in

Chapter 1 that managers seek to maximize the values of their firms’ stocks. A

manager’s actions affect both the stream of income to investors and the riskiness of

that stream. Therefore, managers need to know how alternative actions are likely to

affect stock prices. At this point we develop some models to help show how the value

of a share of stock is determined. We begin by defining the following terms: Dt _

dividend the stockholder expects to receive at the end of Year t. D0 is the most recent

dividend, which has already been paid; D1 is the first dividend expected, and it will be

paid at the end of this year; D2 is the dividend expected at the end of two years; and

so forth. D1 represents the first cash flow a new purchaser of the stock will receive.

Note that D0, the dividend that has just been paid, is known with certainty. However,

all future dividends are expected values, so the estimate of Dt may differ among

investors.5 P0 _ actual market price of the stock today. expected price of the stock at

the end of each Year t (Pronounced “P hat t”). Pˆ 0 is the intrinsic, or theoretical,

value of the stock today as seen by the particular investor doing the analysis; Pˆ 1 is

the price expected at the end of one year; and so on. Note that Pˆ 0 is the intrinsic

value of the stock today based on a particular investor’s estimate of the stock’s

expected dividend stream and the riskiness of that stream. Hence, whereas the market

price P0 is fixed and is identical for all investors, Pˆ 0 could differ among investors

depending on how optimistic they are regarding the Market Price, P0 The price at

which a stock sells in the market. Intrinsic Value, Pˆ0 The value of an asset that, in the

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mind of a particular investor, is justified by the facts; Pˆ0 may be different from the

asset’s current market price.

EXPECTED DIVIDENDS AS THE BASIS FOR STOCK VALUES

In our discussion of bonds, we found the value of a bond as the present value of

interest payments over the life of the bond plus the present value of the bond’s

maturity (or par) value: Stock prices are likewise determined as the present value of a

stream of cash flows, and the basic stock valuation equation is similar to the bond

valuation equation. What are the cash flows that corporations provide to their

stockholders? First, think of yourself as an investor who buys a stock with the

intention of holding it (in your family) forever. In this case, all that you (and your

heirs) will receive is a stream of dividends, and the value of the stock today is

calculated as the present value of an infinite stream of dividends: Value of stock _Pˆ 0

_ PV of expected future dividends.

What about the more typical case, where you expect to hold the stock for a finite

period and then sell it—what will be the value of Pˆ 0 in this case? Unless the

company is likely to be liquidated or sold and thus to disappear, the value of the stock

is again determined by Equation 9-1. To see this, recognize that for any individual

investor, the expected cash flows consist of expected dividends plus the expected sale

price of the stock. However, the sale price the current investor. Receives will depend

on the dividends some future investor expects. Therefore, for all present and future

investors in total, expected cash flows must be based on expected future dividends.

Put another way, unless a firm is liquidated or sold to another concern, the cash flows

it provides to its stockholders will consist only of a stream of dividends; therefore, the

value of a share of its stock must be established as the present value of that expected

dividend stream. The general validity of Equation 9-1 can also be confirmed by

asking the following question: Suppose I buy a stock and expect to hold it for one

year. I will receive dividends during the year plus the value Pˆ 1 when I sell out at the

end of the year. But what will determine the value of Pˆ 1? The answer is that it will

be determined as the present value of the dividends expected during Year 2 plus the

stock price at the end of that year, which, in turn, will be determined as the present

value of another set of future dividends and an even more distant stock price. This

process can be continued ad infinitum, and the ultimate result is Equation.

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Bond market

The bond market (also known as the debt, credit, or fixed income market) is a

financial market where participants buy and sell debt securities, usually in the form of

bonds. As of 2009, the size of the worldwide bond market (total debt outstanding) is

an estimated $82.2 trillion. References to the "bond market" usually refer to the

government bond market, because of its size, liquidity, lack of credit risk and,

therefore, sensitivity to interest rates. Because of the inverse relationship between

bond valuation and interest rates, the bond market is often used to indicate changes in

interest rates or the shape of the yield curve.

Market Structure

Bond markets in most countries remain decentralized and lack common exchanges

like stock, future and commodity markets. This has occurred, in part, because no two

bond issues are exactly alike, and the variety of bond securities outstanding greatly

exceeds that of stocks. Besides other causes, the decentralized market structure of the

corporate and municipal bond markets, as distinguished from the stock market

structure, results in higher transaction costs and less liquidity. A study performed by

Profs Harris and Piwowar in 2004, Secondary Trading Costs in the Municipal Bond

Market, reached the following conclusions: "Municipal bond trades are also

substantially more expensive than similar sized equity trades. We attribute these

results to the lack of price transparency in the bond markets. Additional cross-

sectional analyses show that bond trading costs decrease with credit quality and

increase with instrument complexity, time to maturity, and time since issuance." "Our

results show that municipal bond trades are significantly more expensive than

equivalent sized equity trades.

Types of bond markets

The Securities Industry and Financial Markets Association (SIFMA) classifies the

broader bond market into five specific bond markets.

Corporate

Government & agency

Municipal

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Mortgage backed, asset backed, and collateralized debt obligation

Funding

Bond market participants

Bond market participants are similar to participants in most financial markets and are

essentially either buyers (debt issuer) of funds or sellers (institution) of funds and

often both.

Participants include:

Institutional investors

Governments

Traders

Individuals

Because of the specificity of individual bond issues, and the lack of liquidity in many

smaller issues, the majority of outstanding bonds are held by institutions like pension

funds, banks and mutual funds. In the United States, approximately 10% of the market

is currently held by private individuals.

Bond market size

Amounts outstanding on the global bond market increased 10% in 2009 to a record

$91 trillion. Domestic bonds accounted for 70% of the total and international bonds

for the remainder. The US was the largest market with 39% of the total followed by

Japan (18%). Mortgage-backed bonds accounted for around a quarter of outstanding

bonds in the US in 2009 or some $9.2 trillion. The sub-prime portion of this market is

variously estimated at between $500bn and $1.4 trillion. Treasury bonds and

corporate bonds each accounted for a fifth of US domestic bonds. In Europe, public

sector debt is substantial in Italy (93% of GDP), Belgium (63%) and France (63%).

Concerns about the ability of some countries to continue to finance their debt came to

the forefront in late 2009. This was partly a result of large debt taken on by some

governments to reverse the economic downturn and finance bank bailouts. The

outstanding value of international bonds increased by 13% in 2009 to $27 trillion. The

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$2.3 trillion issued during the year was down 4% on the 2008 total, with activity

declining in the second half of the year.

CHAPTER-5 (FINANCIAL STATEMENTS ANALYSIS)

(a) Financial statements

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Financial statements (or financial reports) are formal records of a business' financial

activities. These statements provide an overview of a business' profitability and

financial condition in both short and long term. There are four basic financial

statements: Balance sheet: also referred to as statement of financial position or

condition, reports on a company's assets, liabilities and net equity as of a given point

in time. Income statement: also referred to as Profit or loss statement, reports on a

company's results of operations over a period of time. Statement of retained earnings:

explains the changes in a company's retained earnings over the reporting period.

Statement of cash flows: reports on a company's cash flow activities, particularly its

operating, investing and financing activities.

For large corporations, these statements are often complex and may include an

extensive set of notes to the financial statements and management discussion and

analysis. The notes typically describe each item on the balance sheet, income

statement and cash flow statement in further detail. Notes to financial statements are

considered an integral part of the financial statements.

Financial statements are used by a diverse group of parties, both inside and outside a

business. Generally, these users are:

1. Internal Users: are owners, managers, employees and other parties who are directly

connected with a company. Owners and managers require financial statements to

make important business decisions that affect its continued operations. Financial

analysis is then performed on these statements to provide management with a more

detailed understanding of the figures. These statements are also used as part of

management's report to its stockholders, as it form part of its Annual Report.

Employees also need these reports in making collective bargaining agreements (CBA)

with the management, in the case of labor unions or for individuals in discussing their

compensation, promotion and rankings.

2. External Users: are potential investors, banks, government agencies and other

parties who are outside the business but need financial information about the business

for a diverse number of reasons. Prospective investors make use of financial

statements to assess the viability of investing in a business. Financial analyses are

often used by investors and is prepared by professionals (financial analysts), thus

providing them with the basis in making investment decisions. Financial institutions

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(banks and other lending companies) use them to decide whether to grant a company

with fresh working capital or extend debt securities (such as a long-term bank loan or

debentures) to finance expansion and other significant expenditures. Government

entities (tax authorities) need financial statements to ascertain the propriety and

accuracy of taxes and other duties declared and paid by a company.

Media and the general public are also interested in financial statements for a variety of

reasons.

Government financial statements

The rules for the recording, measurement and presentation of government financial

statements may be different from those required for business and even for non-profit

organizations. They may use either of two accounting methods: accrual accounting, or

cash accounting, or a combination of the two. A complete set of chart of accounts is

also used that is substantially different from the chart of a profit-oriented business.

Audit and legal implications

Although the legal statutes may differ from country to country, an audit of financial

statements are usually, but not exclusively required for investment, financing, and tax

purposes. These are usually performed by independent accountants or auditing firms.

Results of the audit are summarized in an audit report that either provides an

unqualified opinion on the financial statements or qualifications as to its fairness and

accuracy. The audit opinion on the financial statements is usually included in the

annual report.

There has been much legal debate over who an auditor is liable to. Since audit reports

tend to be addressed to the current shareholders, it is commonly thought that they owe

a legal duty of care to them. But this may not be the case as determined by common

law precedent. In Canada, auditors are liable only to investors using a prospectus to

buy shares in the primary market. In the United Kingdom, they have been held liable

to potential investors when the auditor was aware of the potential investor and how

they would use the information in the financial statements. Nowadays auditors tend to

include in their report liability restricting language, discouraging anyone other than

the addressees of their report from relying on it. Liability is an important issue: in the

UK, for example, auditors have unlimited liability.

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In the United States, especially in the post-Enron era there has been substantial

concern about the accuracy of financial statements. Corporate officers (the chief

executive officer (CEO) and chief financial officer (CFO)) are personally liable for

attesting that financial statements "do not contain any untrue statement of a material

fact or omit to state a material fact necessary to make the statements made, in light of

the circumstances under which such statements were made, not misleading with

respect to the period covered by the report". Making or certifying misleading financial

statements exposes the people involved to substantial civil and criminal liability. For

example Bernie Ebbers (former CEO of WorldCom) was sentenced to 25 years in

federal prison for allowing WorldCom's revenues to be overstated by $11 billion over

five years.

Different countries have developed their own accounting principles over time, making

international comparisons of companies difficult. To ensure uniformity and

comparability between financial statements prepared by different companies, a set of

guidelines and rules are used. Commonly referred to as Generally Accepted

Accounting Principles (GAAP), these set of guidelines provide the basis in the

preparation of financial statements.

Recently there has been a push towards standardizing accounting rules made by the

International Accounting Standards Board ("IASB"). IASB develops International

Financial Reporting Standards that have been adopted by Australia, Canada and the

European Union (for publicly quoted companies only), are under consideration in

South Africa and other countries. The United States Federal Accounting Standards

Board has made a commitment to converge the U.S. GAAP and IFRS over time.

History

Financial statements and records have been produced for as far back as there has been

human writing. The people in the old Mesopotamian societies operated both insurance

and credit (see interest) corporations, and had the obvious need of record keeping. The

primary goal of financial management is to maximize the stock price, not to maximize

accounting measures such as net income or EPS. However, accounting data do in

uence stock prices, and to understand why a company is performing the way it is and

to forecast where it is heading, one needs to evaluate the accounting information

reported in the financial statements. If management is to maximize a firm’s value,

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it must take advantage of the firm’s strengths and correct its weaknesses.

Financial statement analysis involves (1) comparing the firm’s performance with

that of other firms in the same industry and (2) evaluating trends in the firm’s

financial position over time. These stuffs help management identify deficiencies

and then take actions to improve performance. In this chapter, we focus on

how financial managers (and investors) evaluate a firm’s current financial

position. Then, in the remaining chapters, we examine the types of actions

management can take to improve future performance and thus increase its stock

price. This chapter should, for the most part, be a review of concepts you

learned in accounting. However, accounting focuses on how financial statements

are made, whereas our focus is on how they are used by management to improve

the firm’s performance and by investors when they set values on the firm’s stock

and bonds. Like Chapter 2, a spreadsheet model accompanies this chapter. You are

encouraged to use the model and follow along with the textbook examples.

(b) FINANCIAL RATIOS

RATIO ANALYSIS

Financial statements report both on a firm’s position at a point in time and on its

operations over some past period. However, the real value of financial statements lies

in the fact that they can be used to help predict future earnings and dividends. From an

investor’s standpoint, predicting the future is what financial statement analysis is all

about while from management’s standpoint, Financial statement analysis is useful

both to help anticipate future conditions and, more important, as a starting point for

planning actions that will improve the firm’s future performance. Financial ratios are

designed to help one evaluate a financial statement. For example, Firm A might

have debt of $5,248,760 and interest charges of $419,900, while Firm B might

have debt of $52,647,980 and interest charges of $3,948,600. Which company is

stronger? The burden of these debts, and the companies’ ability to repay them, can

best be evaluated (1) by comparing each firm’s debt to its assets and (2) by comparing

the interest it must pay to the in- come it has available for payment of interest.

Such comparisons are made by ratio analysis. In the paragraphs that follow, we will

calculate the Year 2001 financial ratios for Allied Food Products, using data from the

balance sheets and income statements given in Tables 2-1 and 2-2 back in Chapter 2.

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We will also evaluate the ratios in relation to the industry averages. Note that all

dollar amounts in the1ratio calculations are in millions

ASSET MANAGEMENT RATIOS

Asset Management Ratios The second group of ratios, the asset management ratios,

measures how effectively the firm is managing its assets. These ratios are

designed to answer A set of ratios that measure how effectively a firm is managing

its this question: Does the total amount of each type of asset as reported on the

assets. Balance sheet seems reasonable, too high, or too low in view of current and

projected sales levels? When they acquire assets, Allied and other companies must

borrow or obtain capital from other sources. If a firm has too many assets, its cost of

capital will be too high; hence its profits will be depressed. On the other hand, if

assets are too low, profitable sales will be lost. Ratios that analyze the different types

of assets are described in this section. Inventory turnover ratio is defined as sales

divided by inventories: This ratio is calculated by dividing sales by inventories.

Inventory turnover ratio Sales Inventories

TREND ANALYSIS

It is important to analyze trends in ratios as well as their absolute levels, for trends

give clues as to whether a firm’s financial condition is likely to Trend Analysis

improve or to deteriorate. To do a trend analysis, one simply plots a ratio over time, as

shown in Figure 3-1. This graph shows that Allied’s rate of An analysis of a firm’s

financial ratios over time; used to estimate return on common equity has been

declining since 1998, even though the likelihood of improvement or industry average

has been relatively stable. All the other ratios could be deterioration in its financial

analyzed similarly.

CHAPTER- 6 (BOND EVALUATION)

Bond Characteristics, price, yield risks

Bond valuation is the process of determining the fair price of a bond. As with any

security or capital investment, the fair value of a bond is the present value of the

stream of cash flows it is expected to generate. Hence, the price or value of a bond is

determined by discounting the bond's expected cash flows to the present using the

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appropriate discount rate. General relationships The present value relationship The

fair price of a straight bond (a bond with no embedded option; see Callable bond) is

determined by discounting the expected cash flows:

Cash flows:

The periodic coupon payments C, each of which is made once every period;

the par or face value F, which is payable at maturity of the bond after T periods.(NB

final year payment will include the par value plus the coupon payment for the year)

Discount rate: the required (annually compounded) yield or rate of return r.

r is the market interest rate for new bond issues with similar risk ratings

Bond Price =

Because the price is the present value of the cash flows, there is an inverse

relationship between price and discount rate: the higher the discount rate the lower

the value of the bond (and vice versa). A bond trading below its face value is trading

at a discount, a bond trading above its face value is at a premium.

Coupon yield

The coupon yield is simply the coupon payment (C) as a percentage of the face value

(F).

Coupon yield = C / F

Coupon yield is also called nominal yield.

Current yield

The current yield is simply the coupon payment (C) as a percentage of the bond price

(P).

Current yield = C / P0.

Yield to Maturity

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The yield to maturity (YTM) is the discount rate which returns the market price of the

bond. It is thus the internal rate of return of an investment in the bond made at the

observed price. YTM can also be used to price a bond, where it is used as the required

return on the bond.

Solve for YTM where

Market Price =

To achieve a return equal to YTM, the bond owner must: reinvest each coupon

received at this rate, hold the bond until maturity, and redeem the bond at par.

The concept of current yield is closely related to other bond concepts, including yield

to maturity, and coupon yield. The relationship between yield to maturity and coupon

rate is as follows:

When a bond sells at a discount, YTM > current yield > coupon yield.

When a bond sells at a premium, coupon yield > current yield > YTM.

When a bond sells at par, YTM = current yield = coupon yield.

The YTM is of limited use in valuing bonds with uncertain cash flows, such as

mortgage-backed securities or asset-backed securities. In these instances, other

measures such as option adjusted spread should be used instead when comparing

yields across different types of bonds.

Bond pricing

Relative price approach

Here the bond will be priced relative to a benchmark, usually a government security.

The discount rate used to value the bond is determined based on the bond's rating

relative to a government security with similar maturity or duration. The better the

quality of the bond, the smaller the spread between its required return and the YTM

of the benchmark. This required return is then used to discount the bond cash flows as

above.

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Arbitrage free pricing approach

In this approach, the bond price will reflect its arbitrage free price (arbitrage=practice

of taking advantage of a state of imbalance between two or more markets). Here, each

cash flow is priced separately and is discounted at the same rate as the corresponding

government issues Zero coupon bonds. (Some multiple of the bond (or the security)

will produce an identical cash flow to the government security (or the bond in

question).) Since each bond cash flow is known with certainty, the bond price today

must be equal to the sum of each of its cash flows discounted at the corresponding

risk free rate - i.e. the corresponding government security. Were this not the case,

arbitrage would be possible - see rational pricing.

Here the discount rate per cash flow, it, must match that of the corresponding zero

coupon bond's rate.

Bond Price =

The bond market, also known as the debt, credit, or fixed income market, is a

financial market where participants buy and sell debt securities usually in the form of

bonds. The size of the international bond market is an estimated $45 trillion of which

the size of outstanding U.S. bond market debt is $25.2 trillion. Nearly all of the $923

billion average daily trading volume in the U.S. Bond Market takes place between

broker-dealers and large institutions in a decentralized, over-the-counter (OTC)

market. However, a small number of bonds, mainly corporate, are listed on

exchanges.

Equity funds

Equity funds, which consist mainly of stock investments, are the most common type

of mutual fund. Equity funds hold 50 percent of all amounts invested in mutual funds

in the United States. Often equity funds focus investments on particular strategies and

certain types of issuers.

Capitalization

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Fund managers and other investment professionals have varying definitions of mid-

cap and large-cap ranges. The following ranges are used by Russell Indexes:

Russell Microcap Index - micro-cap ($54.8 - 539.5 million)

Russell 2000 Index - small-cap ($182.6 million - 1.8 billion)

Russell Midcap Index - mid-cap ($1.8 - 13.7 billion)

Russell 1000 Index - large-cap ($1.8 - 386.9 billion)

Growth vs. value

Another distinction is made between growth funds, which invest in stocks of

companies that have the potential for large capital gains, and value funds, which

concentrate on stocks that are undervalued. Value stocks have historically produced

higher returns; however, financial theory states this is compensation for their greater

risk. Growth funds tend not to pay regular dividends. Income funds tend to be more

conservative investments, with a focus on stocks that pay dividends. A balanced fund

may use a combination of strategies, typically including some level of investment in

bonds, to stay more conservative when it comes to risk, yet aim for some growth.

Index funds versus active management

Main articles: Index fund and active management

An index fund maintains investments in companies that are part of major stock (or

bond) indices, such as the S&P 500, while an actively managed fund attempts to

outperform a relevant index through superior stock-picking techniques. The assets of

an index fund are managed to closely approximate the performance of a particular

published index. Since the composition of an index changes infrequently, an index

fund manager makes fewer trades, on average, than does an active fund manager. For

this reason, index funds generally have lower trading expenses than actively managed

funds, and typically incur fewer short-term capital gains which must be passed on to

shareholders. Additionally, index funds do not incur expenses to pay for selection of

individual stocks (proprietary selection techniques, research, etc.) and deciding when

to buy, hold or sell individual holdings. Instead, a fairly simple computer model can

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identify whatever changes are needed to bring the fund back into agreement with its

target index.

The performance of an actively managed fund largely depends on the investment

decisions of its manager. Statistically, for every investor who outperforms the market,

there is one who underperforms. Among those who outperform their index before

expenses, though, many end up underperforming after expenses. Before expenses, a

well-run index fund should have average performance. By minimizing the impact of

expenses, index funds should be able to perform better than average.

Certain empirical evidence seems to illustrate that mutual funds do not beat the

market and actively managed mutual funds under-perform other broad-based

portfolios with similar characteristics. One study found that nearly 1,500 U.S. mutual

funds under-performed the market in approximately half of the years between 1962

and 1992. Moreover, funds that performed well in the past are not able to beat the

market again in the future (shown by Jensen, 1968; Grimblatt and Sheridan Titman,

1989.

Bond funds

Bond funds account for 18% of mutual fund assets. Types of bond funds include term

funds, which have a fixed set of time (short-, medium-, or long-term) before they

mature. Municipal bond funds generally have lower returns, but have tax advantages

and lower risk. High-yield bond funds invest in corporate bonds, including high-yield

or junk bonds. With the potential for high yield, these bonds also come with greater

risk.

Money market funds

Money market funds hold 26% of mutual fund assets in the United States. Money

market funds entail the least risk, as well as lower rates of return. Unlike certificates

of deposit (CDs), money market shares are liquid and redeemable at any time. The

interest rate quoted by money market funds is known as the 7 Day SEC Yield.

Interest rate risk is risk to the earnings or market value of a portfolio due to

uncertain future interest rates. Discussions of interest rate risk can be confusing

because there are two fundamentally different ways of approaching the topic. People

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who are accustomed to one often have difficulty grasping the other. The two

perspectives are:

A book value perspective, which perceives risk in terms of its effect on accounting

earnings, and

A market value perspective—sometimes called an economic perspective—which

perceives risk in terms of its effect on the market value of a portfolio.

The first perspective is typical in banking, insurance and corporate treasuries, where

book value accounting prevails. The latter is typical in a trading or investment

management context.

Interest rate risks can be categorized in different ways, and there is usually some

overlap between categories. One approach—that is well suited for a book-value

perspective—is to break interest rate risk into three components:

term structure risk,

basis risk,

options risk.

Term structure risk (also called yield curve risk or repricing risk) is risk due to

changes in the fixed income term structure. It arises if interest rates are fixed on

liabilities for periods that differ from those on offsetting assets. One reason may be

maturity mismatches. Suppose an insurance company is earning 6% on an asset

supporting a liability on which it is paying 4%. The asset matures in two years while

the liability matures in ten. In two years, the firm will have to reinvest the proceeds

from the asset. If interest rates fall, it could end up reinvesting at 3%. For the

remaining eight years, it would earn 3% on the new asset while continuing to pay 4%

on the original liability. Term structure risk also occurs with floating rate assets or

liabilities. If fixed rate assets are financed with floating rate liabilities, the rate payable

on the liabilities may rise while the rate earned on the assets remains constant.

In general, any occasion on which interest rates are to be reset—either due to

maturities or floating rate resets—is called a repricing. The date on which it occurs is

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called the reprising dates. It is this terminology that motivates the alternative name

"repricing risk" for tem structure risk

If a portfolio has assets repricing earlier than liabilities, it is said to be  asset sensitive.

This is because near term changes in earnings are going to be driven by interest rate

resets on those assets. Similarly, if liabilities reprice earlier, earnings are more

exposed to interest rate resets on those liability, and the portfolio is called liability

sensitive.

For example, a bank that is supporting fixed rate liabilities with floating rate assets is

asset sensitive. Earnings risk is posed by the floating rate on the assets. This example

is only meaningful from a book value standpoint—which focuses on earnings risk.

From a market risk standpoint, the floating rate assets pose little risk—floaters have

stable market values. It is the long-dated liabilities that pose market risk. Their market

values fluctuate with changes in long-term interest rates. From the economic

perspective, it would be reasonable to call the bank "liability sensitive!" Of course,

that is not how the terminology is used. However, our example highlights how

fundamentally different the book-value and market-value perspectives are.

It should be emphasized that this discussion uses the terms "asset" and ":liability"

loosely, and not in any strict accounting sense. We include among assets and

liabilities both derivatives and other off-balance sheet instruments that may behave

like assets or liabilities. A pay-fixed interest rate swap might be considered a

combination of a floating rate asset with a fixed rate liability. On a stand-alone basis,

it poses considerable term structure risk.

Basis risk due to possible changes in spreads. In fixed income markets, basis risk

arises from changes in the relationship between interest rates for different market

sectors. If a bank makes loans at prime while financing those loans at Libor, it is

exposed to the risk that the spread between prime and Libor may narrow. If a portfolio

holds junk bonds hedged with short Treasury futures, it is exposed to basis risk due to

possible changes in the yield spread of junk bonds over Treasuries.  Basis risk is

another name for spread risk.

As with term structure risk, book-value and market-value perspectives differ with

respect to basis risk. As always, the book value perspective focuses on risk to

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earnings. If the spread between interest earned on assets and interest paid on liabilities

narrows, those earnings will suffer. The economic perspective considers the risk to the

portfolio's market value. If a spread narrows or widens, the market values of assets

and liabilities may be affected differently—and the net market value of the overall

portfolio could suffer.

Options risk, as a component of interest rate risk, is risk due to fixed income options

—options that have fixed income instruments or interest rates as underliers. Options

may be stand-alone, such as caps or swaptions. They may also be embedded, as with

the call feature of callable bonds or the prepayment of mortgage-baked

securities (MBS). In some respects, options risk is just another component of term

structure risk. This argument needs to be explored differently for the book value and

market value perspectives.

From the book value perspective, the distinction between term structure and options

risk has historical roots. Payoffs of options depends upon changes in interest rates,

which would seem to make options one more source of term structure risk. However,

by shorting embedded options, a depository institution can enhance short-term

earnings at the expense of long-term earnings. This is what happened during the

1980s, when the MBS market was just emerging. Dealers found US thrifts and other

depository institutions to be eager buyers of MBSs. Because of their short embedded

prepayment options, the MBSs offered very highyields—and those high yields flowed

immediately to earnings. Because MBS pricing was far from transparent, dealers

could charge exorbitant prices for the MBS—they priced them to have yields much

higher than Treasury notes, but not high enough to fully compensate for the short

options. From an economic standpoint, thrifts incurred a loss every time they

purchased an MBS, but the thrifts didn't see that. Perceiving the world from a purely

book-value/earnings perspective, all they saw was an immediate jump in earnings.

Only later, when interest rates dropped and prepayments on the MBS surged, did the

thrifts realize their mistake. Loses were staggering and were a primary contributor to

the ensuing crisis in the US thrift industry.

Part of the thrifts' problem was due to being cheated by the dealers who sold them the

MBS at inflated prices. That is a risk distinct from interest rate risk. It is as old as

Wall Street—caveat emptor. However, another significant issue was the emerging

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problem that derivatives and new structures with embedded options made it possible

to do an "end-run" around traditional book value accounting. Increasingly, earnings

could be manipulated for the short-term, with consequences pushed into the future.

Traditional techniques of asset-liability management—which focused on term

structure and basis risk—were ill equipped to address this emerging risk. Hence, the

new risk was given a name—options risk—and managers came under pressure to

supplement old tools with new ones that could assess this new risk.

The economic perspective on options risk is very different. From that standpoint,

options pose immediate risk in the form of changes in their market value. While

shorting embedded options can generate income that immediately flows to earnings, it

does nothing for market value—the option premiums are offset by the negative

market value of the newly shorted options. If the options are shorted at fair prices, the

two cancel—and there is no immediate market value impact.

Market risk of fixed income options arises primarily from two sources:

changes in underlying interest rates, and

changes in applicable implied volatilities.

The first of these, from a market value standpoint, is no different from term structure

risk—the portfolio's value rises or falls with interest rates in a fairly predictable

manner. The latter isn't a form of interest rate risk—it is implied volatility risk.

Accordingly, from an economic perspective, it is more reasonable to identify just two

components of interest rate risk:

Term structure risk, and

Basis risk

Where a term structure includes a component of what we previously called options

risk and the balance of options risk is a new, non-interest rate risk:

Volatility risk

There are many techniques for assessing interest rate risk. Some focus on the earnings

impact of interest rate risk. Others focus on the market value impact. Accordingly, the

choice of tools will be motivated by your perspective.

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Investors with a book value perspective tend to address interest rate risk with the tools

of asset-liability management—cash matching, gap analysis, earnings simulation,

earnings at risk and duration. Those with an economic perspective use some of these

—especially gap analysis and duration—but they also use tools that focus on

economic value—delta, PV01 andvalue-at-risk.

Tools such as earnings simulation and earnings-at-risk quantify risk in terms of its

earnings impact, so they are only applicable from a book-value perspective. Tools like

PV01 and value-at-risk quantify risk in terms of market value impact, so they are only

applicable from a market-value perspective. Gap analysis and duration are interesting

because they can be used with either perspective. Let's look at why.

Gap analysis doesn't consider the consequences of the risk it assesses, so it doesn't

lock the user into one perspective or the other. It simply identifies interest rate gaps.

The book-value and market-value perspectives may see differing implications in those

gaps, but they both see risk. Accordingly, gap analysis is useful for both.

CHAPTER-7 (FUNDAMENTAL ANALYSIS)

ECONOMIC ANALYSIS

Secondary market is the place for sale and purchase of existing securities. It enables

an investor to adjust his holdings of securities in response to changes in his

assessment about risk and return. It also enables him to sell securities for cash to meet

his liquidity needs. It essentially comprises of the stock exchanges which provide

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platform for trading of securities and a host of intermediaries who assist in trading of

securities and clearing and settlement of trades. The securities are traded, cleared and

settled as per prescribed regulatory framework under the supervision of the Exchanges

and SEBI.

1 Stock Exchange

The stock exchanges are the exclusive centers for trading of securities. Listing of

companies on a Stock Exchange is mandatory to provide an opportunity to investors

to invest in the securities of local companies. The trading volumes on exchanges have

been witnessing phenomenal growth for last few years. Since the advent of screen

based trading system in 1994-95, it has been growing by leaps and bounds and

reported a total turnover of Rs.51, 30,816 crore during 2007-08. The growth of

turnover has, however, not been uniform across exchanges as may be seen from Table

3.1. The increase in turnover took place mostly at big exchanges (NSE and BSE) and

it was partly at the cost of small exchanges that failed to keep pace with the changes.

The business moved away from small exchanges to big exchanges, which adopted

technologically superior trading and settlement systems. The huge liquidity and order

depth of big exchanges further diverted liquidity of other stock exchanges. The 19

small exchanges put together reported less than 0.02% of total turnover during 2007-

08, while 2 big exchanges accounted for over 99.98 % of turnover. For most of the

exchanges, the raison d’être for their existence, i.e. turnover, has disappeared. NSE

and BSE are the major exchanges having nationwide operations. NSE operated

through 2,956 VSATs in 245 cities at the end of March 2008. Corporatization &

Demutualization of Stock Exchanges: Corporatization’ means the succession of a

recognized stock exchange, being a body of individuals or a society registered under

the Societies Registration Act 1860 (21 of 1860) by another stock exchange, being a

company incorporated for the purpose of assisting, regulating or controlling the

business of buying, selling or dealing in securities carried on by such individuals or

society. ‘Demutualization’ means the segregation of ownership and management from

the trading rights of the members of a recognized stock exchange in accordance with

the scheme approved by the Securities and Exchange Board of India. Demutualization

is the process through which a member-owned company becomes shareholder-owned

company. Worldwide, stock exchanges have offered striking example of the trend

towards demutualization, as the London Stock Exchange (LSE), New York Stock

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Exchange (NYSE), Toronto Stock Exchange (TSE) and most other exchanges across

the globe have moved towards demutualization and India is no exception to it. In

January 2002, SEBI directed all the recognized stock exchanges to suitably amend

their Rules, Articles etc. within a period of two months from the date of the order to

provide that no broker member of the stock exchanges shall be an office bearer of an

exchange, i.e. hold the position of President, Vice President, Treasurer etc. This was

done to give effect to the decision taken by SEBI and the policy decision of

Government in regard to demutualization/corporatization of exchanges by which

ownership, management and trading membership would be segregated from each

other. Corporatization and demutualization of stock exchanges are complex subjects

and involve a number of legal, accounting, Companies Act related and tax issues.

Therefore, SEBI set up in March 2002 a Group on ‘Corporatizations &

Demutualization of Stock Exchanges’ under the Chairmanship of Shri M. H. Kania,

former Chief Justice of India. The Group submitted its report in August 2002 with the

following recommendations:

(a) A common model for corporatization and demutualization may be adopted for all

stock exchanges. Each stock exchange would be required to submit a scheme drawn

on the lines of the recommendations of the Group to SEBI for approval. Any stock

exchange failing to comply with the requirement of corporatization and

demutualization by the appointed date may be derecognized.

(b) The SCRA may be amended to provide that a stock exchange should be a

company incorporated under the Companies Act. The stock exchanges set up as

association of persons or as companies limited by guarantee may be converted into

companies limited by shares.

(c) The Income Tax Act may be amended to provide that the accumulated reserves of

the stock exchange as on the day of corporatization are not taxed. The reserves may

be taxed in the hands of the shareholders when these are distributed to shareholders as

dividend at the net applicable tax rate. All future profits of the stock exchange after it

becomes a for-profit company may be taxed. Further, the issue of ownership rights

(shares) and trading rights in lieu of the card should not be regarded as transfer and

not attract capital gains tax. However, at the point of sale of any of these two rights,

capital gains tax would be attracted.

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(d) The Indian Stamp Act and the Sales Tax laws may be amended to exempt from

stamp duty and sales tax, the transfer of the assets from the mutual stock exchange

and the issuance of shares by the new demutualised for Profit Company.

(e) While the Group favours the deposit system for trading rights, it likes to leave the

choice of adopting either the card or the deposit system to the exchanges. If the

deposit system is accepted, the value of the card will be segregated into two

independent rights namely the right to share in the net assets and goodwill of the stock

exchange and the right to trade on the stock exchange.

(f) The three stakeholder’s viz. shareholders, brokers and investing public through the

regulatory body should be equally represented on the governing board of the

demutualised exchange. The roles and hence the posts of the Chairman and Chief

Executive should be segregated. The Chairman should be a person who has

considerable knowledge and experience of the functioning of the stock exchanges and

the capital market. The Chairman of the Board should not be a practicing broker. The

exchange must appoint a CEO who would be solely responsible for the day to day

functioning of the exchange, including compliance with various regulations and risk

management practices. The board should not constitute any committee which would

dilute the independence of the CEO.

(g) The demutualised stock exchanges should follow the relevant norms of corporate

governance applicable to listed companies in particular, the constitution of the audit

committee, standards of financial disclosure and accounting standards, disclosures in

the annual reports, disclosures to shareholders and management systems and

procedures. It would be desirable for the demutualised exchanges to list its shares on

itself or on any other exchange. However, this may not be made mandatory; in case

the exchange is listed the monitoring of its listing conditions should be left to the

Central Listing Authority or SEBI.

(h) No specific form of dispersal need be prescribed but there should be a time limit

prescribed, say three years which can be extended by a further maximum period of 2

years with the approval of SEBI, within which at least 51% of the shares would be

held by non-trading members of the stock exchange. There should be a ceiling of 5%

of the voting rights, which can be exercised by a single entity, or groups of related

entities, irrespective of the size of ownership of the shares. Thereafter, various

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activities associated with the C&D were completed by the stock exchanges within

time specified in the respective approved schemes. During the year 2007, SEBI

approved and notified the corporatization and Demutualization Schemes of 19 stock

exchanges, under Section 4B (8) of the Securities Contracts (Regulation) Act, 1956.

Stock Exchanges Subsidiary

SEBI required with effect from February 28, 2003 that the small stock exchanges

which are permitted to promote/float a subsidiary/company to carry out the following

changes in management structure of their subsidiaries and to ensure the compliance:

1. The subsidiary company should appoint a CEO who should not hold any position

concurrently in the stock exchange (parent exchange). The appointment, the terms and

conditions of service, the renewal of appointment and the termination of service of

CEO should be subject to prior approval of SEBI.

2. The governing board of the subsidiary company should have the following

composition viz., (a) the CEO of the subsidiary company should be a director on the

Board of subsidiary and the CEO should not be a sub-broker of the subsidiary

company or a broker of the parent exchange (b) at least 50% of directors representing

on the Governing Board of subsidiary company should not be sub-brokers of the

subsidiary company or brokers of the promoter/holding exchange and these directors

should be called the Public Representatives (c) the public representatives should be

nominated by the parent exchange (subject to prior approval of SEBI) (d) public

representatives should hold office for a period of one year from the date of

assumption of the office or till the Annual General Meeting of subsidiary company

whichever is earlier (e) there should be a gap of at least one year after a consecutive

period of three years before re-nomination of any person for the post of non- member

director (f) the parent exchange should appoint a maximum of two directors who are

officers of the parent exchange.

3. The subsidiary company should have its own staff none of whom should be

concurrently working for or holding any position of office in the parent exchange.

4. The parent exchange should be responsible for all risk management of the

subsidiary company and shall set up appropriate mechanism for the supervision of the

trading activity of subsidiary company.

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1.2. Membership in NSE

The trading platform of the Exchange is accessible to investors only through the

trading members who are subject to its regulatory discipline. Any person can become

a member by complying with the prescribed eligibility criteria and exit by

surrendering trading membership without any hidden/overt cost. There are no

entry/exit barriers to trading membership. The members are admitted to the different

segments of the Exchange subject to the provisions of the Securities Contracts

(Regulation) Act, 1956, the Securities and Exchange Board of India Act, 1992, the

Rules, circulars, notifications, guidelines, etc., issued there under and the Bye laws,

Rules and Regulations of the Exchange.

The standards for admission of members laid down by the Exchange stress on factors

such as, corporate structure, capital adequacy, track record, education, experience, etc.

and reflect a conscious effort on the part of NSE to ensure quality broking services so

as to build and sustain confidence among investors in the Exchange’s operations.

Benefits to the trading membership of NSE include:

1. Access to a nation-wide trading facility for equities, derivatives, debt and hybrid

instruments/products,

2. Ability to provide a fair, efficient and transparent securities market to the investors,

3. Use of state-of-the-art electronic trading systems and technology,

4. Dealing with an organization which follows strict standards for trading &settlement

at par with those available at the top international bourses,

5. A demutualised Exchange which is managed by independent and experienced

professionals, and

6. Dealing with an organization which is constantly striving to move towards a global

marketplace in the securities industry.

New Membership

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Membership of NSE is open to all persons desirous of becoming trading members,

subject to meeting requirements/criteria as laid down by SEBI and the Exchange. The

different segments currently available on the Exchange for trading are:

A. Capital Market

B. Wholesale Debt Market

C. Derivatives (Futures and Options) Market

Persons or Institutions desirous of securing admission as Trading Members

(Stock Brokers) on the Exchange may apply for any one of the following segment

groups:

1. Wholesale Debt Market (WDM) segment

2. Capital Market segment

3. Capital Market (CM) and Wholesale Debt Market (WDM) segments

4. Capital Market (CM) and Futures & Options (F&O) segments

5. Capital Market (CM), Wholesale Debt Market (WDM) and Futures &

Options (F&O) segment,

6. Clearing Membership of National Securities Clearing Corporation Ltd.

(NSCCL) as a Professional Clearing Member (PCM)

2 Listing of securities

Listing means admission of securities of an issuer to trading privileges on a stock

exchange through a formal agreement. The prime objective of admission to dealings

on the Exchange is to provide liquidity and marketability to securities, as also to

provide a mechanism for effective management of trading.

Listing Criteria

As per SEBI directive, an unlisted company may make an initial public offering

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(IPO) of equity shares or any other security which may be converted into or

exchanged with equity shares at a later date, only if it meets all the following

conditions:

(a) The company should have net tangible assets of at least Rs. 3 crore in each of the

preceding 3 full years (of 12 months each), of which not more than 50% is held in

monetary assets;

(b) The company should have a track record of distributable profits in terms of section

205 of the Companies Act, 1956, for at least three

(3 out of immediately preceding five (5) years;

(c) The company should have a net worth of at least Rs. 1 crore in each of the

preceding 3 full years (of 12 months each);

(d) In case the company has changed its name within the last one year, at least 50% of

the revenue for the preceding 1 full year is earned by company from the activity

suggested by the new name; and

(e) The aggregate of the proposed issue and all previous issues made in the same

financial year in terms of size (i.e. offer through offer document + firm allotment +

promoters’ contribution through the offer document), does not exceed five (5) times

its pre-issue net worth as per the audited balance sheet of the last financial year.

Listing agreement

At the time of listing securities of a company on a stock exchange, the company is

required to enter into a listing agreement with the exchange. The listing agreement

specifies the terms and conditions of listing and the disclosures that shall be made by

a company on a continuous basis to the exchange for the dissemination of information

to the market.

Disclosure of audit qualifications:

SEBI has advised the Stock exchanges to modify the listing agreement to incorporate

disclosure of audit qualifications. The same would include: disclosures of amounts at

the year end and the maximum amount of loans/ advances/ investments outstanding

during the year from both parent to subsidiary and vice versa, un-audited quarterly

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results of all listed companies should be subjected to Limited Review from the

quarters ending on or after June 30, 2003, publication of consolidated financial results

along with stand-alone financial results should be applicable on annual basis only.

However, companies may have option to publish consolidated financial results along

with stand alone financial results on a quarterly/half yearly basis, In addition to the

above, the stock exchanges should also be required to inform SEBI in cases where

companies have failed to remove audit qualifications.

3. Delisting of Securities

SEBI (Delisting of Securities) Guidelines 2003 are applicable to delisting of securities

of companies and specifically apply to:

(a) Voluntary delisting being sought by the promoters of a company

(b) Any acquisition of shares of the company (either by a promoter or by any other

person) or scheme or arrangement, by whatever name referred to, consequent to

which the public shareholding falls below the minimum limit specified in the listing

conditions or listing agreement that may result in delisting of securities

(c) Promoters of the companies who voluntarily seek to de-list their securities from all

or some of the stock exchanges

(d) Cases where a person in control of the management is seeking to consolidate his

holdings in a company, in a manner which would result in the public shareholding in

the company falling below the limit specified in the listing conditions or in the listing

agreement that may have the effect of company being de-listed

(e) Companies which may be compulsorily de-listed by the stock exchanges: provided

that company shall not be permitted to use the buy-back provision to delist its

securities.

Voluntary Delisting

Any promoter or acquirer desirous of delisting securities of the company under the

provisions of these guidelines should obtain the prior approval of shareholders of the

company by a special resolution passed at its general meeting, make a public

announcement in the manner provided in these guidelines, make an application to the

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delisting exchange in the form specified by the exchange, and comply with such other

additional conditions as may be specified by the concerned stock exchanges from

where securities are to be de-listed. Any promoter of a company which desires to de-

list from the stock exchange should determine an exit price for delisting of securities

in accordance with the book building process as stated in the guidelines. The stock

exchanges shall provide the infrastructure facility for display of the price at the

terminal of the trading members to enable the investors to access the price on the

screen to bring transparency to the delisting process. The stock exchange shall also

monitor the possibility of price manipulation and keep under special watch the

securities for which announcement for delisting has been made.

Compulsory De-listing of Companies

The stock exchanges may de-list companies which have been suspended for a

minimum period of six months for non-compliance with the listing agreement.

The stock exchanges have to give adequate and wide public notice through

newspapers and also give a show cause notice to a company. The exchange shall

provide a time period of 15 days within which representation may be made to the

exchange by any person who may be aggrieved by the proposed delisting.

Where the securities of the company are de-listed by an exchange, the promoter of the

company should be liable to comp ensate the security holders of the company by

paying them the fair value of the securities held by them and acquiring their securities,

subject to their option to remain security-holders with the company.

Reinstatement of De-listed Securities

Reinstatement of de-listed securities should be permitted by the stock exchanges with

a cooling period of 2 years. It should be based on the respective norms/criteria for

listing at the time of making the application for listing and the application should be

initially scrutinized by the CLA.

Listing of Securities on NSE

NSE plays an important role in helping Indian companies’ access equity capital, by

providing a liquid and well-regulated market. NSE has 1,381 (as on 31s t March

2008) companies listed representing the length, breadth and diversity of the Indian

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economy which includes from hi-tech to heavy industry, software, refinery, public

sector units, infrastructure, and financial services. Listing on NSE raises a company’s

profile among investors in India and abroad. Trade data is distributed worldwide

through various news vending agencies. More importantly, each and every NSE listed

company is required to satisfy stringent financial, public distribution and management

requirements. High listing standards foster investor confidence and also bring

credibility into the markets. NSE lists securities in its Capital Market (Equities)

segment and its Wholesale Debt Market segment. NSE trading terminals are now

situated in 245 cities across the length and breadth of India. Securities listed on the

Exchange are required to fulfill the eligibility criteria for listing. Various types of

securities of a company are traded under a unique symbol and different series.

Benefits of Listing on NSE

Listing on NSE provides qualifying companies with the broadest access to investors,

the greatest market depth and liquidity, cost-effective access to capital, the highest

visibility, the fairest pricing, and investor benefits.

(a) A premier marketplace: The sheer volume of trading activity ensures that the

impact is lower on the Exchange which in turn reduces the cost of trading to the

investor. NSE’s automated trading system ensures consistency and transparency in the

trade matching which enhances investors’ confidence and visibility of our market.

(b) Visibility: The trading system provides unparallel level of trade and post-trade

information. The best 5 buy and sell orders are displayed on the trading system and

the total number of securities available for buying and selling is also dis played. This

helps the investor to know the depth of the market. Further, corporate announcements,

results, corporate actions etc are also available on the trading system.

(c) Largest exchange: NSE is the largest exchange in the county in terms of trading

volumes. The Equity segment of the NSE witnessed an average daily turnover of Rs.

14,056 crore in March 2008. During the year 2007-2008, NSE reported a turnover of

Rs. 35, 51,038 crore in the equities segment accounting for nearly 70 % of the total

Indian securities market.

(d) Unprecedented reach: NSE provides a trading platform that extends across the

length and breadth of the country. Investors from around 245 cities as on 31s t March

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2008 can avail of trading facilities on the NSE Trading Network. The Exchange uses

the latest communication technology to give instant access from every location.

(e) Modern infrastructure: NSE introduced for the first time in India, fully automated

screen based trading. The Exchange uses a sophisticated telecommunication network

with trading terminals connected through 2,956 VSATs (Very Small Aperture

Terminals) at the end of March 2008.

(f) Transaction speed: The speed at which the Exchange processes orders, results in

liquidity and best available prices. The Exchange's trading system on an average

processes 100,062 orders per minute. The highest number of trades in a day of 68,

12,991 was recorded on January 3, 2008 in the equity segment while 14, 20,967 trades

were recorded in the F&O Segment on October 18, 2007.

(g) Short settlement cycles: The Exchange has successfully completed around 2032

settlements as on 31st March 2008 without any delays.

(h) Broadcast facility for corporate announcements: The NSE network is used to

disseminate information and company announcements across the country. Important

information regarding the company is announced to the market through the Broadcast

Mode on the NEAT System as well as disseminated through the NSE website.

Corporate developments such as financial results, book closure, announcements of

bonus, rights, takeover, mergers etc. are disseminated across the country thus

minimizing scope for price manipulation or misuse.

(i) Trade statistics for listed companies: Listed companies are provided with monthly

trade statistics for all the securities of the company listed on the Exchange.

(j) Investor service centers: Six investor-service centers opened by NSE across the

country cater to the needs of investors.

Listing criteria:

The Exchange has laid down criteria for listing of new issues by companies through

IPOs, companies listed on other exchanges in conformity with the Securities

Contracts (Regulation) Rules, 1957 and directions of the Central Government and the

Securities and Exchange Board of India (SEBI). The criteria include minimum paid-

up capital and market capitalization, company/promoter's track record, etc. The listing

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criteria for companies in the CM Segment are presented in Table 3.4. The issuers of

securities are required to adhere to provisions of the Securities Contracts (Regulation)

Act, 1956, the Companies Act, 1956, the Securities and Exchange Board of India Act,

1992, and the rules, circulars, notifications, guidelines, etc. prescribed there under.

Listing Criteria for Companies on the CM Segment of NSE

Criteria Initial Public Offerings (IPOs)

Companies listed on other exchanges Paid-up Equity Capital (PUEC)/Market

Capitalization (MC) /Net Worth

The company shall have a net worth of not less than Rs.50 crores in each of the

preceding financial years.

Company/Promoter's Track Record

At least 3 years track record of either

a) The applicant seeking listing

OR

b) The promoters/promoting company incorporated in or outside India OR

c) Partnership firm and subsequently converted into Company not in existence as a

Company for three years and approaches the Exchange for listing. The Company

subsequently formed would be considered for listing only on fulfillment of conditions

stipulated by SEBI in this regard. At least three years track record of either

a) The applicant seeking listing; OR

b) The promoters/promoting company, incorporated in or outside India.

Dividend Record / Net worth / Distributable Profits

Dividend paid in at least 2 out of the last 3 financial years immediately preceding the

year in which the application has been made OR The net worth of the applicants at

least Rs.50 crores OR

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The applicant has distributable profits in at least two out of the last three financial

years.

Listing

Listed on any other recognized stock exchange for at least last three years OR listed

on the exchange having nationwide trading terminals for at least one year.

Criteria Initial Public Offerings (IPOs) Companies listed on other exchanges Other

Requirements (a) No disciplinary action by other stock exchanges/regulatory authority

in past 3 yrs.

(b) Satisfactory redressal mechanism for investor grievances,

(c) Distribution of shareholding and

(d) Details of litigation record in past 3 years

(e) Track record of Directors of the Company

(f) Change in control of a Company/Utilization of funds raised from public

Note:

1. (a) In case of IPOs, Paid up Equity Capital means post issue paid up equity capital.

(b) In case of Existing companies listed on other exchanges, the existing paid up

equity capital as well as the paid up equity capital after the proposed issue for which

listing is sought shall be taken into account.

2. (a) In case of IPOs, market capitalization is the product of the issue price and the

post-issue number of equity shares.

(b) In case of case of Existing companies listed on other stock exchanges the market

capitalization shall be calculated by using a 12 month moving average of the market

capitalization over a period of six months immediately preceding the date of

application. For the purpose of calculating the market capitalization over a 12 month

period, the average of the weekly high and low of the closing prices of the shares as

quoted on the National Stock Exchange during the last twelve months and if the

shares are not traded on the National Stock Exchange such average price on any of the

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recognized Stock Exchanges where those shares are frequently traded shall be taken

into account while determining market capitalization after making necessary

adjustments for Corporate Action such as Rights / Bonus Issue/Split.

3. In case of Existing companies listed on other stock exchanges, the requirement of

Rs.25 crores market capitalization shall not be applicable to listing of securities issued

by Government Companies, Public Sector Undertakings, Financial Institutions,

Nationalized Banks, Statutory Corporations and Banking Companies who are

otherwise bound to adhere to all the relevant statutes, guidelines, circulars,

clarifications etc. that may be issued by various regulatory authorities from time to

time

4. Net worth means paid-up equity capital + reserves excluding revaluation reserve -

miscellaneous expenses not written off - negative balance in profit and loss account to

the extent not set off.

5. Promoters mean one or more persons with minimum 3 years of experience of each

of them in the same line of business and shall be holding at least 20 % of the post

issue equity share capital individually or severally.

6. In case a company approaches the Exchange for listing within six months of an

IPO, the securities may be considered as eligible for listing if they were otherwise

eligible for listing at the time of the IPO. If the company approaches the Exchange for

listing after six months of an IPO, the norms for existing listed companies may be

applied and market capitalization is computed based on the period from the IPO to the

time of listing.

4. Dematerialization

Traditionally, settlement system on Indian stock exchanges gave rise to settlement

risk due to the time that elapsed before trades were settled. Trades were settled by

physical movement of certificates. This had two aspects: First related to settlement of

trade in stock exchanges by delivery of shares by the seller and payment by the buyer.

The stock exchange aggregated trades over a period of time and carried out net

settlement through the physical delivery of securities. The process of physically

moving the securities from the seller to his broker to Clearing Corporation to the

buyer’s broker and finally to the buyer took time with the risk of delay somewhere

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along the chain. The second aspect related to transfer of shares in favour of the

purchaser by the issuer. This system of transfer of ownership was grossly inefficient

as every transfer involved the physical movement of paper securities to the issuer for

registration, with the change of ownership being evidenced by an endorsement on the

security certificate. In many cases the process of transfer took much longer than the

two months as stipulated in Companies Act, and a significant proportion of

transactions ended up as bad delivery due to faulty compliance of paper work. Theft,

forgery, mutilation of certificates and other irregularities were rampant, and in

addition the issuer had the right to refuse the transfer of a security.

Thus, the buyer did not get good title of the securities after parting with good money.

All this added to costs and delays in settlement, restricted liquidity and made investor

grievance redressal time-consuming and at times intractable. To obviate these

problems, the Depositories Act, 1996 was passed to provide for the establishment of

depositories in securities with the objective of ensuring free transferability of

securities with speed, accuracy and security by making securities of public limited

companies freely transferable subject to certain exceptions; dematerializing the

securities in the depository mode; and Providing for maintenance of ownership

records in a book entry form. In order to streamline both the stages of settlement

process, the Depositories Act envisages transfer of ownership of securities

electronically by book entry without making the securities move from person to

person. The Act has made the securities of all public limited companies freely

transferable by restricting the company’s right to use discretion in effecting the

transfer of securities, and dispensing with the transfer deed and other procedural

requirements under the Companies Act. A depository holds securities in

dematerialized form. It maintains ownership records of securities and effects transfer

of ownership through book entry. By fiction of law, it is the registered owner of the

securities held with it with the limited purpose of effecting transfer of ownership at

the behest of the owner. The name of the depository appears in the records of the

issuer as registered owner of securities. The name of actual owner appears in the

records of the depository as beneficial owner. The beneficial owner has all the rights

and liabilities associated with the securities.

The owner of securities intending to avail of depository services opens an account

with a depository through a depository participant (DP). The securities are transferred

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from one account to another through book entry only on the instructions of the

beneficial owner. In order to promote dematerialization of securities, NSE joined

hands with leading financial institutions to establish the National Securities

Depository Ltd. (NSDL), the first depository in the country, with the objective of

enhancing the efficiency in settlement systems as also to reduce the menace of

fake/forged and stolen securities. This has ushered in an era of dematerialized trading

and settlement. SEBI has made dematerialized settlement mandatory in an ever-

increasing number of securities in a phased, thus bringing about an increase in the

proportion of shares delivered in dematerialized form. This was initially introduced

for institutional investors and was later extended to all investors. Starting with twelve

scrips on January 15, 1998, all investors were required to mandatorily trade in

dematerialized form in respect of 2,335 securities as at end-June 2001. By November

2001, 3811 companies were under demat mode and the rest of the companies were

brought under compulsory demat mode by January 02, 2002. At the end of March

2008, 7,364 and 5,943 companies were connected to NSDL and CDSL respectively.

The number of dematerialized securities together at NSDL & CDSL increased from

39 billion at the end of March 2001 to287 billion at the end of March 2008. Pursuant

to the SEBI directive on providing facility for small investors holding physical shares

in the securities mandated for compulsory demat, the Exchange has provided such

facility for trading in physical shares not exceeding 500 shares in the Limited Physical

(LP) market segment. Primarily all trades are now settled in dematerialized form. The

share of demat delivery in total delivery at NSE increased to almost 100% in value

terms.

INDUSTRY ANALYSIS

Market Types

The Capital Market system (the NEAT system) has four types of active markets:

Normal Market

All orders which are of regular lot size or multiples thereof are traded in the Normal

Market. For shares that are traded in the compulsory dematerialized mode the market

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lot of these shares is one. Normal market consists of various book types wherein

orders are segregated as Regular lot orders, Special Term orders, and Negotiated

Trade Orders and Stop Loss orders depending on their order attributes.

Odd Lot Market

An order is called an odd lot order if the order size is less than regular lot size. These

orders do not have any special terms attributes attached to them. In an odd-lot market,

both the price and quantity of both the orders (buy and sell) should exactly match for

the trade to take place. Currently the odd lot market facility is used for the Limited

Physical Market as per the SEBI directives. Pursuant to the directive of SEBI to

provide an exit route for small investors holding physical shares in securities

mandated for compulsory dematerialized settlement, the Exchange has provided a

facility for such trading in physical shares not exceeding 500 shares. This market

segment is referred to as 'Limited Physical Market' (small window). The Limited

Physical Market was introduced on June 7, 1999. The trading members are required to

ensure that shares are duly registered in the name of the investor(s) before entering

orders on their behalf on a trade date.

Retail Debt Market

In Ret debt market, government securities are traded. At present only the Central

Government Securities are allowed to trade Corporate Hierarchy

The trading member has the facility of defining a hierarchy amongst its users of the

NEAT system. This hierarchy comprises: Corporate Manager

Branch 1 Branch 2

Dealer 11 Dealer 12 Dealer 21 Dealer 22

The users of the trading system can logon as either of the user types. The significance

of each type is explained below:

(a) Corporate Manager: The corporate manager is a term assigned to a user placed at

the highest level in a trading firm. Such a user receives the End of Day reports for all

branches of the trading member. The facility to set Branch Order Value Limits and

User Order Value Limits is available to the corporate manager. Corporate Manager

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can view outstanding order and trade of all users of the trading member. He can

cancel/modify outstanding order of all user of the trading member.

(b) Branch Manager: The branch manager is a term assigned to a user who is placed

under the corporate manager. The branch manager receives End of Day reports for all

the dealers under that branch. The branch manager can set user order value limit for

each of his branch. Branch Manager can view outstanding order and trade of all users

of his branch. He can cancel/modify outstanding order of all user of his branch.

(c) Dealer: Dealers are users at the lower most level of the hierarchy. A dealer can

view and perform order and trade related activities only for oneself and does not have

access to information on other dealers under either the same branch or other branches.

Market Phases

The system is normally made available for trading on all days except Saturdays,

Sundays and NSE specified holidays. A trading day typically consists of a number of

discrete stages as explained below:

Opening

The trading member can carry out the following activities after login to the NEAT

system and before the market opens for trading:

(i) Set up Market Watch (the securities which the user would like to view on the

screen.

(ii) Viewing Inquiry screens.

At the point of time when the market is opening for trading, the trading member

cannot login to the system. A message ‘Market status is changing. Cannot logon for

sometime’ is displayed. If the member is already logged in, he cannot perform trading

activities till market is opened.

Phase

The open period indicates the commencement of trading activity. To signify the start

of trading, a message is sent to all the trader workstations. The market open time for

different markets is notified by the Exchange to all the trading members. Order entry

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is allowed when all the securities have been opened. During this phase, orders are

matched on a continuous basis. Trading in all the instruments is allowed unless they

are specifically prohibited by the exchange. The activities that are allowed at this

stage are Inquiry, Order Entry, Order Modification, Order Cancellation (including

quick order cancellation) Order Matching and trade cancellation.

Market Close

When the market closes, trading in all instruments for that market comes to an end. A

message to this effect is sent to all trading members. No further orders are accepted,

but the user is permitted to perform activities like inquiries and trade cancellation.

Surcon

Surveillance and Control (SURCON) is that period after market close during which,

the users have inquiry access only. After the end of SURCON period, the system

processes the data for making the system available for the next trading day. When the

system starts processing data, the interactive connection with the NEAT system is lost

and the message to that effect is displayed at the trader workstation.

Major Segments of the NEAT Screen

The following windows are displayed on the Trader Workstation screen:

(a) Title bar: It displays trading system name i.e. NEAT, the date and the current time.

(b) Ticker Window: The ticker displays information of all trades in the system as and

when it takes place. The user has the option of selecting the securities that should

appear in the ticker. Securities in ticker can be selected for each market type. On the

extreme right hand of the ticker is the on-line index window that displays the current

index value of NSE indices namely S&P CNX Nifty, S&P CNX Defty, CNX Nifty

Junior, S&P CNX500, CNX Midcap, CNX IT, Bank Nifty, CNX 100 and Nifty

Midcap 50. The user can scroll within these indices and view the index values

respectively. Index point change with reference to the previous close is displayed

along with the current index value. The difference between the previous close index

value and the current index value becomes zero when the Nifty closing index is

computed for the day. The ticker window displays securities capital market segments.

The ticker selection facility is confined to the securities of capital market segment

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only. The first ticker window, by default, displays all the derivatives contracts traded

in the Futures and Options segment.

(c) Tool Bar: The toolbar has functional buttons which can be used with the mouse for

quick access to various functions such as Buy Order Entry, Sell Order Entry, Market

By Price (MBP), Previous Trades (PT), Outstanding Order (OO), Activity Log (AL),

Order Status (OS), Market Watch (MW), Snap Quote (SQ), Market Movement (MM),

Market Inquiry (MI), Auction Inquiry (AI), Order Modification (OM), Order

Cancellation (OCXL), Security List, Net Position, Online Backup, Supplementary

Menu, Index Inquiry, Index Broadcast and Help. All these functions are also

accessible through the keyboard.

(d) Market Watch: The Market Watch window is the main area of focus for a trading

member. This screen allows continuous monitoring of the securities that are of

specific interest to the user. It displays trading information for the selected securities.

(e) Inquiry Window: This screen enables the user to view information such as Market

by Price (MBP), Previous Trades (PT), Outstanding Orders (OO), Activity Log (AL)

and so on. Relevant information for the selected security can be viewed.

(f) Snap Quote: The snap quote feature allows a trading member to get instantaneous

market information on any desired security. This is normally used for securities that

are not already set in the Market Watch window. The information presented is the

same as that of the Marker Watch window.

(g) Order/Trade Window: This enables the user to enter/modify/cancel orders and for

also to send the request for trade cancellation.

(h) Message Window: This enables the user to view messages broadcast by the

Exchange such as corporate actions, any market news, auctions related information

etc. and other messages like order confirmation, order modification, order

cancellation, orders which have resulted in quantity freezes/price freezes and the

Exchange action on them, trade confirmation, trade cancellation requests and

Exchange action on them, name and time when the user logs in/logs off from the

system, messages specific to the trading member, etc. These messages appear as and

when the event takes place in a chronological order.

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Basket Trading

The purpose of Basket Trading is to provide NEAT users with a facility to create

offline order entry file for a selected portfolio. On inputting the value, the orders are

created for the selected portfolio of securities according to the ratios of their market

capitalizations. All the orders generated through the offline order file are priced at the

available market price. Quantities of shares of a particular security in portfolio are

calculated as under:

No. of Shares of a security in portfolio = Current Portfolio Capitalization Amount *

Issued Capital for the Security

Where: Current Portfolio Capitalization = Summation [Last Traded Price (Previous

close if not traded) * No. of Issued shares] In case at the time of generating the basket

if any of the constituents are not traded, the weightage of the security in the basket is

determined using the previous close price. This price may become irrelevant if there

has been a corporate action in the security for the day and the same has not yet been

traded before generation of the file. Similarly, basket facility will not be available for

a new listed security till the time it is traded.

Reverse Basket on Traded Quantity

The Reverse Basket Trading provides the users with an offline file for reversing the

trades that have taken place for a basket order. This file will contain orders for

different securities of the selected basket file. The Orders are created according to the

volume of trade that has taken place for that basket. This helps to monitor the current

status of the basket file as the latest status of the orders are displayed in the list box. It

is advisable to create each basket with a different name and clean up the directories

regularly and not tamper with the original basket file once it has been loaded as it may

give erroneous results.

Index Trading

The purpose of Index Trading is to provide NEAT users with a facility of buying and

selling of Indices, in terms of securities that comprises the Index. Currently, the

facility is only for NIFTY securities. The users have to specify the amount, and other

inputs which are sent to the host, and the host generates the orders. The Index Trading

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provides users with the choice of gaining with the rise/decline in Index values either

by buying or selling them. The buying and selling of Indices are simulated by entering

orders in securities in proportion to the composition of the chosen index. Quantity of

shares of a particular security of NIFTY is calculated as under: No. of Shares of a

security in index = Current Market Capitalization of the Index Amount * Issued

Capital for the security

Where,

Current Market Capitalization of the Index = Summation [Last Traded Price (Previous

close if not traded) * No. of Issued Shares]

Buy Back Trades

The purpose of Buy Back Trade functionality is to give information to the market

about the buyback trades executed from the start of the buyback period till current

trading date in the securities whose buyback period is currently on. The front screen

shows Symbol, Series, Low price (Today), High price (Today), Weight age. Average

price, Volume (Today) and previous day Volume.

Order Management

Order Management consists of entering orders, order modification, order cancellation

and order matching.

Entering Orders

The trading member can enter orders in the normal market and auction market. A user

can place orders in any of the above mentioned markets by invoking the respective

order entry screens.

Active & Passive Orders: When any order enters the trading system, it is an active

order. It tries to find a match on the other side of the books. If it finds a match, a trade

is generated. If it does not find a match, the order becomes a passive order and goes

and sits in the order book.

Order Books: As and when valid orders are entered or received by the trading system,

they are first numbered, time stamped and then scanned for a potential match. This

means that each order has a distinctive order number and a unique time stamp on it. If

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a match is not found, then the orders are stored in the books as per the price/time

priority. Price priority means that if two orders are entered into the system, the order

having the best price gets the higher priority. Time priority means that if two orders

having the same price are entered, then the order that is entered first gets the higher

priority. Best price for a sell order is the lowest price and for a buy order, best price is

highest price. The different order books in the Capital Market segment are as detailed

below:

(a) Regular Lot Book: An order that has no special condition {(like All or None

(AON) or Minimum Fill (MF) or Stop Loss (SL)) associated with it is a Regular Lot

order. When a dealer places this order, the system looks for a corresponding Regular

Lot order existing in that market (Passive orders). If it does not find a match at the

time it enters the system, the order is stacked in the Regular Lot book as a passive

order. By default, the Regular Lot book appears in the order entry screen in the

normal market. Buyback orders can be placed through the Regular Lot (RL) book in

the Normal Market. The member can place a buyback order by specifying

‘BUYBACKORD’ in the Client Account field in the order entry screen. Such

company buyback orders will be identified in MBP screen by an ‘*’ (asterisk)

indicator against such orders.

(b) Special Terms Book: Orders which have a special term attribute attached to it are

known as special terms orders. When a special term order enters the system, it scans

the orders existing in the Regular Lot book as well as Special Terms Book. Currently

this facility is not available in the trading system.

(c) Stop Loss Book: Stop Loss orders are released into the market when the last traded

price for that security in the normal market reaches or surpasses the trigger price.

Before triggering, the order does not participate in matching and the order cannot get

traded. Untriggered stop loss orders are stacked in the stop loss book. The stop loss

orders can be either a market order or a limit price order. For buy SL orders, the

trigger price has to be less than or equal to the limit price. Similarly, for sell SL

orders, the trigger price has to be greater than or equal to the limit price.

d) Negotiated Trade Book: Two trading members can negotiate a trade outside the

Exchange. To regularize the trade each trading member has to enter the respective

order in the system. To enter Negotiated Trade order details, select book type as NT.

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It is mandatory for the trading member to enter the counterparty trading member id.

When both parties to a trade enter orders, then the request goes to the Exchange for

approval. The Exchange can either approve the request or reject it. Further, the

Exchange has the discretion to send either of the two orders or both the orders to the

Regular Lot book so that the orders are available to the entire market. Currently this

facility is not available in the trading system.

(e) Odd Lot Book: The Odd Lot book can be selected in the order entry screen in

order to trade in the Odd Lot market. Order matching in this market takes place

between two orders on the basis of quantity and price. To enter orders in the odd lot

market, select the book type as OL.

(f) RETDEBT Order Book: RETDEBT market orders can be entered into the system

by selecting the RETDEBT Order book. These orders scan only the RETDEBT Order

book for potential matches. If no suitable match can be found, the order is stored in

the book as a passive order. To enter orders in the RETDEBT market, select the book

type as 'D'.

(g) Auction Order Book: Auction order book stores orders entered by the trading

members to participate in the Exchange initiated auctions. Auction orders can be

initiator orders, competitor orders and solicitor orders. For further details kindly refer

to section on 'Auction'.

Symbol & Series: Securities can be selected to the order entry screen from any of the

inquiry screens such as MBP, OO, PT, AL, MI and SQ. In case the security is not set

up in the Market Watch screen, the Security List can also be used to select the codes

as default values.

Order entry in a security is not possible if that security is either suspended from

trading or not eligible to trade in a particular market.

Quantity: Quantity should be mentioned in multiples of regular lot size for that

security.

Price: A user has the option to either enter the order at the default price or overwrite it

with any other desired price. If a user mentions a price, it should be in multiples of the

tick size for that particular security and within the day’s maximum price range. In

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case of stop loss orders, a user has the flexibility of specifying a limit price along with

the trigger price.

Order Types and Conditions: The system allows the trading members to enter orders

with various conditions attached to them as per their requirements. These conditions

are broadly divided into Time Conditions, Quantity Conditions, Price Conditions and

Other Conditions. Several combinations of the above are allowed thereby providing

enormous flexibility to the users. The order types and conditions are summarized

below:

a) Time Conditions

DAY: A DAY order, as the name suggests is an order that is valid for the day on

which it is entered. If the order is not executed during the day, the system cancels the

order automatically at the end of the day.

IOC: An Immediate or Cancel (IOC) order allows the user to buy or sell a security as

soon as the order is released into the system, failing which the order is cancelled from

the system. Partial match is possible for the order, and the unmatched portion of the

order is cancelled immediately.

b) Quantity Conditions

DQ: An order with a Disclosed Quantity (DQ) allows the user to disclose only a

portion of the order quantity to the market. For e.g. if the order quantity is 10,000 and

the disclosed quantity is 2,000, then only 2,000 is disclosed to the market.

Security Wise User Order Quantity Limit (SUOQL) : An additional facility for setting

up Security wise User wise Order Quantity Limits (SUOQL) for buy and/or sell has

now been provided.

(a) The Corporate Manager is allowed to set the SUOQL separately for buy and sell

orders for each security for all the Branch Managers (BMs) and Dealers (except

inquiry only users) under him including himself.

(b) It is possible to modify the SUOQL anytime during trading hours. SUOQL should

not be set lower than the used limit for that security. For a Symbol both Buy and Sell

quantity can be set to unlimited.

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(c) The used limit field is displayed for buy and sells separately for each security.

(d) Any activity like order modification or cancellation gets reflected in used limit

figure for the respective security and respective side.

(e) This limit is applicable for a symbol across all series, across all the markets.

SUOQL setting option is given in supplementary menu.

(f) A bulk upload facility to set the security wise buy sell limit through a (comma

separated values) csv file has been provided. In case of failure to upload a particular

record/s, failure message is written in the input file in the form of an error code. The

file is reusable.

(g) SUOQL bulk upload facility is not available during the market hours.

(h) After the limit is set successfully, the message is sent to the respective

CM/BM/dealer.

(i) A facility to limit trading to the sec unities set up in the SUOQL has been

provided. If limit trading option is set for a user, then the user is allowed to place

orders only for Symbols set in his SUOQL list by the CM. It would however be

possible to enable this facility without having any security in the SUOQL list, which

in turn prevents the user from entering of any fresh orders.

(j) Corporate Manager has been given a facility to allow or disallow a user from

entering Index orders. By default all dealers will be allowed to place index orders.

Index orders are not validated for SUOQL limits. However, orders once entered are

updated in the used limits.

(k) It is possible that dealer is restricted to enter order in particular security, but

allowed to enter index order and that restricted security is a part of Nifty.

(l) If the order is modified by CM/BM for a respective dealer then the used limit will

be updated accordingly, but in this case it can exceed the set limit.

(m) SUOQL used limit will not be validated and updated for Auction orders.

Quantity Freeze: All orders with very large quantities receive quantity alert at member

terminal. If members enter any order exceeding the lowest of the quantity given

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below, it results in an alert which reads as “Order entered exceeds alert quantity limit.

Confirm availability of adequate capital to proceed” and only after the member clicks

the button ‘Yes’ the order will be further processed for execution. Quantity Freeze

parameters:- · 0.5% of the issue size of the security or · value of the order is around

Rs. 2.5 crores or · a global alert quantity limit of more than 25000 irrespective of the

issue size of the security, whichever is less.

c) Price Conditions

Market Orders: Market orders are orders for which price is specified as 'MKT' at the

time the order is entered. For such orders, the system determines the price.

Stop-Loss: This facility allows the user to release an order into the system, after the

market price of the security reaches or crosses a threshold price called trigger price.

Trigger Price: Price at which an order gets triggered from the stop loss book.

Limit Price: Price of the orders after triggering from stop loss book.

Price Freeze: Since no price bands are applicable in respect of securities on which

derivative products are available or securities included in indices on which derivative

products are available, in order to prevent members from entering orders at non-

genuine prices in such securities, the exchange has decided to introduce operating

range of 20% for such securities. Any order above or below 20% over the base price

should come to the exchange as a price freeze.

Market Price Protection

Market Price protection functionality gives an option to a trader to limit the risk of a

market order, within a pre-set percentage of the Last Trade Price (LTP).The pre-set

Market price protection percentage is by default set to 5% of the LTP. The users can

change the pre-set Market price protection percentage from the Order Limit Screen

which can be invoked from the Supplementary Menu. The set percentage will be

applicable till the Ntreltdr EXE is re-inflated.

At the time of order entry, the user can press (Page Up) when the cursor is in the price

field. In case of a buy order, this defaults a price value, which is greater than LTP by a

pre-set percentage. In case of a sell order the default value will be lesser than the LTP

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by a pre set percentage. The time condition in both cases will automatically change to

IOC. The user has the option to change any of the fields. Since the calculations are

based on LTP of broadcast for the security is not received, the default value will be

'MARKET'

d) Other Conditions

PRO/CLI: A user can enter orders on his own account or on behalf of clients. By

default, the system assumes that the user is entering orders on the trading member’s

own account. Participant Code: By default, the system displays the trading member id

of the user in the participant field. Thus, all trades resulting from an order are to be

settled by that trading member. Non-custodial institutional trade (NCIT) orders can be

marked by the user at the order entry level itself. Only a valid participant code can be

entered. In case the participant is suspended a message to this effect is displayed to

the user on the order entry screen. Branch Order Value Limit Check: In addition to the

checks performed for the fields explained above, every order entry is checked for the

branch order value limit. In case the set order value limit is exhausted the subsequent

order is rejected by the system.

Order Modification

All orders can be modified in the system till the time they do not get fully traded and

only during market hours. Once an order is modified, the branch order value limit for

the branch gets adjusted automatically. Order modification is rejected if it results in a

price freeze, message displayed is ‘CFO request rejected’.

Order Cancellation

Order cancellation functionality can be performed only for orders which have not

been fully or partially traded (for the untraded part of partially traded orders only) and

only during market hours and in pre open period.

Order Matching

The buy and sell orders are matched on Book Type, Symbol, Series, Quantity and

Price. Matching Priority: The best sell order is the order with the lowest price and a

best buy order is the order with the highest price. The unmatched orders are queued in

the system by the following priority:

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(a) By Price: A buy order with a higher price gets a higher priority and similarly, a

sell order with a lower price gets a higher priority. E.g. consider the following buy

orders:

1) 100 shares @ Rs. 35 at time 10:30 a.m.

2) 500 shares @ Rs. 35.05 at time 10:43 a.m.

The second order price is greater than the first order price and therefore is the best buy

order.

(b) By Time: If there is more than one order at the same price, the order entered

earlier gets a higher priority. E.g. consider the following sell orders:

1) 200 shares @ Rs. 72.75 at time 10:30 a.m.

2) 300 shares @ Rs. 72.75 at time 10:35 a.m.

Both orders have the same price but they were entered in the system at different time.

The first order was entered before the second order and therefore is the best sell order.

As and when valid orders are entered or received by the system, they are first

numbered, time stamped and then scanned for a potential match. This means that each

order has a distinctive order number and a unique time stamp on it. If a match is not

found, then the orders are stored in the books as per the price/time priority. An active

buy order matches with the best passive sell order if the price of the passive sell order

Company Analysis

A trade is an activity in which a buy and a sell order match with each other.Matching

of two orders is done automatically by the system. Whenever a trade takes place, the

system sends a trade confirmation message to each of the users involved in the trade.

The trade confirmation slip gets printed at the trader workstation of the user with a

unique trade number. The system also broadcasts a message to the entire market

through the ticker window displaying the details of the trade.

Trade Verification

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With a facility to verify trades on the NSE website, an investor who has received a

contract note from a trading member of the Exchange, can check whether the trade

has been executed on the Exchange. This facility is available on the NSE website for

the Capital Market, Derivatives (F&O) and Retail Debt Market segments. Trade

details are available for verification on the same day (i.e. T itself) after 19:00 hours

IST as well as trade details of all trades for the last 5 trading days are available on the

website. (i.e. trades executed on 'T' day, can be verified till the T+4th day. The

investor needs to input minimum details of the trade viz. client code (provided by the

trading member), security details (symbol and series), order number, trade number,

trade quantity and price (excluding brokerage). All the above details are mandatory. If

an identical match is found for the details provided, a confirmation along with the

details of the trade is displayed to the investor. If no match is found, a message is

displayed to that effect. Where no match is found, investors are advised to contact

their trading member for clarification.

Trade Cancellation

The user can use trade cancellation screen for cancelling trades done during the day. If

the user is a corporate manager of a trading member firm, he can request for trade

cancellation for the trades of any dealer of the trading members firm and if he is a

branch manager of a branch, then he can request for trade cancellation for the trades

for any dealer of the branch of the trading member firm. The user can request for trade

cancellation either from the previous trades screen or by using the function key

provided in the workstation. The trade cancellation request is sent to the Exchange for

approval and message to that effect is displayed in the message window. The

counterparty to the trade also receives the message. The counterparty then has to

make similar request on the same trading day. Once both the parties to trade send the

trade cancellation request, the Exchange either approves or rejects it. The message to

that effect is displayed in the message window. When a request for the trade

cancellation is approved by the Exchange, the parties to trade receive a system

message confirming the trade cancellation and the trade cancellation slip is printed at

their respective trader workstations. If the Exchange rejects the trade cancellation

request, the trade cancellation rejection slip is printed at their respective trader

workstations. If counter party to the trade does not entered a trade cancellation request

the Exchange reject the trade cancellation request.

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Auction

Auctions are initiated by the Exchange on behalf of trading members for settlement

related reasons. The main reasons are shortages, bad deliveries and objections. There

are three types of participants in the auction market:

(a) Initiator: The party who initiates the auction process is called an initiator.

(b) Competitor: The party who enters on the same side as of the initiator is called a

competitor.

(c) Solicitor: The party who enters on the opposite side as of the initiator is called a

solicitor.

The trading members can participate in the Exchange initiated auctions by entering

orders as a solicitor. E.g. If the Exchange conducts a Buy-In auction, the trading

members entering sell orders are called solicitors. When the auction starts, the

competitor period for that auction also starts. Competitor period is the period during

which competitor order entries are allowed. Competitor orders are the orders which

compete with the initiator’s order i.e. if the initiator’s order is a buy order, then all the

buy orders for that auction other than the initiator’s order are competitor orders. And

if the initiator order is a sell order then all the sell orders for that auction other than

the initiators order are competitor orders. After the competitor period ends, the

solicitor period for that auction starts. Solicitor period is the period during which

solicitor order entries are allowed. Solicitor orders are the orders which are opposite

to the initiator order i.e. if the initiator order is a buy order, then all the sell orders for

that auction are solicitor orders and if the initiator order is a sell order, then all the buy

orders for that auction are solicitor orders.

After the solicitor period, order matching takes place. The system calculates trading

price for the auction and all possible trades for the auction are generated at the

calculated trading price. After this the auction is said to be complete. Competitor

period and solicitor period for any auction are set by the Exchange.

Entering Auction Orders: Auction order entry allows the user to enter orders into

auctions that are currently running.

Auction Order Modification: The user is not allowed to modify any auction orders.

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Auction Order Cancellation: The user can cancel any solicitor order placed by him in

any auction provided the solicitor period for that auction is not over.

Auction Order Matching: When the solicitor period for an auction is over, auction

order matching starts for that auction. During this process, the system calculates the

trading price for the auction based on the initiator order and the orders entered during

the competitor and the solicitor period. At present for Exchange initiated auctions, the

matching takes place at the respective solicitor order prices. All auction orders are

entered into the auction order book. The rules for matching of auctions are similar to

that of the regular lot book except for the following points:-

a) Auction order matching takes place at the end of the solicitor period for the auction.

b) Auction matching takes place only across orders belonging to the same auction.

c) All auction trades take place at the auction price.

Example 1: Member A places a buy order for 1000 shares of ABC Ltd. in the NEAT

system at 11:22:01 for Rs.155 per share. Member B places a sell order for 2000 shares

of ABC Ltd. at 11:22:02 for Rs.150 per share. Assume that no other orders were

available in the system during this time. Whether the trade will take place and if yes,

at what price?

Yes, 1000 shares will get traded at Rs.155 per share (the passive price). 100

Example 2: Auction is held in TISCO for 5,000 shares.

a) The closing price of TISCO on that day was Rs.155.00

b) The last traded price of TISCO on that day was Rs.150.00

c) The price of TISCO last Friday was Rs.151.00

d) The previous days' close price of TISCO was Rs.160.00

What is the maximum allowable price at which the member can put a sell order in the

auction for TISCO? (Assuming that the price band applicable for auction market is +/

-15%)

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Max price applicable in auction = Previous days' close price * Price band =

Rs.160*1.15 =Rs.184.00

Internet Broking

SEBI Committee has approved the use of Internet as an Order Routing System (ORS)

for communicating clients' orders to the exchanges through brokers. ORS enables

investors to place orders with his broker and have control over the information and

quotes and to hit the quote on an on-line basis. Once the broker’s system receives the

order, it checks the authenticity of the client electronically and then routes the order to

the appropriate exchange for execution. On execution of the order, it is confirmed on

real time basis. Investor receives reports on margin requirement, payments and

delivery obligations through the system. His ledger and portfolio account get updated

online. NSE launched internet trading in early February 2000. It is the first stock

exchange in the country to provide web-based access to investors to trade directly on

the exchange. The orders originating from the PCs of the investors are routed through

the Internet to the trading terminals of the designated brokers with whom they are

connected and further to the exchange for trade execution. Soon after these orders get

matched and result into trades, the investors get confirmation about them on their PCs

through the same internet route.

5.6 Wireless Application Protocol

SEBI has also approved trading through wireless medium on WAP Platform. NSE.IT

launched the Wireless Application Protocol (WAP) in November 2000. This provides

access to its order book through the hand held devices, which use WAP technology.

This serves primarily retail investors who are mobile and want to trade from any place

when the market prices for stocks at their choice are attractive. Only SEBI registered

members who have been granted permission by the Exchange for providing Internet

based trading services can introduce the service after obtaining permission from the

Exchange.

Trading Rules

Insider Trading

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Insider trading is prohibited and is considered an offence. The SEBI (Prohibition of

Insider Trading) Regulations, 1992 prohibit an insider from dealing (on his own

behalf or on behalf of others) in listed securities when in possession of ‘unpublished

price sensitive information’ or communicate, counsel or procure directly or indirectly

any unpublished price sensitive information to any person who while in possession of

such unpublished price sensitive information should not deal in securities. Price

sensitive information is any information, which if published, is likely to materially

affect the price of the securities of a company. Such information may relate to the

financial results of the company, intended declaration of dividends, issue of securities

or buy back of securities, amalgamation, mergers, takeovers, any major policy

changes, etc. SEBI, on the basis of any complaint or otherwise, investigates/inspects

the allegation of insider trading. On the basis of the report of the investigation, SEBI

may prosecute persons found prima facie guilty of insider trading in an appropriate

court or pass such orders as it may deem fit. Based on inspection, an adjudicating

officer appointed by SEBI can impose monetary penalty. In order to strengthen insider

trading regulations, SEBI mandated a code of conduct for listed companies, its

employees, analysts, market intermediaries and professional firms. The insider trading

regulations were amended to include requirements for initial and continual disclosure

of shareholding by directors or officers, who are insiders, and substantial shareholders

(holding more than 5% shares/voting rights) of listed companies. The listed

companies are also mandated to adopt a code of disclosure with regard to price

sensitive information, market rumors, and reporting of shareholding/ownership, etc.

Unfair Trade Practices

The SEBI (Prohibition of Fraudulent and Unfair Trade Practices in relation to the

Securities Market) Regulations, 2003 enable SEBI to investigate into cases of market

manipulation and fraudulent and unfair trade practices. These regulations empower

SEBI to investigate into violations committed by any person, including an investor,

issuer or an intermediary associated with the securities market. The regulations define

frauds as acts, expression, omission or concealment committed whether in a deceitful

manner or not by a person or by any other person or agent while dealing in securities

in order to induce another person with his connivance or his agent to deal in

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securities, whether or not there is any wrongful gain or avoidance of any loss. The

regulations specifically prohibit dealing in securities in a fraudulent manner, market

manipulation, misleading statements to induce sale or purchase of securities, and

unfair trade practices relating to securities. SEBI can conduct investigation, suo moto

or upon information received by it, through an investigation officer in respect of

conduct and affairs of any person buying/selling/dealing in securities. Based on the

report of the investigating officer, SEBI can initiate action for suspension or

cancellation of registration of an intermediary.

Takeovers

The restructuring of companies by way of takeover is governed by the SEBI

(Substantial Acquisition of Shares and Takeovers) Regulations, 1997. As per the

regulations- · No acquirer shall acquire shares or voting rights which (taken together

with shares or voting rights, if any, held by him or by persons acting in concert with

him), entitle such acquirer to exercise to exercise 15% or more of the voting rights in

a company, unless such acquirer makes a public announcement to acquire shares of

such company in accordance with the regulations. No acquirer who, together with

persons acting in concert with him, has acquired, in accordance with the provisions of

law, 15 percent or more but less than 55 percent of the shares or voting rights in a

company, shall acquire, either by himself or through or with person acting in concert

with him, additional shares or voting rights entitling him to exercise more than 5

percent of the voting rights, in any financial year ending on 31s t March unless such

acquirer makes a public announcement to acquire shares in accordance with the

regulations. · No acquirer, who together with persons acting in concert with him

holds, 55 percent or more but less than 75 percent of the shares or voting rights in a

target company, shall acquirer either by himself or though persons acting in concert

with hi him any additional shares or voting rights therein, unless he makes a public

announcement to acquire shares in accordance with the Regulations. Where an

acquirer (together with persons acting in concert with him) holds 55% or more but

less than 75% of the shares or voting rights in a target company, is desirous of

consolidating his holding while ensuring that the public shareholding in the target

company does not fall below the minimum level permitted by the Listing Agreement,

he may do so only by making a public announcement in accordance with the

Regulations. Irrespective of whether or not there has been any acquisition of shares or

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voting rights in a company, no acquirer shall acquire control over the target company,

unless such person makes a public announcement to acquire shares and acquires such

shares in accordance with the regulations. Provided that it does not apply to any

change in control which takes place in pursuance to a special resolution passed by the

shareholders in a general meeting. · The public offer made by the acquirer to the

shareholders of the target company shall be for a minimum twenty percent of the

voting capital of the company and where the public offer is made under sub regulation

2A of regulation 11 the minimum size of the public offer shall be lesser of the

following- (a) twenty percent of the voting capital of the company; or (b) such other

lesser percentage of the voting capital of the company as would, assuming full

subscription to the offer, enable the acquirer, together with the persons acting in

concert with him, to increase his holding to the maximum level possible, which is

consistent with the target company meeting the requirements of minimum public

shareholding laid down in the Listing Agreement. The regulations give enough scope

to existing shareholders for consolidation and also cover the scenario of indirect

acquisition of control. The applications for takeovers are scrutinized by the Takeover

Panel constituted by SEBI (Regulation 4). The public announcement to be made is

required to be made in the newspaper. Simultaneously with publication of the public

announcement in the newspapers, a copy of the same should be submitted to SEBI

though merchant banker, to all the stock exchanges on which the shares of the

company are listed for being notified on the notice board and to the target company at

its registered office for being placed before the Board of Directors of the company.

Further, the regulations also deals with appointment of merchant banker, timing of

public announcement of offer, contents of public announcement of offer, Offer price ,

Creeping acquisition, General obligations of the acquirer, General Obligations of the

board of directors of the target company, General obligations of the merchant banker,

Competitive bid etc.

Buy back

Buy back aims at improving liquidity in the shares of companies and helps corporate

in enhancing the shareholders’ wealth. Under the SEBI (Buy Back of Securities)

Regulations, 1998, a company is permitted to buy back its shares from:

a) The existing security holders on a on a proportionate basis through the tender offer,

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b) The open market through stock exchanges, and book building process; and

c) Shareholders holding odd lot shares.

The regulations provide for extensive disclosures in the explanatory statement to be

annexed to the notice for the general meeting and the letter of offer. The company has

to disclose the pre and post-buy back holdings of the promoters. With a view to

ensure completion of the buyback process speedily, the regulations provide for time

bound steps in every mode. For example, as per the offer procedure prescribed under

Regulation 10 an offer for buy back shall not remain open for more than 30 days and

the verification of shares received in buy back has to be completed within 15 days of

the closure of the offer. The payments for accepted securities has to be made within 7

days of the completion of verification and bought back shares have to be extinguished

and physically destroyed within 7 days of the date of the payment. To ensure security

for performance of its obligation, the company making an offer for buy back will have

to open an escrow account.

Price Bands

Stock market volatility is generally a cause of concern for both policy makers as well

as investors. To curb excessive volatility, SEBI has prescribed a system of price

bands. The price bands or circuit breakers bring about a coordinated trading halt in all

equity and equity derivatives markets nationwide. An index-based market-wide circuit

breaker system at three stages of the index movement either way at 10%, 15% and

20% has been prescribed. The breakers are triggered by movement of either S&P

CNX Nifty or Sensex, whichever is breached earlier (please see chapter 5 for details).

As an additional measure of safety, individual scrip-wise price bands have been fixed

as below: · Daily price bands of 2% (either way) on securities as specified by the

Exchange. · Daily price bands of 5% (either way) on securities as specified by the

Exchange. · Daily price bands of 10% (either way) on securities as specified by the

Exchange. · No price bands are applicable on: scrips on which derivative products are

available or scrips included in indices on which derivative products are available. In

order to prevent members from entering orders at non-genuine prices in such

securities, the Exchange has fixed operating range of 20% for such securities. · Price

bands of 20% (either way) on all remaining scrips (including debentures, warrants,

preference shares etc). The price bands for the securities in the Limited Physical

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Market are the same as those applicable for the securities in the Normal Market. For

auction market the price bands of 20% are applicable. There are no price bands for

those securities which are available for trading in the Futures and Options segment

and securities which form part of the indices on which trading is available in the

Futures and Options segment.

6. CLEARING AND SETTLEMENT

Clearing and Settlement Mechanism

Introduction

The clearing and settlement mechanism in Indian securities market has witnessed

several innovations. These include use of the state-of-art information technology,

compression of settlement cycle, dematerialization and electronic transfer of

securities, securities lending and borrowing, professionalization of trading members,

fine-tuned risk management system, emergence of clearing corporations to assume

counterparty risk etc. The stock exchanges in India were following a system of

account period settlement for cash market transactions and then the T+2 rolling

settlement was introduced for all securities. The members receive the funds/securities

in accordance with the pay-in/pay-out schedules notified by the respective exchanges.

Given the growing volume of trades and market volatility, the time gap between

trading and settlement gives rise to settlement risk. In recognition of this, the

exchanges and their clearing corporations employ risk management practices to

ensure timely settlement of trades. The regulators have also prescribed elaborate

margining and capital adequacy standards to secure market integrity and protect the

interests of investors. The trades are settled irrespective of default by a member and

the exchange follows up with the defaulting member subsequently for recovery of his

dues to the exchange. Due to setting up of the Clearing Corporation, the market has

full confidence that settlements will take place on time and will be completed

irrespective of possible default by isolated trading members. Movement of securities

has become almost instantaneous in the dematerialized environment. Two

depositories viz., National Securities Depositories Ltd. (NSDL) and Central

Depositories Services Ltd. (CDSL) provide electronic transfer of securities and more

than 99% of turnover is settled in dematerialized form. All actively traded scrips are

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held, traded and settled in demat form. The obligations of members are downloaded to

members/custodians by the clearing agency. The members/custodians make available

the required securities in their pool accounts with depository participants (DPs) by the

prescribed pay-in time for securities. The depository transfers the securities from the

pool accounts of members/custodians to the settlement account of the clearing agency.

As per the schedule determined by the clearing agency, the securities are transferred

on the pay-out day by the depository from the settlement account of the clearing

agency to the pool accounts of members/custodians. The pay-in and pay-out of

securities is affected on the same day for all settlements. Select banks have been

empanelled by clearing agency for electronic transfer of funds. The members are

required to maintain accounts with any of these banks. The members are informed

electronically of their pay-in obligations of funds. The members make available

required funds in their accounts with clearing banks by the prescribed pay-in day. The

clearing agency forwards funds obligations file to clearing banks which, in turn, debit

the accounts of members and credit the account of the clearing agency. In some cases,

the clearing agency runs an electronic file to debit members’ accounts with clearing

banks and credit its own account. On pay-out day, the funds are transferred by the

clearing banks from the account of the clearing agency to the accounts of members as

per the member’s obligations. In the T+2 rolling settlement, the pay-in and pay-out of

funds as well as securities take place 2 working days after the trade date.

Transaction Cycle

A person holding assets (securities/funds), either to meet his liquidity needs or to

reshuffle his holdings in response to changes in his perception about risk and return of

the assets, decides to buy or sell the securities. He finds out the right broker and

instructs him to place buy/sell order on an exchange. The order is converted to a trade

as soon as it finds a matching sell/buy order. The trades are cleared to determine the

obligations of counterparties to deliver securities/funds as per settlement schedule.

Buyer/seller delivers funds/securities and receives securities/ funds and acquires

ownership over them. A securities transaction cycle is presented in Figure 3.2

Settlement Process

While NSE provides a platform for trading to its trading members, the National

Securities Clearing Corporation Ltd. (NSCCL) determines the funds/securities

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obligations of the trading members and ensures that trading members meet their

obligations. NSCCL becomes the legal counterparty to the net settlement obligations

of every member. This principle is called novation' and NSCCL is obligated to meet

all settlement obligations, regardless of member defaults, without any discretion.

Once a member fails on any obligations, NSCCL immediately cuts off trading and

initiates recovery. The clearing banks and depositories provide the necessary interface

between the custodians/clearing members (who clear for the trading members or their

own transactions) for settlement of funds/securities obligations of trading members.

The core functions involved in the process are:

a) Trade Recording: The key details about the trades are recorded to provide basis for

settlement. These details are automatically recorded in the electronic trading system

of the exchanges.

b) Trade Confirmation: The counterparties to trade agree upon the terms of trade like

security, quantity, price, and settlement date, but not the counterparty which is the

NSCCL. The electronic system automatically generates confirmation by direct

participants. The ultimate buyers/sellers of securities also affirm the terms, as the

funds/securities would flow from them, although the direct participants are

responsible for settlement of trade.

c) Determination of Obligation: The next step is determination of what counter-parties

owe, and what counter-parties are due to receive on the settlement date. The NSCCL

interposes itself as a central counterparty between the counterparties to trades and nets

the positions so that a member has security wise net obligation to receive or deliver a

security and has to either pay or receive funds.

d) Pay-in of Funds and Securities: The members bring in their funds/securities to the

NSCCL. They make available required securities in designated accounts with the

depositories by the prescribed pay-in time. The depositories move the securities

available in the accounts of members to the account of the NSCCL. Likewise

members with funds obligations make available required funds in the designated

accounts with clearing banks by the prescribed pay-in time. The NSCCL sends

electronic instructions to the clearing banks to debit member’s accounts to the extent

of payment obligations. The banks process these instructions, debit accounts of

members and credit accounts of the NSCCL.

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e) Pay-out of Funds and Securities: After processing for shortages of funds/securities

and arranging for movement of funds from surplus banks to deficit banks through RBI

clearing, the NSCCL sends electronic instructions to the depositories/clearing banks

to release pay-out of securities/funds. The depositories and clearing banks debit

accounts of the NSCCL and credit accounts of members. Settlement is complete upon

release of pay-out of funds and securities to custodians/members.

f) Risk Management: A sound risk management system is integral to an efficient

settlement system. The NSCCL ensures that trading members’ obligations are

commensurate with their net worth. It has put in place a comprehensive risk

management system, which is constantly monitored and upgraded to pre-empt market

failures. It monitors the track record and performance of members and their net worth;

undertakes on-line monitoring of members’ positions and exposure in the market

collects margins from members and automatically disables members if the limits are

breached.

Settlement Agencies

The NSCCL, with the help of clearing members, custodians, clearing banks and

depositories settles the trades executed on exchanges. The roles of each of these

entities are explained below:

(a) NSCCL: The NSCCL is responsible for post-trade activities of a stock exchange.

Clearing and settlement of trades and risk management are its central functions. It

clears all trades, determines obligations of members, arranges for pay-in of

funds/securities, receives funds/securities, processes for shortages in funds/securities,

arranges for pay-out of funds/securities to members, guarantees settlement, and

collects and maintains margins/collateral/base capital/other funds.

(b) Clearing Members: They are responsible for settling their obligations as

determined by the NSCCL. They have to make available funds and/or securities in the

designated accounts with clearing bank/depositories, as the case may be, to meet their

obligations on the settlement day. In the capital market segment, all trading members

of the Exchange are required to become the Clearing Member of the Clearing

Corporation.

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(c) Custodians: Custodian is a clearing member but not a trading member. He settles

trades assigned to him by trading members. He is required to confirm whether he is

going to settle a particular trade or not. If it is confirmed, the NSCCL assigns that

obligation to that custodian and the custodian is required to settle it on the settlement

day. If the custodian rejects the trade, the obligation is assigned back to the trading /

clearing member.

(d) Clearing Banks: Clearing banks are a key link between the clearing members and

NSCCL for funds settlement. Every clearing member is required to open a dedicated

clearing account with one of the clearing banks. Based on his obligation as

determined through clearing, the clearing member makes funds available in the

clearing account for the pay-in and receives funds in case of a pay-out.

(e) Depositories: Depositories help in the settlement of the dematerialized securities.

Each custodian/clearing member is required to maintain a clearing pool account with

the depositories. He is required to make available the required securities in the

designated account on settlement day. The depository runs an electronic file to

transfer the securities from accounts of the custodians/clearing member to that of

NSCCL. As per the schedule of allocation of securities determined by the NSCCL, the

depositories transfer the securities on the pay-out day from the account of the NSCCL

to those of members/custodians.

(f) Professional Clearing Member: NSCCL admits special category of members

namely, professional clearing members. Professional Clearing Member (PCM) may

clear and settle trades executed for their clients (individuals, institutions etc.). In such

an event, the functions and responsibilities of the PCM would be similar to

Custodians. PCMs may also undertake clearing and settlement responsibility for

trading members. In such a case, the PCM would settle the trades carried out by the

trading members connected to them. The onus for settling the trade would be thus on

the PCM and not the trading member. A PCM has no trading rights but has only

clearing rights, i.e. he just clears the trades of his associate trading members and

institutional clients.

Risks in Settlement

The following two kinds of risks are inherent in a settlement system:

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(1) Counterparty Risk: This arises if parties do not discharge their obligations fully

when due or at any time thereafter. This has two components, namely replacement

cost risk prior to settlement and principal risk during settlement.

(a) The replacement cost risk arises from the failure of one of the parties to

transaction. While the non-defaulting party tries to replace the original transaction at

current prices, he loses the profit that has accrued on the transaction between the date

of original transaction and date of replacement transaction. The seller/buyer of the

security loses this unrealized profit if the current price is below/above the transaction

price. Both parties encounter this risk as prices are uncertain. It has been reduced by

reducing time gap between transaction and settlement and by legally binding netting

systems.

(b) The principal risk arises if a party discharges his obligations but the counterparty

defaults. The seller/buyer of the security suffers this risk when he delivers/makes

payment, but does not receive payment/delivery. This risk can be eliminated by

delivery vs. payment mechanism which ensures delivery only against payment. This

has been reduced by having a central counterparty (NSCCL) which becomes the

buyer to every seller and the seller to every buyer.

(c) A variant of counterparty risk is liquidity risk which arises if one of the parties to

transaction does not settle on the settlement date, but later. The seller/buyer who does

not receive payment/delivery when due, may have to borrow funds/securities to

complete his payment/delivery obligations.

(d) Another variant is the third party risk which arises if the parties to trade are

permitted or required to use the services of a third party which fails to perform. For

example, the failure of a clearing bank which helps in payment can disrupt settlement.

This risk is reduced by allowing parties to have accounts with multiple banks.

Similarly, the users of custodial services face risk if the concerned custodian becomes

insolvent, acts negligently etc.

(2) System Risk: This comprises of operational, legal and systemic risks. The

operational risk arises from possible operational failures such as errors, fraud, outages

etc. The legal risk arises if the laws or regulations do not support enforcement of

settlement obligations or are uncertain. Systemic risk arises when failure of one of the

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parties to discharge his obligations leads to failure by other parties. The domino effect

of successive failures can cause a failure of the settlement system. These risks have

been contained by enforcement of an elaborate margining and capital adequacy

standards to secure market integrity, settlement guarantee funds to provide counter-

party guarantee, legal backing for settlement activities and business continuity plan,

etc.

Rolling Settlement

Introduction

Under rolling settlement, all trades executed on a trading day are settled X days later.

This is called ‘T+X’ rolling settlement, where ‘T’ is the trade date and ‘X’ is the

number of business days after trade date on which settlement takes place. The rolling

settlement has started on T+2 basis in India, implying that the outstanding positions at

the end of the day ‘T’ are compulsorily settled 2 days after the trade date. Rolling

settlement was first introduced in India by OTCEI. As dematerialization took off,

NSE provided an option to settle the trades in demat securities on rolling basis. In

January 2000, SEBI made rolling settlement compulsory for trades in 10 scrips

selected on the basis of the criteria that they were in the compulsory demat list and

had daily turnover of about Rs.1 crore or more. This list, however, did not include

scrips, which had carried forward trading facility. SEBI reviewed the progress of

rolling settlement in February 2000. Consequent on the review, SEBI added a total of

156 scrips under rolling settlement. 74 companies, which had changed names to

InfoTech companies, were included in compulsory rolling settlement from May 8,

2000. 31 NBFCs, which are listed and traded on the BSE, but whose applications for

certificate of registration were rejected by RBI, were covered under compulsory

rolling settlement from May 8, 2000. 17 scrips, which exhibited high volatility (i.e., of

more than 110% for 7 weeks or more in the last 10 weeks) were also included in

compulsory rolling settlement from May 8, 2000. In addition, 34 companies out of

199 companies, which were already included in compulsory demat trading for all

investors and did not have carry forward facility in any of the exchanges and had

signed agreements with both the depositories were included for compulsory rolling

settlement from March 21, 2000. Following Finance Minister’s announcement on

March 13, 2001 that the rolling settlement would be extended to 200 category ‘A’

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stocks in MCFS (Modified Carried Forward System), ALBM (Automated Lending

and Borrowing Mechanism) and BLESS (Borrowing and Lending Security Scheme)

by July, 2001, SEBI decided that all 263 scrips included in the ALBM/BLESS or

MCFS in any stock exchange or in the BSE-200 list would be traded only in the

compulsory rolling settlement on all the exchanges from July 2, 2001. Further, SEBI

mandated rolling settlement for the remaining securities from December 31, 2001.

SEBI introduced T+5 rolling settlement in equity market from July 2001.

Subsequently shortened the settlement cycle to T+3 from April 1, 2002. After having

gained experience of T+3 rolling settlement and also taking further steps such as

introduction of STP (Straight Through Processing), it was felt appropriate to further

reduce the settlement cycle to T+2 thereby reducing the risk in the market and to

protect the interest of investors. As a result, SEBI, as a step towards easy flow of

funds and securities, introduced T+2 rolling settlement in Indian equity market from

1s t April 2003. The time schedule prescribed by SEBI for depositories and custodians

for T+2 rolling settlement is as given in Table 3.5.

Time schedule of Rolling Settlement:

T Trade Day by 1.00 pm Confirmation of all trades (including custodial trades).

T+1 by 2.30 pm processing and downloading of obligation files to brokers/custodians

By 11.00 is Pay-in of securities and funds

T+2 by 1.30 pm Pay-out of securities and funds

As per SEBI directive, the Custodians should adhere to the following activities for

implementation of T+2 rolling settlement w.e.f. April 1, 2003:

1. Confirmation of the institutional trades by the custodians latest by 1.00 p.m. on

T+1.

2. Pay-in to be made before 11:00 a.m. on T+2. Rolling settlement offers several

advantages over account period settlement:

(a) The account period settlement does not discriminate between an investor

transacting on the first day and an investor transacting on the last day of the trading

period, as trades are clubbed together for the purposes of settlement and all investors

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realize the securities and/or funds together. Hence some investors have to wait longer

for settlement of their transactions. Under rolling settlement, the investors trading on a

particular day are treated differently from the investors trading on the preceding or

succeeding day. All of them wait for “X” days from the trade date for settlement.

Further, the gap between the trade date and the settlement date is less under rolling

settlement making both securities and funds easily convertible.

(b) The account period settlement combines the features of cash as well as futures

markets and hence distorts price discovery process. In contrast, rolling settlement,

which segregates cash and futures markets and thereby removes excessive

speculation, helps in better price discovery.

(c) Account period settlement allows build up of large positions over a trading period

of five days and consequently, there is a pressure to close them out on the last trading

day, leading to significant market volatility. This does not happen under rolling

settlement, where positions can be built during a day only.

(d) There is scope for both intra-settlement and intra-day speculation under account

period settlement, which allows large outstanding positions and hence poses greater

settlement risks. In contrast, since all open positions under rolling settlement at the

end of a date ‘T’ are necessarily settled ‘X’ working days later, it limits the

outstanding positions and reduces settlement risk.

(e) Till recently, it was possible to shift positions from one exchange to another under

account period as they follow different trading cycles. Rolling settlement took care of

this by making trading cycle uniform.

Settlement Cycle

The NSCCL clears and settles trades as per well-defined settlement cycle. The

settlement cycle for the CM segment of NSE is presented in Table 3.6. NSCCL

notifies the consummated trade details to clearing members/custodians on the trade

day. The custodians affirm back the trades to NSCCL by T+1 day. Based on the

affirmation, NSCCL nets the positions of counterparties to determine their

obligations. A clearing member has to pay-in/pay-out funds and/or securities. A

member has a security-wise net obligation to receive/deliver a security. The

obligations are netted for a member across all securities to determine his fund

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obligations and he has to either pay or receive funds. Members’ pay-in/payout

obligations are determined latest by T+1 day and are forwarded to them on the same

day so that they can settle their obligations on T+2 day. The securities/funds are paid-

in/paid-out on T+2 days and the settlement is complete in 2 days from the end of the

trade day. Under Limited Physical Market segment, settlement for trades is done on a

trade-for-trade basis and delivery obligations arise out of each trade. The settlement

cycle for this segment is same as for the rolling settlement

Pay-in and Pay-out of Funds

NSCCL offers Clearing Members the facility of settlement of funds obligations

through 13 Clearing Banks, namely Axis Bank Ltd, Canara Bank, HDFC Bank,

IndusInd Bank, ICICI Bank, Bank of India, IDBI Bank, Hongkong & Shanghai

Banking Corporation Ltd., Kotak Mahindra Bank, Standard Chartered Bank, Union

Bank of India, State Bank of India and Citibank N.A. Clearing Members are required

to open clearing account with any one bank for the purpose of settlement of their

transactions. They are also required to authorize their Clearing Bank to access their

clearing account for debiting, crediting, reporting of balances and any other

information in accordance with the advice received from NSCCL. Clearing accounts

are used exclusively for clearing and settlement of transactions, i.e. for settling funds

and other obligations to/ from the NSCCL, including payments of margins and penal

charges. Clearing Banks debit/ credit the clearing account of clearing members as per

instructions received from the NSCCL electronically. Members are informed of their

funds obligation for various settlements through the daily clearing data download.

Members are also provided daily funds statement which gives date-wise details of

each debit/ credit transaction in the member’s clearing account. The summary

statement provided to members summarizes the debit/ credit information for a quick

reference. Members can refer to these statements and provide for funds accordingly.

Member's account may be debited for various types of transactions on a daily basis. A

member is required to ensure that adequate funds are available in the clearing

accounts towards all obligations, by the scheduled date and time. It is possible that the

total value of funds pay-in receivable by a bank is different from the value of funds

payout from the bank i.e. the pay-in may be either more than the payout in a bank, or

vice versa. In such cases, funds need to be transferred from the bank there is excess

pay-in to the bank where there is a shortage in pay-in. Based on estimated pay-in and

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payout of funds, on the day preceding the payout day, NSCCL advises the banks

having pay-in in excess of pay-out to issue pay orders to the banks having pay-in less

than the pay-out. The deficit banks accordingly get the funds to facilitate timely

payout. Shortfall of Funds Pay-in Members are required to ensure that adequate funds

are available in their clearing bank account towards all obligations, on the scheduled

date and time. Based on current trends, settlement cycles, risk factors and other trade

practices, in all cases of funds shortages, NSCCL may initiate various actions

including withdrawing the trading facility of the member, withholding the securities

pay-out due to the member, requiring the member to make advance pay-in.

The above provisions shall apply if net cumulative fund shortage for a member is:

1. Equal to or greater than Rs. Five (5) lakhs at the end of pay-in.

2. Equal to or greater than Rs. Two (2) lakhs for six (6) or more occasions in the last

three (3) months on any given day In case, the member is disabled on account of (2)

above, on making good the shortage amount, the member shall be permitted to trade

subject to its providing a deposit equivalent to its cumulative funds shortage as the

'funds shortage collateral'. Such deposit shall be kept with the Clearing Corporation

for a period of ten settlements and shall be released only if no further funds shortages

are reported for the member in next ten consecutive settlements. Members may further

note that there shall not be any margin benefit or any interest payment on the amount

so deposited as 'funds shortage collateral'. The amount may be provided by way of

cash, fixed deposit receipts, or bank guarantee, equivalent to the cumulative funds

shortage. In addition, the member will be required to pay a penal charge at the rate of

0.07% per day computed on the amount outstanding at the end of the day, till the

amount is recovered. However, the above actions are not constant and are subject to

periodical review.

Pay-in and Pay-out of Securities

In order to settle trades in the dematerialized securities, a clearing member needs to

open a clearing account with a depository participant (DP). Clearing members are

informed of their securities obligation for various settlements through the daily

clearing data download and reports. Clearing members are also provided final

delivery/ receipt statement and delivery details statement. Before pay-in, selling

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investors instruct DP to transfer security balances from their beneficiary accounts to

clearing member’s pool account. At or before the time and day specified for pay-in by

NSCCL, the clearing member instructs his DP to move the required balance from his

pool account to his delivery account. On the pay-in day, the depository sends the

balances to NSCCL at the scheduled time. The balances in respective clearing

members' delivery accounts are first transferred to NSCCL’s pool account which is

then matched with the obligations generated by NSCCL system. The quantity and

securities matched are accepted and credited to the pool account of the receiving

clearing members through depository. The quantity and securities, not matched for

any reason whatsoever, are not accepted and as such credited back to Pool Accounts

of the delivering clearing members. On receipt of payout instructions from NSCCL,

the depository credits the clearing members' pool accounts or clients beneficiary

accounts in case of client direct payout instructions. From the pool accounts, the

clearing members distribute the deliveries to the buying clients by issuing instructions

to his DP. Straight Through Processing Straight Through Processing (STP) implies

the automation of the entire process of securities transactions right from trade

initiation to settlement.

7. RISK MANAGEMENT

A sound risk management system is integral to/pre-requisite for an efficient clearing

and settlement system. The National Securities Clearing Corporation Ltd. (NSCCL), a

wholly owned subsidiary of NSE, was incorporated in August 1995. It was set up to

bring and sustain confidence in clearing and settlement of securities; to promote and

maintain, short and consistent settlement cycles; to provide counter-party risk

guarantee, and to operate a tight risk containment system. NSCCL commenced

clearing operations in April 1996. NSCCL ensures that trading members’ obligations

are commensurate with their net worth. In recognition of the fact that market integrity

is the essence of any financial market and believing in the philosophy that prevention

is better than cure, NSCCL has put in place a comprehensive risk management system

which is constantly monitored and upgraded to pre-empt market failures. Risk

containment measures include capital adequacy requirements of members, monitoring

of member performance and track record, stringent margin requirements, position

limits based on capital, online monitoring of member positions and automatic

disablement from trading when limits are breached. To safeguard the interest of the

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investors, NSE administers an effective market surveillance system to curb excessive

volatility, detect and prevent price manipulation and follows a system of price bands.

Further, the exchange maintains strict surveillance over market activities in liquid and

volatile securities.

Capital Adequacy Requirements

The core of the risk management is the liquid assets deposited by members with the

exchange / clearing corporation. The trading members are required to provide liquid

assets which adequately cover various margins & base minimum capital requirements.

Liquid assets of the member include their Initial membership deposits including the

security deposits. Members may provide additional collateral deposit towards liquid

assets, over and above their minimum membership deposit requirements. The

acceptable forms of capital towards liquid assets and the applicable haircuts are listed

below:

1. Cash Equivalents: Cash, Bank Fixed Deposits with approved custodians, Bank

Guarantees from approved banks, Government Securities with 10% haircut, Units of

liquid mutual funds or government securities mutual funds with 10% haircut.

2. Other Liquid assets:

(i) Liquid (Group I) Equity Shares in demat form, as specified by NSCCL from time

to time deposited with approved Custodians. Haircuts applied are equivalent to the

VaR margin for the respective securities.

(ii) Mutual fund units other than those listed under cash equivalents decided by

NSCCL from time to time. Haircut equivalent to the VaR margin for the units

computed using the traded price if available, or else, using the NAV of the unit

treating it as a liquid security.

Margins

Margins form a key part of the risk management system. In the stock markets there is

always an uncertainty in the movement of share prices. This uncertainty leads to risk

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which is addressed by margining system of stock markets. Let us understand the

concept of margins with the help of a following example.

Example: Suppose an investor, purchases 1000 shares of ‘xyz’ company at Rs.100/-

on January 1, 2008. Investor has to give the purchase amount of Rs.1,00,000/- (1000 x

100) to his broker on or before January 2, 2008. Broker, in turn, has to give this

money to stoc k exchange on January 3, 2008. There is always a small chance that the

investor may not be able to bring the required money by required date. As an advance

for buying the shares, investor is required to pay a portion of the total amount of

Rs.1,00,000/- to the broker at the time of placing the buy order. Stock exchange in

turn collects similar amount from the broker upon execution of the order. This initial

token payment is called margin. It is important to remember that for every buyer there

is a seller and if the buyer does not bring the money, seller may not get his / her

money and vice versa. Therefore, margin is levied on the seller also to ensure that

he/she gives the 100 shares sold to the broker who in turn gives it to the stock

exchange. In the above example, assume that margin was 15%. That is investor has to

give Rs.15,000/-(15% of Rs.1,00,000/) to the broker before buying. Now suppose that

investor bought the shares at 11 am on January 1, 2008. Assume that by the end of the

day price of the share falls by Rs.25/-. That is total value of the shares has come down

to Rs.75,000/-. That is buyer has suffered a notional loss of Rs.25,000/-. In our

example buyer has paid Rs.15,000/- as margin but the notional loss, because of fall in

price, is Rs.25,000/-. That is notional loss is more than the margin given. In such a

situation, the buyer may not want to pay Rs.1,00,000/- for the shares whose value has

come down to Rs.75,000/-. Similarly, if the price has gone up by Rs.25/-, the seller

may not want to give the shares at Rs.1,00,000/-. To ensure that both buyers and

sellers fulfill their obligations irrespective of price movements, notional losses are

also need to be collected. Prices of shares keep on moving every day. Margins ensure

that buyers bring money and sellers bring shares to complete their obligations even

though the prices have moved down or up.

IMPOSITION OF MARGINS

For imposition of margins, the stocks are categorized on basis of their trading

frequency and impact cost. The criteria for categorization of stocks for imposition of

margins are mentioned below: The securities are classified into three groups based on

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their liquidity. The Stocks which have traded atleast 80% of the days for the previous

six months constitute Group I (Liquid Securities) and Group II (Less Liquid

Securities). Out of the scrips identified above, the scrips having mean impact cost of

less than or equal to 1% are categorized under Group I and the scrips where the

impact cost is more than 1, are categorized under Group II. The remaining stocks are

classified into Group III (Illiquid Securities). · The impact cost is calculated on the

15th of each month on a rolling basis considering the order book snapshots of the

previous six months. On the basis of the impact cost so calculated, the scrips are

moved from one group to another group from the 1st of the next month.

Group Trading frequency (over the previous six months*) Impact Cost (over the

previous six months*)

Liquid Securities (Group I) At least 80 % of the days Less than or equal to 1 % Less

Liquid Securities (Group II) At least 80 % of the days More than 1 %. Illiquid

Securities (Group III)

Less than 80 % of the days N/A. For securities that have been listed for less than 6

months, the trading frequency and the impact cost is computed using the history of the

scrip.

Categorization of newly listed securities For the first month and till the time of

monthly review a newly listed security is categorized in that Group where the market

capitalization of the newly listed security exceeds or equals the market capitalization

of 80% of the securities in that particular group. Subsequently, after one month,

whenever the next monthly review is carried out, the actual trading frequency and

impact cost of the security is computed, to determine the liquidity categorization of

the security.

In case any corporate action results in a change in ISIN, then the securities bearing the

new ISIN is treated as newly listed security for group categorization.

Let us deal with this aspect in more detail while exploring different types of margins.

Daily margins payable by the trading members in the Cash market consists of the

following:

1) Value at Risk (VaR) margin

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2) Extreme Loss Margin

3) Mark to Market Margin

The margins are computed at client level. A member entering an order, needs to enter

the client code. Based on this information, margin is computed at the client level,

which will be payable by the trading members on upfront basis. Let us see in details

what is meant by these margins.

Value at Risk Margin

VaR is a single number, which encapsulates whole information about the risk in a

portfolio. It measures potential loss from an unlikely adverse event in a normal market

environment. It involves using historical data on marke t prices and rates, the current

portfolio positions, and models (e.g., option models, bond models) for pricing those

Positions. These inputs are then combined in different ways, depending on the

method, to derive an estimate of a particular percentile of the loss distribution,

typically the 99th percentile loss. Computation of VaR Margin VaR Margin is a

margin intended to cover the largest loss that can be encountered on 99% of the days

(99% Value at Risk). For liquid securities, the margin covers one-day losses while for

illiquid securities; it covers three-day losses so as to allow the clearing corporation to

liquidate the position over three days. This leads to a scaling factor of square root of

three for illiquid securities. For liquid securities, the VaR margins are based only on

the volatility of the security while for other securities, the volatility of the market

index is also used in the computation.

Computation of the VaR margin requires the following definitions:

Security sigma means the volatility of the security computed as at the end of the

previous trading day. The computation uses the exponentially weighted moving

average method applied to daily returns in the same manner as in the derivatives

market.

Security VaR means the higher of 7.5% or 3.5 security sigmas.

Index sigma means the daily volatility of the market index (S&P CNX Nifty or BSE

Sensex) computed as at the end of the previous trading day. The computation uses the

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exponentially weighted moving average method applied to daily returns in the same

manner as in the derivatives market.

Index VaR means the higher of 5% or 3 index sigmas. The higher of the Sensex VaR

or Nifty VaR would be used for this purpose. The VaR Margins are specified as

follows for different groups of securities:

All securities are classified into three groups for the purpose of VaR margin. For the

securities listed in Group I, scrip wise daily volatility calculated using the

exponentially weighted moving average methodology is applied to daily returns. The

scrip wise daily VaR would be 3.5 times the volatility so calculated subject to a

minimum of 7.5%. For the securities listed in Group II, the VaR margin is higher of

scrip VaR (3.5 sigma) or three times the index VaR, and it shall be scaled up by root

3. For the securities listed in Group III, the VaR margin would be equal to five times

the index VaR and scaled up by root 3. Upfront margin rates (VaR margin + Extreme

Loss Margin) applicable for all securities in Trade for Trade- Surveillance (TFTS)

shall be 100 %. VaR margin rate for a security constitutes the following:

(1) Value at Risk (VaR) based margin, which is arrived at, based on the methods

stated above. The index VaR, for the purpose, would be the higher of the daily Index

VaR based on S&P CNX NIFTY or BSE SENSEX. The index VaR would be subject

to a minimum of 5%.

(2) Security specific Margin: NSCCL may stipulate security specific margins for the

securities from time to time. The VaR margin rate computed as mentioned above will

be charged on the net outstanding position (buy value-sell) of the respective clients on

the respective securities across all open settlements. There would be no netting off of

positions across different settlements. The net positions at a client level for a member

are arrived at and thereafter, it is grossed across all the clients including proprietary

position to arrive at the gross open position. For example, in case of a member, if

client A has a buy position of 1000 in a security and client B has a sell position of

1000 in the same security, the net position of the member in the security would be

taken as 2000. The buy position of client A and sell position of client B in the same

security would not be netted. It would be summed up to arrive at the member’s open

position for the purpose of margin calculation.

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Collection of VaR Margin:

(a) The VaR margin is collected on an upfront basis by adjusting against the total

liquid assets of the member at the time of trade.

(b) The VaR margin is collected on the gross open position of the member. The gross

open position for this purpose would mean the gross of all net positions across all the

clients of a member including its proprietary position.

(c) For this purpose, there would be no netting of positions across different

settlements.

(d) Upfront margin rates (VaR margin + Extreme Loss Margin) applicable for all

securities in Trade for Trade- Surveillance (TFTS) shall be 100 %.

(e) The Intra-day VAR files shall be generated based on the prices at 11.00 a.m.,

12.30 p.m., 2.00 p.m., and 3.30 p.m. every day. Such intra-day VAR files shall be

used for margining of intra-day member positions. In addition to the above, a VAR

file at end of day and begin of day shall be provided and the same is applicable on the

positions for next trading day

Mark-to-Market Margin

Mark to market loss is calculated by marking each transaction in security to the

closing price of the security at the end of trading. In case the security has not been

traded on a particular day, the latest available closing price at the NSE is to be

considered as the closing price. In case the net outstanding position in any security is

nil, the difference between the buy and sell values is considered as notional loss for

the purpose of calculating the mark to market margin payable.

The mark to market margin (MTM) is collected from the member before the start of

the trading of the next day. The MTM margin is collected/adjusted from/against the

cash/cash equivalent component of the liquid net worth deposited with the Exchange.

The MTM margin is collected on the gross open position of the member. The gross

open position for this purpose would mean the gross of all net positions across all the

clients of a member including its proprietary position. For this purpose, the position of

a client would be netted across its various securities and the positions of all the clients

of a broker would be grossed. There would be no netting off of the positions and

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setoff against MTM profits across two rolling settlements i.e. T day and T-1 day.

However, for computation of MTM profits/losses for the day, netting or setoff against

MTM profits would be permitted. In case of Trade for Trade Segment (TFT segment)

each trade is marked to market based on the closing price of that security. The MTM

margin so collected is released on completion of pay-in of the settlement.

Extreme Loss Margin

The Extreme Loss Margin for any security is higher of:

(1) 5%, or

(2) 1.5 times the standard deviation of daily logarithmic returns of the security price in

the last six months. This computation is done at the end of each month by taking the

price data on a rolling basis for the past six months and the resulting value is

applicable for the next month. The Extreme Loss Margin is collected/ adjusted against

the total liquid assets of the member on a real time basis. The Extreme Loss Margin is

collected on the gross open position of the member. The gross open position for this

purpose would mean the gross of all net positions across all the clients of a member

including its proprietary position. There would be no netting off of positions across

different settlements. The Extreme Loss Margin collected is released on completion of

pay-in of the settlement.

0.07% per day +Rs.5000/- per instance from

2nd to 5th instance

6th to 10th instance of disablement

0.07% per day+ Rs. 20000 (for 2nd to 5thinstance) +Rs.10000/- per instance from 6th

to 10th instance11th instance onwards 0.07% per day +Rs. 70,000/- (for 2nd to 10th

instance) +Rs.10000/- per instance from 11th instance onwards. Additionally, the

member will be referred to the Disciplinary Action Committee for suitable action

Instances as mentioned above refer to all disablements during market hours in a

calendar month. The penal charge of 0.07% per day is applicable on all disablements

due to margin violation anytime during the day.

Margins for institutional deals:

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Institutional businesses i.e., transactions done by all institutional investors shall be

margined in the capital market segment from T+1 day subsequent to confirmation of

the transactions by the custodians.

CHAPTER-8 TECHNICAL ANALYSIS

What is technical analysis? :

The analysis of these historical growth rates both visually with the time-series graph

and the alternative calculations should provide you with significant insights into the

trend of the growth rates as well as the variability of the growth rates over time. This

could provide information on the unit’s business risk with the analysis of sales and

EBIT growth. The underlying factors that determine the growth rates for foreign

stocks are similar to those for U.S. stocks, but the value of the equation’s components

may differ substantially from what is common in the United States. The differences in

the retention rate or the components of ROE result from differences in accounting

practices as well as alternative management performance or philosophy. Retention

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Rates The retention rates for foreign corporations differ within countries, but

differences also exist among countries due to differences in the countries’ investment

opportunities.

As an example, firms in Japan have a higher retention rate than firms in the United

States, whereas the rate of retention in France is much lower. Therefore, you need to

examine the retention rates for a number of firms in a country as a background for

estimating the standard rate within a country.

Net Profit Margin The net profit margin of foreign firms can differ because of

different accounting conventions between countries. As noted in Chapter 10, foreign

accounting rules allow firms to recognize revenue and allocate expenses differently

from U.S. firms. For example, German firms are allowed to build up large reserves for

various reasons. As a result, they report low earnings for tax purposes. Also, different

foreign depreciation practices require adjustment of earnings and cash flows. Total

Asset Turnover Total asset turnover can likewise differ among countries because of

different accounting conventions on the reporting of asset values at cost or market

values. For example, in Japan, a large part of the market values for some firms comes

from their real estate holdings and their common stock investments in other firms.

These assets are reported at cost, which typically has substantially understated their

true value. This also means that the total asset

Turnover ratio for these firms is substantially overstated. This ratio will also be

impacted by leases that are not capitalized on the balance sheet—that is, both assets

and liabilities are understated. Total Asset/Equity Ratio This ratio, a measure of

financial leverage, differs among countries because of differences in economic

environments, tax laws, management philosophies regarding corporate debt, and

accounting conventions. In several countries, the attitude toward debt is much more

liberal than in the United States. A prime example is Japan, where debt as a

percentage of total assets is almost 50 percent higher than a similar ratio in the United

States. Notably, most corporate debt in Japan entails borrowing from banks at fairly

low rates of interest. Balance sheet debt ratios may be higher in Japan than in the

United States or other countries; but, because of the lower interest rates in Japan, the

fixed-charge coverage ratios, such as the times interest earned ratio, might be similar

to those in other countries. The point is, it is important to consider the several cash

flow financial risk ratios along with the balance sheet debt ratios. Consequently, when

analyzing a foreign stock market or an individual foreign stock that involves

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estimating the growth rate for earnings and dividends, you must consider the three

components of the ROE just as you would for a U.S. stock. You must recognize that

the financial ratios for foreign firms can differ from those of U.S. firms, as discussed

in Chapter 10 references.

Subsequent chapters on valuation applied to the aggregate market, to various

industries, and to companies contain examples of these differences. Institutional

transactions shall be identified by the use of the participant code at the time of order

entry. In respect of institutional transactions confirmed by the custodians the margins

shall be levied on the custodians. In respect of institutional transactions rejected/not

accepted by the custodians the margins shall be levied on the members who have

executed the transactions. The margins shall be computed and levied at a client

(Custodial Participant code) level in respect of institutional transactions and collected

from the custodians/members. Reporting and other procedures regarding Institution

transactions shall continue as per the current procedure.

Retail Professional Clearing Member:

In case of transactions which are to be settled by Retail Professional Clearing

Members (PCM), all the trades with PCM code shall be included in the trading

member’s positions till the same are confirmed by the PCM. Margins shall be

collected from respective trading members until confirmation of trades by PCM. On

confirmation of trades by PCM, such trades will be reduced from the positions of

trading member and included in the positions of PCM. The PCM shall then be liable

to pay margins on the same.

Exemption upon early pay-in of securities

In cases where early pay-in of securities is made prior to the securities pay-in, such

positions for which early pay-in (EPI) of securities is made shall be exempt from

margins. The EPI of securities would be allocated to clients having net deliverable

position, on a random basis unless specific client details are provided by the member/

custodian. However, member/ custodian shall ensure to pass on appropriate early pay-

in benefit of margin to the relevant clients. Additionally, member/custodian can

specify the clients to whom the early pay-in may be allocated.

Exemption upon early pay-in of funds

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In cases where early pay-in of funds is made prior to the funds pay-in, such positions

for which early pay-in (EPI) of funds is made shall be exempt from margins based on

the client details provided by the member/ custodian. Early pay-in of funds specified

by the member/custodians for a specific client and for a settlement shall be allocated

against the securities in the descending order of the net buy value of outstanding

position of the client.

On-Line Exposure Monitoring

NSCCL has put in place an on-line monitoring and surveillance system whereby

exposure of the members is monitored on a real time basis. A system of alerts has

been built in so that both the member and NSCCL are alerted as per pre-set levels

(reaching 70%, 85%, 90%, 95% and 100%) when the members approach their

allowable limits. The system enables NSSCL to further check the micro-details of

members' positions, if required and take pro-active action. The on-line surveillance

mechanism also generates various alerts/reports on any price/volume movement of

securities not in line with past trends/patterns. For this purpose the exchange

maintains various databases to generate alerts. Alerts are scrutinized and if necessary

taken up for follow up action. Open positions of securities are also analyzed. Besides

this, rumors in the print media are tracked and where they are price sensitive,

companies are contacted for verification. Replies received are informed to the

members and the public.

Off-line Monitoring

Off-line surveillance activity consists of inspections and investigations. As per

regulatory requirement, a minimum of 20% of the active trading members are to be

inspected every year to verify the level of compliance with various rules, byelaws and

regulations of the Exchange. Usually, inspection of more members than the regulatory

requirement is undertaken every year. The inspection verifies if investor interests are

being compromised in the conduct of business by the members. The investigation is

based on various alerts, which require further analysis. If further analysis reveals any

suspicion of irregular activity which deviates from the past trends/patterns and

concentration of trading at NSE at the member level, then a more detailed

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investigation is undertaken. If the detailed investigation establishes any irregular

activity, then disciplinary action is initiated against the member. If the investigation

suggests suspicions of possible irregular activity across exchanges and/or possible

involvement of clients, then the same is informed to SEBI.

Index-based Market-wide Circuit Breakers/ Price

Bands for Securities

An index based market-wide circuit breaker system applies at three stages of the index

movement either way at 10%, 15% and 20%. These circuit breakers bring about a

coordinated trading halt in trading on all equity and equity derivatives markets across

the country. The breakers are triggered by movements in either Nifty 50 or Sensex,

whichever is breached earlier. In case of a 10% movement in either of these indices,

there would be a one-hour market halt if the movement takes place before 1:00 p.m.

In case the movement takes place at or after 1:00 p.m. but before 2:30 p.m. there

would be trading halt for ½ hour. In case movement takes place at or after 2:30 p.m.

there will be no trading halt at the 10% level and market would continue trading. In

case of a 15% movement of either index, there should be a two-hour halt if the

movement takes place before 1 p.m. If the 15% trigger is reached on or after 1:00 p.m.

but before 2:00 p.m., there should be a one-hour halt. If the 15% trigger is reached on

or after 2:00 p.m. the trading should halt for remainder of the day. In case of a 20%

movement of the index, trading should be halted for the remainder of the day.

NSE may suo moto cancel the orders in the absence of any immediate confirmation

from the members that these orders are genuine or for any other reason as it may

deem fit. The Exchange views entries of non-genuine orders with utmost seriousness

as this has market wide repercussion. As an additional measure of safety, individual

scrip-wise price bands have been fixed as below:

Daily price bands of 2% (either way) on a set of specified securities

Daily price bands of 5% (either way) on a set of specified securities

Daily price bands of 10% (either way) on a set of specified securities

Price bands of 20% (either way) on all the remaining securities (including debentures,

warrants, preference shares etc. which are traded on CM segment of NSE),

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No price bands are applicable on scrip on which derivative products are available or

scripts included in indices on which derivative products are available. However in

order to prevent members from entering orders at non genuine prices in such

securities, the Exchange has fixed operating range of 20% for such securities. The

price bands for the securities in the Limited Physical Market are the same as those

applicable for the securities in the Normal Market. For Auction market the price

bands of 20% are applicable.

Settlement Guarantee Mechanism

NSCCL assumes the counter party risk of each member and guarantees financial

settlement. Counter party risk is guaranteed through a fine tuned risk management

system and an innovative method of on-line position monitoring and automatic

disablement. A large Settlement Guarantee Fund provides the cushion for any residual

risk. In the event of failure of a trading member to meet settlement obligations or

committing default, the Fund is utilized to the extent required for successful

completion of the settlement. This has eliminated counter party risk of trading on the

Exchange. The market has now full confidence that settlements will take place in time

and will be completed irrespective of possible default by isolated trading members.

The concept of guaranteed settlements has completely changed the way market safety

is perceived. The Settlement Guarantee Fund is an important element in facilitating

the settlement process. The Fund operates like a self-insurance mechanism and is

funded through the contributions made by trading members, transaction charges,

penalty amounts, fines etc. recovered by NSCCL.

There is a provision that as and when volumes of business increase, members may be

required to make additional contributions allowing the fund to grow along with the

market volumes.

Direct Pay-out of Securities

NSCCL has put in place a system for giving direct pay-out of securities to investor’s

account. The system is applicable for both the depositories. The trading member/

clearing member indicates the beneficiary account to which the securities payout is to

be made by way of file upload. In order to smoothen the back office work of the

trading members for providing this information, NSCCL has provided a front end for

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creating the file through which the information is passed on to NSCCL. On the pay-

out day, pay-out goes to such investors' account directly from NSCCL. In case of any

wrong information provided by the trading member, the pay-out goes to the pool

account of the trading member.

No-delivery Period

Whenever a book closure or a record date is announced by a company for corporate

actions other than AGM, EGM, dividend & Bonus, the exchange sets up a ‘no-

delivery’ period for that security. During this period, trading is permitted in the

security. However, these trades are settled only after the no delivery period is over.

This is done to ensure that investor’s entitlement for the corporate benefits is clearly

determined.

Penalty

The Clearing Corporation levies penalties on trading members for non compliances

and defaults like:

1. Funds Shortages

2. Securities Shortages

3. Margin Shortages

4. Security Deposit Shortages

5. Client Code Modification

6. Non-acceptance / rejection / allocation of Institutional trades

7. Ineligible client in Inter-institutional deals

8. Others

1. Funds Shortages : Members failing to fulfill their funds obligations (all markets

including the valuation debit raised on account of securities shortages) to Clearing

Corporation shall be subjected to the following penalty structure:-

Type of Non-Fulfillment Penalty Charge % per day

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Value Rs. 5 lakhs or more 0.07

Value less than Rs. 5 lakhs 0.07

2. Securities Shortages in respect of cleared deals:- Members failing to fulfill their

securities deliverable obligations to Clearing Corporation shall be subjected to the

following penalty structure:-

Type of Non-Fulfillment Penalty Charge % per day on value of shortage

Security Shortage 0.05

3. Margin Shortages: Penalty for violation on account of initial margin limit/exposure

margin and/or open interest limit may be levied on a monthly basis based on slabs

mentioned below:

Instances of Disablement Penalty to be levied

1st instance 0.07% per day

2nd to 5th instance of disablement

0.07% per day +Rs.5000/- per instance from 2nd to 5th instance

6th to 10th instance of disablement

0.07% per day+ Rs. 20000 (for 2nd to 5th instance) +Rs.10000/- per instance from 6th

to 10th instance

11th instance onwards

0.07% per day +Rs. 70,000/- (for 2nd to 10th instance) +Rs.10000/- per instance from

11th instance onwards.

Additionally, the member will be referred to the Disciplinary Action Committee for

suitable action Instances as mentioned above shall refer to all disablements during

market hours in a calendar month. The penal charge of 0.07% per day shall be

applicable on all disablements due to margin violation anytime during the day.

4. Security deposit shortage: Penal charges for shortages in the minimum deposit

requirement are 0.07% per day.

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5. Client code modification: Penalties shall be imposed in respect of client code

modifications in non-institutional orders only. The penalty structure is given below :

Percentage of modified client codes for non-institutional orders beyond the first 5

orders to total non-institutional orders (matched) on a daily basis Amount (in Rs)

Less than or equal to 1% NIL

Greater than 1% but less than or equal to 5% 500/- per day

Greater than 5% but less than or equal to 10% 1000/- per day

Greater than 10% 10000/- per day

6. Non-acceptance / rejection / allocation of Institutional trades:

Penalty is imposed where the institutional trades are rejected / non accepted by

Custodians or not allocated by the trading members. A penalty at the rate of 0.10% of

the total value of all such transactions for a settlement for a member or Rs.10,000/-

whichever is lower.

7. Ineligible client in Inter-institutional deals: Clearing and settlement procedure for

inter-institutional deals involves eligibility of clients. For sell orders only FIIs are

permitted, for buy orders FIIs, DFIs, Banks, Mutual Funds and Insurance Companies

and such other institutions as may be approved from time to time. Where RBI has

stipulated collective limits for FIIs, NRIs, and PIOs etc in certain securities, these

entities shall be permitted to place orders on both buy and sell sides. Penalties are

imposed if trades are executed by ineligible clients as under:

If the selling client is not eligible - the trade shall be compulsorily closed out and a

penalty of Rs.25000 shall be imposed.

If the buying client is not eligible - a penalty at the rate of 1% of the value of the trade

or Rs 1 lakh whichever is lower shall be imposed.

8. Others: There are certain penalties imposed on members which are related to

physical settlement:

1. Failure to give Good Delivery: In case of bad deliveries rectified, delayed good

delivery processing charges will be at the rate of 0.09 % per day computed from the

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day on which securities were originally due to be brought in up to the day on which

the securities are replaced/rectified. In case of bad deliveries not rectified, bad

delivery processing charges will be @ 0.09% per day computed from the day on

which securities were originally due to be brought in upto

(i) The day on which the securities are brought in or

(ii) Till auction settlement is completed or

(iii) Where auction is partially successful or not successful and the deal is deemed

closed out or when the deal is squared off and the corresponding funds adjustments

are completed, whichever is later? In case of auction bad deliveries and rectified /

replaced objection cases which are reported as bad delivery, the penal interest will be

0.09% per day from the rectification date till the date of closing out.

Type of Default Charges

Wrong claims of dividend, bonus, interest etc. Rs. 100/- per claim

Same set of shares reported twice under objection 10% of value of shares reported

under objection subject to a minimum of Rs. 5,000/- per claim

2. Incorrect claim for corporate benefits:

Incorrect undertaking on form 6-I 10% of the value of shares reported under

objection, subject to a minimum of Rs. 5,000/- per claim.

3. Late withdrawal of company objection: Processing fee for late withdrawal at the

rate of Rs. 2 per share subject to a minimum of Rs.200/- shall be levied for all

withdrawals where a member has not withdrawn the invalid/incorrect

objection/corporate benefits claim on the scheduled withdrawal date, for the following

reasons:

a. The shares under objection have not been introduced by the member on the

Exchange; however he is not able to produce the delivery slip / delivery details

statement on the scheduled withdrawal day.

b. Where the Introducing Member (IM) had not approached the Clearing House on the

scheduled withdrawal date on account of oversight/mistake. Members wanting to

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avail 'late' withdrawals will be required to affix prepaid coupons for the late

withdrawal fee, at the time of reporting the same. Acceptance of such late withdrawals

shall be subject to approval only.

Trade for Trade

Types of default Penalty Charge

a. Non settlement of trade 0.5% of the trade value

b. Cancellation of trade Rs. 1000/- per trade per side

c. Failure to settle within the stipulated time Rs. 500/- per trade per day, subject to

maximum of 2.50 times the value of the trade for each side with a ceiling of Rs.

10000/-

d. Failure to report within the stipulated time Rs. 500/- per trade per day subject to

maximum of 2.50 times the value of the trade for each side with a ceiling of Rs. 5000/

Investigation and Inspection

As per regulatory requirement, a minimum of 20% of the active trading members are

to be inspected every year to verify the level of compliance with various rules,

byelaws and regulations of the Exchange. Usually, inspection of more members than

the regulatory requirement is undertaken every year. The inspection randomly verifies

if investor interests are being compromised in the conduct of business by the

members. The investigation is based on various alerts which require further analysis.

If further analysis suggests any possible irregular activity which deviates from the

past trends/patterns and concentration of trading at NSE at the member level, then a

more detailed investigation is undertaken. If the detailed investigation establishes any

irregular activity, then disciplinary action is initiated against the member. If the

investigation suggests possible irregular activity across exchanges and/or possible

involvement of clients, then the same is informed to SEBI.

Investor Protection Fund

Investor Protection Fund (IPF) has been set up as a trust under Bombay Public Trust

Act, 1950 under the name and style of National Stock Exchange Investor Protection

Fund Trust and is administered by the Trustees. The IPF is maintained by NSE to

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make good investor claims, which may arise out of non-settlement of obligations by

the trading member, who has been declared defaulter / expelled, in respect of trades

executed on the Exchange. The IPF is utilized to settle claims of such investors where

the trading member through whom the investor has dealt has been declared a defaulter

or expelled by the Exchange. Payments out of the IPF may include claims arising on

account of nonpayment of funds by the defaulter /expelled member or non receipt of

securities purchased by the investor through the trading member who has been

declared a defaulter/expelled member Quantum of Compensation: The maximum

amount of claim payable from the IPF to the investor is Rs. 11 lakh. Procedure for

filing claims: A notice is published in widely circulated daily newspapers notifying

the trading member who has been declared defaulter/expelled member. Claims against

the defaulter/expelled member specified in the notice are required to be made, on or

before three months from the date of such notice. The claimant is required to submit

the requisite documents/details in substantiation of his claim. The admissibility of the

claim is decided by the Defaulters’ Committee which recommends the payment of the

admissible amount out of the Investor Protection Fund in case of insufficient assets in

respect of the defaulter /expelled member vesting in the Exchange. Both the

Committee and the Trustees may at any time and from time to time require any person

to produce and deliver any documents or statements of evidence necessary to support

any claim made or necessary for the purpose of establishing his claim. In default of

delivery of such documents, the Committee and the Trustees may disallow (wholly or

partly) any claim made by him. On recommendation by the Defaulters’ Committee,

the Trustees, if satisfied that the default on which the claim is founded was actually

committed, may admit the claim and act accordingly. The Trustees have an absolute

discretion as regards the mode and method of assessing the nature of the claims

including their genuineness and at their discretion may accept, reject or partially grant

or allow claims and make payment thereof subject to the limits mentioned above The

Trustees in disallowing (whether wholly or partly) a claim for compensation shall

serve notice of such disallowance on the claimant.

Transaction Costs

Liquidity to a large extent depends on transaction costs. Lower the transaction cost,

the lower is the bid-ask spread and higher the volumes. SEBI released a Working

Paper titled ‘Trade Execution Cost of Equity Shares in India’ in January 2002. The

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study has measured implicit (indirect) costs in terms of quoted spread (possible cost of

trading in a stock) and effective bid ask spread (actual cost incurred by an investor to

execute a trade in a stock) and their behavior in relation to volume traded, market

capitalization, volatility and market hour. The major findings of the study are as

follows:

1. Effective spread is, by and large, lower than the quoted spread.

2. Market micro-structural changes appear to have influenced spread size.

3. The spread is inversely related to volume traded and market capitalization and

positively related to volatility (variance). Efforts to reduce volatility will also lead to

reduction in bid-ask spread.

4. Speed and time of arrival of information in the market also affects trade cost. The

spreads are very high at the open of market hours and they slowly taper off as trading

progresses. An investor who postpones his decision to buy or sell towards close of

trading saves more than 50% in terms of spread.

5. Spreads are mostly independent of quantity quoted and traded.

Charting techniques:

Traditionally, indices have been used as benchmarks to monitor markets and judge

performance. Modern indices were first proposed by two 19th century

mathematicians: Etienne Laspeyres and Hermann Paasche. The grandfather of all

equity indices is the Dow Jones Industrial Average which was first published in 1896;

since then indices have come a long way - not only in their sophistication - but also in

the variety. There are three main types of indices, namely price index, quantity index

and value index. The price index is most widely used. It measures changes in the

levels of prices of products in the financial, commodities or any other markets from

one period to another. The indices in financial markets measure changes in prices of

securities like equities, debentures, government securities, etc. The most popular

index in financial market is the stock (equity) index which uses a set of stocks that are

representative of the whole market, or a specified sector, to measure the change in

overall behavior of the markets or sector over a period of time.

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A stock index is important for its use:

1. as the lead indicator of the performance of the overall economy or a sector of the

economy: A good index tells us how much richer or poorer investors have become.

2. as a barometer for market behavior: It is used to monitor and measure market

movements, whether in real time, daily, or over decades, helping us to understand

economic conditions and prospects.

3. as a benchmark for portfolio performance: A managed fund can communicate its

objectives and target universe by stating which index or indices serve as the standard

against which its performance should be judged.

4. as an underlying for derivatives like index futures and option. It also underpins

products such as, exchange-traded funds, index funds etc. These index-related

products form a several trillion dollar business and are used widely in investment,

hedging and risk management.

5. as it supports research (for example, as benchmarks for evaluating trading rules,

technical analysis systems and analysts' forecasts); risk measurement and

management; and asset allocation. In addition to the above functional use, a stock

index reflects changing expectations of the market about future of the corporate

sector. The index rises if the market expects the future to be better than previously

expected and drops if the expectation about future becomes pessimistic. Price of a

stock moves for two reasons, namely, company specific development (product launch,

closure of a factory, arrest of chief executive) and development affecting the general

environment (nuclear bombs, election result, budget announcement), which affects the

stock market as a whole. The stock index captures the second part, that is, impact of

environmental change on the stock market as a whole. This is achieved by averaging

which cancels out changes in prices of individual stocks.

Understanding the index number

An index is a summary measure that indicates changes in value(s) of a variable or a

set of variables over a time or space. It is usually computed by finding the ratio of

current values(s) to a reference (base) value(s) and multiplying the resulting number

by 100 or 1000. For instance, a stock market index is a number that indicates the

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relative level of prices or value of securities in a market on a particular day compared

with a base-day price or value figure, which are usually 100 or 1000.

Illustration: The values of a market portfolio at the close of trading on Day 1 and Day

2 are:

Value of portfolio Index value

DAY1 (base day)

Rs. 20,000 /1000

Day 2 Rs. 30,000 /1500

Assume that Day 1 is the base day and the value assigned to the base day index is

1000. On Day 2 the value of the portfolio has changed from Rs. 20,000 to Rs. 30,000,

a 50% increase. The value of the index on Day 2 should reflect a corresponding 50%

increase in market value.

Thus,

Index on Day2 = Index Value of Base Day*Portfolio Value of Base Day/Portfolio

Value of Day = 1000* 20,000/30,000 Rs = 1500Rs

Day 2's index is 1500 as compared to the 1000 of day 1. The above illustration only

serves as an introduction to how an index is constructed. The daily computation of a

stock index involves more complexity especially when there are changes in market

capitalization of constituent stocks, e.g., rights offers, stock dividend etc.

Attributes of an index

A good stock market index should have the following attributes:

(a) Capturing behavior of portfolios: A good market index should accurately reflect

the behavior of the overall market as well as of different portfolios. This is achieved

by diversification in such a manner that a portfolio is not vulnerable to any individual

stock or industry risk. A well-diversified index is more representative of the market.

However there are diminishing returns from diversification. There is very little gain

by diversifying beyond a point. Including illiquid stocks actually worsens the index

since an illiquid stock does not reflect the current price behavior of the market, its

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inclusion in index results in an index, which reflects, delayed or stale price behavior

rather than current price behavior of the market. Thus a good index should include the

stocks which best represent the universe.

(b) Including liquid stocks: Liquidity is much more than reflected by trading

frequency. It is about ability to transact at a price, which is very close to the current

market price. For example, when the market price of a stock is at Rs.320, it will be

considered liquid if one can buy some shares at around Rs.320.05 and sell at around

Rs.319.95. A liquid stock has very tight bid-ask spread. Impact cost is the most

practical and operational definition of liquidity.

(c) Maintaining professionally: An index is not a constant. It reflects he market

dynamics and hence changes are essential to maintain its representative character.

This necessarily means that the same set of stocks would not satisfy index criteria at

all times. A good index methodology must therefore incorporate a steady pace of

change in the index set. It is crucial that such changes are made at a steady pace.

Therefore the index set should be reviewed on a regular basis and, if required,

changes should be made to ensure that it continues to reflect the current state of

market. Methodology for index construction Stock market indices differ from one

another basically in their sampling and/or weighting methods.

Evaluation

Unlike market indices such as American Stock Market Index and the Hong Kong

Stock Exchange All-Ordinaries Index that comprise of all stocks listed in a market,

under sampling method, an index is based on a fraction or a certain percentage of

select stocks which is highly representative of total stocks listed in a market.

WEIGHTING METHOD

In a value-weighted index, the weight of each constituent stock is proportional to its

market share in terms of market capitalization. In an index portfolio, we can assume

that the amount of money invested in each constituent stock is proportional to its

percentage of the total value of all constituent stocks. Examples include all major

stock market indices like S&P CNX Nifty.

There are three commonly used methods for constructing indices:

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Price weighted method

Equally weighted method

Market capitalization weighted method

A price-weighted index is computed by summing up the prices, of the various

securities included in the index, at time 1, and dividing it by the sum of prices of the

securities at time 0 multiplied by base index value. Each stock is assigned a weight

proportional to its price. Market capitalization weighted index: The most commonly

used weight is market capitalization (MC), that is, the number of outstanding shares

multiplied by the share price at some specified time. In this method,

Index = Base Value*Base Market Capitalization/Current Market Capitalization

Where,

Current MC = Sum of (number of outstanding shares*Current Market Price) all stocks

in the index

Base MC = Sum of (number of outstanding shares*Market Price) all stocks in index

as on base date

Base value = 100 or 1000

Difficulties in index construction:

The major difficulties encountered in constructing an appropriate index are:

· deciding the number of stocks to be included in the index,

· selecting stocks to be included in the index,

· selecting appropriate weights, and

· selecting the base period and base value.

8.2 Understanding S&P CNX NIFTY

S&P CNX Nifty (Nifty), the most popular and widely used indicator of the stock

market in the country, is a 50-stock index comprising the largest and the most liquid

stocks from about 25 sectors in India. These stocks have a MC of over 50% of the

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total MC of the Indian stock market. The index was introduced in 1995 by the

National Stock Exchange (NSE) keeping in mind it would be used for modern

applications such as index funds and index derivatives besides reflecting the stock

market behaviour. NSE maintained it till July 1998, after which the ownership and

management rights were transferred to India Index Services & Products Ltd. (IISL),

the only professional company in India which provides index services.

Choice of index set size:

While trying to construct Nifty, a number of calculations were done to arrive at the

ideal number of stocks. A simple index construction algorithm was implemented

which did not pre-specify the size of the index set, but added and deleted stocks based

on criteria of MC and liquidity. Ten index time-series (from 1990 to 1995) were

generated by using various thresholds for addition and deletion of stocks from/into the

index set. These index sets turned out to range from 69 to 182 stocks as of end-1995

indicating that the ideal number of stocks for the index could be somewhere in the

range 69 to 182. For each of these ten index time -series, the correlation between the

index time-series and thousands of randomly chosen portfolios was calculated. This

gave a quantitative sense of how increasing the index set size helps improve the extent

to which the index reflects the behavior of the market. It was observed that the gain

from increasing the number of stocks from 69 to 182 was quite insignificant. It was

corroborated by the theory on portfolio diversification, which suggests that

diversifying from 10 to 20 stocks results in considerable reductions in ris k, while the

gains from further diversification are smaller. An analysis of liquidity further

suggested that the Indian market had comfortable liquidity of around 50 stocks.

Beyond 50, the liquidity levels became increasingly lower. Hence the index set size of

50 stocks was chosen.

Selection of stocks:

From early 1996 onwards, the eligibility criteria for inclusion of stocks in S&P CNX

Nifty are based on the criteria of Market Capitalization (MC), liquidity and floating

stock. Market capitalization: Stocks eligible for inclusion in Nifty must have a six

monthly average market capitalization of Rs.500 crore or more during the last six

months. Liquidity (Impact cost): Liquidity can be measured in two ways:

Traditionally liquidity is measured by volume and number of trades. The new

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international practice of measuring liquidity is in terms of impact cost. An ideal stock

can be traded at its ruling market price. However practically, when one tries to buy a

stock, one pays a price higher than the ruling price for purchase, or receives a price

lower than the ruling price from sale, due to sufficient quantity not being available at

the ruling price. This difference from the ruling price in percentage terms is the

impact cost. It is defined as the percentage degradation suffered in the price for

purchase or sale of a specified quantity of shares, when compared to the ideal price. It

can be computed for each individual stock based on order book snapshots. It can also

be computed for a market index based on the impact cost of constituent stocks, using

their respective index weights. The impact cost of a market index is effectively the

cost incurred when simultaneously placing market orders for all constituents of the

index, in the proportion of their weights in the index. A highly liquid market index is

one where the impact cost of buying or selling the entire index is low. It is the

percentage mark up suffered while buying / selling the desired quantity of a stock

compared to its ideal price, that is, (best buy + best sell)/2.

Let us assume the order book for a stock looks as follows:

Impact cost for sell can also be worked out. The impact cost criterion requires that the

stocks traded for 85% of the trading days at an impact cost of less than 0.75% can be

included in the index. Floating Stock: Companies eligible for inclusion in S&P CNX

Nifty should have at least 12% floating stock. For this purpose, floating stock shall

mean stocks which are not held by the promoters and associated entities (where

identifiable) of such companies.

Base date and value:

The base date selected for S&P CNX Nifty index is the close of prices on November

3, 1995, which marks the completion of one year of operations of NSE’s Capital

Market segment. The base value of the index has been set at 1000. S&P CNX Nifty

has a historical time series dating back to January 1990. It is worth explaining the

manner of calculation of the series. On 1st July 1990, BSE (the Stock Exchange,

Bombay) data for the preceding six months was analyzed to shortlist a set of stocks

which had adequate liquidity. The top fifty companies were included in the index set,

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and the index time series was calculated for three months from 1st July 1990 to 30th

September 1990. The index set was re-calculated afresh at this point (i.e. by dropping

some low liquidity or low MC stocks, and adding better alternatives), and this new

index set was used for the next three months, and so on. This methodology avoided

selection bias associated with the simple back-calculation, which generates higher

returns in the back-calculated series than is really the case. This happens because the

index set chosen today is likely to contain stocks, which have fared well in the recent

past. Conversely, stocks that fared badly in the past are likely to have lower MC and

hence not get included in today’s index set. The historical time -series of Nifty truly

reflects the behavior of an index populated with the biggest 50 stocks, which have

required levels of liquidity through out.

Index maintenance

An index is required to be maintained professionally to ensure that it continues to

remain a consistent benchmark of the equity markets. This involves transparent

policies for inclusion and exclusion of stocks in the index and for day-to-day tracking

and giving effect to corporate actions on individual stocks. At IISL, an Index Policy

Committee comprising of eminent professionals from mutual funds, broking houses,

financial institutions, academicians etc. formulates policy and guidelines for

management of the Indices. An Index Maintenance Sub Committee, comprising of

representatives from NSE, CRISIL, S&P and IISL takes all decisions on addition/

deletion of stocks in any Index and the day to day index maintenance.

On-line computation and dissemination:

The index is calculated afresh every time a trade takes place in an index stock. Hence,

we often see days where there are more than 5,00,000 observations for Nifty. The

index data base provides data relating to Open, High, Low, and Close values of index

every day, the number of shares traded for each of the index stocks, the sum of value

of the stocks traded of each of the index stocks, the sum of the MC of all the stocks in

the index etc. Nifty is calculated on-line and disseminated over trading terminals

across the country. This is also disseminated on real-time basis to information vendors

such as Bloomberg, Reuters etc.

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8.3 India Index Services & Products Ltd. (IISL)

IISL is jointly promoted by NSE, the leading stock exchange and The Credit Rating

and Information Services of India Ltd. (CRISIL), the leading credit rating agency in

India. IISL has a consulting and license agreement with Standard & Poor’s (S&P), the

leading index services provider in the world. S&P CNX Nifty, the most popular and

widely used indicator of the stock in India, is the owned and managed by IISL, which

also maintains over 80 indices comprising broad based benchmark indices, sectoral

indices and customized indices. The prominent indices provided by IISL include:

Name of t he Index Description

S&P CNX Nifty 50-stock large M Cap Index

S&P CNX 500 A broad based 500 stock Index

S&P CNX Defty US $ denominated Index of S&P CNX Nifty

S&P CNX Industry indices The S&P CNX 500 in classified in 72 industry sectors.

Each such sector forms an Index by itself.

Name of the Index Description

CNX Nifty Junior 50-stock Index which comprise the next rung of large and liquid

stocks after S&P CNX Nifty

CNX PSE Index Public Sector Enterprises Index

CNX MNC Index Multinational Companies Index

CNX IT Index Information Technology Index

CNX FMCG Index Fast Moving Consumer Goods Index

CNX Midcap Midcap Index

Traditionally, indices have been used as benchmarks to monitor markets and judge

performance. Modern indices were first proposed by two 19th century

mathematicians: Etienne Laspeyres and Hermann Paasche. The grandfather of all

equity indices is the Dow Jones Industrial Average which was first published in 1896;

since then indices have come a long way - not only in their sophistication - but also in

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the variety. There are three main types of indices, namely price index, quantity index

and value index. The price index is most widely used. It measures changes in the

levels of prices of products in the financial, commodities or any other markets from

one period to another. The indices in financial markets measure changes in prices of

securities like equities, debentures, government securities, etc. The most popular

index in financial market is the stock (equity) index which uses a set of stocks that are

representative of the whole market, or a specified sector, to measure the change in

overall behavior of the markets or sector over a period of time.

A stock index is important for its use:

1. as the lead indicator of the performance of the overall economy or a sector of the

economy: A good index tells us how much richer or poorer investors have become.

2. as a barometer for market behavior: It is used to monitor and measure market

movements, whether in real time, daily, or over decades, helping us to understand

economic conditions and prospects.

3. as a benchmark for portfolio performance: A managed fund can communicate its

objectives and target universe by stating which index or indices serve as the standard

against which its performance should be judged.

4. as an underlying for derivatives like index futures and option. It also underpins

products such as, exchange-traded funds, index funds etc. These index-related

products form a several trillion dollar business and are used widely in investment,

hedging and risk management.

5. as it supports research (for example, as benchmarks for evaluating trading rules,

technical analysis systems and analysts' forecasts); risk measurement and

management; and asset allocation. In addition to the above functional use, a stock

index reflects changing expectations of the market about future of the corporate

sector. The index rises if the market expects the future to be better than previously

expected and drops if the expectation about future becomes pessimistic. Price of a

stock moves for two reasons, namely, company specific development (product launch,

closure of a factory, arrest of chief executive) and development affecting the general

environment (nuclear bombs, election result, budget announcement), which affects the

stock market as a whole. The stock index captures the second part, that is, impact of

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environmental change on the stock market as a whole. This is achieved by averaging

which cancels out changes in prices of individual stocks.

8.1 Understanding the index number

An index is a summary measure that indicates changes in value(s) of a variable or a

set of variables over a time or space. It is usually computed by finding the ratio of

current values(s) to a reference (base) value(s) and multiplying the resulting number

by 100 or 1000. For instance, a stock market index is a number that indicates the

relative level of prices or value of securities in a market on a particular day compared

with a base-day price or value figure, which are usually 100 or 1000.

Illustration: The values of a market portfolio at the close of trading on Day 1 and Day

2 are:

Value of portfolio Index value

DAY1 (base day)

Rs. 20,000 /1000

Day 2 Rs. 30,000 /1500

Assume that Day 1 is the base day and the value assigned to the base day index is

1000. On Day 2 the value of the portfolio has changed from Rs. 20,000 to Rs. 30,000,

a 50% increase. The value of the index on Day 2 should reflect a corresponding 50%

increase in market value.

Thus,

Index on Day2 = Index Value of Base Day*Portfolio Value of Base Day/Portfolio

Value of Day = 1000* 20,000/30,000 Rs = 1500Rs

Day 2's index is 1500 as compared to the 1000 of day 1. The above illustration only

serves as an introduction to how an index is constructed. The daily computation of a

stock index involves more complexity especially when there are changes in market

capitalization of constituent stocks, e.g., rights offers, stock dividend etc.

MAJOR STOCK EXCHANGE IN INDIA (NSE & BSE)

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NSE (NATIONAL STOCK EXCHANGE OF INDIA)

Type Stock Exchange

Location Mumbai, India

Coordinates19°3′37″N 72°51′35″E / 19.06028°N

72.85972°E / 19.06028; 72.85972

Founded 1992

OwnerNational Stock Exchange of India

Limited

Key people Mr.Ravi Narain - MD

Currency INR

No. of listings 1810

Market Cap Rs 47,01,923 crore (2009 August)

Indexes

S&PCNXNifty

CNXNiftyJunior

S&P CNX 500

Website www.nse-india.com

The National Stock Exchange (NSE) is a stock exchange located at Mumbai, India. It

is the largest stock exchange in India in terms of daily turnover and number of trades,

for both equities and derivative trading. NSE has a market capitalization of around Rs

47,01,923 crore (7 August 2009) and is expected to become the biggest stock

exchange in India in terms of market capitalization by 2009 end. Though a number of

other exchanges exist, NSE and the Bombay Stock Exchange are the two most

significant stock exchanges in India, and between them are responsible for the vast

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majority of share transactions. The NSE's key index is the S&P CNX Nifty, known as

the Nifty, an index of fifty major stocks weighted by market capitalization.

NSE is mutually-owned by a set of leading financial institutions, banks, insurance

companies and other financial intermediaries in India but its ownership and

management operate as separate entities. There are at least 2 foreign investors NYSE

Euronext and Goldman Sachs who have taken a stake in the NSE. As of 2006[update],

the NSE VSAT terminals, 2799 in total, cover more than 1500 cities across India. In

October 2007, the equity market capitalization of the companies listed on the NSE

was US$ 1.46 trillion, making it the second largest stock exchange in South Asia.

NSE is the third largest Stock Exchange in the world in terms of the number of trades

in equities.[6]It is the second fastest growing stock exchange in the world with a

recorded growth of 16.6%. Origin NSE building at BKC, Mumbai The National Stock

Exchange of India was promoted by leading Financial institutions at the behest of the

Government of India, and was incorporated in November 1992 as a tax-paying

company. In April 1993, it was recognized as a stock exchange under the Securities

Contracts (Regulation) Act, 1956. NSE commenced operations in the Wholesale Debt

Market (WDM) segment in June 1994. The Capital market (Equities) segment of the

NSE commenced operations in November 1994, while operations in the Derivatives

segment commenced in June 2000. Innovations NSE has remained in the forefront of

modernization of India's capital and financial markets, and its pioneering efforts

include: Being the first national, anonymous, electronic limit order book (LOB)

exchange to trade securities in India. Since the success of the NSE, existent market

and new market structures have followed the "NSE" model. Setting up the first

clearing corporation "National Securities Clearing Corporation Ltd." in India. NSCCL

was a landmark in providing innovation on all spot equity market (and later,

derivatives market) trades in India. Co-promoting and setting up of National

Securities Depository Limited, first depository in India. Setting up of S&P CNX

Nifty. NSE pioneered commencement of Internet Trading in February 2000, which

led to the wide popularization of the NSE in the broker community. Being the first

exchange that, in 1996, proposed exchange traded derivatives, particularly on an

equity index, in India. After four years of policy and regulatory debate and

formulation, the NSE was permitted to start trading equity derivatives being the first

and the only exchange to trade GOLD ETFs (exchange traded funds) in India. NSE

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has also launched the NSE-CNBC-TV18 media centre in association with CNBC-

TV18. NSE.IT Limited, setup in 1999, is a 100% subsidiary of the National Stock

Exchange of India. A Vertical Specialist Enterprise, NSE.IT offers end-to-end

Information Technology (IT) products, solutions and services. Markets Currently,

NSE has the following major segments of the capital market:

Equity

Futures and Options

Retail Debt Market

Wholesale Debt Market

Currency futures

MUTUAL FUND

STOCKS LENDING & BROWING

August 2008 Currency derivatives were introduced in India with the launch of

Currency Futures in USD INR by NSE. Currently it has also launched currency

futures in EURO, POUND & YEN. Interest Rate Futures was introduced for the first

time in India by NSE on 31st August 2009, exactly after one year of the launch of

Currency Futures.

NSE became the first stock exchange to get approval for Interest rate futures as

recommended by SEBI-RBI committee, on 31 August,2009, a futures contract based

on 7% 10 Year GOI bond (NOTIONAL) was launched with quarterly maturities.

Hours

NSE's normal trading sessions are conducted from 9:00 am India Time to 3:30 pm

India Time on all days of the week except Saturdays, Sundays and Official Holidays

declared by the Exchange (or by the Government of India) in advance.[8] The

exchange, in association with BSE (Bombay Stock Exchange Ltd.), is thinking of

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revising its timings from 9.00 am India Time to 5.00 pm India Time. There were

System Testing going on and opinions, suggestions or feedback on the New Proposed

Timings are being invited from the brokers across India. And finally on Nov 18, 2009

regulator decided to drop their ambitious goal of longest Asia Trading Hours due to

strong opposition from its members. On Dec 16, 2009, NSE announced that it would

pre-pone the market opening at 9am from Dec 18, 2009. So NSE trading hours will be

from 9:00 am till 3:30 pm India Time. However, on Dec 17, 2009, after strong

protests from brokers, the Exchange decided to postpone the change in trading hours

till Jan 04, 2010.

NSE new market timing from Jan 04, 2010 is 9:00 am till 3:30 pm India Time.

NSE Mile Stones

November 1992 Incorporation

April 1993 Recognition as a stock exchange

May 1993 Formulation of business plan?

June 1994 Wholesale Debt Market segment goes live

November 1994 Capital Market (Equities) segment goes live

March 1995 Establishment of Investor Grievance Cell

April 1995 Establishment of NSCCL, the first Clearing Corporation

June 1995 Introduction of centralized insurance covers for all trading members

July 1995 Establishment of Investor Protection Fund

October 1995 became largest stock exchange in the country

April 1996 Commencement of clearing and settlement by NSCCL

April 1996 Launch of S&P CNX Nifty

June 1996 Establishment of Settlement Guarantee Fund

November 1996 setting up of National Securities Depository Limited, first depository

in India, co-promoted by NSE

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November 1996 Best IT Usage award by Computer Society of India

December 1996 Commencement of trading/settlement in dematerialized securities

December 1996 Dataquest award for Top IT User

December 1996 Launch of CNX Nifty Junior

February 1997 Regional clearing facility goes live

November 1997 Best IT Usage award by Computer Society of India

May 1998 Promotion of joint venture, India Index Services & Products Limited

(IISL)

May 1998 Launch of NSE's Web-site: www.nse.co.in

July 1998 Launch of NSE's Certification Program in Financial Market

August 1998 CYBER CORPORATE OF THE YEAR 1998 award

February 1999 Launch of Automated Lending and Borrowing Mechanism

April 1999 CHIP Web Award by CHIP magazine

October 1999 setting up of NSE.IT

January 2000 Launch of NSE Research Initiative

February 2000 Commencement of Internet Trading

June 2000 Commencement of Derivatives Trading (Index Futures)

September 2000 Launch of 'Zero Coupon Yield Curve'

November 2000 Launch of Broker Plaza by Dotex International, a joint venture

between NSE.IT Ltd. and i-flex Solutions Ltd.

December 2000 Commencement of WAP trading

June 2001 Commencement of trading in Index Options

July 2001 Commencement of trading in Options on Individual Securities

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November 2001 Commencement of trading in Futures on Individual Securities

December 2001 Launch of NSE VaR for Government Securities

January 2002 Launch of Exchange Traded Funds (ETFs)

May 2002 NSE wins the Wharton-Infosys Business Transformation Award in the

Organization-wide Transformation category

October 2002 Launch of NSE Government Securities Index

Diffusion Indexes As the name implies, diffusion indexes indicate how pervasive a

given movement is in a series. Diffusion index values are measured by computing the

percentage of reporting units in a series that indicate a given result. For example, if

100 companies constitute the sample reporting new orders for equipment, the

diffusion index for this series would indicate what proportion of the 100 companies

was reporting higher orders during an expansion. In addition to knowing that

aggregate new orders are increasing, it is helpful to know whether 55 percent or 95

percent of the companies in the sample are reporting higher orders. This information

on the pervasiveness of the increase in new orders would help you project the future

length and strength of an expansion.

You also would want to know the prevailing trend for a diffusion index. The diffusion

index for a series almost always reaches its peak or trough before the peak or trough

in the corresponding aggregate series. Therefore, you can use the diffusion index for a

series to predict the behavior of the series itself. Assume that you are interested in the

leading series, Manufacturers’ New Orders in 1992 dollars—Consumer Goods. If the

diffusion index for this series drops from 85 percent to 75 percent and then to 70

percent, it indicates a widespread receipt of new orders, but it also indicates a

diminishing breadth to the increase and possibly a forthcoming decline in the series

itself. Besides creating diffusion indexes for individual series, there is also a diffusion

index that shows the percentage of the 10 leading indicators rising or falling during a

given period. This particular diffusion index is widely reported each month as an

indicator of the future state of the economy. Rates of Change Knowing whether a

series is increasing is useful, but more helpful is knowing that a 7 percent increase one

month followed a 10 percent increase the previous month.

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The point is, the series is growing but at a declining rate. Similar to the diffusion

index, the rate of change values for a series reaches peaks or troughs prior to the peak

or trough in the aggregate series. Direction of Change Direction of change tables

show which series rose or fell (indicated by plus or minus signs) during the most

recent period and how long the movement in this direction has persisted. Comparison

with Previous Cycles A set of tables and charts shows the movements of individual

series during the current business cycle and compares these movements to previous

cycles for the same economic series. This comparison reveals whether a given series

is moving slower or faster than during prior cycles. This information can be useful

because, typically, movements in the initial months of an expansion or contraction

indicate their ultimate length and strength.3 The NBER consistently has attempted to

improve the usefulness of the cyclical indicators while acknowledging some

limitations. The most obvious limitation is false signals. Past patterns might suggest

that current indicator values signal a contraction, but then the indicator series turns up

again and nullifies previous signals.

January 2003 Commencement of trading in Retail Debt Market

June 2003 Launch of Interest Rate Futures

August 2003 Launch of Futures & options in CNXIT Index

June 2004 Launch of STP Interoperability

The Equity Risk Premium The attitude toward the estimation of the equity risk

premium has undergone significant changes during the 1990s. The initial empirical

estimate of an equity risk premium was provided by the pioneering work of Ibbotson

and Sinque field in their monograph for the Financial Analysts Research Foundation.

They estimated the risk premium on common stock as the arithmetic mean of the

difference in the annual rate of return from stocks minus the return on Treasury bills.1

Although the original estimate was for 1926–1981, this estimated risk premium has

been updated annually in a yearbook provided by Ibbotson Associates.2 For example,

the equity risk premium as of 2002 for 1926–2001 was 9.1 percent using the

arithmetic mean of the annual values and 7.5 percent using the geometric mean of the

annual values. The geometric mean is appropriate for long-run asset class

comparisons, whereas the arithmetic mean is what you would use to estimate the

premium for a given year (e.g., the expected performance next year). Because our

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application is to the long-term DDM model, the geometric mean value would

probably be more appropriate, which implies using the 7.5 percent risk premium

value.

An additional adjustment is suggested to reflect the belief that the typical investment

horizon is longer than that implied by the T-bill rate. Assuming that most investors

consider the intermediate time frame (5–10 years) a more appropriate investment

horizon, the risk premium should be computed as the stock return less the return on

intermediate government bonds. Given the typical upward-sloping yield curve, it is

not surprising that this measure of the risk premium is about 1 percent less than the T-

bill premium that is, the arithmetic mean of the annual risk premiums relative to

intermediate government bonds was 8.2 percent during 1926–2001, and the geometric

mean of the annual risk premiums was 6.6 percent. In recent years, Ibbotson

Associates has also provided a long-horizon risk premium estimate that employs the

long-term government bond return. The arithmetic average for this series was 7.8

percent and the geometric average was 6.2 percent. Therefore, the long-term historical

risk premium to use should be about 6.5 percent. Several authors have contended that

there are problems with this estimate in a dynamic real world environment. The major

criticism is that it is too long term and assumes that the market risk premium is almost

a constant value.3 Given that we are dealing with an average value that encompasses

almost 76 years, this technique will not reflect any changes over time. There are ways

to adjust for this constant value problem, and there are other estimation approaches

that have been suggested.

August 2004 Launch of NSE’s electronic interface for listed companies

March 2005 ‘India Innovation Award’ by EMPI Business School, New Delhi

June 2005 Launch of Futures & options in BANK Nifty Index

December 2006 'Derivative Exchange of the Year', by Asia Risk magazine

January 2007 Launch of NSE – CNBC TV 18 media centre

March 2007 NSE, CRISIL announce launch of IndiaBondWatch.com

June 2007 NSE launches derivatives on Nifty Junior & CNX 100

October 2007 NSE launches derivatives on Nifty Midcap 50

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January 2008 Introduction of Mini Nifty derivative contracts on 1st January 2008

An alternative estimate of the equity risk premium is suggested by Reichenstein and

Rich namely, the Value Line forecast of dividends and capital gain.5 This estimated

total market return less the short-term government bond yield is shown to provide

better and more consistent results than an earnings price value or dividend yield,

although it provides consistently biased results that can be adjusted.

A comparison used by Wool ridge to justify a change in the equity risk premium is the

relative volatility of stocks versus bonds.6 Wool ridge argues that the risk premium

for equity has declined from the 6 percent estimate based on the Ibbotson-Sinque field

data to about 2.5 percent because of the increase in bond market volatility relative to

stock volatility.7 Specifically, the equity risk premium spread has declined, not

because stocks have become less volatile but because bonds have become more

volatile. Thus, the difference in risk between the two asset classes is less than before,

so the risk premium spread has declined. Finally, a recent study by Claus and Thomas

derives an estimate of the equity risk premium from the discount rate that equates

market valuations with prevailing expectations of future flows.8 Their results indicate

a risk premium between 1985 and 1998 of 3 percent or less. In summary, if you use

the current intermediate government bond rate as your estimate of the minimal NRFR,

these studies indicate that the equity risk premium should be somewhere between 2.5

percent and 6.0 percent, depending on the current environment. In turn, you can

derive an indicator of the current environment by examining the dividend yield, the

prevailing credit risk spread, or the relative volatility of bonds versus stocks.

Once you have estimated the required rate of return for the current period, you must

determine whether the expected rate of inflation or the risk premium on common

stock will change during your investment horizon. March 2008 Introduction of long

term option contracts on S&P CNX Nifty Index April 2008 Launch of India VIX

April 2008 Launch of Securities Lending & Borrowing Scheme August 2008 Launch

of Currency Derivatives August 2009 Launch of Interest Rate Futures November

2009 Launch of Mutual Fund Service System December 2009 Commencement of

settlement of corporate bonds February 2010 Launch of Currency Futures on

additional currency pairs Indices

NSE also set up as index services firm known as India Index Services & Products

Limited (IISL) and has launched several stock indices, including

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S&P CNX Nifty (Standard & Poor's CRISIL NSE Index)

CNX Nifty Junior

CNX 100 (= S&P CNX Nifty + CNX Nifty Junior)

S&P CNX 500 (= CNX 100 + 400 major players across 72 industries)

CNX Midcap (introduced on 18 July 2005 replacing CNX Midcap 200)

S&P CNX Nifty (Standard & poor’s CRISIL NSE Index)

The Standard & Poor's CRISIL NSE Index 50 or S&P CNX Nifty nicknamed Nifty 50

or simply Nifty (NSE: ^NSEI), is the leading index for large companies on the

National Stock Exchange of India. The Nifty is a well diversified 50 stock index

accounting for 21 sectors of the economy. It is used for a variety of purposes such as

benchmarking fund portfolios, index based derivatives and index funds. Nifty is

owned and managed by India Index Services and Products Ltd. (IISL), which is a

joint venture between NSE and CRISIL. IISL is India's first specialized company

focused upon the index as a core product. IISL has a marketing and licensing

agreement with Standard & Poor's. The S&P CNX Nifty covers 22 sectors of the

Indian economy and offers investment managers exposure to the Indian market in one

portfolio. The S&P CNX Nifty stocks represent about 60% of the total market

capitalization of the National Stock Exchange (NSE). The base period for the S&P

CNX Nifty index is November 3, 1995, which marked the completion of one year of

operations of NSE's Capital Market Segment. The base value of the index has been set

at 1000, and a base capital of Rs 2.06 trillion. The S&P CNX Nifty Index was

developed by Ajay Shah and Susan Thomas.

S&P CNX 500

The S&P CNX 500 is India’s first broad-based stock market index of the Indian stock

market. The S&P CNX 500 represents about 96% of total market capitalization and

about 93% of the total turnover on the National Stock Exchange of India (NSE). The

S&P CNX 500 companies are disaggregated into 72 industry indices, the S&P CNX

Industry Indices. Industry weights in the index reflect the industry weights in the

market. For e.g. if the banking sector has a 5% weight in the universe of stocks traded

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on the NSE, banking stocks in the index would also have an approximate

representation of 5% in the index.

Exchange Traded Funds on NSE

NSE has a number of exchange. These are typically index funds and GOLD etfs.

Some of the popular etf's on NSE are.

1. NIFTYBEES - ETF based on NIFTY index Nifty BEES Live quote 2. Gold Bees -

ETF based on Gold prices. Tracks the price of Gold. Each unit is equivalent to 1 gm

of gold and bears the price of 1gm of gold. 3. Bank Bees - ETF that tracks the CNX

Bank Index.

Certifications

NSE also conducts online examination and awards certification, under its programmes

of NSE's Certification in Financial Markets (NCFM). Currently, certifications are

available in 19 modules, covering different sectors of financial and capital markets.

Branches of the NSE are located throughout India. With most investments, an

individual or business spends money today with the expectation of earning even more

money in the future. The concept of return provides investors with a convenient way

of expressing the financial performance of an investment. To illustrate, suppose you

buy 10 shares of a stock for $1,000. The stock pays no dividends, but at the end of

one year, you sell the stock for $1,100. What is the return on your $1,000 investment?

One way of expressing an investment return is in dollar terms. The dollar return is

simply the total dollars received from the investment less the amount invested: Dollar

return _ Amount received _ Amount invested $1,100 _ $1,000

If at the end of the year you had sold the stock for only $900, your dollar return would

have been _$100. Although expressing returns in dollars is easy, two problems arise:

(1) to make a meaningful judgment about the return, you need to know the scale (size)

of the investment; a $100 return on a $100 investment is a good return (assuming the

investment is held for one year), but a $100 return on a $10,000 investment would be

a poor return. (2) You also need to know the timing of the return; a $100 return on a

$100 investment is a very good return if it occurs after one year, but the same dollar

return after 20 years would not be very good. The solution to the scale and timing

problems is to express investment results as rates of return, or percentage returns. For

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example, the rate of return on the 1-year stock investment, when $1,100 is received

after one year, is 10 percent: The rate of return calculation “standardizes” the return

by considering the return per unit of investment. In this example, the return of 0.10, or

10 percent, indicates that each dollar invested will earn 0.10($1.00) _ $0.10. If the rate

of 0.10 _ 10%. Rate of return _

Amount received _ Amount invested

Amount invested

INVESTMENT RETURNS

Return had been negative; this would indicate that the original investment was not

even recovered. For example, selling the stock for only $900 results in a 10 percent

rate of return, which means that each dollar invested lost 10 cents. Note also that a

$10 return on a $100 investment produces a 10 percent rate of return, while a $10

return on a $1,000 investment results in a rate of return of only 1 percent. Thus, the

percentage return takes account of the size of the investment. Expressing rates of

return on an annual basis, which is typically done in practice, solves the timing

problem. A $10 return after one year on a $100 investment results in a 10 percent

annual rate of return, while a $10 return after five years yields only a 1.9 percent

annual rate of return. We will discuss all this in detail in Chapter 7, which deals with

the time value of money. Although we illustrated return concepts with one outflow

and one inflow, in later chapters we demonstrate that rate of return concepts can easily

be applied in situations where multiple cash flows occur over time. For example,

when Intel makes an investment in new chip-making technology, the investment is

made over several years and the resulting inflows occur over even more years. For

now, it is sufficient to recognize that the rate of return solves the two major problems

associated with dollar returns, size and timing. Therefore, the rate of return is the most

common measure of investment performance.

BOMBAY STOCK EXCHANGE

Type Stock Exchange

Location Mumbai, India

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Coordinates

18°55′47″N 72°50′01″E /

18.929681°N 72.833589°E /

18.929681; 72.833589

Founded 1875

Owner Bombay Stock Exchange Limited

Key people Madhu Kannan (CEO & MD)

Currency INR

No. of listings 4,900

MarketCap US$1.28 trillion (Feb, 2010)

Volume US$980 billion (2006)

Indexes BSE Sensex

The Bombay Stock Exchange (BSE) (formerly, The Stock Exchange, Mumbai;

popularly called Bombay Stock Exchange, or BSE) is the oldest stock exchange in

Asia and has the third largest number of listed companies in the world, with 4900

listed as of Feb 2010. It is located at Dalal Street, Mumbai, India. On Feb, 2010, the

equity market capitalization of the companies listed on the BSE was US$1.28 trillion,

making it the largest stock exchange in South Asia and the 12th largest in the world.

With over 4900 Indian companies listed & over 7700 scrips on the stock exchange, it

has a significant trading volume. The BSE SENSEX (SENSitive indEX), also called

the "BSE 30", is a widely used market index in India and Asia. Though many other

exchanges exist, BSE and the National Stock Exchange of India account for most of

the trading in shares in India.

Hours of operation

Session Timing

Beginning of the Day Session 8:00 - 9:00

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Trading Session 9:00 - 15:30

Position Transfer Session 15:30 - 15:50

Closing Session 15:50 - 16:05

Option Exercise Session 16:05 - 16:35

Margin Session 16:35 - 16:50

Query Session 16:50 - 17:35

End of Day Session 17:30

The hours of operation for the BSE quoted above are stated in terms of the local time

(i.e. GMT +5:30) in Mumbai (Bombay), India. BSE's normal trading sessions are on

all days of the week except Saturdays, Sundays and holidays declared by the

Exchange in advance.

History

The Bombay Stock Exchange is known as the oldest exchange in Asia. It traces its

history to the 1850s, when 4 Gujarati and 1 Parsi stockbroker would gather under

banyan trees in front of Mumbai's Town Hall. The location of these meetings changed

many times, as the number of brokers constantly increased. The group eventually

moved to Dalal Street in 1874 and in 1875 became an official organization known as

'The Native Share & Stock Brokers Association'. In 1956, the BSE became the first

stock exchange to be recognized by the Indian Government under the Securities

Contracts Regulation Act. The Bombay Stock Exchange developed the BSE Sensex in

1986, giving the BSE a means to measure overall performance of the exchange. In

2000 the BSE used this index to open its derivatives market, trading Sensex futures

contracts. The development of Sensex options along with equity derivatives followed

in 2001 and 2002, expanding the BSE's trading platform. Historically an open outcry

floor trading exchange, the Bombay Stock Exchange switched to an electronic trading

system in 1995. It took the exchange only fifty days to make this transition. This

automated, screen-based trading platform called BSE On-line trading (BOLT)

currently has a capacity of 80 lakh orders per day. The BSE has also introduced the

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world's first centralized exchange-based internet trading system, BSEWEBx.co.in to

enable investors anywhere in the world to trade on the BSE platform.

Timeline

Following is the timeline on the rise and rise of the Sensex through Indian stock

market history. 1830's Business on corporate stocks and shares in Bank and Cotton

presses started in Bombay. 1860-1865 Cotton price bubble as a result of the American

Civil War 1870 - 90's Sharp increase in share prices of jute industries followed by a

boom in tea stocks and coal 1978-79 Base year of Sensex, defined to be 100. 1986

Sensex first compiled using a market Capitalization-Weighted methodology for 30

component stocks representing well-established companies across key sectors. 30

October 2006 The Sensex on October 30, 2006 crossed the magical figure of 13,000

and closed at 13,024.26 points, up 117.45 points or 0.9%. It took 135 days for the

Sensex to move from 12,000 to 13,000 and 123 days to move from 12,500 to 13,000.

5 December 2006 The Sensex on December 5, 2006 crossed the 14,000-mark to touch

14,028 points. It took 36 days for the Sensex to move from 13,000 to the 14,000

mark. 6 July 2007 The Sensex on July 6, 2007 crossed the magical figure of 15,000 to

touch 15,005 points in afternoon trade. It took seven months for the Sensex to move

from 14,000 to 15,000 points. 19 September 2007 The Sensex scaled yet another

milestone during early morning trade on September 19, 2007. Within minutes after

trading began, the Sensex crossed 16,000, rising by 450 points from the previous

close. The 30-share Bombay Stock Exchange's sensitive index took 53 days to reach

16,000 from 15,000. Nifty also touched a new high at 4659, up 113 points. The

Sensex finally ended with a gain of 654 points at 16,323. The NSE Nifty gained 186

points to close at 4,732. 26 September 2007 The Sensex scaled yet another height

during early morning trade on September 26, 2007. Within minutes after trading

began, the Sensex crossed the 17,000-mark . Some profit taking towards the end, saw

the index slip into red to 16,887 - down 187 points from the day's high. The Sensex

ended with a gain of 22 points at 16,921.9 October 2007 The BSE Sensex crossed the

18,000-mark on October 9, 2007. It took just 8 days to cross 18,000 points from the

17,000 mark. The index zoomed to a new all-time intra-day high of 18,327. It finally

gained 789 points to close at an all-time high of 18,280. The market set several new

records including the biggest single day gain of 789 points at close, as well as the

largest intra-day gains of 993 points in absolute term backed by frenzied buying after

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the news of the UPA and Left meeting on October 22 put an end to the worries of an

impending election. Rate of Inflation The precise effect of inflation on the aggregate

profit margin is unresolved. Finkel and Tuttle hypothesized a positive relationship

between inflation and the profit margin for several reasons. First, it was contended

that a higher level of inflation increases the ability of firms to pass higher costs on to

the consumer and thereby raise their profit margin. Second, assuming the classic

demand-pull inflation, the increase in prices would indicate an increase in general

economic activity, which typically is accompanied by higher margins. Finally, an

increase in the rate of inflation might stimulate consumption as individuals attempt to

shift their holdings from financial assets to real assets, which would contribute to an

expansion. In contrast, many observers doubt that most businesses can consistently

increase prices in line with rising costs. Assume a 5 percent rate of inflation that

impacts labor and material costs. The question is whether all firms can completely

pass these cost increases along to their customers. If a firm increases prices at the

same rate as cost increases, the result will be a constant profit margin, not an increase.

Only if a firm can raise prices by more than cost increases can it increase its margin.

Many firms are not able to raise prices in line with increased costs because of the

elasticity of demand for their products.19 such an environment will cause the profit

margin to decline. Given the alternative scenarios, it is contended that most firms will

not be able to increase their profit margins or even hold them constant. Because many

firms will experience lower profit margins during periods of inflation, it is expected

that the aggregate profit margin will probably decline when there is an increase in the

rate of inflation. Given the contrasting expectations, one would need to consider the

empirical evidence to determine the relationship between inflation and the operating

profit margin. Foreign Competition Finkel and Tuttle contend that export markets are

more competitive than domestic markets so export sales are made at a lower margin.

This implies that lower exports by U.S. firms would increase profit margins. In

contrast, Gray believed that only exports between independent firms should be

considered and they should be examined relative to total output exported.20 Further,

he felt that imports could have an important negative impact on the operating profit

margin because they influence the selling price of all competing domestic products.

Therefore, there is a divergence of expectations regarding the ultimate effect of

foreign trade on the operating profit margin, so it is likewise an empirical question.

Analysis of the annual data for the period 1977 to 1997 by the authors confirmed that

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the relationship between the operating profit margin and the capacity utilization rate

was always significant and positive, whereas the relationship between the unit labor

cost and the operating profit margin was always negative and significant.

Alternatively, the rate of inflation and foreign trade variables were never significant in

the multiple regression. Finally, the simple correlation between the profit margin and

inflation was consistently negative 15 October 2007 The Sensex crossed the 19,000-

mark backed by revival of funds-based buying in blue chip stocks in metal, capital

goods and refinery sectors. The index gained the last 1,000 points in just four trading

days. The index touched a fresh all-time intra-day high of 19,096, and finally ended

with a smart gain of 640 points at 19,059.The Nifty gained 242 points to close at

5,670. 29 October 2007 The Sensex crossed the 20,000 mark on the back of

aggressive buying by funds ahead of the US Federal Reserve meeting. The index took

only 10 trading days to gain 1,000 points after the index crossed the 19,000-mark on

October 15. The major drivers of today's rally were index heavyweights Larsen and

Toubro, Reliance Industries, ICICI Bank, HDFC Bank and SBI among others. The

30-share index spurted in the last five minutes of trade to fly-past the crucial level and

scaled a new intra-day peak at 20,024.87 points before ending at its fresh closing high

of 19,977.67, a gain of 734.50 points. The NSE Nifty rose to a record high 5,922.50

points before ending at 5,905.90, showing a hefty gain of 203.60 points. 8 January

2008 The sensex peaks. It crossed the 21,000 mark in intra-day trading after 49

trading sessions. This was backed by high market confidence of increased FII

investment and strong corporate results for the third quarter. However, it later fell

back due to profit booking. 13 June 2008 The sensex closed below 15,200 mark,

Indian market suffer with major downfall from January 21, 2008 25 June 2008 The

sensex touched an intra day low of 13,731 during the early trades, then pulled back

and ended up at 14,220 amidst a negative sentiment generated on the Reserve Bank of

India hiking CRR by 50 bps. FII outflow continued in this week. 2 July 2008 The

sensex hit an intra day low of 12,822.70 on July 2, 2008. This is the lowest that it has

ever been in the past year. Six months ago, on January 10, 2008, the market had hit an

all time high of 21206.70. This is a bad time for the Indian markets, although Reliance

and Infosys continue to lead the way with mostly positive results. Bloomberg lists

them as the top two gainers for the Sensex, closely followed by ICICI Bank and ITC

Ltd. 6 October 2008 The sensex closed at 11801.70 hitting the lowest in the past 2

years. 10 October 2008 The Sensex today closed at 10527,800.51 points down from

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the previous day having seen an intraday fall of as large as 1063 points. Thus, this

week turned out to be the week with largest percentage fall in the SenseX 18 May

2009 after the result of 15th Indian general election Sensex gained 2110.79 points

from the previous close of 12173.42, a record one-day gain. In the opening trade itself

the Sensex evinced a 15% gain over the previous close which led to a two-hour

suspension in trading. After trading resumed, the Sensex surged again, leading to a

full day suspension of trading.

BSE indices

For the premier stock exchange that pioneered the securities transaction business in

India, over a century of experience is a proud achievement. A lot has changed since

1875 when 318 persons by paying a then princely amount of Re. 1, became members

of what today is called Bombay Stock Exchange Limited (BSE). Over the decades,

the stock market in the country has passed through good and bad periods. The journey

in the 20th century has not been an easy one. Till the decade of eighties, there was no

measure or scale that could precisely measure the various ups and downs in the Indian

stock market. BSE, in 1986, came out with a Stock Index-SENSEX- that subsequently

became the barometer of the Indian stock market. The launch of SENSEX in 1986

was later followed up in January 1989 by introduction of BSE National Index (Base:

1983-84 = 100). It comprised 100 stocks listed at five major stock exchanges in India

- Mumbai, Calcutta, Delhi, Ahmedabad and Madras. The BSE National Index was

renamed BSE-100 Index from October 14, 1996 and since then, it is being calculated

taking into consideration only the prices of stocks listed at BSE. BSE launched the

dollar-linked version of BSE-100 index on May 22, 2006. With a view to provide a

better representation of the increasing number of listed companies, larger market

capitalization and the new industry sectors, BSE launched on 27th May, 1994 two

new index series viz., the 'BSE-200' and the 'DOLLEX-200'. Since then, BSE has

come a long way in attuning itself to the varied needs of investors and market

participants. In order to fulfill the need for still broader, segment-specific and sector-

specific indices, BSE has continuously been increasing the range of its indices. BSE-

500 Index and 5 sectoral indices were launched in 1999. In 2001, BSE launched BSE-

PSU Index, DOLLEX-30 and the country's first free-float based index - the BSE

TECk Index. Over the years, BSE shifted all its indices to the free-float methodology

(except BSE-PSU index). BSE disseminates information on the Price-Earnings Ratio,

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the Price to Book Value Ratio and the Dividend Yield Percentage on day-to-day basis

of all its major indices. The values of all BSE indices are updated on real time basis

during market hours and displayed through the BOLT system, BSE website and news

wire agencies. All BSE Indices are reviewed periodically by the BSE Index

Committee. This Committee which comprises eminent independent finance

professionals frames the broad policy guidelines for the development and

maintenance of all BSE indices. The BSE Index Cell carries out the day-to-day

maintenance of all indices and conducts research on development of new indices.

Sensex correlation with emerging market indices Sensex is significantly correlated

with the stock indices of other emerging markets.

Awards

The World Council of Corporate Governance has awarded the Golden Peacock Global

CSR Award for BSE's initiatives in Corporate Social Responsibility (CSR).The

Annual Reports and Accounts of BSE for the year ended March 31, 2006 and March

31 2007 have been awarded the ICAI awards for excellence in financial reporting.The

Human Resource Management at BSE has won the Asia - Pacific HRM awards for its

efforts in employer branding through talent management at work, health management

at work and excellence in HR through technology

BSE Sensex

BSE Sensex or Bombay Stock Exchange Sensitivity Index is a value-weighted index

composed of 30 stocks that started January 1, 1986. The Sensex is regarded as the

pulse of the domestic stock markets in India. It consists of the 30 largest and most

actively traded stocks, representative of

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CHAPTER-9-PORTFOLIO THEORY

Diversification and portfolio risk:

The portfolio manager provides to the client the Disclosure Document at least two

days prior to entering into an agreement with the client. The Disclosure Document ,

inter alia, contains the quantum and manner of payment of fees payable by the client

for each activity for which service is rendered by the portfolio manager directly or

indirectly ( where such service is out sourced), portfolio risks, complete disclosures

in respect of transactions with related parties as per the accounting standards

specified by the Institute of Chartered Accountants of India in this regard, the

performance of the portfolio manager and the audited financial statements of the

portfolio manager for the immediately preceding three years.

Investors would find in the Disclosure Document the name, address and telephone

number of the investor relation officer of the portfolio manager who attends to the

investor queries and complaints. To help out the investors the grievance redressal

and dispute mechanism is also provided by the portfolio manager in the Disclosure

Document. Investors can approach SEBI for redressal of their complaints. On

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receipt of complaints, SEBI takes up the matter with the concerned portfolio

manager and follows up with them. Investors may send their complaints to:

Office of Investor Assistance and Education,

Securities and Exchange Board of India,

The performance of a discretionary portfolio manager is calculated using weighted

average method taking each individual category of investments for the immediately

preceding three years and in such cases performance indicators is also disclosed.

As the growth of the economy chugs forward and consequently generates more

employment and raises the standard of living of the middle class population; the

demand for dynamic and processed food products will witness a manifold rise. The

processed food comes with enhanced food life and value added services to the raw

form of food products. It also provides boost to the farmers as increasingly modern

techniques goes into production of food and other activities involved thereafter. As

per an estimate, Indian food industry is expected to grow to $280 billion by 2015.The

food processing treatment can be spread across various food products like products

with low shelf life such as fruits and vegetables, dairy products & grain processing

and storage among various other fields related to food products.

The upcoming years are likely to witness a fast growth in ready-to-consumer food

products like health drinks, frozen food products for low-shelf life food articles,

readymade Aata (flour), fruit juices, ready-to-cook meals, quicker snack products like

noodles and pastas, etc. with increase in percentage of working couples and busy life

style. The total plan allocation to the food processing industry has gone up sharply

from Rs.650 crore during the 10th Five year plan to Rs.4030 crore during the 11th

Five year plan.

Top stocks of food processing sectors

Company Last Price Change (%)52Week

High

52Week

Low

Market Cap

(Rs.Cr.)

K S Oils Ltd 57.70 -1.28 77.00 47.60 2,288.38

Gokul Refoils and

Solvent Ltd74.35 -0.47 82.70 42.40 980.68

Ruchi Infrastructure Ltd 42.25 0.00 74.95 22.65 866.97

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Sanwaria Agro Oils Ltd 47.45 0.42 98.00 28.55 825.63

Agro Tech Foods Ltd 300.40 0.25 328.25 123.50 732.07

Stock Picks: ITC, Ruchi Soya, LT Foods and REI Agro.

3) Banking & Finance

Banking industry is said to be a mirror of an economy’s health. A Sound banking

system serves as a significant trade enabler to the country. During the recent global

crisis, Indian banking industry came out with flying colors on the back of stringent

stipulations laid down the Central bank.

With the opening up of the sector in early Nineties by the government, the industry

has received a significant boost by the emergence of the private sector banks which

increased competitiveness and enhanced the level of banking facilities to a top notch

level.

Portfolio risk and return:

However, during the recent global recession, even the lagging public sector banks

have made a big come back on the back of large up gradations to suit the hi-tech

services provided by the private sector and foreign banks.

For a sustained economic growth for the country, unmatched banking and financial

services is a must in order to facilitate the increasing need of swift and hassle-free

transactions. Banking sector is an enabler to the economic growth. various sectors, on

the Bombay Stock Exchange. These companies account for around fifty per cent of

the market capitalization of the BSE. The base value of the sensex is 100 on April 1,

1979, and the base year of BSE-SENSEX is 1978-79.

At a regular interval, the Bombay Stock Exchange (BSE) authorities review and

modify its composition to be sure it reflects current market conditions. The index is

calculated based on a free-float capitalization method; a variation of the market cap

method. Instead of using a company's outstanding shares it uses its float, or shares that

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are readily available for trading. The free-float method, therefore, does not include

restricted stocks, such as those held by promoters, government and strategic investors.

Initially, the index was calculated based on the ‘full market capitalization’ method.

However this was shifted to the free float method with effect from September 1, 2003.

Globally, the free float market capitalization is regarded as the industry best practice.

As per free float capitalization methodology, the level of index at any point of time

reflects the free float market value of 30 component stocks relative to a base period.

The Market Capitalization of a company is determined by multiplying the price of its

stock by the number of shares issued by the company. This Market capitalization is

multiplied by a free float factor to determine the free float market capitalization. Free

float factor is also referred as adjustment factor. Free float factor represent the

percentage of shares that are readily available for trading. The Calculation of Sensex

involves dividing the free float market capitalization of 30 companies in the index by

a number called Index divisor. The Divisor is the only link to original base period

value of the Sensex. It keeps the index comparable over time and is the adjustment

point for all Index adjustments arising out of corporate actions, replacement of scrips,

etc. The index has increased by over ten times from June 1990 to the present. Using

information from April 1979 onwards, the long-run rate of return on the BSE Sensex

works out to be 18.6% per annum, which translates to roughly 9% per annum after

compensating for inflation.

Riskless borrowing and lending:

1000, July 25, 1990 - On July 25, 1990, the Sensex touched the four-digit figure for

the first time and closed at 1,001 in the wake of a good monsoon and excellent

corporate results.

2000, January 15, 1992 - On January 15, 1992, the Sensex crossed the 2,000-mark

and closed at 2,020 followed by the liberal economic policy initiatives undertaken by

the then finance minister and current Prime Minister Dr Manmohan Singh.

3000, February 29, 1992 - On February 29, 1992, the Sensex surged past the 3000

mark in the wake of the market-friendly Budget announced by Manmohan Singh.

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4000, March 30, 1992 - On March 30, 1992, the Sensex crossed the 4,000-mark and

closed at 4,091 on the expectations of a liberal export-import policy. It was then that

the Harshad Mehta scam hit the markets and Sensex witnessed unabated selling.

5000, October 11, 1999 - On October 8, 1999, the Sensex crossed the 5,000-mark as

the Bharatiya Janata Party-led coalition won the majority in the 13th Lok Sabha

election.

6000, February 11, 2000 - On February 11, 2000, the information technology boom

helped the Sensex to cross the 6,000-mark and hit and all time high of 6,006.

7000, June 21, 2005 - On June 20, 2005, the news of the settlement between the

Ambani brothers boosted investor sentiments and the scrips of RIL, Reliance Energy,

Reliance Capital and IPCL made huge gains. This helped the Sensex crossed 7,000

points for the first time.

8000, September 8, 2005 - On September 8, 2005, the Bombay Stock Exchange's

benchmark 30-share index – the Sensex - crossed the 8000 level following brisk

buying by foreign and domestic funds in early trading.

9000, December 9, 2005 - The Sensex on November 28, 2005 crossed 9000 to touch

9000.32 points during mid-session at the Bombay Stock Exchange on the back of

frantic buying spree by foreign institutional investors and well supported by local

operators as well as retail investors.

10,000, February 7, 2006 - The Sensex on February 6, 2006 touched 10,003 points

during mid-session. The Sensex finally closed above the 10,000-mark on February 7,

2006.

11,000, March 27, 2006 - The Sensex on March 21, 2006 crossed 11,000 and touched

a peak of 11,001 points during mid-session at the Bombay Stock Exchange for the

first time. However, it was on March 27, 2006 that the Sensex first closed at over

11,000 points.

12,000, April 20, 2006 - The Sensex on April 20, 2006 crossed 12,000 and touched a

peak of 12,004 points during mid-session at the Bombay Stock Exchange for the first

time.

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13,000, October 30, 2006 - The Sensex on October 30, 2006 crossed 13,000 for the

first time. It touched a peak of 13,039.36 and finally closed at 13,024.26.

14000, December 5, 2006 - The Sensex on December 5, 2006 crossed 14,000.

15,000, July 6, 2007 - The Sensex on July 6, 2007 crossed 15,000 mark.

16,000, September 19, 2007 - The Sensex on September 19, 2007 crossed the 16,000

mark.

17,000, September 26, 2007 - The Sensex on September 26, 2007 crossed the 17,000

mark for the first time.

18,000, October 9, 2007 - The Sensex on October 9, 2007 crossed the 18,000 mark for

the first time.

19,000, October 15, 2007 - The Sensex on October 15, 2007 crossed the 19,000 mark

for the first time.

20,000, October 29, 2007 - The Sensex on October 29, 2007 crossed the 20,000 mark

for the first time.

21,000, Jan 08, 2008 - The Sensex on January 8, 2008 touched all time peak of 21078

before closing at 20873.

May 2006

On May 22, 2006, the Sensex plunged by 1100 points during intra-day trading,

leading to the suspension of trading for the first time since May 17, 2004. The

volatility of the Sensex had caused investors to lose Rs 6 lakh crore (US$131 billion)

within seven trading sessions. The Finance Minister of India, P. Chidambaram, made

an unscheduled press statement when trading was suspended to assure investors that

nothing was wrong with the fundamentals of the economy, and advised retail

investors to stay invested. When trading resumed after the reassurances of the Reserve

Bank of India and the Securities and Exchange Board of India (SEBI), the Sensex

managed to move up 700 points, still 450 points in the red.

The Sensex eventually recovered from the volatility, and on October 16, 2006, the

Sensex closed at an all-time high of 12,928.18 with an intra-day high of 12,953.76.

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This was a result of increased confidence in the economy and reports that India's

manufacturing sector grew by 11.1% in August 2006.

13,000, October 30, 2006 - The Sensex on October 30, 2006 crossed 13,000 and still

riding high at the Bombay Stock Exchange for the first time. It took 135 days to reach

13,000 from 12,000. And 124 days to reach 13,000 from 12,500. On October 30, 2006

it touched a peak of 13,039.36 & closed at 13,024.26.

14,000, December 5, 2006 - The Sensex on December 5, 2006 crossed 14,000 and

touched a peak of 14028 at 9.58AM(IST) while opening for the day December 5,

2006.

15,000, July 6, 2007- The Sensex on July 6, 2007 crossed another milestone and

reached a magic figure of 15,000. it took almost 7 month and 1 day to touch such a

historic milestone. Coincidentally, Sachin Tendulkar achieved the same mark (15000

runs in international cricket) around the same time. (A refrain at that time was,

"Sachin, make runs, so that the Sensex rises too!")

May 2009

On May 18, 2009, the sensex surged 2110.79 points from the previous closing of

12174.42 this leading to the suspension of trade for the whole day.This event created

history in Dalal Street, by being the first ever time that trade had been suspended for

an increase in value. This rally is primarily due to the victory of the UPA in the 15th

General elections. Trading was open for that day only for 55 seconds. Initially 25

seconds and 30 seconds market reached upper freeze limit twice in that day itself.

Effects of the Subprime crisis in the U.S on Monday July 23, 2007, the Sensex

touched a new hight of 15,733 points. On July 27, 2007 the Sensex witnessed a huge

correction because of selling by Foreign Institutional Investor (FII)s and global cues

to come back to 15,160 points by noon. Following global cues and heavy selling in

the international markets, the BSE Sensex fell by 615 points in a single day on

Wednesday August 1, 2007. 16,000, September 19, 2007- The Sensex (Sensitivity

Index) on September 19, 2007 crossed the 16,000 mark and reached a historic peak of

16322 while closing. The bull hits because of the rate cut of 50 bit/s in the discount

rate by the Fed chief Ben Bernanke on September 26, 2007 crossed the 17,000 mark

for the first time, creating a record for the second fastest 1000 point gain in just 5

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trading sessions. It failed however to sustain the momentum and closed below 17000.

The Sensex closed above 17000 for the first time on the following day. Reliance

group has been the main contributor in this bull run, contributing 256 points. This also

helped Mukesh Ambani's net worth to grow to over $50 billion or Rs.2 trillion. It was

also during this record bull run that the Sensex for the first time zoomed ahead of the

Nikkei of Japan. 18,000, October 9, 2007- The Sensex crossed the 18k mark for the

first time on October 9, 2007. The journey from 17k to 18k took just 8 trading

sessions which is the third fastest 1000 point rise in the history of the sensex. The

sensex closed at 18,280 at the end of day. This 788 point gain on October 9 was the

second biggest single day absolute gains. 19,000, October 15, 2007- The Sensex

crossed the 19k mark for the first time on October 15, 2007. It took just 4 days to

reach from 18k to 19k. This is the fastest 1000 points rally ever and also the 640 point

rally was the second highest single day rally in absolute terms. This made it a record

3000 point rally in 17 trading sessions overall. Therefore the US Subprime crisis has a

great effect even on INDIA. Gold cross the psychological barrier. Participatory notes

issue On October 16, 2007, SEBI (Securities & Exchange Board of India) proposed

curbs on participatory notes which accounted for roughly 50% of FII investment in

2007. SEBI was not happy with P-notes because it was not possible to know who

owned the underlying securities, and hedge funds acting through P-notes might

therefore cause volatility in the Indian markets. However the proposals of SEBI were

not clear and this led to a knee-jerk crash when the markets opened on the following

day (October 17, 2007). Within a minute of opening trade, the Sensex crashed by

1744 points or about 9% of its value - the biggest intra-day fall in Indian stock

markets in absolute terms till then. This led to automatic suspension of trade for 1

hour. Finance Minister P. Chidambaram issued clarifications, in the meantime, that

the government was not against FIIs and was not immediately banning PNs. After the

market opened at 10:55 AM, the index staged a comeback and ended the day at

18715.82, down 336.04 from the last day's close. This was, however not the end of the

volatility. The next day (October 18, 2007), the Sensex tumbled by 717.43 points —

3.83 per cent — to 17998.39. The slide continued the next day when the Sensex fell

438.41 points to settle at 17559.98 at the end of the week, after touching the lowest

level of that week at 17226.18 during the day. After detailed clarifications from the

SEBI chief M. Damodaran regarding the new rules, the market made a 879-point gain

on October 23, thus signalling the end of the PN crisis.

215

20,000, October 29, 2007- The Sensex crossed the 20k mark for the first time with a

massive 734.5 point gain but closed below the 20k mark. It took 11 days to reach

from 19k to 20k. The journey of the last 10,000 points was covered in just 869

sessions as against 7,297 sessions taken to touch the 10,000 mark from 1,000 levels.

In 2007 alone, there were six 1,000-point rallies for the Sensex.

21,000, January 8, 2008 Business Standard

January 2008

In the third week of January 2008, the Sensex experienced huge falls along with other

markets around the world. On January 21, 2008, the Sensex saw its highest ever loss

of 1,408 points at the end of the session. The Sensex recovered to close at 17,605.40

after it tumbled to the day's low of 16,963.96, on high volatility as investors panicked

following weak global cues amid fears of a recession in the US. The next day, the

BSE Sensex index went into a free fall. The index hit the lower circuit breaker in

barely a minute after the markets opened at 10 AM. Trading was suspended for an

hour. On reopening at 10.55 AM IST, the market saw its biggest intra-day fall when it

hit a low of 15,332, down 2,273 points. However, after reassurance from the Finance

Minister of India, the market bounced back to close at 16,730 with a loss of 875

points. Over the course of two days, the BSE Sensex in India dropped from 19,013 on

Monday morning to 16,730 by Tuesday evening or a two day fall of 13.9%. 9,975,

October 17, 2008 - Sensex crashes below the psychological 5 figure mark of 10K,

following extremely negative global financial indications in US and other countries.

Exactly one year back in October 2007, Sensex had gone past the 20K mark. 8701.07,

October 24, 2008 lost 10.96% of its value on the intraday trade, the 3rd highest loss

for a one day period in its history.

Major crashes since 2000 May 2006

On May 22, 2006, the Sensex plunged by 1100 points during intra-day trading,

leading to the suspension of trading for the first time since May 17, 2004. The

volatility of the Sensex had caused investors to lose Rs 6 lakh crore ($131 billion)

within seven trading sessions. The Finance Minister of India, P. Chidambaram, made

an unscheduled press statement when trading was suspended to assure investors that

nothing was wrong with the fundamentals of the economy, and advised retail

216

investors to stay invested. When trading resumed after the reassurances of the Reserve

Bank of India and the Securities and Exchange Board of India (SEBI), the Sensex

managed to move up 700 points, still 450 points in the red.The Sensex eventually

recovered from the volatility, and on October 16, 2006, the Sensex closed at an all-

time high of 12,928.18 with an intra-day high of 12,953.76

CHAPTER-10 (PORTFOLIO MANAGEMENT

FRAMEWORK)

Specification of investment objectives:

Step 1: Use the Markowitz portfolio selection model to identify optimal combinations

Estimate expected returns, risk, and each covariance between returns

Step 2: Choose the final portfolio based on your preferences for return relative to risk

Optimal diversification takes into account all available information

Assumptions in portfolio theory

A single investment period (one year)

Liquid position (no transaction costs)

Preferences based only on a portfolio’s expected return and risk

Smallest portfolio risk for a given level of expected return

Largest expected return for a given level of portfolio risk

217

From the set of all possible portfolios

Only locate and analyze the subset known as the efficient set

Lowest risk for given level of return

Assume investors are risk averse

Indifference curves help select from efficient set

Description of preferences for risk and return

Portfolio combinations which are equally desirable

Greater slope implies greater the risk aversion

Selection of assets:

MARKOWITZ PORTFOLIO THEORY

Risk is the uncertainty of future outcomes. An alternative definition might be

the probability of an adverse outcome. Subsequently, in our discussion of

portfolio theory, we will consider several measures of risk that are used when

developing the theory. In the early 1960s, the investment community talked

about risk, but there was no specific measure for the term. To build a portfolio

model, however, investors had to quantify their risk variable. The basic

portfolio model was developed by Harry Markowitz, who derived the expected

rate of return for a portfolio of assets and an expected risk measure.2

Markowitz showed that the variance of the rate of return was a meaningful

measure of portfolio risk under a reasonable set of assumptions, and he

derived the formula for computing the variance of a portfolio. This portfolio

variance formula indicated the importance of diversifying your investments to

reduce the total risk of a portfolio but also showed how to effectively

diversify. The Markowitz model is based on several assumptions regarding

investor behavior: 1. Investors consider each investment alternative as being

represented by a probability distribution of expected returns over some

holding period. 2. Investors maximize one-period expected utility, and their

utility curves demonstrate diminishing marginal utility of wealth.

218

3. Investors estimate the risk of the portfolio on the basis of the variability of

expected returns.

4. Investors base decisions solely on expected return and risk, so their utility

curves are a function of expected return and the expected variance (or standard

deviation) of returns only.

5. For a given risk level, investors prefer higher returns to lower returns.

Similarly, for a given level of expected return, investors prefer less risk to

more risk. Under these assumptions, a single asset or portfolio of assets is

considered to be efficient if no other asset or portfolio of assets offers higher

expected return with the same (or lower) risk, or lower risk with the same (or

higher) expected return. One of the best-known measures of risk is the

variance, or standard deviation of expected

Returns.3 it is a statistical measure of the dispersion of returns around the

expected value whereby a larger variance or standard deviation indicates

greater dispersion. The idea is that the more disperse the expected returns, the

greater the uncertainty of future returns. Another measure of risk is the range

of returns. It is assumed that a larger range of expected returns, from the

lowest to the highest return, means greater uncertainty and risk regarding

future expected returns. Instead of using measures that analyze all deviations

from expectations, some observers believe that when you invest you should be

concerned only with returns below expectations, which means that you only

consider deviations below the mean value. A measure that only considers

deviations below the mean is the semi variance.

The index hit the lower circuit breaker in barely a minute after the markets opened at

10 AM. Trading was suspended for an hour. On reopening at 10.55 AM IST, the

market saw its biggest intra-day fall when it hit a low of 15,332, down 2,273 points.

However, after reassurance from the Finance Minister of India, the market bounced

back to close at 16,730 with a loss of 875 points.

Over the course of two days, the BSE Sensex in India dropped from 19,013 on

Monday morning to 16,730 by Tuesday evening or a two day fall of 13.9%

Companies in the Sensex

Code Name Sector Adj. Weight in

219

Factor Index(%)

500410 ACC Housing Related 0.55 0.77

500103 BHEL Capital Goods 0.35 3.26

532454 Bharti Airtel Telecom 0.35 3

532868 DLF Universal Limited Housing related 0.25 1.02

500300 Grasim Industries Diversified 0.75 1.5

500010 HDFC Finance 0.90 5.21

500180 HDFC Bank Finance 0.85 5.03

500182 Hero Honda Motors Ltd. Transport Equipments 0.50 1.43

500440 Hindalco Industries Ltd.Metal,Metal Products &

Mining0.7 1.75

500696Hindustan Lever

LimitedFMCG 0.50 2.08

532174 ICICI Bank Finance 1.00 7.86

500209 Infosys Information Technology 0.85 10.26

500875 ITC Limited FMCG 0.70 4.99

532532 Jaiprakash Associates Housing Related 0.55 1.25

500510 Larsen & Toubro Capital Goods 0.90 6.85

500520Mahindra & Mahindra

LimitedTransport Equipments 0.75 1.71

532500 Maruti Suzuki Transport Equipments 0.50 1.71

532541 NIIT Technologies Information Technology 0.15 2.03

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532555 NTPC Power 0.15 2.03

500304 NIIT Information Technology 0.15 2.03

500312 ONGC Oil & Gas 0.20 3.87

532712Reliance

CommunicationsTelecom 0.35 0.92

500325 Reliance Industries Oil & Gas 0.50 12.94

500390 Reliance Infrastructure Power 0.65 1.19

500112 State Bank of India Finance 0.45 4.57

500900 Sterlite IndustriesMetal, Metal Products,

and Mining0.45 2.39

524715Sun Pharmaceutical

IndustriesHealthcare 0.40 1.03

532540Tata Consultancy

ServicesInformation Technology 0.25 3.61

500570 Tata Motors Transport Equipments 0.55 1.66

500400 Tata Power Power 0.70 1.63

500470 Tata SteelMetal, Metal Products &

Mining0.70 2.88

507685 Wipro Information Technology 0.20 1.61

DLF replaced Dr. Reddy's Lab on November 19, 2007.

Trading mechanism of National Stock Exchange.

The trading on stock exchanges in India used to take place through open outcry

without use of information technology for immediate matching or recording of trades.

This was time consuming and inefficient. This imposed limits on trading volumes and

221

efficiency. In order to provide efficiency, liquidity and transparency, NSE introduced

a nation-wide on-line fully automated screen based trading system (SBTS) where a

member can punch into the comp uter quantities of securities and the prices at which

he likes to transact and the transaction is executed as soon as it finds a matching sale

or buy order from a counter party. SBTS electronically matches orders on a strict

price/time priority and hence cuts down on time, cost and risk of error, as well as on

fraud resulting in improved operational efficiency. It allows faster incorporation of

price sensitive information into prevailing prices, thus increasing the informational

efficiency of markets. It enables market participants, irrespective of their geographical

locations, to trade with one another simultaneously, improving the depth and liquidity

of the market. It provides full anonymity by accepting orders, big or small, from

members without revealing their identity, thus providing equal access to everybody. It

also provides a perfect audit trail, which helps to resolve disputes by logging in the

trade execution process in entirety. This diverted liquidity from other exchanges and

in the very first year of its operation, NSE became the leading stock exchange in the

country, impacting the fortunes of other exchanges and forcing them to adopt SBTS

also. Today India can boast that almost 100% trading takes place through electronic

order matching.

Technology was used to carry the trading platform from the trading hall of stock

exchanges to the premises of brokers. NSE carried the trading platform further to the

PCs at the residence of investors through the Internet and to handheld devices through

Wireless Application Protocol (WAP) for convenience of mobile investors. This made

a huge difference in terms of equal access to investors in a geographically vast

country like India.

TRANSACTION CYCLE

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Placing Orders

Trade Execution

Clearing of

Trades

Settlement of

Trades

Funds/Securities

DecisionTo

Trade

In brief, the investor willing to buy security i.e. decide to trade in equity, and order the

dealer to place the order of particular share at particular trading price and also

mention the total quantity of shares. When the willing price meets the current market

price, the order will be executed automatically, and clearing of trades are over. At the

end of the trading day, the settlement will take place between broker and investors and

equity shares will be transfer in trading account of the investor and investor fund will

be debited from account.

Clearing and Settlement process in NSE.

After trade, the following process will take place.

(1) Trade details from Exchange to NSCCL (real-time and end of day trade file).

(2) NSCCL notifies the consummated trade details to CMs/custodians who affirm

back. Based on the affirmation, NSCCL applies multilateral netting and determines

obligations.

(3) Download of obligation and pay-in advice of funds/securities.

223

CLEARING AND SETTLEMENT IN NSE

(4) Instructions to clearing banks to make funds available by pay-in time.

(5) Instructions to depositories to make securities available by pay-in time.

(6) Pay-in of securities (NSCCL advises depository to debit pool account of

custodians/CMs and credit its account and depository does it).

Formulation of portfolio strategies:

Where an applicant is a corporate, not less than two directors of the company (in case

of a sole proprietorship, individual and in case of a partnership firm, two partners)

should satisfy the following criteria: They should be at least graduates and each of

them should possess at least two years' experience in an activity related to broker,

sub-broker, authorized agent or authorized clerk or authorized representative or

remisier or apprentice to a member of a recognized stock exchange. Such experience

will include working as a dealer, jobber, market maker, or in any other manner in the

224

NSE

Custodian/CM

Clearing Banks

NSCCL

NSDL/CDSL

dealing in securities or clearing and settlement thereof, as portfolio manager or

merchant bankers or as a researcher with any individual or organization operating in

the securities market.

Shareholding Pattern

Securities markets have the inherent tendency to be volatile and risky. Therefore,

there should be adequate risk containment mechanisms in place for the Stock

Exchanges. One such risk tool is the concept of ‘Dominant Promoter/Shareholder

Group’ which is very unique for applicants acquiring membership on the NSE.

Though membership on NSE is granted to the entity applying for it, but for all

practical purposes the entity is managed by a few shareholders who have controlling

interest in the company. The shareholders holding the majority of shares have a

dominant role in the affairs of the company. In case of any default by the broking

entity, the Exchange should be able to identify and take action against the persons

who are behind the company. The Exchange, therefore, needs to know the

background, financial soundness and integrity of these shareholders holding such

controlling interest. Hence, during the admission process the dominant shareholders

are called for an interview with the Membership Recommendation Committee.

Indian economy is a vicious circle of calculations that decide the financial power of

our country. Some of the main constituents in this economy are price of the share,

stock market, business infrastructure, foreign exchange and import or export business.

Let’s first discuss the share market India that needs a special consideration. This will

include the number of readily available liquid assets that can be traded at once. The

share price is, basically, all about the company’s capability of trading and the

available stock with them. It is something that allows you to hold a certain percentage

of stakes in a particular company. Another thing to note down is the stock market

India. With the help of information on this matter, the investor is able to predict the

loss and profit to be incurred by a company. In fact, the details on the stock market are

highly essential for the people, who invest on regular basis or a novice in this field.

After all, no one invests in a particular company to incur loss. It is all about getting in

to the depth of company profile, their product range and their goodwill in the market.

After all, this information is extremely essential for any aspirant investor. The news

related to these matters also act as an important piece of information for any person

225

interested in financial matters. In fact, stock market news tells the masses about a

company’s market value and its ability to carry out corporate dealings. In the business

world, each and every type of possible information is essential to keep oneself

updated on the latest market trends. Moreover, the need to know everything about the

Indian economy and financial market is an advantage for all of us. No one knows that

what sort of information is useful at what time. We all know that even the minutest

negligence about the information on financial market can be problematic for all of us.

The stock market news is not just about the availability of stock in the company; but,

you can also get to know about the mergers or acquisitions of the companies and their

joint stocks. All these details will enable you to make careful investments in the right

company and reap profits. You can catch hold of this information on television news

channels, financial newspapers, radio channels and financial websites. One can access

any source of information as per his or her ease.

India's Informal Economy and the Global Recession

There are four distinct characteristics of the Indian economy that soften the impact of

today's conditions: demographics, regulation, exports, and the informal economy.

First, India's demographics are favorable to growth. It's a young country with low

dependency ratios. Millions of Indians under the age of 30 are slowly receiving better

access to healthcare and education, which enables younger Indians to drive the

economy by virtue of middle class growth. They will become consumers, spend

discretionary income, and enjoy the associated status. This growing middle class will

continue to create large levels of domestic customer demand for goods and services.

Second, the fall of Satyam may turn out to be a blessing in disguise for India. The

scandal has intensified calls in the country for greater financial transparency,

corporate governance, and shareholder activism. Furthermore, the swift and strong

response by the country's regulatory agencies has provided global investors with a

positive signal that the Indian government, while not perfect, is dead serious about

smart financial regulations and accountability.

Third, the Indian parliament is on the verge of passing a bill that would create

hundreds of special economic zones (SEZs) around the coastal perimeter of the

country. These zones provide the Indian government a vehicle with which to attract

significant foreign direct investment (FDI) from overseas and indigenous

226

multinational corporations (MNCs). The SEZs, while not without controversy, are

attractive to global investors for their favorable land policies and generous tax

incentives. In the global race for FDI, India's SEZs could afford it an unmatched

competitive advantage among other emerging economies.

Finally, and most critically, the country's vibrant informal economy, in which goods

and services have been traded in the absence of official markets for hundreds of years,

affords India's overall economy an invaluable -- and unique -- layer of protection.

While traditional development and financial statistics estimate Indian market

segments for the global business community, these analyses rarely capture the true

weight of this economic activity, which by nature is difficult to approximate. As the

global recession affects its foreign direct investment inflows and exports, India's

informal economy acts as a piece of elastic, connective tissue that picks up slack in

the system and provides markets for goods and services that may not have been

otherwise traded given the circumstances. The existence of this informal economy

combined with an emerging middle class, a growing financial regulatory environment,

and the creation of more SEZs makes India uniquely situated to survive the current

economic storm, no matter if it is a roaring tiger or a slowly moving elephant.

For the past year, Indian stock prices had been pushed up by large inflows from

foreign portfolio investors, who had recently "discovered" India as an attractive

emerging market that has not yet had a financial crisis. This meant that, despite the

fact that very little had changed in the so-called "fundamentals" of the economy, there

were substantial inflows from financial investors that also caused the rupee to

appreciate.

Foreign investors use emerging markets like India to hedge against changes in other

markets; they also like to focus on particular countries in any one period, where herd

behavior creates a boom and the countries concerned become the temporary darlings

of international capital. In India in the recent past, the numerous concessions provided

by the NDA government to such mobile capital also allowed for large super-profits to

be made through such transactions. Because the Indian stock market still has

relatively thin trading, these foreign institutional investors made a big difference at the

margin, and were responsible for pushing up stock values well beyond what would be

"sensible" values according to standard international norms of price-equity ratios.

This is typical of the bubbles that have been created by internationally mobile finance

227

in various developing countries, especially since the early 1990s. It is inevitable that

such bubbles must eventually come to an end, whether through a sharp burst in the

shape of a financial crisis or through a slower and more managed shrinking of values.

When this happens, it is true that a lot of players who have put their bets on

continuously rising share values will be affected, but this need not mean that there has

been any other bad news in the economy. Of course, it is always difficult to attribute

causes to stock market movements, since financial markets are notoriously prone to

"noise" and irrational behaviour. However, more than the actual causes, the

implications of such falls are what matter to most of us, and this is where the

mainstream media have been the most misleading.

It is usually argued that stock market behaviour is a reflection of "investor

confidence" and this in turn affects important real variables such as productive

investment in the economy, which is critical for growth and development. This is not

really the case, and has become even less true in the recent period. Especially since

the early 1990s, the stock market has experienced huge increases and wild swings,

while investment has not shown any such volatility and indeed has barely increased in

real terms.

The other impact that movements in the stock market have nowadays is on the

exchange rate, especially since so much of the change is caused by the behavior of

foreign institutional investors. Their movements over the past year have helped to

build up the RBI's foreign exchange reserves to an almost embarrassing amount,

partly because their inflows are not being used to increase productive investment, and

partly because the RBI kept buying dollars in an effort to keep the rupee from

appreciating even further. While the large forex reserves may have provided a macho

feeling of false confidence to some, in reality they were a reflection of huge

macroeconomic waste, since they implied that the capital inflows were not being

productively used. They were also expensive for the economy to hold, since the

interest received on such reserves by the RBI is typically very low, whereas the

external commercial borrowing by Indian firms in the current liberalized environment

was at significantly higher interest rates. In this background, some dilution of the

forex reserves may even be welcome. Of course, if the current outflow turns into a

capital flight which is also joined by Indian residents, then clearly the situation can

become more serious. Such a possibility is now more open because of all the recent

228

measures liberalizing capital outflow that the NDA government brought in during the

closing months of its rule. The new government may have to address some of these

measures quite quickly, to prevent excessive capital outflows which can then become

another means of pressurizing the government on its economic policies.

But otherwise, the current downslide in the stock markets is really not a matter of

serious concern for most Indians, and it should certainly not be much of an issue for

the new government either. The mainstream English language media, whose business

interests increasingly coincide with those of finance capital, may continue to shout

itself hoarse about it. But then, as the recent electoral cataclysm has shown, these

media also do not reflect the interests of the Indian people, nor do they even

understand them. Forecasting of share markets with explanation of major drivers of

growth New financial year 2010-11 kicks-off much on the back of pompous global

recovery witnessed during the second half of the FY 2009-10. And, equity markets

are no laggards in terms of catching these cues beforehand. However, the markets

have remained largely range bound since June 2009 to May 2010 within the range of

4500 to 5300 on the Nifty index. This range bound movement can be termed as a

broad based consolidation after a scorching pace of market recovery from its

recessionary trough levels. Now, that markets are again back at Nifty 5300 levels, it is

on the verge of a likely breakout. Hence, it would be a prudent idea to have a check as

to which sectors and industries would it be worthwhile for the investors to plough

their hard earned money. Investors would be keen to know which sectors are placed

better to be among winners for the FY 2010-11.

The five best sector based picks for more than doubling the returns in equities.

Evaluation of portfolio revision:

With the rising population and growth story of India, the need of fast paced growth in

power generation is increasingly gaining importance. Energy is one of the major

contributors to the economic development of a country.

The government has targeted electricity for all by 2012 by the end of 11th Five Year

Plan. The demand of electricity is growing exponentially. And, herein lays the

229

opportunities for investors to plough their money in public and private sector

companies both.

At present, coal based thermal power plants accounts for almost two-thirds of the

energy needs of the country. However, the government is increasingly becoming

aware about the benefits of generating power through cleaner nuclear power plants.

More recently, during the Budget 2010 announcement, the government has also laid

emphasis on the development of non-conventional energy resources such as Solar and

Wind Energy. Rural electrification is also a significant initiative by the government to

allow access to electricity in remote regions in India.

Prices of top power scripts

Company Last Price Change (%)52Week

High

52Week

Low

Market Cap

(Rs.Cr.)

Power Grid Corporation

of India Ltd103.45 0.24 121.45 95.00 43,540.45

Reliance Power Ltd 175.15 3.33 181.80 130.00 41,979.95

NHPC Ltd 31.90 -0.62 39.75 27.60 39,239.36

Tata Power Company

Ltd1,306.15 0.02 1,518.55 995.00 30,996.25

Reliance Infrastructure

Ltd1,197.05 -1.14 1,404.45 951.35 29,312.16

Stock Picks: NTPC (Power Generation), Power Grid Corporation (Power

Transmission), Tata Power (Power Generation) and Rural Electrification (Power

Sector NBFC) and BHEL (Power Equipments).

2) Food Processing

As the growth of the economy chugs forward and consequently generates more

employment and raises the standard of living of the middle class population; the

demand for dynamic and processed food products will witness a manifold rise.

230

The processed food comes with enhanced food life and value added services to the

raw form of food products. It also provides boost to the farmers as increasingly

modern techniques goes into production of food and other activities involved

thereafter. As per an estimate, Indian food industry is expected to grow to $280 billion

by 2015.

The upcoming years are likely to witness a fast growth in ready-to-consume food

products like health drinks, frozen food products for low-shelf life food articles,

readymade Aata (flour), fruit juices, ready-to-cook meals, quicker snack products like

noodles and pastas, etc. with increase in percentage of working couples and busy life

style.

The total plan allocation to the food processing industry has gone up sharply from

Rs.650 crore during the 10th Five year plan to Rs.4030 crore during the 11th Five

year plan.

Top stocks of food processing sectors

Company Last Price Change (%)52Week

High

52Week

Low

Market Cap

(Rs.Cr.)

K S Oils Ltd 57.70 -1.28 77.00 47.60 2,288.38

Gokul Refoils and

Solvent Ltd74.35 -0.47 82.70 42.40 980.68

Ruchi Infrastructure Ltd 42.25 0.00 74.95 22.65 866.97

Sanwaria Agro Oils Ltd 47.45 0.42 98.00 28.55 825.63

Agro Tech Foods Ltd 300.40 0.25 328.25 123.50 732.07

3) Banking & Finance

Banking industry is said to be a mirror of an economy’s health. A Sound banking

system serves as a significant trade enabler to the country. During the recent global

crisis, Indian banking industry came out with flying colors on the back of stringent

stipulations laid down the Central bank.

231

With the opening up of the sector in early Nineties by the government, the industry

has received a significant boost by the emergence of the private sector banks which

increased competitiveness and enhanced the level of banking facilities to a top notch

level. However, during the recent global recession, even the lagging public sector

banks have made a big come back on the back of large up gradations to suit the hi-

tech services provided by the private sector and foreign banks.

For a sustained economic growth for the country, unmatched banking and financial

services is a must in order to facilitate the increasing need of swift and hassle-free

transactions. Banking sector is an enabler to the economic growth.

4(e) top stocks of banking and finance sector

Company Last

Price

Change

(%)

52Week

High

52Week

Low

Market

Cap

(Rs.Cr.)

HDFC Bank Ltd 1,913.00 0.31 2,009.90 1,333.00 87,938.7

0

Axis Bank Ltd 1,236.95 0.60 1,318.00 705.15 50,398.2

9

Kotak Mahindra Bank

Ltd

759.20 -1.20 878.00 530.55 26,449.7

7

Yes Bank Ltd 268.65 -0.30 299.50 124.15 9,161.50

IndusInd Bank Ltd 205.40 0.12 211.75 72.75 8,439.06

Source: www.indiainfoline.com.

Stock Picks: HDFC Bank, SBI, ICICI and Bank of Baroda.

4) Infrastructure

The economic development of a country is directly linked with the infrastructural

status of the country. Infrastructure not only acts as a enabler to higher growth but

also generates employment and serves the social needs of the people of the country.

232

If the economy is an emerging one like India which is a laggard on the infrastructural

front, the growth in the infrastructure industry gains all the more importance. High

transaction costs arising from inadequate and inefficient enabling infrastructure can

go a long way in stunting the growth rate of the economy.

The broad term of infrastructure can cover a wide range of infrastructural facilities

from ports and road, rail, transport, aviation, water needs, mining and construction

among other fields of operations. Better infrastructure can lead to faster enabling

services. Top stocks of real estate sectors.

Company Last Price Change (%)52Week

High

52Week

Low

Market Cap

(Rs.Cr.)

DLF Ltd 282.30 -0.53 490.80 251.50 47,917.60

Jaiprakash Associates

Ltd127.45 -0.39 180.00 109.70 27,078.03

Unitech Ltd 72.65 -0.27 118.35 61.30 18,292.18

Jaypee Infratech Ltd 89.15 -1.11 98.50 76.20 12,382.31

D B Realty Ltd 379.75 0.80 540.10 368.50 9,237.80

Stock Picks: L&T, Patel Engineering, GMR Infra, Reliance Infra, IVRCL

Infrastructure, Hindustan Construction (HCC) and Thermax.

5) Oil & Gas

One sector that has disappointed until now is Oil and Gas sector. The prospects of the

sector have witnessed a lagging demand as the global economy is still to witness a

complete recovery. The recent crisis has stolen a huge chunk of the demand of oil and

gas which is needed to stoke the growth engines of every major economy.

Most of the large companies were building new capacities before the breakout of the

recession. This new capacities led to excess supply and falling demand at a time when

the demand was hit on account of slowdown and crisis. This led to plunge in the

operating margins of the refiners who were stuck with excess supplies of crude

products.

233

However, with the recent advent of a recovery on the horizon, there is a gradual pick-

up in the global demand for oil and gas, as economies are back to pump money for

higher capacity utilization of their resources in order to meet increasing demand of

goods and products. Demand for petro products is expected to improve over next one

year.

Before presenting portfolio theory, we need to clarify some general assumptions of

the theory. This includes not only what we mean by an optimum portfolio but also

what we mean by the terms risk aversion and risk. One basic assumption of portfolio

theory is that as an investor you want to maximize the returns from your investments

for a given level of risk. To adequately deal with such an assumption, certain ground

rules must be laid. First, your portfolio should include all of your assets and liabilities,

not only your stocks or even your marketable securities but also such items as your

car, house, and less-marketable investments, such as coins, stamps, art, antiques, and

furniture. The full spectrum of investments must be considered because the returns

from all these investments interact, and this relationship between the returns for assets

in the portfolio is important. Hence, a good portfolio is not simply a collection of

individually good investments. Portfolio theory also assumes that investors are

basically risk avers, meaning that, given a choice between two assets with equal rates

of return, they will select the asset with the lower level of risk. Evidence that most

investors are risk averse is that they purchase various types of insurance, including

life insurance, car insurance, and health insurance. Buying insurance basically

involves an outlay of a given amount to guard against an uncertain, possibly larger

outlay in the future. When you buy insurance, this implies that you are willing to pay

the current known cost of the insurance policy to avoid the uncertainty of a potentially

large future cost related to a car accident or a major illness. Further evidence of risk

aversion is the difference in promised yield (the required rate of return) for different

grades of bonds that supposedly have different degrees of credit risk. Specifically, the

promised yield on bonds increases as you go from AAA (the lowest-risk class) to AA

to A, and so on—that is, investors require a higher rate of return to accept higher risk.

This does not imply that everybody is risk averse or that investors are completely risk

averse regarding all financial commitments. The fact is, not everybody buys insurance

for everything. Some people have no insurance against anything, either by choice or

because they cannot afford it. In addition, some individuals buy insurance related to

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some risks such as auto accidents or illness, but they also buy lottery tickets and

gamble at race tracks or in casinos, where it is known that the expected returns are

negative, which means that participants are willing to pay for the excitement of the

risk involved. This combination of risk preference and risk aversion can be explained

by an attitude toward risk that depends on the amount of money involved. Friedman

and Savage speculate that this is the case for people who like to gamble for small

amounts (in lotteries or slot machines) but buy insurance to protect themselves against

large potential losses, such as fire or accidents.1 While recognizing this diversity of

attitudes, our basic assumption is that most investors committing large sums of money

to developing an investment portfolio are risk averse. Therefore, we expect a positive

relationship between expected return and expected risk. Notably, this is also what we

generally find in terms of long-run historical results—that is, there is generally a

positive relationship between the rates of return on various assets and their measures

of risk as shown in Chapter 3. Although there is a difference in the specific definitions

of risk and uncertainty, for our purposes and in most financial literature the two terms

are used interchangeably. In fact, one way to define portfolio.

CHAPTER-11

(GUIDELINES FOR INVESTMENT DECISION)

Basic guidelines:

In real estate, foreclosure is the termination of the equity of redemption of a

mortgagor or the grantee in the property covered by the mortgage. Foreclosure

investment has become more important recently in response to skyrocketing real

estate costs. The average person nowadays needs to investigate all avenues to

purchase real estate at a 'reasonable' cost. By investigating the foreclosure market, the

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investor can get a better grasp of the real estate investment arena. Depending on the

type of foreclosure proceeding, the sale may be administered by the courts (Judicial

Foreclosure) or by an appointed trustee (Statutory Foreclosure). Proceeds from the

sale are used to satisfy the claims of the mortgagee primarily, with any excess going

to the mortgagor. Anyone may bid on properties sold at a foreclosure sale. As a

practical matter, however, most properties are acquired by the lender, often for the

amount owed on the foreclosed loan.

When interest rates rise, home owners with variable interest rates often become over

extended, providing opportunities for foreclosure investment professionals to obtain

investment properties at depressed prices. The most common reason for foreclosure is

dissolution of a marriage. The next most common reason for is a failed business

venture. Foreclosure investing can provide favorable returns. However, there is an

awful lot to know in order to avoid the problems that can occur; thus, it is not

recommended for beginners to the market.

The foreclosure process begins when a financially distressed homeowner fails to make

a loan payment and is served with a summons from his or her creditors. After service,

papers will be filed with the county clerk's office and be made a matter of public

record (in some areas the place where deeds and mortgages are registered may go by a

different name, such as the office of the land registrar). This notice is usually known

as Lis Pendens, which is Latin for "pending legal action." At this point, any attempts

by the homeowner to borrow from public credit sources will be met with a negative

response. On completion of the publication process, the foreclosure action will be

permitted to proceed and the owners have a limited amount of time to pay up, sell, or

make other deals with creditors. If none of these actions are taken, a forclosure sale

will take place. If no one bids the amount owed, the property reverts to the lender and

becomes a REO (real estate owned) property held in inventory by the lender.

Experienced foreclosure investors may work in all of these various stages, but the

possibility of making a transaction with the homeowner is no longer possible after the

property is a REO.

Why investing in foreclosures can be difficult

Often, the home owner in foreclosure is in a financially difficult situation, and in

addition to the calls from creditors, the home owner may also be inundated with calls

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from other investors, mortgage brokers and real estate agents. It can be difficult to

find a home owner who is willing to work with you, and who is in a situation where

you can help. In addition, rejection can run high as foreclosures are stopped, doors are

slammed, and telephones are hung-up on you.

Steps to take to get started in foreclosure investing

One of the key components of getting started is education, making sure that the

information studied is state specific. Depending on residence, much of the national

content may not apply in a particular state or may be illegal. After understanding the

specific state's foreclosure process the next step is to find a foreclosure data provider

who can supply the latest foreclosures as they start in the state. While foreclosure

information for the most part is public record, working with a foreclosure data

provider can save a lot of time. With a fresh list of foreclosures, the next step is to

contact home owners in foreclosure and begin working with them directly to stop the

foreclosure proceedings.

Alternative

Measures of Risk

2Harry Markowitz, “Portfolio Selection,” Journal of Finance 7, no. 1 (March 1952):

77–91; and Harry Markowitz, Portfolio Selection—Efficient Diversification of

Investments (New York: John Wiley & Sons, 1959). 3We consider the variance and

standard deviation as one measure of risk because the standard deviation is the square

root of the variance. specific asset such as T-bills, the rate of inflation, or a

benchmark. These measures of risk implicitly assume that investors want to minimize

the damage from returns less than some target rate. Assuming that investors would

welcome returns above some target rate, the returns above a target return are not

considered when measuring risk. Although there are numerous potential measures of

risk, we will use the variance or standard deviation of returns because (1) this measure

is somewhat intuitive, (2) it is a correct and widely recognized risk measure, and (3) it

has been used in most of the theoretical asset pricing models. The expected rate of

return for an individual investment is computed as shown in Exhibit 7.1. The expected

return for an individual risky asset with the set of potential returns and an assumption

of equal probabilities used in the example would be 11 percent. The expected rate of

return for a portfolio of investments is simply the weighted average of the expected

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rates of return for the individual investments in the portfolio. The weights are the

proportion of total value for the investment. The expected rate of return for a

hypothetical portfolio with four risky assets is shown in Exhibit 7.2. The expected

return for this portfolio of investments would be 11.5 percent. The effect of adding or

dropping any investment from the portfolio would be easy to determine because you

would use the new weights based on value and the expected returns for each of the

investments. This computation of the expected return for the portfolio can be

generalized.

BROKER-CLIENTS RELATIONS

Know your client

The TM shall enter into an agreement in the specified format provided by NSE shall

be executed on non-judicial stamp paper of adequate value, duly signed by both the

parties on all the pages. Copy of the said agreement is to be kept with the TM

permanently. In addition to the agreement, the TM shall seek information from the

client in the 'Client Registration Application Form' obtaining information like:

investor risk profile, financial profile, investor identification details, address details,

income, PAN number, employment, age, investments, other assets and financial

liabilities. The TM shall obtain recent passport size photographs of each of their

clients in case of individual clients and of all partners in case of partnership firms and

of the dominant promoter in case of corporate clients. The TM shall also take proof of

identification and address of the client. Trading Member shall make the Constituent

aware of trading segment to which Trading Member is admitted, particulars of SEBI

registration number, employee primarily responsible for the Constituents affairs, the

precise nature of the Trading Member’s liability for business to be conducted, basic

risks involved in trading on the Exchange (equity and other instruments) including

any limitations on the liability and the capacity in which the Trading Member acts and

the Constituent’s liability thereon, investors’ rights and obligations, etc. by issuing to

the Constituent a Risk Disclosure Document in such format, as may be prescribed by

the Exchange from time to time and shall obtain the same from his Constituents duly

signed. Execution of client registration form, member constituent agreement and Risk

Disclosure Document is optional in case of institutional clients a stock-broker shall

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not deal knowingly, directly or indirectly, with a client who defaults to another stock-

broker. There is no limit on the number of clients for a TM.

6.3.2 Unique Client Code

SEBI made it mandatory for all brokers to use unique client codes for all clients.

Brokers shall collect and maintain in their back office the Permanent Account

Number (PAN) allotted by Income Tax Department for all their clients. Brokers shall

verify the documents with respect to the unique code and retain a copy of the

document. They shall also be required to furnish the above particulars of their clients

to the stock exchanges/clearing corporations and the same would be updated before

placing orders for the clients. The stock exchanges shall be required to maintain a

database of client details submitted by brokers.

6.3.3 Margins from the Clients

Members should have a prudent system of risk management to protect themselves

from client default. Margins are likely to be an important element of such a system.

The same shall be well documented and be made accessible to the clients and the

Stock Exchanges. However, the quantum of these margins and the form and mode of

collection are left to the discretion of the members. The margin so collected shall be

kept separately in the client bank account and utilized for making payment to the

clearing house for margin and settlement with respect to that client.

6.3.4 Execution of Orders

Where the constituent requires an order to be placed or any of his order to be modified

after the order has entered the system but has not been traded, the Trading Member

may, if it so desires, obtain order placement/modification details in writing from the

constituent. The Trading Member shall accordingly provide the constituent with the

relevant order confirmation/modification slip or copy thereof, forthwith, if so required

by the constituent. Where the constituent requires any of his orders to be cancelled

after the order has been entered in the system but has not been executed, the Trading

Member may, if it so desires, obtain the order cancellation details in writing from the

constituent. The Trading Member shall accordingly provide the constituent with the

relevant order cancellation details, forthwith, if so required by the constituent. The

Trading Member may, if it so desires, obtain in writing, the delivery and payment

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requirement in any instructions of an order that it receives from the constituent.

Where a Trading Member receives a request for order modification or order

cancellation from the constituent, it shall duly bring it to their notice that if the order

results in a trade in the meantime, the requests for modification or cancellation cannot

be executed.

6.3.5 Contract Note

Contract note is a confirmation of trade(s) done on a particular day for and on behalf

of a client. A stock-broker shall issue a contract note to his clients for trades

(purchase/sale of securities) executed with all relevant details as required therein to be

filled in. A contract note shall be issued to a client within 24 hours of the execution of

the contract duly signed by the TM or his Authorized Signatory. As per Regulation 18

of SEBI (Stock-Brokers & Sub-Brokers) Regulations, 1992, the TM shall preserve the

duplicate copy of the contract notes issued for a minimum of five years.

The TM shall ensure that:

(a) Contract notes are in the prescribed format,

(b) Stamp duty is paid,

(c) All statutory levies are shown separately in the contract note, and

Guidelines for equity investments:

The NSCCL, with the help of clearing members, custodians, clearing banks and

depositories settles the trades executed on exchanges. The roles of each of these

entities are explained below:

(a) NSCCL: The NSCCL (National Securities Clearing Corporation of India Limited)

is responsible for post-trade activities of a stock exchange. Clearing and settlement of

trades and risk management are its central functions. It clears all trades, determines

obligations of members, arranges for pay-in of funds/securities, receives

funds/securities, processes for shortages in funds/securities, arranges for pay-out of

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funds/securities to members, guarantees settlement, and collects and maintains

margins/collateral/base capital/other funds.

(b) Clearing Members: They are responsible for settling their obligations as

determined by the NSCCL. They have to make available funds and/or securities in the

designated accounts with clearing bank/depositories, as the case may be, to meet their

obligations on the settlement day. In the capital market segment, all trading members

of the Exchange are required to become the Clearing Member of the Clearing

Corporation.

(c) Custodians: Custodian is a clearing member but not a trading member. He settles

trades assigned to him by trading members. He is required to confirm whether he is

going to settle a particular trade or not. If it is confirmed, the NSCCL assigns that

obligation to that custodian and the custodian is required to settle it on the settlement

day. If the custodian rejects the trade, the obligation is assigned back to the trading /

clearing member.

(d) Clearing Banks: Clearing banks are a key link between the clearing members and

NSCCL for funds settlement. Every clearing member is required to open a dedicated

clearing account with one of the clearing banks. Based on his obligation as

determined through clearing, the clearing member makes funds available in the

clearing account for the pay-in and receives funds in case of a pay-out.

(e) Depositories: Depositories help in the settlement of the dematerialized securities.

Each custodian/clearing member is required to maintain a clearing pool account with

the depositories. He is required to make available the required securities in the

designated account on settlement day. The depository runs an electronic file to

transfer the securities from accounts of the custodians/clearing member to that of

NSCCL. As per the schedule of allocation of securities determined by the NSCCL, the

depositories transfer the securities on the pay-out day from the account of the NSCCL

to those of members/custodians.

(f) Professional Clearing Member: NSCCL admits special category of members

namely, professional clearing members. Professional Clearing Member (PCM) may

clear and settle trades executed for their clients (individuals, institutions etc.). In such

an event, the functions and responsibilities of the PCM would be similar to

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Custodians. PCMs may also undertake clearing and settlement responsibility for

trading members. In such a case, the PCM would settle the trades carried out by the

trading members connected to them. The onus for settling the trade would be thus on

the PCM and not the trading member. A PCM has no trading rights but has only

clearing rights, i.e. he just clears the trades of his associate trading members and

institutional clients.

BROKER

A broker is an intermediary who arranges to buy and sell securities on behalf of

clients (the buyer and the seller). According to Rule 2 (e) of SEBI (Stock Brokers and

Sub-Brokers) Rules, 1992, a stockbroker means a member of a recognized stock

exchange. No stockbroker is allowed to buy, sell or deal in securities, unless he or she

holds a certificate of registration granted by SEBI. A stockbroker applies for

registration to SEBI through a stock exchange or stock exchanges of which he or she

is admitted as a member. SEBI may grant a certificate to a stockbroker [as per SEBI

(Stock Brokers and Sub-Brokers) Rules, 1992] subject to the conditions that:

a) He holds the membership of any stock exchange;

b) He shall abide by the rules, regulations and bye-laws of the stock exchange or stock

exchanges of which he is a member;

c) In case of any change in the status and constitution, he shall obtain prior permission

of SEBI to continue to buy, sell or deal in securities in any stock exchange;

d) He shall pay the amount of fees for registration in the prescribed manner; and

e) He shall take adequate steps for redressal of grievances of the investors within one

month of the date of the receipt of the complaint and keep SEBI informed about the

number, nature and other particulars of the complaints.

While considering the application of an entity for grant of registration as a stock

broker, SEBI shall take into account the following namely, whether the stock broker

applicant –

a) Is eligible to be admitted as a member of a stock exchange;

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b) Has the necessary infrastructure like adequate office space, equipment and man

power to effectively discharge his activities;

c) Has any past experience in the business of buying, selling or dealing in securities;

d) Is being subjected to any disciplinary proceedings under the rules, regulations and

bye-laws of a stock exchange with respect to his business as a stock-broker involving

either himself or any of his partners, directors or employees.

Membership in NSE

There are no entry/exit barriers to the membership in NSE. Anybody can become

member by complying with the prescribed eligibility criteria and exit by surrendering

membership without any hidden/overt cost. The members are admitted to the different

segments of the Exchange subject to the provisions of the Securities Contracts

(Regulation) Act, 1956, the Securities and Exchange Board of India Act, 1992, the

Rules, circulars, notifications, guidelines, etc., issued there under and the Bye laws,

Rules and Regulations of the Exchange. The standards for admission of members laid

down by the Exchange stress on factors such as, corporate structure, capital adequacy,

track record, education, experience, etc. and reflect a conscious effort on the part of

NSE to ensure quality broking services so as to build and sustain confidence among

investors in the Exchange’s operations. Benefits to the trading membership of NSE

include:

1) Access to a nation-wide trading facility for equities, derivatives, debt and hybrid

instruments products,

2) Ability to provide a fair, efficient and transparent securities market to the

investors,

3) Use of state-of-the-art electronic trading systems and technology,

4) Dealing with an organization which follows strict standards for trading &

settlement at par with those available at the top international bourses,

5) A demutualised Exchange which is managed by independent and experienced

professionals, and

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6) Dealing with an organization which is constantly striving to move towards a global

marketplace in the securities industry.

New Membership

Membership of NSE is open to all persons desirous of becoming trading members,

subject to meeting requirements/criteria as laid down by SEBI and the Exchange. The

different segments currently available on the Exchange for trading are:

Capital Market (Equities and Retail Debt)

Wholesale Debt Market

Derivatives (Futures and Options) Market

Admission to membership of the Exchange to any of the segments is currently open

and available. Persons or Institutions desirous of securing admission as Trading

Members (Stock Brokers) on the Exchange may apply for any one of the following

segment groups:

I. Wholesale Debt Market (WDM) Segment

II. Capital Market (CM) and Wholesale Debt Market (WDM) segments

III. Capital Market (CM) and Futures & Options (F&O) segments

IV. Capital Market (CM), Wholesale Debt Market (WDM) and Futures & Options

(F&O) segment

V. Clearing Membership of National Securities Clearing Corporation Ltd. (NSCCL)

as a Professional Clearing Member (PCM)

Eligibility for acquiring new membership of NSE

1) The following persons are eligible to become trading members:

(a) Individuals

(b) Partnership firms registered under the Indian Partnership Act, 1932 Individual and

Partnership firm are not eligible to apply for membership on WDM segment.

(c) Institutions, including subsidiaries of banks engaged in financial services.

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(d) Body Corporate including companies as defined in the Companies Act, 1956. A

company shall be eligible to be admitted as a member if:

i) Such company is formed in compliance with the provisions of Section 12 of the

said Act;

ii) Such company undertakes to comply with such financial requirements and norms

as may be specified by the Securities and Exchange Board of India for the registration

of such company;

iii) the directors of such company are not disqualified for being members of a stock

exchange and have not held the offices of the Directors in any company which had

been a member of the stock exchange and had been declared defaulter or expelled by

the stock exchange; and

(e) Such other persons or entities as may be permitted from time to time by RBI/SEBI

under the Securities Contracts (Regulations) Rules, 1957.

2) No person shall be admitted as a trading member if:

(a) He has been adjudged bankrupt or a receiver order in bankruptcy has been made

against him or he has been proved to be insolvent even though he has obtained his

final discharge;

(b) He has compounded with his creditors for less than full discharge of debts;

(c) He has been convicted of an offence involving a fraud or dishonesty;

(d) He is engaged as a principal or employee in any business other than that of

Securities, except as a broker or agent not involving any personal financial liability or

for providing merchant banking, underwriting or corporate or investment advisory

services, unless he undertakes to severe its connections with such business on

admission, if admitted;

(e) He has been at any time expelled or declared a defaulter by any other Stock

Exchange or he has been debarred from trading in securities by any Regulatory

Authorities like SEBI, RBI etc;

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(f) He has been previously refused admission to trading membership by NSE unless a

period of one year has elapsed since the date of such rejection;

(g) He incurs such disqualification under the provisions of the Securities Contract

(Regulations) Act, 1956 or Rules made there under so as to disentitle him from

seeking membership of a stock exchange;

(h) incurs such disqualification consequent to which NSE determines it to be not in

public interest to admit him as a member on the Exchange Provided that in case of

registered firms, body corporate and companies, the condition from (a) to (h) above

will apply to all partners in case of partnership firms, and all directors in case of

companies;

(i) It is a body corporate which has committed any act which renders it liable to be

wound up under the provisions of the law;

(j) It is a body corporate or a company in respect of which a provisional liquidator or

receiver or official liquidator has been appointed by a competent court;

SUB-BROKER-CLIENTS RELATIONS

1) Sub-broker

Sub-broker is an important intermediary between stock broker and client in Capital

Market segment “Sub-broker” means any person not being a member of a stock

exchange who acts on behalf of a stock broker as an agent or otherwise for assisting

the investors in buying, selling or dealing in securities through such stock brokers.

2) Registration

A broker shall deal with a person who is acting as a sub-broker only if such person is

registered with SEBI as a sub-broker. It is a responsibility of a Broker to ensure that

none of its client is acting as a sub-broker unless it is registered with SEBI. A broker

of the Exchange executing transactions on behalf of its clients through a broker of

other stock exchange is also required to be registered with SEBI as sub-broker of

respective broker. Application for sub-broker registration has to be submitted to the

Exchange with recommendation of the associated stock broker, in a prescribed format.

3) Relationship with clients/role

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A sub-broker shall have to enter into a tripartite agreement with its clients and the

stock broker specifying the scope of rights and obligations of the subbroker, stock

broker and such client of the sub-broker as per format prescribed by SEBI for dealing

in securities in cash segment. There shall be privity of contract between the stock

broker and the sub-broker’s client. A separate agreement has to be executed for each

Exchange. Sub-broker will help the client in redressal of grievance in respect of

transactions executed through its associated broker. Sub-broker will also assist and

co-operate in ensuring faster settlement of any arbitration proceeding arising out of

the transaction entered through its associated broker and shall be jointly / severally

liable to implement the arbitration award. A sub-broker will provide assistance to

stock broker and clients introduced to by it to reconcile their accounts at the end of

each quarter with reference to all the settlements where payouts have been declared

during the quarter.

Contract notes

A stock broker shall issue contract note as per the format prescribed by the Exchange

to client introduced through a sub-broker. A sub-broker shall render necessary

assistance to its client in obtaining the contract note from the stock broker. Sub-broker

shall not issue any purchase/sale note or confirmation memo to its client.

Securities/ Funds

Transactions in securities executed on behalf of a client introduced through the sub-

broker shall be settled by delivery/ payment between the stock broker and the client

directly, in accordance of the rules, regulations and byelaws of the Exchange and such

settlements shall not take place through sub-broker. Delivery of securities and

payment of funds relating to the transactions of a client introduced by the sub-broker

shall be directly between the stock broker and the client of the sub broker.

Sub-brokerage

Sub-broker is entitled to sub-brokerage not exceeding 1.5% of the transaction value.

DISPUTE, ARBITRATION AND APPEAL

Investor complaints received against the trading members / companies in respect of

claims/disputes for transactions executed on the Exchange are handled by the Investor

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Service Cell (ISC). The complaints are forwarded to the trading members for

resolution and seeking clarifications. The ISC follows-up with the trading members

and makes efforts to resolve the complaint expeditiously. However, in certain cases,

on account of conflicting claims made by the investor and the trading member, when

it is not possible to administratively resolve the complaint, investors are advised to

take recourse to the arbitration mechanism prescribed by the Exchange.

Arbitration, which is a quasi judicial process, is an alternate dispute resolution

mechanism prescribed under the Arbitration and Conciliation Act, 1996. The

Exchange Bye Laws prescribe the provisions in respect of Arbitration and the

procedure therein has been prescribed in the Regulations. The claim, difference or

dispute between the trading members inter se, between trading members and

constituents/registered sub-brokers between investors and listed companies arising out

of transactions executed on the Exchange can be referred to arbitration in accordance

with the provisions prescribed under the Byelaws and Regulations of the Exchange.

To establish that the disputes have arisen out of trades done on the Exchange, it is

essential that the parties produce adequate documents viz. contract notes, bills, ledger

accounts, etc.

The aggrieved parties can file for arbitration at the regional centres viz. Mumbai,

Delhi, Kolkata and Chennai based on the region where the constituent ordinarily

resides. The reference for arbitration should be filed within six months from the date

when the dispute arose between the parties in the prescribed form along with a list of

Arbitrators (selected from the names of persons who are eligible to act as Arbitrators

provided by the Exchange). The time taken by ISC for resolution of the complaint is

excluded by the Arbitrator, while considering the issue of limitation. The arbitration

application received from the applicant (aggrieved party) is forwarded to the other

party i.e. the respondent. The respondent is called upon to file his reply along with the

list of Arbitrators within the specified time. The parties (applicant and respondent)

have to select seven names in the descending order of preference from the eligible list

of Arbitrators if arbitration reference is filed at Mumbai and five names in the

descending order of preference from the eligible list of Arbitrators if arbitration

reference is filed at Delhi, Chennai or Kolkata. The sole arbitrator or panel of

arbitrators to whom the highest preference has been given by both the parties is/are

appointed by the Exchange to conductthe arbitration proceeding and pass the award in

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the respective arbitration matter. If no common person/s are identifiable from the list

submitted by both the parties, the sole arbitrator or panel of Arbitrators is/are

appointed by the Exchange from the list of persons eligible to act as Arbitrators after

excluding the names of Arbitrators given by the parties. Sole Arbitrator is appointed if

the claim amount is upto Rs.25 lakhs and panel of Arbitrators comprising of three

persons are appointed if the claim amount is more than Rs.25 lakhs based on the list

of Arbitrators submitted by the parties. The sole Arbitrator/panel of Arbitrators would

fix a hearing in the matter unless both parties waive their right for such hearing in

writing. In cases the claim amount is Rs. 25,000/- or less, it is not mandatory to hold a

hearing of the parties and the matter is decided based on the documents and

submissions made by the parties. In case, either of the parties fails to make

submissions/be present for the hearing repeatedly, even though notices has been

issued, the Arbitrator may proceed to decide the matter ex-parte. Based on the

submissions made by the parties and the documentary evidence produced before the

Arbitrator, the award is passed by the Arbitrator. The award is pronounced in writing

and signed by the sole Arbitrator or in case of a panel of Arbitrators by all the three

Arbitrators. The Arbitrator may include an interest component on the amount

awarded, at such rate and for such period, as the Arbitrator deems reasonable. In case

the award is passed in favor of the constituent (investor) the trading member is

requested to comply with the award failing which the award amount is debited and set

aside from the available deposit of the trading member. The party who is aggrieved

with the arbitration award can initiate appropriate steps for setting aside the award by

filing a petition in the appropriate court under section 34 of the Arbitration and

Conciliation Act, 1996. The petition has to be filed normally within a period three

months from the date of receipt of the award. On expiry of three months, the award

amount set aside shall be released to the constituent incase petition is not filed under

section 34 of the Arbitration and Conciliation Act, 1996 by either of the parties. In

case petition is filed, the award amount set aside is dealt in accordance with the court

order.

CODE OF ADVERTISEMENT

Trading Members of the Exchange while issuing advertisements in the media have to

comply with the Code of Advertisement prescribed by the Exchange. In pursuance of

that, a copy of an advertisement has to be submitted to the Exchange to get a prior

249

approval before its issue in publication/media. Trading members not complying with

the Code of Advertisement may have to face disciplinary proceedings. The code of

advertisement is as under:

(1) The term advertisement as referred in this code shall have the following meaning:

Advertisement means and includes any document, pamphlets, circulars, brochures,

notice or any research reports, material published, or designed for use in a newspaper,

magazine or other periodical, radio, television, telephone or tape recording, video tape

display, signs or bill boards, motion pictures, telephone directories (other than routine

listings) or other public media, whether in print or audio visual form.

(2) The trading member should designate and authorize a person to ensure the

correctness of the information given in any advertisement.

(3) The trading member issuing any such advertisement should inform the name of

such authorized person to the Exchange.

(4) The advertisement should be related to the nature of services that the trading

member can offer. If the trading member is engaged in any other business then any

advertisement if permissible for such business should not indicate the name of the

Trading member as a member of the Exchange.

(5) The advertisement should be written in clear language and should not be such

which may prejudice interest of the investors in general.

(6) The advertisement should not contain any confusing, misleading or offensive

information.

(7) It should be free from inaccuracies.

(8) The advertisement should not contain a recommendation regarding purchase or

sale of any particular share or security of any company. It should not make any

promise including guaranteeing of any return to the investing public.

(9) The material should not contain anything which is otherwise prohibited.

(10) The Advertisement shall contain:

a) Name and/or his logo, code of National Stock Exchange membership.

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b) Registration Number allotted by the Securities and Exchange Board of India.

(11) The Advertisement may be issued individually or jointly with other Trading

members provided that the trading member shall not allow its name to be advertised

or caused to be published in the advertisement of other trading members, unless such

advertisement is issued by it.

(12) In the event of suspension of any trading member by the Exchange, the trading

member so suspended shall not issue any advertisement either singly or jointly with

any other trading member, during the period of suspension.

(13) In the event of any proceeding/action initiated against a Trading member by a

regulatory body other than National Stock Exchange,

National Stock Exchange reserves the right to direct the trading member to refrain

from issuing any advertisement for such a period as it may deem fit.

(14) National Stock Exchange reserves the right to call for the advertisement and/or

such other information/explanation as it may require, after the publication of the said

advertisement. National Stock Exchange shall have cease and desist powers in this

behalf.

SEBI has advised the Stock Exchanges to ensure that their brokers/subbrokers do not

advertise their business, including in their internet sites, by subsidiaries, group

companies etc., in prohibition of code of conduct specified in the Schedule II of the

SEBI (Stock Brokers and Sub-brokers) Regulations, 1992.The code of conduct in the

regulations require a stock broker/sub broker not to advertise his business publicly

unless permitted by the stock exchange and not to resort to unfair means inducing

clients from other stock brokers.

1: Indian corporate sector is critical and has a dominant role in the economy.

The major characteristic of Corporate India is that it accounts for 14 per cent of the

national income. In fact, it is the non-corporate sector consisting of

partnership/proprietorship firms which has the largest share in our national income,

(nearly 38 per cent) followed by agriculture (24 per cent) and government (24 per

cent).

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Incidentally, in activities like trade (wholesale and retail), transport (other than

railways), construction, and hotels and restaurants, the share of non-corporate sector

in national income is more than 70 per cent. The service sector, consisting of all these

activities is currently the main driver of GDP growth. In the last decade, the average

annual growth rate of the service sector was more than 8 per cent, while the growth

rate of the industrial sector was around 5 per cent. The share of the corporate sector in

our domestic savings is less than 5 per cent. In contrast, in developed countries it is

more than 50 per cent. The largest component of our savings (more than 90 per cent)

comes from the household sector, which includes all partnership/proprietorship firms

even if they are in manufacturing or trade or transport, construction or hotels. Hence

the proposition that the corporate sector is critical to our economy is not borne out by

facts. So proposition 1 is neither true nor valid; even if the entire corporate sector

vanishes, the national income will only drop by some 14 per cent. Incidentally, our

national income is under-estimated by at least 30 per cent and to that extent there is no

loss at all in the total picture.

2: The stock market is the barometer for performance (past and future) of the

corporate sector.

There are nearly seven lakh companies in India, of which some 6,000 or so are listed

on our exchanges. Though nearly 9,000 scrips are listed on our exchanges, more than

half were not quoted or traded last year. Another 25 per cent were quoted only a

couple of times last year. The shares of just the top 10 companies commanded nearly

45 per cent of the trade turnover last year. Contrast this with the NYSE, where no

single scrip normally enjoys more than one per cent of the turnover. Though market

players and exchanges brag about India having the largest number of listed scrips (like

having the largest cattle population in the world), only about a hundred are active.

More than 70 per cent of trading, even in these hundred or so scrips, is not for

delivering these shares. It is for squaring-off purposes. In other words, the participants

do not even see these scrips, and a true "scripless trading" is in place. A substantial

portion of the transaction is for gains or losses at the margin and it is the day-traders

(who square-off within the day) who are active in the market. Hence, the stock market

is no barometer, either for India's corporate or its economy.

3: The stock market helps channel savings in our economy.

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This is the most amusing assumption of the lot. At the best of times, the primary

market did generate some savings from the public who saluted the spirit of

entrepreneurship of several business groups, including the Oswals, the Bhansalis, the

Orkay Mehras, the Deepaks and the Ruias. The savings data suggests that at the best

of times (not for the investors), the proportion of "shares and debentures" as a

percentage of financial savings of households was 17 per cent in the early 1990s. As

of 2003, it was less than 5 per cent. A large chunk of our investors are in postal

savings, provident funds and life insurance funds. Hence we find that the corporate

sector plays a small role in our economy while the share of the non-corporates is

significant. The latter are not listed in the market; they are not even companies.

Rather, they are proprietorship and partnership firms. They dominate the fastest

growing activities of the service sector, namely trade, transport, restaurants and

construction. The share of households in the national economy is very significant

(more than 90 per cent). Of this, only around five per cent is invested in bonds and

shares. The largest saving avenues are banking deposits, small savings, insurance and

provident fund. The stock market is important to 10 per cent of the economy and it

cannot be categorized as the barometer of the economy. If there is a lot of

construction activity going on, many trucks plying on the roads, and plenty of food

joints and retail outlets, then you know that economic activity is increasing. Noting

that the Indian stock market volatility was reflecting the global developments. The

stock market is not the sole indicator of India’s economy. The stock market is

reflecting worldwide developments. In fact, it is really reflecting the developed

economies as well as the Asian economies. Volatility can be expected especially when

there is turbulence in the international financial markets.

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CHAPTER 12 (MY PERSONAL EXPERIENCE)

LIMITATIONS

There have been a lot of findings through this final project which includes the share

trading procedure in NSE & BSE India. The most important part portfolio

management in India and how the broking firms are actually managing the portfolios

of customers to provide best return out of it. In India the share trading pattern was

very orthodox or it can be said it was not technologically advanced before 1990. Also

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there has been lot of time taken for the final clearing and settlement of the transaction,

which after the introduction of the online share trading system was eliminated to a

great extent and also the efficiency and effectiveness of the transactions is improved

and the volume of trading is also increased to a great extent. But still it can be said

that even though due to the increase in volume of trading still the growth of the online

trading is not increased to a good extent in India. Still only 10% of the investors are

involved in the trading of shares through online basis. Still there are many people

having good income and are not concerned with the investment in various securities

and the rural market related to our country is also not very strong and has not been

explored much. In India the individual investors are not been encouraged to the online

trading and there number has to be increased for increasing the growth of the stock

market and the broking firm. In India the way the online trading was accepted, its

growth has been slow. Specially the rural sector has been unexplored and not has been

done by the SEBI and the government to increase their contribution so as to

strengthen the capital market of the country. On the practical aspect we talk about the

online trading but still it is in initial stage in India as internet facility in India has not

been very good and hampers to deliver a smooth service to the customers. But even

though many brokers feel that the growth rate of the online trading will increase and

the customers will become used to this service and can easily handle operation

through internet. Internet trading since 10 years have been working and need more

time to fully develop in India, but once developed in India then online trading will

provide a lot of benefits to the customers as fast service and fast execution of the

order and also making the order executed in time. Also through internet trading quick

updates can be provided to the customers regarding the market condition and the stock

which will give them good returns for their investment. In all online trading provide

the clients with the flexibility that can trade and also help in the order management in

which they can cancel or even modify their orders as per their choice thus making an

overall package of convenience with comfort and making the investor of India

technologically advance but some time is required on the part of the investors for

understanding their right choice and accepting online trading in stock market and the

SEBI to make the investors understand the benefits of the online trading. Also on the

part of the SEBI there has been many flaws in the rules and regulation for the security

market and many a times they have been failed to protect the interest if the customers

and thus giving a chance to the scrupulous persons to take advantage of it.

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MY LEARNING’S

The most important part portfolio management in India and how the broking firms are

actually managing the portfolios of customers to provide best return out of it. In India

the share trading pattern was very orthodox or it can be said it was not technologically

advanced before 1990. Also there has been lot of time taken for the final clearing and

settlement of the transaction, which after the introduction of the online share trading

system was eliminated to a great extent and also the efficiency and effectiveness of

the transactions is improved and the volume of trading is also increased to a great

extent. But still it can be said that even though due to the increase in volume of

trading still the growth of the online trading is not increased to a good extent in India.

Still only 10% of the investors are involved in the trading of shares through online

basis. Still there are many people having good income and are not concerned with the

investment in various securities and the rural market related to our country is also not

very strong and has not been explored much. In India the individual investors are not

been encouraged to the online trading and there number has to be increased for

increasing the growth of the stock market and the broking firm. In India the way the

online trading was accepted, its growth has been slow. Specially the rural sector has

been unexplored and not has been done by the SEBI and the government to increase

their contribution so as to strengthen the capital market of the country. On the

practical aspect we talk about the online trading but still it is in initial stage in India as

internet.

BIBLIOGRAPHY

Internet

http://www.articlesbase.com/organizational-articles/online-trading-india-simplified-

2660740.html

Article Name: Online trading India-Simplified

Author: Sushil Finance www.sushilfinance.com

Date of Site Visited: 21/06/2010

256

http://www.expresscomputeronline.com/20011210/indtrend1.shtml

Article Name: Will online share trading ever take off in India? - Express Computer

India

Author: Rajneesh De and Srikant R P

Date of Site Visited: 22/06/2010

http://hindu.com//businessline/iw/2000/09/03/stories/0703g051.htm

Article Name: Emergence of e-broking

Author Name: Krishnan Thiagarajan

Date of Site Visited: 23/06/2010

http://www.articlesbase.com/investing-articles/shares-trading-in-india-the-nuances-

1911258.html

Article name: Shares Trading in India – The Nuances

Author Name: Nirmal Kumar

Date of Site Visited: 24/06/2010

http://economictimes.indiatimes.com/Markets/Analysis/Online-trading-fails-to-click-

as-retail-growth-slows-down/articleshow/5613475.cms?curpg=2

Article Name: Online trading fails to click as retail growth slows down-Analysis-

Markets

Author Name: Shailesh Menon

Date of Site Visited: 24/06/2010

http://www.thehindubusinessline.com/iw/2005/07/24/stories/2005072400741300.htm

Article Name: Online trading: Paperless and convenient

Author Name: Gautam Sharma

Date of Site Visited: 1/07/2010

http://www.articlesbase.com/finance-articles/the-scope-of-online-trading-in-india-

1095803.html

Article name: The scope of Online Trading in India

Author Name: Ajay Santoshi

Date of Site Visited: 1/07/2010

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Books:

Title: NCFM (NSE’s Certification in Financial Market): Capital Market

Author: NSE India

Place of Publication: NSE, Mumbai, Exchange plaza Bandra (East), Mumbai- 400051

Publisher: NSE India

Date of Publication: May 2008

Number of Pages referred from “7 to 28 “ ,66 to 72 and 168 to 205

ANNEXURE

Press Release related to the SEBI

SEBI nod must for ULIPs by insurance companies

10 Apr 2010, 0838 hrs IST, ET Bureau

MUMBAI: Market regulator SEBI has barred 14 private life insurance companies

from selling unit-linked insurance plans without its approval, giving a fresh twist to

the turf war between SEBI and insurance watchdog IRDA. “We expect some

companies to move the court” said the CEO of a life company. “It is unfortunate that

this dispute has been allowed to reach this stage. It is time for the finance ministry to

intervene” he added. In an order signed by Prashant Sharn, whole time director, SEBI,

said, “I hereby direct the entities mentioned in this order not to issue any offer

document, advertisement, brochure soliciting money from investors or raise money

from investors by way of new and/or additional subscription for any product

(including Ulips) having an investment component in the nature of mutual funds, till

they obtain the requisite certificate of registration from SEBI”. The 14 companies

mentioned in this order include Aegon Religare, Aviva, Bajaj Allianz Life Insurance,

Bharti AXA, Birla Sun Life, HDFC Standard Life, ICICI Prudential, ING Vyasa Life,

Kotak Mahindra Old Mutual Life, Max New York Life, Metlife India, Reliance Life,

SBI Life, TATA AIG Life. Companies had responded individually that insurance

laws permit them to offer an investment component within a life insurance policy.

They also said that they were regulated by SEBI who had cleared all these products.

The life companies were supported by the market regulator, who reiterated the stand

258

taken by life companies. In its final order SEBI said, “I find that the entities by their

own admission have stated that there are two components of Ulips - an insurance

component where the risk on the life insurance portion vests with the insurer and the

investment component where the risk lies with the investor. This establishes

conclusively that Ulips are a combination product and the investment component need

to be registered with and regulated by SEBI” .SEBI’s order has implications not only

for the life insurance companies but also for their promoters who have sunk in over Rs

26,000 crore in the form paidup capital. According to analyst report suggest that, a

significant portion of the value of various companies including, ICICI Bank, Aditya

Birla Nuvo, SBI Life If and Bajaj Finserve. Most of the business written by these

companies is through Ulips. These companies are barred from selling Ulips, their

valuations are likely to be hit.

Trading online in vogue among Indian investors

9 Mar 2011, 1554 hrs IST, REUTERS

NEW DELHI: Indians eager to invest extra income are signing up in droves at

Internet trading sites, data from the nation's largest stock exchange shows. The

number of investors registered for online trading has grown by at least 150 percent

over 2006-07 figures, with 2.9 million in the cash segment and 5.5 million for both

cash and F&O, according to records at the National Stock Exchange (NSE). "Online

trading helps me manage my portfolio better as there is more transparency and value-

added services such as research reports," says Akif Ahmad, a manager at a call centre

in Gurgaon. Traditionally, equities trading in India has been done through brokers, in

person or over the phone, but with the convergence of mobile and Internet, shopping

for shares has become as easy as making a few clicks from one's PC or mobile phone.

Internet Security

Online trading in India, Asia's third largest economy, is still at a nascent stage.

Though the country is witnessing a 30 percent growth year-on-year in internet and

mobile user base, not all investors are convinced that trading the cyber way is safe.

"Issues that need to be addressed are education on cyber crime and the security

solutions around it," says Vinesh Menon, Deputy CEO & Head for Online Investment

& Branch Channel, Bajaj Capital. To work around this issue, most brokerages now

offer the services of a relationship manager who assists with information on share

prices and places orders online using the investor's login details. Some internet trading

259

sites have also launched low-bandwidth platforms to facilitate trading through mobile

phones and low-bandwidth connections. With more than 400 million mobile users,

India is the world's second-largest market after China for such services and operators

have been adding more than 10 million users a month -- making it the fastest-growing

market in the world. "It's a matter of time when we will see exponential growth in the

online trading segment, not just through the computer but also through our mobile

phones," adds Menon.

SEBI eases listing norms for SMEs

Fe Bureau | Posted: Wednesday, May 19, 2011 at 2316 hrs IST

WORD OF THANKS

We take the opportunity to pay hearty regards to Dr. D. K. GARG (Chairman) and

Mr. M. K. VERMA (Dean) for lending us their kind support for completion of our

project. We would like to thank all those who directly or indirectly supported us

morally, financially and through providing knowledge by which we could complete

our project. Also we would like to thank our seniors for their support and cooperation.

We are thankful to Mr. Gaurav Kumar (Project Guide) who was our guide and mentor

for this project and supported us a lot and encouraged us to ahead with this project.

We would also like to thank Mr. Sanjeev Kumar who is an employee in MODEX

260

INTERNATIONAL SECURITIES LTD. and he had given us special attention and

guided me from time to time. We would also like to thank our friends for their support

which encouraged us to complete this project. Last but not the least we would like to

thank god for giving us strength and his blessings for the completion of the project.

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