Taxmann's Fundamentals of Investments

Preface

Investment is a skill and mastering its tools and techniques requires lots of efforts in this VUCA (Volatile, Uncertain, Complex and Ambiguous) environment surrounding investment. Investment in financial assets has seen unprecedented growth especially in the last two decades despite turbulent financial environment. Growth in securities market has been parallel to the growth of economy. A larger portion of household savings is now being invested in financial instruments to provide the much needed capital for growth. Securities markets have also witnessed a number of innovations in terms of innovative financial products, innovative financial practices and conducive policies at domestic and global level.

The main motivation of writing this book has been my students, many of them are now teachers and investment professionals. I have been teaching the paper of Security Analysis and Portfolio Management at post graduate level for about 18 years and doing research in various areas of Investment management including market efficiency, stock market anomalies, mutual funds, derivatives, socially responsible investing etc.

The present book “Fundamentals of Investments” is written with objective of providing the user a comprehensive understanding of the investment environment and investment decision process. It explains various concepts, tools and techniques related with investment in financial assets with lively examples and suitable illustrations. The focus of the book is investment management. There is a comprehensive discussion on the concept of risk and returns, their sources and measurement, valuation of securities, approaches to security valuation, portfolio analysis, selection and management including performance evaluation. The book takes to the reader on a journey of investment process.

The book comprises of 12 chapters :

Chapters 1 & 2 discusses the investment environment. The entire discussion presented in Chapters 1 and 2 revolves around the types of investment alternatives, risk return trade off and structure and trading in Indian Securities Market. Special attention has been given to the role of SEBI and prohibition of Insider Trading. Latest developments like Algorithmic Trading and Direct Market Access are also discussed along with the reforms initiated in the past three decades. The updated information in Chapter 2 is provided.

Chapter 3, Security Analysis, provides at one place the concepts and measurement of various types of returns and risks in financial investment. The reader will definitely have an enriching experience and will have a better understanding of risk and returns concepts which are largely misunderstood.

Chapter 4, presents a comprehensive explanation of fixed income securities, various types of fixed income securities, valuation of bonds and convertible debentures, and various types of bond yields. Advanced concepts such as Bond Duration and Immunisation have also been discussed.

Chapters 5 to 8 provide various approaches to equity analysis such as - Fundamental analysis, Technical analysis and Efficient Market Hypothesis with suitable examples. An attempt has been made to provide the necessary skills and tools for Fundamental Analysis as well as Technical Analysis. The reader can apply these models and tools and techniques in real life decisions. Equity valuation models have also been explained with suitable illustrations.

Chapters 9 & 10 deal with portfolio management & portfolio analysis, portfolio construction and portfolio selection. Capital market theory is also elaborated. Further these provide detailed explanation of CAPM (Capital Asset Pricing Model), the most popular model of asset pricing in finance as well as explanation of need and measure of portfolio performance evaluation such as Sharpe index, Treynor’s Index and Jensen’s alpha.

Chapters 11 & 12 explain Financial Derivatives and Investor Protection in India.

The salient features of the text presented in this book are:

1. Learning outcomes - Every chapter begins with a list of learning outcomes which the reader will achieve after successful completion of the chapter. Its sets the broad framework for the chapter.

2. Main Text - Various concepts and techniques have been explained in a lucid and well knit manner. Wherever required the explanation is supplemented by suitable illustrations and examples.

3. Solved Problems - Each chapter provides sufficient number of solved problems for better understanding and application of the concepts explained in the main text.

4. Summary - Each chapter provides summary points to recapitulate the concepts and tools explained in the chapter. It helps the reader to glance over the entire discussion presented in that chapter.

5. Test Yourself - Every chapter provides a variety of assignments to test the knowledge of the reader. It comprises of True/False statements, theory questions and numerical problems.

6. Project work - The topic of Investments is very lively and the reader may want to apply various concepts and techniques in real life. For this “project work” is provided at the end of every chapter. Project work helps the students and other readers of this book to actually apply various concepts of investments in real life.

Sufficient care has been taken while preparing the manuscript for the book. However there may be some unintentional errors. Readers are welcome to send all comments & suggestions at vanitatripathi.dse@gmail.com

Happy reading !

Prof. VANITA TRIPATHI

Acknowledgements

The contribution of the omnipresent, omnipotent and omniscient invisible hand cannot be expressed in words. I can only say that my faith in Him becomes more and more intense by each passing day.

I gratefully acknowledge the support and best wishes of my teachers and students. Special thanks to the following colleagues in Delhi UniversityDr. Neeta Tripathi and Dr. Madhu Sehrawat (DSC), Dr. Pankaj Chaudhry, Sh. H.N. Tiwari, Dr. Vandana Jain, Sh. Harish Kumar, Ms. Namita Jain, Ms. Sarita Gautam and Dr. Abhay Jain (SRCC), Dr. Megha Aggarwal, Ms. Anshika Aggarwal (Rajdhani College), Dr. Deepak Sehgal, Dr. Shalini

Bhatia, Dr. Renu Aggarwal (DDU), Dr. Loveleen Gupta (Hindu College), Dr. Bhawna Rajput, Ms. Nitu Dabas (AMV), Dr. V.K. Arora, Dr. Naresh Dhawan (ARSD College), Dr. Sushma Bareja DSC(E), Dr. Renu Aggarwal, Ms. Renu Yadav, Ms. Mandeep Kaur, Ms. Priyanka (SPM), Dr. Manju Tanwar (SBSC), Dr. Phoolchand, Dr. Shuchi Pahuja, Sh. Ramesh Kumar (PGDAV College), T. Jeya Christy (I.P. College), Dr. Vipin Kumar (AUR), Dr. Vibha Jain (JDM), Dr. Vidisha Garg (Maitreyi), Dr. Gurmeet Bakshi (JMC), Ms. Sonia Kamboj (Kalindi), Dr. Shalini Pawar (KMV), Dr. Rajnikant Verma [ZHC(E)], Dr. Sadhna Gupta (ANDC), Dr. Mansi Bansal, Dr. Sukhvinder Singh, Dr. T. Venugopala [SGTB(D)], Mrs. Deepa Garg (CVS), Dr. B.R. Sachdeva (DBC), Dr. Vandana Gupta, Dr. Abha Wadhwa (DDU), Dr. V.K. Aggarwal, Dr. Kavita Arora (SLC), Dr. Gurcharan Singh), Dr. S.S. Lamba, Dr. Harvinder Kaur, Sh. Balkrishan (SGGSCC), Dr. Sonali Dua (Gargi College), Dr. Sonal Sharma (Hansraj), Dr. Anupama Rajput (JDM), Dr. Sarika Bhatnagar, Dr. Janaki (LBC), Dr. Alka Agarwal (KNC), Dr. Sunaina Sardana (LSR), Dr. Nirmal Jain (MAC), Dr. Monika Gupta, Ms. Rashmi Shingh (MLN), Dr. G.K. Arora (SGND), Mrs. Priti Rai (SPM), Dr. Shruti Mathur (ZHC) and Dr. G.R. Luthra (SSC), Dr. Bawna Rajput (Aditi Mahavidyalaya).

Special thanks to Ms. Priti Aggarwal, Ms. Roshni Garg and Ms. Neerza for their help. I am also thankful to Dr. Ashu Lamba and Varun Bhandari for their help.

The book could have never taken its present shape without the great support and encouragement provided by my family especially my husband Mr. Yogesh Misra. I cannot forget acknowledging my sons, Advay and Atulya who received much less attention from their mother, during the period of manuscript preparation, than they actually deserved.

I am grateful to the staff of Ratan Tata Library for making available necessary reference material, help and facilities timely.

Last but not the least I am thankful to the publisher TAXMANN for bringing out this book timely.

Prof. VANITA TRIPATHI

Syllabus

I

B.COM. (HONS.): SEMESTER VI

PAPER: BCH-6.3 DSE GROUP (a): FUNDAMENTALS OF INVESTMENT

Objective: To familiarize the students with different investment alternatives, introduce them to the framework of their analysis and valuation and highlight the role of investor protection.

COURSE CONTENTS

UNIT I:

The Investment Environment

The investment decision process, Types of Investments - Commodities, Real Estate and Financial Assets, the Indian securities market, the market participants and trading of securities, security market indices, sources of financial information. Return and risk: Concept, Calculation, Trade off between return and risk, Impact of taxes and inflation on return.

UNIT II:

Fixed Income Securities

Bond Fundamentals, Estimating bond yields, Bond Valuation, Types of bond risks, default risk and credit rating.

UNIT III:

Approaches to Equity Analysis

Fundamental Analysis, Technical Analysis and Efficient Market Hypothesis Valuation of Equity Shares using various models.

UNIT IV:

Portfolio Analysis and Financial Derivatives

(a) Portfolio and Diversification, Portfolio Risk and Return (b) Mutual Funds (c) Introduction to Financial Derivatives-Forwards, Futures & Options, Financial Derivatives Markets in India.

UNIT V: Investor Protection

Role of SEBI and stock exchanges in investor protection; Investor grievances and their redressal system, insider trading, investors’ awareness and activism.

Spreadsheet is the recommended software for doing basic calculations in finance and hence can be used for giving students subjects related assignments for their internal assessment purposes.

B.COM. : SEMESTER VI

PAPER BC 6.2 (e):

IIFUNDAMENTALS OF INVESTMENT

Objective: To familiarize the students with different investment alternatives, introduce them to the framework of their analysis and valuation and highlight the role of investor protection.

COURSE CONTENTS

UNIT I: The Investment Environment

The investment decision process, Savings, Investment and Speculation, Types of Investments-Commodities, Real Estate and Financial Assets, the Indian securities market, the market participants and trading of securities, security market indices, sources of financial information, Concept of return and risk: Calculation, Tradeoff between return and risk, impact of taxes and inflation on return.

UNIT II: Fixed Income Securities

Bond Fundamentals, Estimating bond yields, Bond Valuation, Types of bond risks.

UNIT III: Approaches to Equity Analysis

Fundamental Analysis, Technical Analysis and Efficient Market Hypothesis, Valuation of Equity Shares.

UNIT IV:

Portfolio Analysis and Financial Derivatives

(

a) Portfolio and Diversification, Portfolio Risk and Return (b) Mutual funds

(

c) Introduction to Financial Derivatives-Forwards, Futures & Options, Financial Derivatives Markets in India.

UNIT V: Investor Protection

Role of SEBI and stock exchanges in investor protection; Investor grievances and their redressal system, insider trading.

Spreadsheet is the recommended software for doing basic calculations in finance and hence can be used for giving students subjects related assignments for their internal assessment purposes.

III

SCHOOL OF OPEN LEARNING, UNIVERSITY OF DELHI

[B.COM. (HONS.)]

PAPER XX - YEAR III FUNDAMENTALS OF INVESTMENTS

Objective : To familiarize students with different investment alternatives, introduce them to the framework of their analysis and valuation and highlight the role of investor protection.

COURSE CONTENTS

UNIT I:

1. The Investment Environment - The investment decision process, Types of investments - commodities, real estate and financial assets, the Indian securities market, the market participants and trading of securities, security market indices, sources of financial information, concept of return and risk, impact of taxes and inflation on return. (18 Lectures)

UNIT II:

2. Fixed Income Securities - Bond features, types of bonds, estimating bond yields, types of bond risks, default risk and credit rating. (12 Lectures)

UNIT III:

3. Approaches to Equity Analysis - Introduction to fundamental analysis, technical analysis and efficient market hypothesis, dividend capitalisation models, and price earnings multiple approach to equity valuation. (20 Lectures)

UNIT IV:

4. Portfolio Analysis and Financial Derivatives - Portfolio and diversification, portfolio risk and return, commodities, real estate, and mutual funds. Introduction to financial derivatives, financial derivatives markets in India. (12 Lectures)

UNIT V:

5. Investor Protection - SEBI & role of stock exchanges in investor protection, investor grievances and their redressal system, insider trading, investors’ awareness and activism. (13 Lectures)

Chapter-heads

FINANCIAL DERIVATIVESFORWARDS, FUTURES AND OPTIONS

LEARNING OUTCOMES

After reading this chapter you will be able to Know the meaning of derivatives and various types of derivatives. Understand participants in derivative markets. Differentiate forward and futures contracts. Know salient features of futures contracts

Determine forward and futures price using Cost of Carry Model. Define an options contract and explain its various types

Distinguish between futures and options

Determine payoffs from various positions on Call and Put options. Use options for hedging

Analyse various types of derivatives available in Indian markets.

11.1 INTRODUCTION TO DERIVATIVES

Derivatives are financial instruments whose value depend upon or is derived from some underlying assets. The underlying assets can be real assets such as commodities, gold etc. or financial assets such as index, interest rate etc. A derivative does not have its own physical existence. It emerges out of the contract between the buyer and seller of the derivative instrument. Its value depends upon the value of the underlying asset. Hence returns from derivative instruments are linked to the returns from underlying assets. The most common underlying assets include stocks, bonds, commodities,

Para 11.2

currencies, interest rates and market indexes. Stock futures are derivative contracts based on individual stocks in the securities market. Stock index futures are derivative contracts where the underlying asset is an index. In case of wheat futures, the underlying asset is wheat. In case of gold futures the underlying asset is gold. Similarly we have derivatives based on various real as well as financial assets. Now a days we also find derivatives which are based on other derivatives. The derivative itself is merely a contract between two or more parties.

Securities Contracts (Regulation) Act, 1956 defines derivative as under:

“Derivative” includes—

(A) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security,

(B) a contract which derives its value from the prices, or index of prices, of underlying securities.

11.2 CLASSIFICATION OF DERIVATIVES

Derivatives can be classified into broad categories depending upon the type of underlying asset, the nature of derivative contract or the trading of derivative contract.

1. Commodity derivatives and Financial derivatives

Derivatives can be classified into Commodity derivatives and Financial derivatives on the basis of the type of underlying asset. In case of Commodity derivatives the underlying asset is a physical or real asset such as wheat, rice, jute, pulses, or even metals such as gold, silver, copper, aluminium, oil etc. In case of financial derivatives the underlying asset is a financial asset such as equity shares, bonds, debentures, interest rate, stock index, current, exchange rate etc. Financial derivatives are more popular the world over. Commodity derivatives are traded on Multi Commodity Exchange (MCX) and National Commodities and Derivatives Exchange (NCDEX) in India. Commodity derivatives based on agricultural commodities are more popular than those based on metals. It must be noted that the derivatives were developed to hedge the price risk in case of agricultural commodities. Hence initially commodity derivatives were developed. Financial derivatives were developed later in the decade of 1980s. Financial derivatives are traded on BSE, NSE, United stock exchange (USE) and MCX-SX in India.

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2. Elementary derivatives and Complex derivatives

Elementary or basic derivatives are those derivatives which are simple and easily understandable. Such derivatives are futures and options. Complex derivatives have complex provisions and features which make them difficult to understand by an investor. Complex derivatives include exotic options, synthetic futures and options and so on.

3. Exchange traded derivatives and Over The Counter (OTC) derivatives

Derivatives may be traded on an exchange or they may be privately traded over the counter (OTC). Exchange traded derivatives are standardised derivative product traded as per the rules and regulations of the exchange. For example Stock index futures, stock index options and Stock futures and options in India are exchange traded derivatives. OTC derivatives are private bilateral contracts between two parties and are non standardised. These derivatives are specific to the needs of the parties involved. For example forward contracts in foreign exchange market are OTC derivatives.

11.3 PARTICIPANTS (OR TRADERS) IN DERIVATIVES MARKET

Different types of parties participate in derivatives market and make it a liquid and smooth market. Derivatives were initially developed to provide hedging against price risk. However now a days these instruments are also widely used for the purpose of speculation. Further, if there is any mispricing then arbitrage opportunities arise which can be exploited to restore equilibrium. Three categories of traders in derivative market are- Hedgers, Speculators and Arbitrageurs.

1. Hedgers : Investors having long position in assets are exposed to price risk i.e. the risk that asset prices will go down. On the other hand investors having short position in assets are also exposed to price risk i.e. the price of the asset may go up. Hence they want to hedge their position to be immune to price risk. Hedgers use financial derivatives to reduce or eliminate the risk associated with price of an asset. Futures contracts enable both the parties (having long or short position) to hedge or eliminate their risk. In case of hedging, risk is actually transferred from the hedger to the speculator. Options are widely used by hedgers to reduce their risk exposure.

2. Speculators use derivatives to get extra leverage and earn quick and large potential gains on the basis of future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. Speculators

Para 11.4

take position on the basis of their assessment of future price movements. Futures are widely used by speculators. If a speculator expects that the stock price will go up, he buys futures and vice versa.

3. Arbitrageurs are those traders who take advantage of any discrepancy in pricing and exploit it to bring in equilibrium. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. Arbitrage is possible over space as well over time. Derivatives allow arbitrageurs to exploit arbitrage opportunities over time as well. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets (overtime) to lock in a profit.

Types of Financial derivatives

The subject matter of this chapter is financial derivatives. Financial derivatives are those derivatives where the underlying asset is the financial asset or instrument such as index, stocks, bonds, currency, interest rates etc. Financial Derivatives are generally classified as Forwards, Futures, Options and Swaps depending upon their nature and features. In this book we focus only on the first three categories i.e. Forwards, Futures and Options. They are explained below:

11.4 FORWARDS

A forward contract is a private bilateral agreement between two parties to buy and sell a specified asset at a specified price on a specified future date. Consider a farmer in Punjab, Mr. Singh, plans to grow 5000 Kgs of wheat this year. He can sell his wheat for whatever the price is when he harvests it, or he could lock in a price now by selling a forward contract that obligates him to sell 5000 kgs of wheat to Pillsbury after the harvest for a fixed or specified price. By locking in the price now, he can actually eliminate the risk of falling wheat prices. On the down side, if prices rise later, he is foreclosing the opportunity of super profits. But then, he must have played safe and insured himself against the possibility of prices falling down eventually. The transaction that Mr. Singh has entered into is known as Forward transaction and the contract covering such transaction is known as Forward Contract. Hence a forward is a contract between two parties to buy or sell a specified asset at a pre-determined price on a specified future date.

A financial forward contract is that forward contract where the underlying is a financial asset such as currency. For example assume that an Indian company XYZ Ltd. has to pay its import bills in 20000 US dollars after three

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months. However the company faces the risk of rupee depreciation, i.e. the price of the US dollar may go up. To guard against this exchange rate risk, the company may enter into a forward agreement with some other company to buy 20000 US dollars at a specified price after 3 months. This way it has hedged its position. If after three months the exchange rate is higher, the company `stands to gain. If on the other hand the rupee appreciates and US dollars are available at a lower price, the company stands to lose. In any case the company’s position is certain in the sense that it will get 20000 US dollars at the pre specified price after 3 months.

Features-

Forward contract has following features:

Customised - Each contract is custom designed and parties may agree upon the contract size, expiration date, the asset type, quality, etc.

Underlying asset - The underlying asset can be a stock, bond, commodity, foreign currency, interest rate or any combination thereof.

Symmetrical rights and obligations - Both the parties to a forward contract have equal rights and obligations. The buyer is obliged to buy and the seller is obliged to sell at maturity. They can also enforce each other to perform the contract.

Non-regulated market - Forward contracts are private and are largely non-regulated, consisting of banks, government, corporations and investment banks. It is not regulated by any exchange.

Counter-party Risk or default risk - This is a risk of non-performance of obligation by either party as regards to payment (buyer) or delivery (seller). Being a private contract, there are chances of default or counter party risk.

Held till maturity - The contracts are generally held till maturity. A forward contract cannot be squared up at the wish of one party. It can be cancelled only with the consent of the other party.

Liquidity - Liquidation is low, as contracts are customised catering to the needs of parties involved. They are not traded on an exchange.

Settlement of Contract - Settlement of a derivative contract can be in two ways - through delivery or through cash settlement. Most of the forward contracts are settled through delivery. In this case the buyer pays the price and seller gives the delivery of the specified asset at maturity. Some of the forward contracts are also cash settled. In case of cash settlement, the parties only pay/receive the price

Para 11.5

differential so as to settle the contract. No physical delivery of asset takes place and hence no full payment is made for the contract.

11.5 FUTURES

A Futures contract is a refined or modified forward contract. A futures contract is a contract to buy or sell a specified asset (physical or financial asset) at a specified price on a specified future date. It is traded on an exchange and is a standardised contract. A financial futures contract is a contract wherein two parties agree to buy or sell a specified financial asset at a specified price on a specified future date. Futures contracts are generally traded on an exchange which sets the basic standardized rules for trading in the futures contracts.

Features:

Standardised Contract - Terms and conditions of future contracts are standardized. They are specified by the exchange where they are traded.

Exchange based Trading - Trading takes place on a formal exchange which provides a place to engage in these transactions and sets a mechanism for the parties to trade these contracts.

No default risk - Futures contract has virtually no default risk because the exchange acts as a counterparty and guarantees delivery and payment with the help of a clearing house.

Clearing house - The clearing house protects the parties from default by requiring the parties to deposit margin and settle gains and losses (or mark to market their positions) on a daily basis.

Liquidity - Futures contracts are highly liquid contracts as they are continuously traded on the exchange. Any party can square up his position any time.

Before maturity settlement possible - An investor can offset his future position by engaging in an opposite transaction before the stipulated maturity of the contract.

Margin requirement - All futures contracts have margin requirements. Margin money is required to be deposited with the exchange by both the buyer as well as seller at the time of entering into the contract. Margin is important to safeguard the interest of the other party. There are two types of margins – initial margin and maintenance margin. Initial margin is the margin amount to be deposited initially with the exchange. If contract value is Rs. 100000, initial margin requirement

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is 5% and maintenance margin is 2%, then the buyer of the contract has to deposit Rs. 5000 with the exchange in his margin account. Now margin account is settled on daily basis i.e. mark to market settlement. If margin amount in the account on any day falls below the maintenance margin of Rs. 2000, then a variable call is made to replenish the margin amount to the level of initial margin.

Settlement mechanism - Settlement of a derivative contract can be in two ways- through delivery or through cash settlement. Very few of the futures contracts are settled through delivery. In this case the buyer pays the price and seller gives the delivery of the specified asset at maturity. Most of the futures contracts are cash settled. In case of cash settlement, the parties only pay/receive the price differential so as to settle the contract. No physical delivery of asset takes place and hence no full payment is made for the contract. In case of Index futures the settlement is done only through cash as an Index cannot be delivered.

11.5.1 Futures Contract Terminology

Spot price - The price at which an underlying asset trades in the spot market.

Futures price - The price that is agreed upon at the time of the futures contract for the delivery of an asset at a specific future date.

Contract cycle - It is the period over which a contract trades on the exchange. Every month on Friday following the last Thursday; a new contract having a three-month expiry is introduced for trading, on NSE and BSE

Expiry date - Is the date on which the final settlement of the contract takes place. Last Thursday of every month is expiry date for futures contracts. If that happens to be a trading holiday then previous working day.

Contract Size or Lot size - The quantity of the underlying asset that has to be delivered under one contract.

Price steps - The minimum difference between two price quotes. The price step in respect of CNX Nifty futures contracts is Re. 0.05.

Price bands - The minimum and maximum price change allowed in a day is termed as price bands. It is generally +- 10%. There are no day minimum/maximum price ranges applicable for CNX Nifty futures contracts. However, in order to prevent erroneous order entry by trading members, operating ranges are kept at +/- 10%.

11.5.2 Comparison between Forwards and Futures

Though both forwards and futures share common characteristics, they differ on the following grounds:

BASIS FORWARDS FUTURES

S tandardisation of contract

Forward contracts are private agreements between two parties and are non-standardised.

Trading & Regulation Forwards are not traded on stock exchange. They are not regulated.

Counter party default risk

There is always a possibility that a party may default.

Liquidity Liquidity is low, as contracts are tailor-made contracts catering to the needs of parties involved. Further, they are not easily accessible to other market participants.

Price Discovery

Price discovery is not efficient, as markets are scattered.

Settlement Settlement of the Forward contract occurs at the end of the contract, i.e. S ettlement date only.

Hedging/speculation Forward contracts are popular among hedgers.

Margin Requirements T here is no requirement for depositing margin money by either party.

Futures contracts are exchange traded and standardised contracts as terms and conditions are set in advance.

Futures are traded on stock exchange and are regulated.

Clearing houses guarantee the transaction, thus minimising the default risk.

Liquidity is high, as contracts are standardised exchange-traded contracts.

Price discovery is efficient, as markets are centralised.

Futures contracts are marked-to market on daily basis which means that they are settled day by day until the end of the contract.

Futures are popular among speculators.

Both the buyer and seller have to deposit margin money with the exchange.

Examples F oreign Currency market in India Commodities futures, Index futures and Individual Stock futures in India.

11.5.3 Types of Financial Futures Contracts

Financial futures contracts can be - index futures, stock futures, currency futures, interest rate futures depending upon the underlying asset. In case of

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index futures, the underlying asset is an Index. In this chapter we deal with only two types of financial futures viz - Index futures and Stock Futures.

a. INDEX FUTURES

In case of Index futures the underlying asset is a stock index say NIFTY or SENSEX. A stock index is constructed by selecting a number of stocks and is used to measure changes in the prices of that group of stocks over a period of time. Futures contracts are also available on these indices. This helps investors make money on the performance of the index.

Contract size : Index futures contracts are dealt in lots. The stock indices points – the value of the index – are converted into rupees.

For example, suppose the BSE Sensex value was 6000 points. The exchange stipulates that each point is equivalent to Rs. 1, Further each contract has a lot size of 100. Then the value of one contract will be 100 times the index value – Rs. 6,00,000 i.e. 1×6,000×100.

Expiry : An open position in index futures can be settled by conducting an opposing transaction on or before the day of expiry.

Duration: Index futures have three contract series open for trading at any point in time - the near-month (1 month), middle-month (2 months) and far-month (3 months) index futures contracts.

Example : If the index stands at 3550 points in the cash market today and an investor decide to purchase one Nifty 50 July future, he would have to purchase it at the price prevailing in the futures market. The price of one July futures contract could be anywhere above, below or at Rs. 3.55 lakh (i.e., 3550×100), depending on the prevailing market conditions. Investors and traders try to profit from the opportunity arising from this difference in prices.

b. STOCK FUTURES

Stock futures are futures contracts where the underlying is an individual stock. For example SBI stock futures have SBI stock as the underlying asset.

Lot/Contract size : In the financial derivatives market, the contracts are not traded for a single share. Instead, every stock futures contract consists of a fixed lot of the underlying share.

The size of this lot is determined by the exchange and it differs from stock to stock. For instance, a Reliance Industries Ltd. (RIL) futures contract has a lot of 250 RIL shares, i.e., when you buy one futures contract of RIL, you are actually trading 250 shares of RIL Similarly, the lot size for Infosys is 125 shares.

Duration : Stock Futures contracts are also available in durations of 1 month, 2 months and 3 months. These are called near month, middle month and far month, respectively. The month in which it expires is called the contract month and new future contracts are issued on the day after expiry of the last contract.

Expiry : All three maturities contracts are traded simultaneously on the exchange and expire on the last Thursday of their respective contract months. If the last Thursday of the month is a holiday, they expire on the previous business day. In this system, as nearmonth contracts expire, the middle-month (2 month) contracts become near-month (1 month) contracts and the far-month (3 month) contracts become middle-month contracts.

Example: If an investor purchased a single June futures contract of XYZ Ltd., he has to buy at price at which the June futures contracts are currently available in the derivatives market. Let’s say these futures are trading at Rs. 1,000 per share. This implies, the investor agrees to buy/sell at a fixed price of Rs. 1,000 per share on the last Thursday in June. However, it is not necessary that the price of the stock in the cash market (or spot market) on last Thursday has to be Rs. 1,000. It could be Rs. 992 or Rs. 1,005 or anything else, depending on the prevailing market conditions. This difference in prices lead to profit or loss.

11.5.4 Pricing (Or Valuation) of Futures Contract (Or a Forward Contract)

When an investor enters a futures contract, he agrees either to buy or to sell the asset underlying the futures contract on a fixed date in future at a specified price. Pricing of futures contract means determination of the specified price at which contract will be executed. The theoretical or fair price of a futures contract can be determined through Cost of Carry Model. The actual price of a futures contract is however determined through the forces of demand and supply in futures market.

Cost of Carry Model:

The fair value or theoretical price of a futures contract must be equal to the

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current value of the underlying shares or index, plus an amount referred to as the ‘cost of carry’. The cost of carry reflects the cost of holding the underlying asset or shares over the life of the futures contract reduced by the amount the shareholder would receive in dividends or incomes on those assets or shares during that time.

Based upon the payment and non-payment of dividend, the following situations may arise:

Situation

Applicable Pricing Model

When the underlying asset provides no income (or dividend) = rt FSe

When the underlying asset provides known income (or dividend)

When the underlying asset provides known income yield (or dividend yield)

Where

F = Futures Price

S = Spot Price of the underlying asset

e = 2.71828 (base of natural logarithm)

rt FSIe ()=−

rqt FSe () =

r = Continuously compounding rate of interest p.a.

t = Time duration of futures in years

I = Present value of income or dividend at r

q = Income yield (or Dividend yield)

Note :

The above futures price needs to be multiplied with the lot size or contract size in order to determine the value of a futures contract.

The Cost of Carry model provides the theoretical or fair price of the futures contract. The actual price is determined in the market according to demand and supply forces.

Investment decision : If fair or theoretical price of a futures contract is higher than its actual market price then a prospective investor should buy it. In such a case the futures contract is underpriced. On the other hand if fair or theoretical price of a futures contract is lower than its actual market price then a prospective investor should not buy it. If the investor holds such a futures contract then he should immediately sell it. In this case futures contract is overpriced. If fair or theoretical price of a futures contract is equal to its actual market price then the contract is efficiently and correctly priced in the market.

Para 11.5

Illustration 11.1 Consider a stock futures contract on a non-dividend paying share which is currently trading at Rs. 70 in the spot market. The futures contract mature in 3 months and the continuously compounded risk free rate is 8% per annum. Calculate the price of one stock futures contract having lot size of 100. (e0.02= 1.0202).

Solution:

F = Sert = 70e(0.08)3/12 = 70e0.02 = Rs. 71.41

Lot size = 100, Hence the price of one futures contract = 100 × 71.41 = Rs. 7141

Illustration 11.2 Consider a 3-month stock index futures contract NIFTY Index. The current value of the index is 520 and continuously compounded dividend yield expected on the underlying shares is 4% per annum and continuously compounded risk free rate is 10% per annum. Calculate the price of one futures contract if lot size is 100. (e0.015= 1.015)

Solution:

F = Se(r-q)t = 100 × 520 e(0.10-0.04)3/12 = 100 × 520e0.015 = Rs. 52,785

Illustration 11.3 Consider a 12-month stock index futures contract on NIFTY Index. The current value of the index is 5200 and continuously compounded risk free rate is 10% per annum. The stock index is expected to provide a dividend of Rs. 120 at the end of the year. Calculate the price of one futures contract if lot size is 100. (e0.10= 1.105)

Solution: The present value of Rs. 120 dividend to be received at the end of the years will be calculated as follows: (r =10%)

P.V of Dividend = I = 120 e–(0.10) = 108.58

F = (S - I)ert = 100 × (5200 - 108.58)e(0.10)) = Rs. 562689

Illustration 11.4 The price of shares of XYZ Ltd. is Rs. 50 in the spot market. The risk free rate is 12% per annum with continuous compounding. An investor wants to enter into a 6 months forward contract. Calculate the forward price. (e0.06= 1.062)

Solution: F = Sert = 50e(0.12)6/12 = 50e0.06 = Rs. 53.09

Illustration 11.5 The shares of PQR Ltd. are currently selling at Rs. 900 per share. The 4 months futures contract on this share is available at Rs. 915. Should the investor buy this future if the risk free rate of interest is 12%.

Solution:

F = Sert = 900e(0.12)4/12 = 900e0.04 = Rs. 936.73

Para 11.6 FINANCIAL DERIVATIVES - FORWARDS, FUTURES & OPTIONS 438

As the futures are available at Rs. 915 only, the investor should buy the futures.

Illustration 11.6 An investor buys Sensex futures at a price of 5500 in the market lot size of 400. On the settlement date, the Sensex is 5700. Find out his profit or loss for one futures contract.

Solution:

Profit = (5700-5500) × 400 = Rs. 80000

Illustration 11.7 A share is currently selling at Rs. 900 in the spot market. Dividend of Rs. 20 is expected after 6 months and after 12 months. The risk free rate is 18% per annum with continuous compounding. What is price of a 12 months futures contract?

Solution : Here we have dividend income of Rs. 20 at the end of 6 months and Rs. 20 at the end of 12 months.

Hence the present value of dividend incomes = I = 20e-(0.18)6/12 + 20e-(0.18)12/12 = 20e-0.09 + 20e-(0.18) = 20(0.913) + 20(0.835) = 18.27 + 16.70 = Rs. 34.98

Futures Price = (900 - 34.98)e(0.18)12/12 = (865.02)(1.197)

= Rs. 1035.6

11.6 OPTIONS

An options is a contract that gives its buyer (holder) a right (but not obligation) to buy or sell a specified asset at a specified price (exercise price) on or before a specified future date. An options is a contract sold by one party (option-writer) to another party (option holder). The holder of the options can exercise the option at specified price or may allow it to lapse. The specified price is also termed as strike price or exercise price. The options contract gives a right to the buyer. The seller has the obligation but no right. If the option holder exercises the option, then the writer or seller of the option will be obliged to perform. Hence when the option holder has a right to buy, the option writer has the obligation to sell. When option holder has a right to sell, then the option writer has the obligation to buy. Hence in case of options, the buyer and sellers are not on equal footing. The buyer has a privileged position. Since the buyer has a right but no obligation, he has to pay some price, known as options premium to the seller (or writer) of the option. NO RIGHT COMES FREE OF COST

Hence the buyer pays options premium to the seller to buy the right to buy or sell. The seller receives this options premium as a compensation for the obligation he undertakes. Hence options contracts are asymmetrical

w.r.t. rights and obligations. The buyer of the options contract has a right but no obligation. The seller or writer of the options has an obligation but no right. Since the holder of the option has a right, he may not exercise his right if the conditions are unfavourable. Hence it is possible that the options contract is not exercised at all.

This clearly differentiate options contract from futures contract discussed above. In case of futures contracts, both the buyer as well as seller has equal rights and obligations. They can enforce each other to perform the contract. At the same time they are obliged to perform the contract.

COMPARISON BETWEEN FUTURES AND OPTIONS

BASIS FUTURES OPTIONS

Rights Both the parties have right to ask for the performance of the contract.

Only the buyer (or holder) of the options has the right to buy or sell. Seller does not have any right.

Obligations Both the parties are obliged to perform the contract. Only the seller is obliged to perform the contract.

Premium payment

Margin requirement

No premium is paid by either party. The buyer pays the options premium to seller.

Both the parties have to deposit some initial margin as per the requirements of the exchange.

Profit and loss potential

Only the option writer has to deposit initial margin with the exchange as only the seller is exposed to price risk. No margin is to be deposited by the option holder, as he has a right but no obligation.

Realisation of profits/ losses

The buyer as well as the seller of the futures contract are exposed to all the downside risk and has potential for all upside profits. The gain to the buyer is loss to the seller and the loss to the buyer is gain to the seller. There is unlimited gain and loss possibility for both the parties.

Profit or loss on futures are ‘marked to market’ daily, meaning the change in the value of the positions is attributed to the accounts of the parties at the end of every trading day - but a futures holder can realize profits/losses

The option holder’s loss is limited (to the extent of premium paid), but has potential for all upside profits. The seller’s gain is limited to the amount of options premium but he is exposed to all the downside risk (i.e. potential loss is unlimited).

The gain on option can be realized in the following ways:

a. E xercising the option at expiry

Para 11.6 FINANCIAL DERIVATIVES - FORWARDS, FUTURES & OPTIONS 440

BASIS FUTURES OPTIONS

by going to the market and taking the opposite position.

b Going to the market and taking the opposite position, or

c Waiting until expiry and collecting the difference between the asset price and the strike price.

Execution of contract

F utures contract are settled through cash or delivery but they are always executed.

Buyer may or may not exercise the option and therefore the option contract may lapse without being exercised or become a waste.

Purpose Futures are used to hedge and speculate. Usually used as a hedge instrument. Options are a better hedging instrument than futures. This is because here the hedger keeps all the potential for upside gain but his loss is limited.

Types of Options:

a. Call options - An options contract that gives its holder the ‘right to buy’ a specified asset at a specified price on or before a specified future date, is termed as call option. The seller has the obligation to sell. A call option is bought when the buyer of the call option fears a rise in underlying asset’s price. A call option is exercised when the stock price is greater than the exercise price. In such a case the holder of the call options can buy the stock or asset at the exercise price which is lower than the prevailing market price.

For example: Let us assume that the current price of SBI shares is Rs. 119. Mr. A expects that the price of SBI share will go up, hence he buys a call option on SBI shares at the exercise price of Rs. 120. The expiration date is after 1 month. Further assume that the option can be exercised only on the expiry date and not before that. Now if on the expiry date, the prevailing market price of SBI share is more than 120, say Rs. 125, then Mr. A will exercise the option. He will buy a share of SBI by exercising his call option at the price of Rs. 120. He can sell it at the market price of 125 in spot market and make a gain of Rs. 5. If on the other hand the market price is Rs. 115 on the date of expiry, then Mr. A will not exercise this call option. His loss in this case will be the amount of option premium that he must have paid at the time of buying this call option.

Para 11.6

b. Put option - A put option provides a right to sell. An option contract that gives its holder the ‘right to sell’ a specified asset at a specified price on or before a specified future date, is termed as put option The seller has the obligation to buy. A put option is bought when the buyer of the put option fears a decline in underlying asset’s price. A put option is exercised when the stock price (or the underlying asset’s price) is lower than the exercise price. In such a case the holder of the put option can sell the stock (or asset) at the exercise price which is higher than the prevailing market price.

For example: Let us assume that the current price of SBI shares is Rs. 119. Mr. A expects that the price of SBI share will go down, hence he buys a put option on SBI shares at the exercise price of Rs. 120. The expiration date is after 1 month. Further assume that the option can be exercised only on the expiry date and not before that. Now if on the expiry date, the prevailing market price of SBI share is less than 120, say Rs. 116, then Mr. A will exercise the option. He will sell a share of SBI by exercising his put option at the price of Rs. 120, and make a gain of Rs. 4. If on the other hand the market price is Rs. 123 on the date of expiry, then Mr. A will not exercise this put option. His loss in this case will be the amount of option premium that he must have paid at the time of buying this put option.

Styles of Options:

a. European options - A European style options contract can be exercised only on the expiration date. In the above examples the call options as well as put options were of European style as it is given that they can be exercised only on the expiration date and not before that.

b. American options - An American style options contract can be exercised at any time before the expiration or on the expiration date. American options provide more flexibility to the holder of the options, as he may exercise the options anytime till maturity. Therefore, American style of options have higher options premium than the European style of options.

Covered Options and Naked options

There are two ways to write options – Covered option writing and Naked option writing.

a. Covered option – Covered option means an option for which the seller owns the underlying securities. When the option writer has the underlying stock and writes (or sells) the option to buy that stock (i.e.

FUNDAMENTALS OF INVESTMENTS

AUTHOR : VANITA

TRIPATHI

PUBLISHER : TAXMANN

DATE OF PUBLICATION : JANUARY 2023

EDITION : 6th Edition

ISBN NO : 9789356225848

NO.OF PAGES : 646

BINDING TYPE : PAPERBACK

DESCRIPTION

Rs. 645 USD 39

The present book on 'Fundamentals of Investments' is written to provide the reader with a comprehensive understanding of the investment environment and investment decision process. It explains the various concepts, tools, and techniques related to investment in financial assets with lively examples and suitable illustrations. This book features a comprehensive discussion of the following concepts:

• Risk and Returns

• Sources and Measurements

• Valuation of Securities

• Approaches to Security Valuation

• Portfolio Analysis

• Selection and Management, including performance evaluation

This book is a comprehensive, up-to-date, illustrated textbook on Investment Management. This book covers the entire syllabus prescribed for students pursuing Undergraduate Courses in Commerce & Management & specifically for the students of B.Com. (Hons.)/B.Com. under CBCS Programme at Delhi University and Other Central Universities throughout India.

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