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INDUSTRY PROFILE
Journey of Indian stock market
Indian Stock Markets are one of the oldest in Asia. Its history dates
back to nearly 200 years ago. The earliest records of security
dealings in India are meager and obscure. The East India Company
was the dominant institution in those days and business in its loan
securities used to be transacted towards the close of the eighteenth
century.
By 1830's business on corporate stocks and shares in Bank andCotton presses took place in Bombay. Though the trading list was
broader in 1839, there were only half a dozen brokers recognized
by banks and merchants during 1840 and 1850.
The 1850's witnessed a rapid development of commercial
enterprise and brokerage business attracted many men into the
field and by 1860 the number of brokers increased into 60.
In 1860-61 the American Civil War broke out and cotton supply from
United States of Europe was stopped; thus, the 'Share Mania' in
India begun. The number of brokers increased to about 200 to 250.
However, at the end of the American Civil War, in 1865, a
disastrous slump began (for example, Bank of Bombay Share which
had touched Rs 2850 could only be sold at Rs. 87).
At the end of the American Civil War, the brokers who thrived out of
Civil War in 1874, found a place in a street (now appropriately
called as Dalal Street) where they would conveniently assemble
and transact business. In 1887, they formally established in
Bombay, the "Native Share and Stock Brokers' Association" (which
is alternatively known as "The Stock Exchange "). In 1895, the
Stock Exchange acquired a premise in the same street and it was
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inaugurated in 1899. Thus, the Stock Exchange at Bombay was
consolidated.
Growth Pattern of the Indian Stock Market
Sr.No.
As on 31stDecember
1946 1961 1971 1975 1980 1985 1991 1995
1No. ofStockExchanges
7 7 8 8 9 14 20 22
2No. ofListed Cos.
1125 1203 1599 1552 2265 4344 6229 8593
3No. ofStockIssues ofListed Cos.
1506 2111 2838 3230 3697 6174 8967 11784
4
Capital ofListedCos. (Cr.Rs.)
270 753 1812 2614 3973 9723 32041 59583
5
Marketvalue ofCapital of
ListedCos. (Cr.Rs.)
971 1292 2675 3273 6750 25302 110279 478121
6
Capital perListed Cos.(4/2)(Lakh Rs.)
24 63 113 168 175 224 514 693
7
MarketValue ofCapital perListed
Cos. (LakhRs.)(5/2)
86 107 167 211 298 582 1770 5564
8
Appreciatedvalueof CapitalperListed Cos.(Lakh Rs.)
358 170 148 126 170 260 344 803
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COMPANY PROFILE
Kotak Securities Limited
Kotak Securities Ltd., a subsidiary of Kotak Mahindra Bank Limited,
is one of Indias largest private brokerage and distribution house,
set up in 1994, by Mr. Uday Kotak; it has equity participation from
Goldman Sachs L. I. P. (25%).
Kotak Securities is a corporate member of both the Bombay Stock
Exchange (BSE) and the National Stock Exchange (NSE). Its
operations include stock broking, distribution of various Investment
products including private and secondary placement of debt and
equity, mutual funds, fixed deposits and the like. Currently Kotak
Securities is one of the largest broking houses in India with offices
in more than fifteen cities. In India as well as a presence in US,
Europe and the Middle East (through our associate companies
Kotak Mahindra U.K. Limited and Kotak Mahindra International
Limited, Kotak Mahindra Inc).
Our core strengths are our expertise in equity research and a wide
retail distribution network. We have an outstanding research
division involved in macro economic studies, industry andcompany specific equity research, with analyst specializing in
particular economic sectors and large cap stocks.
In August 2000, Kotak Securities launched Kotakstreet.com, its e
broking service for retail investors on the net and currently has over
20,000 registered users.
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Kotak Securities Limited is one of the larger players in distribution of
IPOs - it was ranked number One in 2003-04 as Book Running
Lead Manager in public equity offerings by PRIME Database. It has
also won the Best Equity House Award from Finance Asia - April
2004.
The Company has a full-fledged Research division involved in
macro economic studies, sectoral research and Company specific
equity research combined with a strong and well networked sales
force which helps deliver current and up-to-date market information
and news.
Kotak Securities Limited is also a depository participant with
National Securities Depository Limited (NSDL) and Central
Depository Services Limited (CDSL) providing dual benefit services
wherein the investors can use the brokerage services of the
Company for executing the transactions and the depository services
for settling them.
The Company has 113 branches servicing around 1,00,000
customers, through our own offices and a large franchisee network.
Its has an Online presence through Kotakstreet.com where we
offer Internet Broking services and also online IPO and Mutual Fund
Investments.
Kotak Securities Limited manages assets over Rs. 1700 crores
through its Portfolio Management Services (PMS) servicing high
net worth clients with a large investible surplus through its preferred
client services in the mass affluent and wealth management
segments.
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OBJECTIVE OF THE STUDY
To provide basic idea of different stock market investment
instruments to investor.
To provide knowledge to investor about various type of
risk associated with various investment instruments.
To provide investor knowledge about P\E, P\BV and Beta
that would help them in selection of script and creation of
portfolio.
To help investor in learning about derivative instrument
future for the purpose of speculation and hedging.
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METHODOLOGY OF THE PROJECT
Research problem:
To identified the Stock Market Investment Avenue and methods to
help investor in selection of script to create portfolio. And the
measures of hedging the portfolio with the use of derivative
instrument future.
Research design:
Research design is exploratory as the basic objective is to identified
the stocks and methods to create and protect portfolio.
Data collection:
Primary data : - Primary data are collected by my regularly
tracking the stock price of various script selected
Secondary data :- Secondary data are collected from various
journals , websites and financial news paper.
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LIMITATIONS OF THE PROJECT
The time duration given to complete the report was
not sufficient.
The report is basically is made between the horizon of
two months and the situation of market is very
dynamic so the conclusion or the return might not
reflect the true picture.
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ANALYSIS OF INVESTMENT
WHAT IS INVESTMENT?
Investment is the activity, which is made with the objective of
earning some sort of positive returns in the future. It is the
commitment of the funds to earn future returns and it involves
sacrificing the present investment for the future return. Every
person makes the investment so that the funds he has increases as
keeping cash with himself is not going to help as it will not generateany returns and also with the passage of time the time value of the
money will come down. As the inflation will rise the purchasing
power of the money will come down and this will result that the
investor who does not invest will become more poor as he will not
have any funds whose value have been increased. Thus every
person whether he is a businessman or a common man will make
the investment with the objective of getting future returns.
TYPES OF INVESTMENT:-
There are basically three types of investments from which the
investors can choose. The three kinds of investment have their own
risk and return profile and investor will decide to invest taking into
account his own risk appetite. The main types of investments are: -
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Economic investments:-
These investments refer to the net addition to the capital stock of
the society. The capital stock of the society refers to the
investments made in plant, building, land and machinery which are
used for the further production of the goods. This type of
investments are very important for the development of the economy
because if the investment are not made in the plant and machinery
the industrial production will come down and which will bring down
the overall growth of the economy.
Financial Investments:-
This type of investments refers to the investments made in the
marketable securities which are of tradable nature. It includes the
shares, debentures, bonds and units of the mutual funds and any
other securities which is covered under the ambit of the Securities
Contract Regulations Act definition of the word security. The
investments made in the capital market instruments are of vital
important for the country economic growth as the stock market
index is called as the barometer of the economy.
General Investments:-
These investments refer to the investments made by the common
investor in his own small assets like the television, car, house,
motor cycle. These types of investments are termed as the
household investments. Such types of investment are important for
the domestic economy of the country. When the demand in the
domestic economy boost the over all productions and the
manufacturing in the industrial sectors also goes up and this causes
rise in the employment activity and thus boost up the GDP growth
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rate of the country. The organizations like the Central Statistical
Organization (CSO) regularly takes the study of the investments
made in the household sector which shows that the level of
consumptions in the domestic markets.
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CHARACTERISICS OF INVESTMENT
Certain features characterize all investments. The following are the
main characteristics features if investments: -
1.Return: -
All investments are characterized by the expectation of a return. In
fact, investments are made with the primary objective of deriving a
return. The return may be received in the form of yield plus capital
appreciation. The difference between the sale price & the purchase
price is capital appreciation. The dividend or interest received from
the investment is the yield. Different types of investments promise
different rates of return. The return from an investment depends
upon the nature of investment, the maturity period & a host of other
factors.
2.Risk: -
Risk is inherent in any investment. The risk may relate to loss of
capital, delay in repayment of capital, nonpayment of interest, or
variability of returns. While some investments like government
securities & bank deposits are almost risk less, others are more
risky. The risk of an investment depends on the following factors.
The longer the maturity period, the longer is the risk.
The lower the credit worthiness of the borrower, the higher is
the risk.
The risk varies with the nature of investment. Investments in
ownership securities like equity share carry higher risk compared to
investments in debt instrument like debentures & bonds.
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3. Safety: -
The safety of an investment implies the certainty of return of capital
without loss of money or time. Safety is another features which an
investors desire for his investments. Every investor expects to getback his capital on maturity without loss & without delay.
4. Liquidity: -
An investment, which is easily saleable, or marketable without loss
of money & without loss of time is said to possess liquidity. Some
investments like company deposits, bank deposits, P.O. deposits,
NSC, NSS etc. are not marketable. Some investment instrumentlike preference shares & debentures are marketable, but there are
no buyers in many cases & hence their liquidity is negligible. Equity
shares of companies listed on stock exchanges are easily
marketable through the stock exchanges.
An investor generally prefers liquidity for his investment, safety of
his funds, a good return with minimum risk or minimization of risk &
maximization of return.
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IMPORTANCE
In the current situation, investment is becomes necessary for
everyone & it is important & useful in the following ways:
1. Retirement planning: -
Investment decision has become significant as people retire
between the ages of 55 & 60. Also, the trend shows longer life
expectancy. The earning from employment should, therefore, be
calculated in such a manner that a portion should be put away as a
savings. Savings by themselves do not increase wealth; these must
be invested in such a way that the principal & income will be
adequate for a greater number of retirement years. Increase in
working population, proper planning for life span & longevity have
ensured the need for balanced investments.
2. Increasing rates of taxation: -
Taxation is one of the crucial factors in any country, which introduce
an element of compulsion, in a persons saving. In the form
investments, there are various forms of saving outlets in our
country, which help in bringing down the tax level by offering
deductions in personal income.
For examples: -
Unit linked insurance plan,
Life insurance,
National saving certificates,
Development bonds,
Post office cumulative deposit schemes etc.
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3. Rates of interest: -
It is also an important aspect for sound investment plan. It varies
between investment & another. This may vary between risky & safe
investment, they may also differ due different benefits schemesoffered by the investments. These aspects must be considered
before actually investing. The investor has to include in his portfolio
several kinds of investments stability of interest is as important as
receiving high rate of interest.
4. Inflation: -
Since the last decade, now a days inflation becomes a continuousproblem. In these years of rising prices, several problems are
associated coupled with a falling standard of living. Before funds
are invested, erosion of the resource will have to be carefully
considered in order to make the right choice of investments. The
investor will try & search outlets, which gives him a high rate of
return in form of interest to cover any decrease due to inflation. He
will also have to judge whether the interest or return will be
continuous or there is a likelihood of irregularity. Coupled with high
rate of interest, he will have to find an outlet, which will ensure
safety of principal. Beside high rate of interest & safety of principal
an investor also has to always bear in mind the taxation angle, the
interest earned through investment should not unduly increase his
taxation burden otherwise; the benefit derived from interest will be
compensated by an increase in taxation.
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5. Income: -
For increasing in employment opportunities in India., investment
decisions have assumed importance. After independence with the
stage of development in the country a number of organization &services came into being.
For example: -
The Indian administrative services,
Banking recruitment services,
Expansion in private corporate sector,
Public sector enterprises,
Establishing of financial institutions, tourism, hotels, and education.
More avenues for investment have led to the ability & willingness of
working people to save & invest their funds.
6. Investment channels: -
The growth & development of country leading to greater economic
activity has led to the introduction of a vast array of investment
outlays. Apart from putting aside saving in savings banks where
interest is low, investor have the choice of a variety of instruments.
The question to reason out is which is the most suitable channel?
Which media will give a balanced growth & stability of return? The
investor in his choice of investment will give a balanced growth &
stability of return? The investor in his choice of investment will have
try & achieve a proper mix between high rates of return to reap the
benefits of both.
For example: -
Fixed deposit in corporate sector
Unit trust schemes.
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INVESTMENTS AVENUES:-
There are various investments avenues provided by a country to its
people depending upon the development of the country itself. Thedeveloped countries like the USA and the Japan provide variety of
investments as compared to our country. In India before the post
liberalization era there were limited investments avenues available
to the people in which they could invest. With the opening up of the
economy the number of investments avenues have also increased
and the quality of the investments have also improved due to the
use of the professional activity of the players involved in this
segment. Today investment is no longer a process of trial and error
and it has become a systematized process, which involves the use
of the professional investment solution provider to play a greater
role in the investment process.
Earlier the investments were made without any analysis as the
complexity involved the investment process were not there and also
there was no availability of variety of instruments. But today as the
number of investment options have increased and with the variety
of investments options available the investor has to take decision
according to his own risk and return analysis.
An investor has a wide array of Investment Avenue. They are
as under:
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Investment
Fixed Income
Deposits
Life Insurance
Precious
Tax Sheltered
Real Estate
Financial Derivatives
Mutual Fund
Equity
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Types of Equity Instruments:
Ordinary Shares
Ordinary shareholders are the owners of a company, and each
share entitles the holder to ownership privileges such as dividends
declared by the company and voting rights at meetings. Losses as
well as profits are shared by the equity shareholders. Without anyguaranteed income or security, equity shares are a risk investment,
bringing with them the potential for capital appreciation in return for the
additional risk that the investor undertakes in comparison to debt
instruments with guaranteed income.
Preference Shares
Unlike equity shares, preference shares entitle the holder to dividendsat fixed rates subject to availability of profits after tax. If preference
shares are cumulative, unpaid dividends for years of inadequate
profits are paid in subsequent years. Preference shares do not
entitle the holder to ownership privileges such as voting rights at
meetings.
Equity Warrants
These are long term rights that offer holders the right to purchase
equity shares in a company at a fixed price (usually higher than the
current market price) within a specified period. Warrants are in the
nature of options on stocks.
EQUITY SHARES: -
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Classification in terms of Market Capitalisation
Market capitalisation is equivalent to the current value of a company
i.e. current market price per share times the number of outstandingshares. There are Large Capitalisation companies, Mid-Cap
companies and Small-Cap companies. Different schemes of a fund
may define their fund objective as a preference for Large or Mid or
Small-Cap companies' shares. Large Cap shares are more liquid and
hence easily tradable. Mid or Small Cap shares may be thought of
as having greater growth potential. The stock markets generally
have different indices available to track these different classes ofshares.
Classification in terms of Anticipated Earnings
In terms of the anticipated earnings of the companies, shares are
generally classified on the basis of their market price in relation to
one of the following measures:
* Price/Earnings Ratio is the price of a share divided by the
earnings per share, and indicates what the investors are willing
to pay for the company's earning potential. Young and/or fast
growing companies usually have high P/E ratios. Established
companies in mature industries may have lower P/E ratios. The
P/E analysis is sometimes supplemented with ratios such as
Market Price to Book Value and Market Price to Cash Flow per
share.
Dividend Yield for a stock is the ratio of dividend paid per share
to current market price. Low P/E stocks usually have high
dividend yields. In India, at least in the past, investors have
indicated a preference for the high dividend paying shares. What
matters to fund managers is the potential dividend yields based on
earnings prospects.
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Based on companies' anticipated earnings and in the light of the
investment management experience the world over, stocks are
classified in the following groups:
Cyclical Stocks are shares of companies whose earnings are
correlated with the state of the economy. Their earnings (and
therefore, their share prices) tend to go up during upward
economic cycles and vice versa. Cement or Aluminium
producers fall into this category, just as an example. These
companies may command relatively lower P/E ratios, and
have higher dividend pay-outs.
Growth Stocks are shares of companies whose earnings are
expected to increase at rates that exceed normal market levels.
They tend to reinvest earnings and usually have high P/E ratios and
low dividend yields. Software or information technology
company shares are an example of this type. Fund managers
try to identify the sectors or companies that have a high growth
potential.
Value Stocks are shares of companies in mature industries
and are expected to yield low growth in earnings. These
companies may, however, have assets whose values have not
been recognised by investors in general. Fund managers try to
identify such currently under-valued stocks that in their opinion
can yield superior returns later. A cement company with a lot of
real estate and a company with good brand names are
examples of potential value shares.
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Many instruments give regular income. Debt instruments may be
secured by the assets of the borrowers as generally in case of
Corporate Debentures, or be unsecured as is the case with Indian
Financial Institution Bonds.
A debt security is issued by a borrower and is often known by the
issuer category, thus giving us Government Securities and Corporate
Securities or FI bonds. Debt instruments are also distinguished by theirmaturity profile. Thus, instruments issued with short-term maturities,
typically under one year, are classified as Money Market Securities.
Instruments carrying longer than one-year maturities are generally
called Debt Securities.
Most debt securities are interest-bearing. However, there are
securities that are discounted securities or zero-coupon bonds that
do not pay regular interest at intervals but are bought at a discount
to their face value. A large part of the interest-bearing securities are
generally Fixed Income-paying, while there are also securities that
pay interest on a Floating Rate basis.
A Review of the Indian Debt Market
The Wholesale Debt Market segment deals in fixed incomesecurities and is fast gaining ground in an environment that has
largely focused on equities.
The Wholesale Debt Market (WDM) segment of the Exchange
commenced operations on June 30, 1994. This provided the first
formal screen-based trading facility for the debt market in the
country.
FIXED INCOME SECURITIES
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This segment provides trading facilities for a variety of debt
instruments including Government Securities, Treasury Bills and
Bonds issued by Public Sector Undertakings/ Corporates/ Banks
like Floating Rate Bonds, Zero Coupon Bonds, Commercial Papers,
Certificate of Deposits, Corporate Debentures, State Government
loans, SLR and Non-SLR Bonds issued by Financial Institutions,
Units of Mutual Funds and Securitized debt by banks, financial
institutions, corporate bodies, trusts and others.
Large investors and a high average trade value characterize this
segment. Till recently, the market was purely an informal market
with most of the trades directly negotiated and struck between
various participants. The commencement of this segment by NSE
has brought about transparency and efficiency to the debt market,
along with effective monitoring and surveillance to the market.
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Business Growth in WDM Segment
YearMarket
Capitalisation(Rs.crores)
Numberof
Trades
Net TradedValue
(Rs.crores)
Average
DailyValue
(Rs.crores)
AverageTrade Size(Rs.crores)
2005-2006
1,553,448 60,159 458,434.94 1,833.74 7.62
2004-2005
1,461,734 124,308 887,293.66 3,028.31 7.14
2003-2004
1,215,864 189,518 1,316,096.24 4,476.52 6.94
2002-2003
864,481 167,778 1,068,701.54 3,598.32 6.37
2001-2002
756,794 144,851 947,191.22 3,277.48 6.54
2000-2001
580,835 64,470 428,581.51 1,482.98 6.65
1999-2000
494,033 46,987 304,216.24 1,034.75 6.47
1998-
1999 411,470 16,092 105,469.13 364.95 6.55
1997-1998
343,191 16,821 111,263.28 377.16 6.61
1996-1997
292,772 7,804 42,277.59 145.28 5.42
1995-1996
207,783 2,991 11,867.68 40.78 3.97
1994-1995
158,181 1,021 6,781.15 30.41 6.64
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Instruments in the Indian Debt Market
Certificate of Deposit
Certificates of Deposit (CD) are issued by scheduled commercial
banks excluding regional rural banks. These are unsecured
negotiable promissory notes. Bank CDs have a maturity period of 91
days to one year, while those issued by FIs have maturities
between one and three years.
Commercial Paper
Commercial paper (CP) is a short term, unsecured instrument
issued by corporate bodies (public & private) to meet short-term
working capital requirements. Maturity varies between 3 months and 1
year. This instrument can be issued to individuals, banks,
companies and other corporate bodies registered or incorporated in
India. CPs can be issued to NRIs on non-repatriable and non-
transferable basis.
Corporate Debentures
The debentures are usually issued by manufacturing companies with
physical assets, as secured instruments, in the form of certificates
They are assigned a credit rating by rating agencies. Trading in
debentures is generally based on the current yield and market values
are based on yield-to-maturity. All publicly issued debentures are
listed on exchanges.
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Floating Rate Bonds (FRB)
These are short to medium term interest bearing instruments
issued by financial intermediaries and corporates. The typicalmaturity of these bonds is 3 to 5 years. FRBs issued by financial
institutions are generally unsecured while those from private
corporates are secured. The FRBs are pegged to different reference
rates such as T-bills or bank deposit rates. The FRBs issued by the
Government of India are in the form of Stock Certificates or issued
by credit to SGL accounts maintained by the RBI.
Government Securities
These are medium to long term interest-bearing obligations issued
through the RBI by the Government of India and state governments.
The RBI decides the cut-off coupon on the basis of bids received
during auctions. There are issues where the rate is pre-specified and
the investor only bids for the quantity. In most cases the coupon is
paid semi-annually with bullet redemption features.
Treasury Bills
T-bills are short-term obligations issued through the RBI by the
Government of India at a discount. The RBI issues T-bills for different
tenures: now 91 -days and 364-days. These treasury bills are issued
through an auction procedure. The yield is determined on the basis
of bids tendered and accepted.
Bank/FI Bonds
Most of the institutional bonds are in the form of promissory notes
transferable by endorsement and delivery. These are negotiable
certificates, issued by the Financial Institutions such as the
IDBI/ICICI/ IFCI or by commercial banks. These instruments have
been issued both as regular income bonds and as discounted long-
term instruments (deep discount bonds).
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Public Sector Undertakings (PSU) Bonds
PSU Bonds are medium and long term obligations issued by public
sector companies in which the government share holding is
generally greater than 51%. Some PSU bonds carry tax
exemptions. The minimum maturity is 5 years for taxable bonds and
7 years for tax-free bonds. PSU bonds are generally not guaranteed
by the government and are in the form of promissory notes
transferable by endorsement and delivery. PSU bonds in electronic
form (demat) are eligible for repo transactions.
An investor can participant in various schemes floated by mutual
fund instead of buying equity shares. In mutual funds invest in
equity shares & fixed income securities. There are three broad
types of mutual fund schemes.
Growth schemes
Income schemes
Balanced schemes
MUTUAL FUND SCHEMES
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It is just like fixed income securities earn a fixed return. However,
unlike fixed income securities, deposits are negotiable or
transferable. The important types of deposits in India are:
Bank deposits
Company deposits
Postal deposits.
It provides benefits to those who participate in them. The most
important tax sheltered saving schemes in India is:
Employee provident fund scheme
Public provident fund schemes
National saving certificate
In a broad sense, life insurance may be viewed as an investment.
Insurance premiums represent the sacrifice & the assured sum the
benefit. In India, the important types of insurance polices are:
Endowment assurance policy
Money back policy
Whole life policy
Premium back term assurance policy
TAX-SHELTERED SAVING SCHEMES
DEPOSITS
TAX-SHELTERED SAVING SCHEMES
LIFE INSURANCE
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For the bilk of the investors the most important asset in their
portfolio is a residential house. In addition to a residential house,
the more affluent investors are likely to be interested in the following
types of real estate:
Agricultural land
Semi-urban land
PRECIOUS OBJECTS: -
It is highly valuable in monetary terms but generally they are small
in size. The important precious objects are:
Gold & silver
Precious stones
Art objects
FINANCIAL DERIVATIVES: -
A financial derivative is an instrument whose value is derived from
the value of underlying asset. It may be viewed as a side bet on the
asset. The most import financial derivatives from the point of view of
investors are:
Options
Futures.
REAL ESTATE
PRECIOUS OBJECTS
FINANCIAL DERIVATIVES
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RISK RETURN OF VARIOUS INVESTMENT
AVENUES
Every investment is characterized by return & risk. Investors
intuitively understand the concept of risk. A person making an
investment expects to get some return from the investment in the
future. But, as future is uncertain, so is the future expected return. It
is this uncertainty associated with the returns from an investment
that introduces risk into an investment. Risk arises where there is a
possibility of variation between expectation and realization with
regard to an investment.
Meaning of Risk
Risk & uncertainty are an integrate part of an investment
decision. Technically risk can be define as situation where the
possible consequences of the decision that is to be taken are
known. Uncertainty is generally defined to apply to situations
where the probabilities cannot be estimated. However, risk &
uncertainty are used interchangeably.
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Types of risks
1. Systematic risk: -
Systematic risk is non diversifiable & is associated with the
securities market as well as the economic, sociological, political, &
legal considerations of prices of all securities in the economy. The
affect of these factors is to put pressure on all securities in such a
way that the prices of all stocks will more in the same direction.
Example: -
During a boom period prices of all securities will rise & indicate that
the economy is moving towards prosperity. Market risk, interest rate
risk & purchasing power risk are grouped under systematic risk.
RISKS
SYSTAMATIC UNSYSTAMATIC
Market Risk Business Risk
Interest Rate Risk Financial Risk
Purchasing power Risk
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1. Systematic Risk
(A) Market risk
Market risk is referred to as stock variability due to changes in
investors attitudes & expectations. The investor reaction towards
tangible and intangible events is the chief cause affecting market
risk.
(B) Interest rate risk
There are four types of movements in prices of stocks in the
markets. These may termed as (1) long term, (2) cyclical (bull and
bear markets), (3) intermediate or within the cycle, and (4) short
term. The prices of all securities rise or fall depending on the
change in interest rates. The longer the maturity period of a security
the higher the yield on an investment & lower the fluctuations in
prices.
(C) Purchasing Power risk
Purchasing power risk is also known as inflation risk. This risk
arises out of change in the prices of goods & services and
technically it covers both inflation and deflation periods. During the
last two decades it has been seen that inflationary pressures have
been continuously affecting the Indian economy. Therefore, in India
purchasing power risk is associated with inflation and rising prices
in the economy.
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2. Unsystematic Risk: -
The importance of unsystematic risk arises out of the uncertainty
surrounding of particular firm or industry due to factors like labour
strike, consumer preferences and management policies. These
uncertainties directly affect the financing and operating enviourment
of the firm. Unsystematic risks can owing to these considerations be
said to complement the systematic risk forces.
(A) Business risk
Every corporate organization has its own objectives and goals and
aims at a particular gross profit & operating income & also accepts
to provide a certain level of dividend income to its shareholders. It
also hopes to plough back some profits. Once it identifies its
operating level of earnings, the degree of variation from this
operating level would measure business risk.
Example:-
If operating income is expected to be 15% in a year, business risk
will be low if the operating income varies between 14% and 16%. If
the operating income were as low as 10% or as high as 18% it
would be said that the business risk is high.
(B) Financial Risk: -
Financial risk in a company is associated with the method through
which it plans its financial structure. If the capital structure of a
company tends to make earning unstable, the company may fail
financially. How a company raises funds to finance its needs and
growth will have an impact on its future earnings and consequently
on the stability of earnings. Debt financing provides a low cost
source of funds to a company, at the same time providing financialleverage for the common stock holders. As long as the earnings of
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the company are higher than the cost of borrowed funds, the
earning per share of common stock is increased. Unfortunately, a
large amount of debt financing also increases the variability of the
returns of the common stock holder & thus increases their risk. It is
found that variation in returns for shareholders in levered firms
(borrowed funds company) is higher than in unlevered firms. The
variance in returns is the financial risk.
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Risk Return Of Various Investment Alternatives
Managem
ent
Decision
Required
Investment
Market
RiskBusiness
Risk
Interest
Risk
Purchasin
g
Power
Risk
H Growth stock H H L L
HSpeculative
common stockH H L L
M Blue chips M M L L
MConvertible
referred stockM M L L
LConvertible
debenturesM M L L
LCorporate
bondsL L H H
LGovernment
bonds
L L H H
LShort-term
bondsL L L H
LMoney market
fundsL L L H
O Life insurance L L L H
OCommercial
banks
L L L H
O Unit trusts L L L M-H
O Saving a/c L L L H
O Cash L L L H
So, there are so many investment options & the different option
have different benefits & limitations in the sense risk associated
with it. So it is difficult for them to chose option, which givemaximum return at minimum risk.
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PORTFOLIO
Meaning of portfolio:-
Portfolio
A combination of securities with different risk & return
characteristics will constitute the portfolio of the investor. Thus, a
portfolio is the combination of various assets and/or instruments of
investments. The combination may have different features of risk &
return, separate from those of the components. The portfolio is also
built up out of the wealth or income of the investor over a period of
time, with a view to suit his risk and return preference to that of the
portfolio that he holds. The portfolio analysis of the risk and return
characteristics of individual securities in the portfolio and changes
that may take place in combination with other securities due to
interaction among themselves and impact of each one of them on
others.
An investor considering investments in securities is faced with the
problem of choosing from among a large number of securities. His
choice depends upon the risk and return characteristics of individual
securities. He would attempt to choose the most desirable
securities and like to allocate is funds over this group of securities.
Again he is faced with the problem of deciding which securities to
hold and how much to invest in each. The investor faces an infinite
number of possible portfolios or groups of securities. The risk and
return characteristics of portfolio differ from those of individual
securities combining to form a portfolio. The investor tries to choose
the optimal portfolio taking in to consideration the risk return
characteristics of all possible portfolios.
As the economy and the financial environment keep changing therisk return characteristics of individual securities as well as
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portfolios also change. This calls for periodical review and revision
of investment portfolios of investors. An investor invests his funds in
a portfolio expecting to get a good return consistent with the risk
that he has to bear. The return realized from the portfolio has to be
measured and the performance of the portfolio has to be evaluated.
It is evident that rational investment activity involves creation of an
investment portfolio. Portfolio management comprises all the
processes involved in the creation and maintenance of an
investment portfolio. It deals specifically with the security analysis,
portfolio analysis, portfolio selection, portfolio revision and portfolio
evaluation. Portfolio management makes use of analytical
techniques of analysis and conceptual theories regarding rational
allocation of funds. Portfolio management is a complex process
which tries to make investment activity more rewarding and less
risky.
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Before designing a portfolio one will have to know the intention ofthe investor or the returns that the investor is expecting from his
investment. This will help in adjusting the amount of risk. This
becomes an important point from the point of view of the portfolio
designer because if the investor will be ready to take more risk at
the same time he will also get more returns. This can be more
appropriately understood from the figure drawn below.
R1
EExxppeecctteedd RReettuurrnnss
R2
Risk less
Investment
M1 M2
Risk
From the above figure we can see that when the investor is ready
to take risk of M1, he is likely to get expected return of R1, and if
the investor is taking the risk of M2, he will be getting more returns
i.e. R2. So we can conclude that risk and returns are directly
related with each other. As one increases the other will also
increase in same of different proportion and same if one
decreases the other will also decrease.
PORTFOLIO DESIGN
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From the above discussion we can conclude that the investors
can be of the following three types:
1. Investors willing to take minimum risk and at the same timeare also expecting minimum returns.
2. Investors willing to take moderate risk and at the same time
are also expecting moderate returns.
3. Investors willing to take maximum risk and at the same time
are also expecting maximum returns.
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Your age will help you determine what a good mix is / portfolio is
Age Portfoliobelow 30 80% in stocks or mutual funds
10% in cash10% in fixed income
30 t0 40 70% in stocks or mutual funds10% in cash20% in fixed income
40 to 50 60% in stocks or mutual funds10% in cash30% in fixed income
50 to 60 50% in stocks or mutual funds10% in cash40% in fixed income
above 60 40% in stocks or mutual funds10% in cash50% in fixed income
These aren't hard and fast allocations, just guidelines to get you
thinking about how your portfolio should look. Your risk profile will
give you more equities or more fixed income depending on your
aggressive or conservative bias. However, it's important to always
have some equities in your portfolio (or equity funds) no matter
what your age. If inflation roars back, this will be the portion of your
investments that protects you from the damage, not your fixed
income.
Also, the fixed income of your portfolio should be diversified. If you
buy bonds and debentures directly or if you invest in FDs, then
make sure you have at least five different maturities to spread out
the interest rate risk.
PORTFOLIO AGE RELATIONSHIP
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Diversifying in equities and bonds means more than buying a
number of positions. Each position needs to be scrutinized as to
how it fits into the stocks or bonds that already are in your portfolio,
and how they might be affected by the same event such as higher
interest rates, lower fuel prices, etc. Put your portfolio together like
a puzzle, adding a piece at a time, each one a little different from
the other but achieving a uniform whole once the portfolio is
complete.
Types of portfolio for study:
In portfolio Design, we are considering only two types of portfolio.
They are as follow:
1. Random Portfolio
2. Sector Portfolio
1. Random portfolio
Random portfolio consists of the scripts that are randomly selected
by the investor by its own knowledge and preference of the stocks.
Here there is no analysis is done of the script, they are selected on
the tips and buts received by the investors from the external
sources.
Features of random portfolio
There is no method used for selection of the script in the
portfolio.
Selection is based on the individual criteria for the scripts.
The investment is made for higher return in short term.
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Generally in India most of the portfolio are selected
according to this random methods as no investor himself in
that much analysis of the script.
Advantages of random portfolio
Easier to keep a track on the market as not much time
wasted in the analysis.
This portfolio seems to have perform better in short term as
script are generally which are performing better at that time.
Tips are available every where for the investor to pouch. It is the experience of the individual that can fetch him good
return.
Disadvantages of random portfolio
There is every chance that you may select a script that has a
very bad background in the market. Not every time the tips pay off for you. You need to have
strong reason to select that script.
Such portfolios are not able to sustain when there is a crisis
in the market.
There is a very high risk and return involve in such portfolio.
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2. Sector specific portfolio
Sector specific portfolio includes securities of those companies
which are in the same business. Sector portfolios are very useful
when there is a particular sector which is doing very good and has a
bright future a head. Sector portfolio has the securities of those
companies that engage in same kind of business.
e.g. In late 1990s sector that was providing the highest return was
information technology. Investors who have invested their money
in these securities had earned very high return.
Features of sector portfolio
Script form the same group of companies that are in to the
similar type of business.
Maximum exposure to the industry/sector. So any news or
event has the direct effect on the portfolio. Risk regarding the portfolio increases as it is expose to
sector specific ups and downs.
Useful investment tools for speculator and short-sellers.
It is better suited for the sectors which have been providing
good revenue in the near past.
Advantages of sector portfolio
It is better suited to investors who are willing to take risk.
It provides better short term return then other portfolios.
It is easy to keep a watch on one sector rather than many.
You can have a good command over the things happening.
Limited exposure to other sectors keeps the portfolio safe
from the performance of other sectors in the economy.
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Disadvantages of sector portfolio
It is a highly risky portfolio as risk associated with the sector
directly affects the performance of the portfolio. These types of portfolios are not suited for long-term investor
as risk taken for the return can be too high.
There is always the possibly many scripts in the sector may not be
giving that much good attractive return as others. They may eat the
profits from other scripts.
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Book value is based on historical costs, not current values, but can
provide an important measure of the relative value of a company
over time. Book value can be figured as assets minus liabilities, or
assets minus liabilities and intangible items such as goodwill; either
way, the figure that results is the company's net book value. This is
contrasted with its market capitalization, or total share price value,
which is calculated by multiplying the outstanding shares by their
current market price.
You can also compare a company's market value to its book
value on a per-share basis. Divide book value by the number ofshares outstanding to get book value per share and compare the
result to the current stock price to help determine if the company's
stock is fairly valued. Most stocks trade above book value because
investors believe that the company will grow and the value of its
shares will, too. When book value per share is higher than the
current share price, a company's stock may be undervalued and a
bargain to investors.
In case of our sensex as we can see that it is currently trading at a
P/B ratio of 4.41 this shows the average P/B ratio prevailing in the
market. So any script trading below the P/B of 4.41 can said to be
under valued if we keep the BSE SENSEX as bench mark. But it
would be advisable for an investor to also look at the sector leaders
P/B ratio to know what is the common industry P/B and based on
that he can decide about whether to invest in the company or not.
As such there is no guarantee that low P/B would able to give
better return but this stocks are considered to be undervalued so
one can think that this companies are undervalued so chances of
appreciation are very high in case of low P/B scrip. Such companies
having low P/B ratio can be considered as value stock and one can
thin about investing in those companies.
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The P/E ratio as a guide to investment decisions
Earnings per share alone mean absolutely nothing. In order to get a
sense of how expensive or cheap a stock is, you have to look atearnings relative to the stock price and hence employ the P/E ratio.
The P/E ratio takes the stock price and divides it by the last four
quarters' worth of earnings. If AB ltd is currently trading at Rs. 20 a
share with Rs. 4 of earnings per share (EPS), it would have a P/E of
5. Big increase in earnings is an important factor for share value
appreciation. When a stock's P-E ratio is high, the majority of
investors consider it as pricey or overvalued. Stocks with low P-E's
are typically considered a good value. However, studies done and
past market experience have proved that the higher the P/E, the
better the stock.
First, one can obtain some idea of a reasonable price to pay for the
stock by comparing its present P/E to its past levels of P/E ratio.
One can learn what is a high and what is a low P/E for the individual
company. One can compare the P/E ratio of the company with that
of the market giving a relative measure. One can also use the
average P/E ratio over time to help judge the reasonableness of the
present levels of prices. All this suggests that as an investor one
has to attempt to purchase a stock close to what is judged as a
reasonable P/E ratio based on the comparisons made. One must
also realize that we must pay a higher price for a quality company
with quality management and attractive earnings potential.
In the case if we look at the benchmark of BSE sensex on 1 st of
December it is trading at a P/E of 24.49. So if we just keep the
benchmark P/E in mind then we can say that any stock which is
trading bellow the P/E of 24.49 is available cheaply. But for an
investor it is also advisable to look at the industry P/E as it is more
important because just looking at the above position we can see
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that SBI is trading at a very low P/E of around 8 but if you see that
in banking sector that to public sector banks the normal industry
P/E is 8 all most all banks are trading around 8 or bellow the P/E of
8.
So always it is advisable to look at what is the P/E of industry in
which we want to invest to get the better idea, because if we take
the example of IT industry there almost you will find companies
around P/E of 30. so if any IT company having of P/E would
considered to be a cheap option for the investor to invest in to. So
the investor should also look at the industry average P/E. The new
investor can know about the industry P/E or any other companies
P/E in any financial magazine or from the internet also if he does
not know how to calculate the P/E or is not having the data
available with them.
The formula for calculating the P/E ratio is
P/E = Current Market Price
Earning Per Share
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RANDOM PORTFOLIO
Random portfolio consists of the scripts that are randomly selected
by the investor by its own knowledge and preference of the stocks.
Here there is no analysis is done of the script, they are selected on
the tips and buts received by the investors from the external
sources.
We are considering BETA factor to design our Random Portfolio.
Beta Factor Beta indicates the proportion of the yield of a
portfolio to the yield of the entire market (as indicated by someindex). If there is an increase in the yield of the market, the yield of
the individual portfolio may also go up. If the index goes up by 1.5%
and the yield of your portfolio goes up by 0.9%, the beta is 0.9/1.5
i.e 0.6. in other words, beta indicates that for every 1 % increase in
the market yield, the yield of the portfolio goes up by 0.6%. High
beta shares do move higher than the market when the market rises
and the yield of the fund declines more than the yield of the market
when the market falls. In the Indian context a beta of 1.2% is
considered very bullish.
You can be indifferent to market swings if you know your stocks
well. Or you can put your portfolio into neutral or bias for the upside
if you're bullish or a little for the downside if you're bearish. One way
to do that is to have a mix of stocks that have certain betas in your
portfolio. When investors are bullish on the market, they like to have
high beta stocks in their portfolios because if they're right, then their
stocks go up faster than the market in general, and their
performance is better than the market. If investors are bearish on
the market, then they use the low beta or negative beta stocks
because their portfolios will go down less than the market and their
performance will be better than the general market. And if they want
to be neutral, they can then make sure that they have stocks with a
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beta of 1 or develop a portfolio that has stocks with betas greater
than 1 and less than 1 so that they have the whole portfolio with an
average beta of 1.
A beta for a stock is derived from historical data. This means it has
no predictive value for the future, but it does show that if the stock
continues to have the same price patterns relative to the market in
general as it has in the past, you've got a way of knowing how your
portfolio will perform in relation to the market. And with a portfolio
with an average beta of 1, you can create your own index fund
since you'll move more or less in tandem with the market.
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IInntteerrpprreettaattiioonn ooff BBeettaa
WWhheennBB == 11 mmeeaannss tthhaatt tthhee ssccrriipp hhaass ssaammee vvoollaattiilliittyy aass ccoommppaarreedd
ttoo IInnddeexx.. SSuuiittaabbllee ffoorr mmooddeerraattee iinnvveessttoorr..
WWhheennBB>>11 mmeeaannss tthhaatt ssccrriipp iiss mmoorree vvoollaattiillee aass ccoommppaarreedd ttoo mmaarrkkeett
ssuuiittaabbllee ffoorr aaggggrreessssiivvee iinnvveessttoorrss..
WWhheenn BB
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DEFENSIVE PORTFOLIO
SR NO. SCRIPT BETA PRICE ON 2-01-2006 Wi
1 ACC 0.72 530.45 9.68
2 CIPLA 0.78 440.00 10.48
3 DR REDDY 0.69 963.00 9.27
4 GRASIM 0.76 1375.3 10.22
5 HDFC BANK 0.76 713.45 10.22
6 ITC 0.81 140.10 10.89
7 RANBUXY 0.69 444.35 9.27
8 HERO HONDA 0.8 846.10 10.75
9 HDFC 0.82 1191.3 11.02
10 GLAXO 0.61 1111.6 8.20
Total Portfolio Beta = Wi * BETA
=6.97 +8.18+6.40+7.76+7.76
+8.82+6.40+8.60+9.04+5.00
= 74.93 ~ 75
Total Portfolio Investment = 10,00,000 Rs.
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RETURN ON INDIVIDUAL SCRIPTS
1ST MONTH
SR NO. SCRIPT BETA 2-01-2006 31-01-06 RETURNIN %
1 ACC 0.72 530.45 574.20 8.25
2 CIPLA 0.78 440.00 442.25 0.51
3 DR REDDY 0.69 963.00 1121.25 16.43
4 GRASIM 0.76 1375.30 1454.25 5.74
5 HDFC BANK 0.76 713.45 762.45 6.87
6 ITC 0.81 140.10 154.80 10.49
7 RANBUXY 0.69 444.35 399.40 -10.12
8 HERO HONDA 0.80 846.10 857.20 1.31
9 HDFC 0.82 1191.30 1339.70 12.46
10 GLAXO 0.61 1111.60 1282.80 15.40
2ND MONTH
SR NO. SCRIPT BETA 2-01-06 28-02-06 RETURNIN %
1 ACC 0.72 530.45 626.30 18.07
2 CIPLA 0.78 440.00 552.15 25.493 DR REDDY 0.69 963.00 1306.10 35.634 GRASIM 0.76 1375.30 1742.60 26.715 HDFC BANK 0.76 713.45 737.15 3.326 ITC 0.81 140.10 172.45 23.097 RANBUXY 0.69 444.35 429.50 -3.34
8 HERO HONDA 0.80 846.10 889.30 5.119 HDFC 0.82 1191.30 1365.65 14.6410 GLAXO 0.61 1111.60 1315.55 18.35
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RETURN IN DEFENSIVE PORT FOLIO
TOTAL PORTFOLIO INVESTMENT = 10,00,000
VALUE OF PORTFOLIO AS ON 28-02-2006 = 1166628.41
TOTAL RETURN IN % TERM = 16.66 %
TOTAL RETURN ON PORTFOLIO
= 1166628.41 - 1000000
=166628.41
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MODRATE PORTFOLIO
SR NO. SCRIPT BETA PRICE ON 2-01-2006 Wi
1 BHARTI 0.99 340.05 10.73
2 GUJARAT AMBUJA 0.86 79.30 9.32
3 BAJAJ AUTO 0.85 450.05 9.21
4 HLL 0.88 195.10 9.53
5 HINDALCO 1.00 146.20 10.83
6 LT 0.86 1825.65 9.32
7 MTNL 0.89 142.15 9.64
8 ZEE 0.90 157.90 9.75
9BHEL
1.00 1389.90 10.83
10 PNB 1.00 472.00 10.83
Total Portfolio Beta = Wi * BETA
= 10.62 + 8.01+7.83+8.39+10.83+
8.01+8.58+8.78+10.83+10.83
= 92.72 ~ 93
Total Portfolio Investment = 10,00,000/- Rs.
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RETURN ON INDIVIDUAL SCRIPTS
1ST MONTH
SR NO. SCRIPT BETA 2-01-2006 31-01-06 RETURNIN %
1 BHARTI 0.99 340.05 357.25 5.06%2 GUJARAT AMBUJA 0.86 79.30 88.55 11.66%3 BAJAJ AUTO 0.85 450.05 513.25 14.04%4 HLL 0.88 195.10 195.25 0.08%5 HINDALCO 1.00 146.20 164.80 12.72%6 LT 0.86 1825.65 2172.10 18.98%7 MTNL 0.89 142.15 141.70 -0.32%8 ZEE 0.90 157.90 164.70 4.31%9 BHEL 1.00 1389.90 1795.60 29.19%10 PNB 1.00 472.00 465.35 -1.41%
2ND
MONTH
SR NO. SCRIPT BETA 2-01-2006 28-02-06
RETURNIN %
1 BHARTI 0.99 340.05 361.05 6.18%2 GUJARAT AMBUJA 0.86 79.30 88.30 11.35%3 BAJAJ AUTO 0.85 450.05 550.10 22.23%
4 HLL 0.88 195.10 243.70 24.91%5 HINDALCO 1.00 146.20 153.35 4.89%6 LT 0.86 1825.65 2396.95 31.29%7 MTNL 0.89 142.15 142.65 0.35%8 ZEE 0.90 157.90 196.60 24.51%9 BHEL 1.00 1389.90 2027.00 45.84%10 PNB 1.00 472.00 442.10 -6.33%
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RETURN IN MODRATE PORT FOLIO
TOTAL PORTFOLIO INVESTMENT = 10,00,000/- Rs..
VALUE OF PORTFOLIO AS ON 28-02-2006 = 1162912.70/- Rs.
TOTAL RETURN IN % TERM = 16.29 %
TOTAL RETURN ON PORTFOLIO
= 1162912.70 Rs. - 1000000 Rs.
= 162912.70 Rs.
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AGGRESSIVE PORTFOLIO
SR NO. SCRIPT BETA PRICE ON 2-01-2006 Wi
1 ICICI BANK LTD 1.09 597.00 9.64
2 INFOSYS 1.07 2979.35 9.46
3 ONGC 1.02 1191.65 9.02
4 RELIANCE 1.05 441.05 9.28
5 SATYAM 1.23 731.55 10.88
6 SBIN 1.09 904.90 9.64
7 TATA POWER 1.11 434.20 9.81
8 TATA MOTER 1.19 639.55 10.52
9 TATA STEEL 1.13 379.00 9.99
10 WIPRO 1.33 461.70 11.76
Total Portfolio Beta = Wi * BETA
=10.50+10.12+9.20+9.75+13.38+
10.50+10.89+12.52+11.29+15.64
= 113.80 ~ 114
Total Portfolio Investment = 10,00,000/- Rs.
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RETURN ON INDIVIDUAL SCRIPTS
1ST MONTH
SR NO. SCRIPT BETA 2-01-2006 31-01-06 RETURNIN %
1 ICICI BANK LTD 1.09 597.00 609.25 2.052 INFOSYS 1.07 2979.35 2880.30 -3.323 ONGC 1.02 1191.65 1237.30 3.834 RELIANCE 1.05 441.05 480.15 8.875 SATYAM 1.23 731.55 746.75 2.086 SBIN 1.09 904.90 886.35 -2.057 TATA POWER 1.11 434.20 471.80 8.668 TATA MOTER 1.19 639.55 708.45 10.77
9 TATA STEEL 1.13 379.00 404.45 6.7210 WIPRO 1.33 461.70 529.70 14.73
2ND MONTH
SR NO. SCRIPT BETA 2-01-200628-02-
06 RETURNIN %
1 ICICI BANK LTD 1.09 597.00 615.25 3.062 INFOSYS 1.07 2979.35 2828.95 -5.053 ONGC 1.02 1191.65 1136.40 -4.644 RELIANCE 1.05 441.05 500.55 13.495 SATYAM 1.23 731.55 769.65 5.216 SBIN 1.09 904.90 877.50 -3.037 TATA POWER 1.11 434.20 511.20 17.738 TATA MOTER 1.19 639.55 816.20 27.629 TATA STEEL 1.13 379.00 431.00 13.7210 WIPRO 1.33 461.70 520.45 12.72
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RETURN IN AGGRESSIVE PORT FOLIO
TOTAL PORTFOLIO INVESTMENT = 10,00,000/- Rs.
VALUE OF PORTFOLIO AS ON 28-02-2006 =10,84,397.28/- Rs.
TOTAL RETURN IN % TERM = 8.44 %
TOTAL RETURN ON PORTFOLIO
= 1084397.28 Rs - 1000000Rs
= 84397.28 Rs.
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Interpretation of Random Portfolio
As in the theoretical way we have scene that the Beta showsthe movement or change in the price of script vis--vis index.
And a Beta >1 is more riskier and hence should give more
return as compared to the script having Beta < 1. as the
person is taking more risk then he should get more return.
But in our case we have scene that Moderate portfolio
having Beta < 1 has given more return as compared to
Aggressive Portfolio.
So we can easily say that the investment in equity market is
subject to market risk and any one having long-term
investment horizon should only enter into equity market. This
analysis that has been carried out was only for a period of
two month there are chances that in the long run aggressive
portfolio would outperform the other portfolio
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DERIVATIVES
Derivatives is a product whose value is derived from the value of
one or more basic variables, called bases (underlying asset, index,
or reference rate), in a contractual manner. The underlying asset
can be equity, forex or commodity or any other asset. For example,
wheat farmer may wish to sell their harvest at a future date to
eliminate the risk of a change in prices by the date. Such a
transaction is an example of a derivative. The price of this derivative
is driven by the spot price of wheat which is the underlying.
In the Indian context the Securities Contracts (Regulation) Act.
1956 (SC(R)A) defines derivative to include
1. A security derived from a debts instrument, share, loan
whether secured or unsecured, risk instrument or contract for
differences or any other form of security.
2. A contract, which derives its value from the prices, or index
of price, of underlying securities.
The derivatives are securities under the (SC(R)A) and hence the
trading of derivatives is governed by the regulatory framework
under the (SC(R)A).
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TYPES OF DERIVATIVES
The most commonly used types of derivatives are as follows:
o Forwards: A forward contract is a customized contract
between two entities, where settlement takes place on a
specific date in the future at todays pre-agreed price.
o Futures: A future contract is an agreement between two
parties to buy or sell an asset at a certain time in the
future at a certain price. Future contracts are specialtypes of forward contract in the sense that the former are
standardized exchange-traded contracts.
o Options: Options are of two types call and put. Calls
give the buyer the right but not the obligation to buy a
gives quantity of the underlying asset, at a given price on
or before a given future date. Plus give the buyer the
right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given
date.
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INTRODUCTION TO FUTURE
Future markets were designed to solve the problems that exist in
forward markets. A future contract is an agreement between two
parties to buy or sell an asset at a certain time in the future at a
certain price. But unlike forward contracts, the future contracts are
standardized and exchange traded. To facilitate liquidity in the
future contracts, the exchange specifies certain standard features of
the contract. It is a standardized contract with standard underlying
instrument, a standard quantity and quality of the underlying
instrument that can be delivered, (or which can be used for
reference purpose in settlement) and a standard time of such
settlement. A future contract may be offset prior to maturity by
entering into an equal and opposite transaction. More than 99% of
future transactions ate offset this way.
The standardized items in a future contract are:
Quantity of the underlying.
Quality of the underlying.
The date and the month of delivery.
The units of price quotation and minimum price change.
Location of settlement.
FEATURES OF A FUTURE CONTRACT
Future contracts are organized / standardized contracts,
which are traded on the exchanges.
These contracts, being standardized and traded on the
exchanges are very liquid in nature.
In futures market, clearing corporation/ house provides
the settlement guarantee.
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DDIISSTTIINNCCTTIIOONN BBEETTWWEEEENN FFUUTTUURREE AANNDD FFOORRWWAARRDDCCOONNTTRRAACCTTSS::
Future contracts are often confused with future contracts. The
confusion is primarily because both serve essentially the same
economic functions of allocating risk in the presence of future price
uncertainty. However futures are a significant improvement over the
forward contracts as they eliminate counterparty risk and offer more
liquidity.
Features Forward ContractFuture Contract
Operational
Mechanism
Not traded on
exchange
Traded on exchange
Contract
Specifications
Differs from trade to
trade.
Contracts are
standardizedcontracts.
Counterparty Risk Exists Exists, but assumed
by Clearing
Corporation/ house.
Liquidation Profile Poor Liquidity as
contracts are tailormaid contracts.
Very high Liquidity as
contracts arestandardized
contracts.
Price Discovery Poor; as markets are
fragmented.
Better; as fragmented
markets are brought
to the common
platform.
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FFUUTTUURREE TTEERRMMIINNOOLLOOGGYY
Spot Price: The price at which an asset trades in the spot
market.
Future Price: The price at which the future contracts trades
in the market.
Contract Cycle: The period over which a contract trades.
The index futures contracts on the NSE have one-month,
two-months and three-months expiry cycle, which expire onthe last Thursday of the month. Thus a January expiration
contract would expire on the last Thursday of January and a
February expiration contract would cease trading on the last
Thursday of February. On the Friday following the last
Thursday, a new contract having a three-month expiry would
be introduced for trading.
Expiry Date: It is the date specified in the future contract.
This is the last day on which the contract will be traded, at
the end of which it will cease to exist