equity bond basics
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STOCK MARKET:
Stock market is a term used to describe the physical location where the buying and selling of
stocks take place as well as the overall activity of the market within a particular country. The
correct term to be used in pertaining to the physical location for trading stocks is stock
exchange. Every country may have a couple of different stock exchanges that are usually traded
on only one exchange although a lot of large corporations may be listed in several different
locations.
Stock markets perform the following functions:
y Connecting those who seek money with those who can provide it.y Create an auction mechanism in which prices can be decided for investments.y Distributing the future risk of investments across many millions of individuals.y Connecting financial institutions together to create money.
HOW A TRADE ACTUALLY TAKES PLACE ON A STOCK EXCHANGE?
If you are the owner of a restaurant and you want t0o sell your stock of goods lying in the
restaurant, you might do it by word-of-mouth, or by placing an ad in the newspaper. This would
certainly make the whole process a lot easier.
However, it creates a problem down the line for investors who want to sell their shares in the
restaurant. The seller has to go out and find a buyer, which can be hard. A "stock market" solves
this problem. Stocks/Shares of publicly traded companies are bought and sold at a stock market
(also known as a stock exchange). Bombay Stock Exchange (BSE) is an example of such a
market.
In your neighborhood, you have a "supermarket" (like Big Bazaar) that sells food. The reason
you go to Big Bazaar is because you can go to one place and buy all of the different types of
food that you need in one stop -- it's a lot more convenient than driving around to the vegetable
vendor, the dairy farmer, the baker, etc. The BSE is a supermarket for shares. The BSE can be
thought of as a big room where everyone who wants to buy and sell shares of stocks can go to, to
do their buying and selling.
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The exchange makes buying and selling easy. You don't have to actually travel to Mumbai to
visit BSE -- you can call a stock broker who does business with the BSE, and he or she will deal
with the BSE on your behalf to buy or sell your shares. If the exchange did not exist, buying or
selling shares would be a lot harder. You would have to place a classified ad in the newspaper,
wait for a call and haggle on a price whenever you wanted to sell stock. With an exchange in
place, you can buy and sell shares instantly.
INDIAN STOCK MARKET:
The Bombay Stock Exchange (BSE) and the National Stock Exchange of India Ltd (NSE) are
the two primary exchanges in India. In addition, there are about 22* Regional Stock Exchanges.
However, the BSE and NSE that have established themselves as the two leading exchanges and
account for about eighty per cent of the equity volume traded in India.
The Indian stock markets operate five days a week from 9.55 am to 3.30 pm. They are closed on
Saturdays, Sundays and other declared Public Holidays.
The key regulator governing Stock Exchanges, Brokers, Depositories, Depository participants,
Mutual Funds, FIIs and other participants in Indian secondary and primary market is the
Securities and Exchange Board ofIndia (SEBI) Ltd.
EQUITY BASICS:
Wouldn't you love to be the owner of a prosperous business without actually working for the
company? Imagine having the ownership in companies, seeing those companies grow, and
collecting the dividend cheques year after year, without involving yourself in the workings of the
business. This situation might sound like a fancy dream, but it's closer to reality than you might
think.
Materializing this flight of imagination could be possible only by holding one of the greatest
tools ever invented for building wealth, undoubtedly, the stocks or equities!!!
A share of stock (also referred to as equity shares) represents a share of ownership in a company.
For growth of the business, a company can raise money from the public by offering them
ownership in return for their money. Once the money is raised, the company lists on the stock
exchange where the shares of the company can be openly bought and/or sold by the investors. So
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basically if you want to invest in a company, you will have to buy the shares of that particular
company from the stock exchange at the current share price, provided that company is listed on
the stock exchange.
Equities are a part, if not the cornerstone, of nearly every investment portfolio. When you start
on your road to financial freedom, you need to have a solid understanding of equities and how
they trade on the stock market.
In an accounting context, Shareholders' equity (or stockholders' equity, shareholders' funds,
shareholders' capital or similar terms) represents the remaining interest in assets of a company,
spread among individual shareholders of common or preferred stock.
EQUITY INVESTMENTS:
An equity investment generally refers to the buying and holding of shares of stock on a stock
market by individuals and firms in anticipation of income from dividends and capital gains, as
the value of the stock rises. It may also refer to the acquisition of equity (ownership)
participation in a private (unlisted) company or a startup company. When the investment is in
infant companies, it is referred to as venture capital investing and is generally understood to be
higher risk than investment in listed going-concern situations.
The equities held by private individuals are often held via mutual funds or other forms of
collective investment scheme, many of which have quoted prices that are listed in financial
newspapers or magazines; the mutual funds are typically managed by prominent fund
management firms, such as Schroders, Fidelity Investments or The Vanguard Group. Such
holdings allow individual investors to obtain the diversification of the fund(s) and to obtain the
skill of the professional fund managers in charge of the fund(s). An alternative, which is usually
employed by large private investors and pension funds, is to hold shares directly; in the
institutional environment many clients who own portfolios have what are called segregated
funds, as opposed to or in addition to the pooled mutual fund alternatives.
A calculation can be made to assess whether an equity is over or underpriced, compared with a
long-term government bond. This is called the Yield Gap or Yield Ratio. It is the ratio of the
dividend yield of an equity and that of the long-term bond
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Ownership equity includes both tangible and intangible items (such as brand names and
reputation / goodwill).
Accounts listed under ownership equity include (example):
y Share capital (common stock)y Preferred stocky Capital surplusy Retained earningsy Treasury stocky Stock optionsy Reserve
SHARE CAPITAL:
Share capital or issued capital or capital stock refers to the portion of a company's equity that has
been obtained (or will be obtained) by trading stock to a shareholder for cash or an equivalent
item of capital value. For example, a company can set aside share capital, to exchange for
computer servers instead of directly purchasing the servers from existing equity.
Share capital usually comprises the nominal values of all shares issued, less those repurchased by
the company. It includes both common stock (ordinary shares) and preferred stock (preference
shares). If the market value of shares is greater than the their nominal value (value at par), the
shares are said to be at a premium (called share premium, additional paid-in capital or paid-in
capital in excess of par).
PREFERRED STOCK:
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special
equity security that has properties of both an equity and a debt instrument and is generally
considered a hybrid instrument. Preferreds are senior (i.e., higher ranking) to common stock, but
are subordinate to bonds.
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Preferred stock usually carries no voting rights, but may carry a dividend and may have priority
over common stock in the payment of dividends and upon liquidation. Preferred stock may have
a convertibility feature into common stock. Terms of the preferred stock are stated in a
"Certificate ofDesignation".
Similar to bonds, preferred stocks are rated by the major credit rating companies. The rating for
preferreds is generally lower since preferred dividends do not carry the same guarantees as
interest payments from bonds and they are junior to all creditors.
CAPITAL SURPLUS:
Capital surplus (also referred to as additional paid in capital, paid in capital in excess of par or
share premium), is an accounting term that frequently appears as a balance sheet item as a
component of shareholders' equity. Capital surplus is used to account for the capital that a firm
raises in excess of the par value (nominal value) of the shares (common stock).
Taken together, common stock (and sometimes preferred stock) issued and paid plus capital
surplus represent the total amount actually paid by investors for shares when issued (assuming no
subsequent adjustments or changes).
Shares, for which there is no par value, will generally not have any form of capital surplus on the
balance sheet; all funds from issuing shares will be credited to common stock issued.
RETAINED EARNINGS:
In accounting, retained earnings refer to the portion of net income which is retained by the
corporation rather than distributed to its owners as dividends. Similarly, if the corporation takes a
loss, then that loss is retained and called variously retained losses, accumulated losses or
accumulated deficit. Retained earnings and losses are cumulative from year to year with losses
offsetting earnings.
Retained earnings are reported in the shareholders' equity section of the balance sheet.
Companies with net accumulated losses may refer to negative shareholders' equity as a
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shareholders' deficit. A complete report of the retained earnings or retained losses is presented in
the Statement of Retained Earnings or Statement of Retained Losses.
TREASURY STOCK:
A treasury stock or reacquired stock is stock which is bought back by the issuing company,
reducing the amount of outstanding stock on the open market ("open market" including insiders'
holdings).
Stock repurchases are often used as a tax-efficient method to put cash into shareholders' hands,
rather than paying dividends. Sometimes, companies do this when they feel that their stock is
undervalued on the open market. Other times, companies do this to provide a "bonus" to
incentive compensation plans for employees. Rather than receive cash, recipients receive an asset
that might appreciate in value faster than cash saved in a bank account. Another motive for stock
repurchase is to protect the company against a takeover threat.
The United Kingdom equivalent of treasury stock as used in the United States is treasury share.
Treasury stocks in the UK refer to government bonds or gilts.
STOCK OPTION:
In finance, an option is a derivative financial instrument that establishes a contract between two
parties concerning the buying or selling of an asset at a reference price. The buyer of the option
gains the right, but not the obligation, to engage in some specific transaction on the asset, while
the seller incurs the obligation to fulfill the transaction if so requested by the buyer. The price of
an option derives from the difference between the reference price and the value of the underlying
asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the
time remaining until the expiration of the option. Other types of options exist, and options can in
principle be created for any type of valuable asset.
An option which conveys the right to buy something is called a call; an option which conveys the
right to sell is called a put. The reference price at which the underlying may be traded is called
the strike price or exercise price. The process of activating an option and thereby trading the
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underlying at the agreed-upon price is referred to as exercising it. Most options have an
expiration date. If the option is not exercised by the expiration date, it becomes void and
worthless.
In return for granting the option, called writing the option, the originator of the option collects a
payment, the premium, from the buyer. The writer of an option must make good on delivering
(or receiving) the underlying asset or its cash equivalent, if the option is exercised.
An option can usually be sold by its original buyer to another party. Many options are created in
standardized form and traded on an anonymous options exchange among the general public,
while other over-the-counter options are customized ad hoc to the desires of the buyer, usually
by an investment bank.
RESERVE
In financial accounting, the term reserve is most commonly used to describe any part of
shareholders' equity, except for basic share capital. Sometimes, the term is used instead of the
term provision; such a use, however, is inconsistent with the terminology suggested by
International Accounting Standards Board.
Equity reserves are created from several possible sources:
y Reserves created from shareholders' contributions, the most common examples of whichare:
o Legal reserve fund - it is required in many legislations and it must be paid as apercentage of share capital
o Share premium - amount paid by shareholders for shares in excess of theirnominal value
y Reserves created from profit, especially retained earnings, i.e. accumulated accountingprofits. However, profits may be distributed also to other types of reserves, for example:
o Legal reserve fund from profit - many legislations require creation of the fund as apercentage of profits
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o Remuneration reserve - will be used later to pay bonuses to employees ormanagement.
o Translation reserve - arises during consolidation of entities with differentreporting currencies
Reserve is the profit achieved by a company where a certain amount of it is put back into the
business which can help the business in their rainy days.
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SECURITIES:
This is an introduction to the different types of debt and equity instruments floated by a firm. The
various types of securities and explanations as to the distinguishing characteristic and purpose
are discussed here.
1. Corporate securities
A. Equity SharesB. Preference SharesC. BondsD. DebenturesE. Warrants
2. Deposits in banks and non-banking companies.
3. UTI and other mutual fund schemes.
4. Post office deposits and certificates
5. Life insurance policies
6. Provident fund schemes.
7. Government and semi-Government securities.
1. CORPORATE SECURITIES:Corporate securities are the securities issued by joint stock companies in the private sector.
These include equity shares, preference shares and debentures. Equity shares have variable
dividend and hence belong to the high risk - high return category, while preference shares and
debentures have fixed returns with lower risk.
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A. EQUITY SHARES:Equity shares are commonly referred to as common stock or ordinary shares. Even though the
words shares and stocks are interchangeably used, there is a difference between them. Share
capital of a company is divided into a number of small units of equal value called shares. The
term stock is the aggregate of a member's fully paid up shares of equal value merged into one
fund. It is a set of shares put together in a bundle. The "stock" is expressed in terms of money
and not as many shares. Stock can be divided into fractions of any amount and such fractions
may be transferred like shares.
Share certificate means a certificate under the common seal of the company specifying the
number of shares held by any member. Share certificate provides the prima facie evidence of title
of the members to such shares. This gives the shareholder the facility of dealing more easily with
the shares in the market. It enables the sale of shares by showing marketable title.
Equity shares have the following rights according to section 85 (2) of the Companies Act 1956 in
India.
1. Right to vote at the general body meetings of the company.2. Right to control the management of the company.3. Right to share in the profits in the form of dividends and bonus shares.4. Right to claim on the residual value after repayment of all the claims in the case of
winding up of the company.
5. Right of pre-emption in the matter of issue of new capital.6. Right to apply to court if there is any discrepancy in the rights set aside.7. Right to receive a copy of the statutory report, copies of annual accounts along with
audited report.
8. Right to appeal to the central government to call an annual meeting when a company failsto call such a meeting.
9. Right to appeal to the Company Law Board for calling an extraordinary general meeting.
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In a limited company the equity shareholders are liable to pay the company's debt only to the
extent of their share in the paid up capital. The equity shares have certain advantages. The main
advantages are :
1. Capital appreciation2. Limited liability3. Free tradeability4. Tax advantages (in certain cases) and5. Hedge against inflation
TYPES OF EQUITY SHARES
y Non-voting Sharesy Rights Sharesy Bonus sharesy Sweat Equity
NON-VOTING SHARES
Non-voting shares carry no voting rights. They carry additional dividends instead of the voting
rights. Even though the idea was widely discussed in 1987, it was only in the year 1994 that the
Finance Ministry announced certain broad guidelines for the issue of non-voting shares.
They have right to participate in the bonus issue. The non-voting shares also can be listed and
traded in the stock exchanges. If non-voting shares are not paid dividend for two years, the
shares would automatically get voting rights. The company can issue this to a maximum of 25
per cent of the voting stock. The dividend on non-voting shares would have to be 20 percent
higher than the dividend on the voting shares. All rights and bonus shares for the non-voting
shares have to be issued in the form of non-voting shares only.
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RIGHTS SHARES
Shares offered to the existing shareholders at a price by the company are called rights shares.
They are offered to the shareholders as a matter of legal right. If a public company wants to
increase its subscribed capital by way of issuing shares after two years from its formation date or
one year from the date of first allotment, whichever is earlier, such shares should be offered first
to the existing shareholders in proportion to the capital paid up on the shares held by them at the
date of such offer. This pre-emptive right can be forfeited by the shareholders through a special
resolution. The shareholder can renounce the rights shares in favour of a nominee in part or fully.
The rights shares may be partly paid. Minimum subscription limit is prescribed for rights issues.
In the event of company failing to receive 90% subscription, the company shall have to return
the entire money received. At present, SEBI has removed this limit. Rights issues are regulated
under the provisions of the Companies Act and SEBI.
BONUS SHARES
Bonus share is the distribution of shares in addition to the cash dividends to the existing
shareholders. Bonus shares are issued to the existing shareholders without any payment of cash.The aim of bonus share is to capitalise the free reserves. The bonus issue is made out of free
reserves built out of genuine profit or share premium collected in cash only. The bonus issue
could be made only when all the partly paid shares, if any, existing are made fully paid up.
The declaration of the bonus issue used to have favourable impact on the psychology of the
shareholders. They take it as an indication of higher future profits. Bonus shares are declared by
the directors only when they expect a rise in the profitability of the concern. The issue of bonus
shares enables the shareholders to sell the shares and get capital gains while retaining their
original shares.
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SWEAT EQUITY
Sweat equity is a new equity instrument introduced in the Companies (Amendment) Ordinance,
1998. Newly inserted Section 79A of the Companies Act, 1956 allows issue of sweat equity.
However, it should be issued out of a class of equity shares already issued by the company. It
cannot form a new class of equity shares. Section 79A (2) explains that all limitations,
restrictions and provisions applicable to equity shares are applicable to sweat equity. Thus, sweat
equity forms a part of equity share capital.
The definition of sweat equity has two different dimensions:
i. Shares issued at a discount to employees and directors.ii. Shares issued for consideration other than cash for providing know- how or making
available rights in the nature of intellectual property rights or value additions.
In its first form, issue of sweat equity may be priced at a discount to the preferential pricing or at
a discount to face value. Issue of sweat equity falls in the category of preferential issue under
Section 81 (lA) of the Companies Act,1956. Agreed upon price of shares of the company is
derived in accordance with preferential pricing norm, which may be called as normal price.
The level of discount to normal price may be decided on the basis of the valuation of the
intangibles to be acquired. Discount is the difference between the normal price and price at
which sweat equity is issued.
Discount may also mean any issue of sweat equity below the par value. This eases the restriction
on issue of shares at discount as stated in Section 79. This route can be used by a company
whose share price is 10-20% above the par value. Issue of shares at discount under Section 79
can be carried at 10% discount. In case of sweat equity, it becomes imperative to decide the
maximum level of discount that can be offered to the employees and directors.
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The second type of sweat equity can be issued at par or above par. In other words, the sweat
equity can be issued against know-how, intellectual property rights or in recognition of value
additions. Issue of sweat equity for consideration other than cash should be at the normal
preferential price.
Reasons for issuing sweat equityDirectors and employees contribute intellectual property rights
to the company. This may be in the form of providing technical know-how captured by way of
research, contributing to the company in the form of strategy, software developed for the
company, or adding profit.
Traditional way of recognizing the employees and directors in the form of monetary and non-
monetary benefit is deficient. Even incentive bonus on the basis of performance fails to reward
them adequately. Rather in the matter of intellectual property right, the contributing
employees/directors are not well protected.
In case a director/employee leaves the company or is asked to leave, the generatation of cash
flows to the company for an unidentified future period is not stopped and the director/employee
also gets adequate return.
Sweat equity is especially for
y Directors/employees who designed strategic alliance.y Directors/employees who worked for strategic market penetration and helped the
company attain sustainable market share.
In the service industry, sweat equity has a special relevance. The major industries where the
directors and employees can be rewarded through sweat equity are:
y Computer hardware and software development
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y Management consultancy where a standard strategy is issued to earn a fee, likeEnterprise Resource Planning (ERP) solution
y NBFCs where product design is crucialy Other non-traditional financial service industries like custodians, depositories and credit
rating wherein basic service design is important
y In the life insurance segment, commission-based business can be converted into sweatequity with development officers and branch managers (sales)
B. PREFERENCE SHARESThe characters of the preferred share are hybrid in nature. Some of its features resemble the bond
and others the equity shares. Like the bonds, their claims on the company's income are limited
and they receive fixed dividend. In the event of liquidation of the company their claims on the
assets of the firm are also fixed. At the same time like the equity, it is a perpetual liability of the
corporate. The decision to pay dividend to the preferred stock is at the discretion of the Board of
Directors. In the case of bonds, payment of interest rate is mandatory.
The dividend received by the preferred share is treated on par with the dividend received from
the equity share for tax purposes. These shareholders do not enjoy any of the voting powers
except when any resolution affects their rights.
Types of Preference Shares
y Cumulative preference sharesy Non-cumulative preference sharesy Convertible preference sharesy Non-Convertible preference sharesy Redeemable preference sharesy Irredeemable preference sharesy Cumulative Convertible Preference shares
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Cumulative preference shares Here, the cumulative total of all unpaid preferred dividends must
be paid before dividends are paid on the common equity. The unpaid dividends are known as
arrears. The arrears do not earn interest. The nonpayment of the dividend only continues to grow.
The arrears occur only for a limited number of years and not indefinitely. Generally three years
of arrears accrue and the accumulative feature ceases after three years. But the dividends in
arrears continue if there is no provision in the Articles of Association. In the case of liquidation,
no arrears of dividends are payable unless there is a provision for them in the Articles of
Association.
Non-cumulative shares As the name suggests, the dividend does not accumulate. If there is no
profit or inadequate profit in the company in a particular year, the company does not pay it.When the company is wound up if the preference and equity shares are fully paid they have no
further rights to have claims in the surplus. If there is a provision in the Articles of Association
for such claims, then they have the rights to claim.
Convertible preference shares The convertibility feature makes the preference share a more
attractive investment security. The conversion feature is almost identical with that of the bonds.
These preference shares are convertible as equity shares at the end of the specified period and are
quasi-equity shares. This gives the additional privilege of sharing the potential increase in the
equity value, along with the security and stability of income.
Non-Convertible preference shares The non-convertibility feature implies that the preference
shares retain their characteristics of a preference share document.
Redeemable preference shares If there is a provision in the Articles of Association,
redeemable preference shares can be issued. But redemption of the shares can be done only
when:
a) The partly paid up shares are made fully paid up.
b) The fund for redemption is created from the profits, which would otherwise be available for
distribution of dividends or out of the proceeds of a fresh issue of shares for the purpose.
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c) If any premium has to be paid on redemption, it should be paid out of the profits or out of the
company's share premium account.
d) When redemption is made out of profits, a sum equal to the nominal value of the redeemed
shares should be transferred to the capital redemption reserve account.
Irredeemable preference shares This type of shares is not redeemable except on occasion like
winding up of the business. In India, this type of shares were permitted till 15th June 1988. The
introduction of section 80A in the Companies Act 1956 has put an end to it.
Cumulative Convertible Preference Shares (CCPS) This CCPS was introduced by the
Government in 1984 This preference share gives a regular return say 10% during the gestation
period from three years to five years and then are converted into equity as per the agreement.
According to the guidelines, CCPS can be issued for any of the following purposes (a) setting up
of new projects (b) expansion or diversification of existing projects (c) normal capital
expenditure for modernisation and (d) working capital requirements. CCP failed to attract the
interest of the investors because the rate of interest is very low and the gain that could be
received from the conversion into equity also depends on the profitable functioning of the
company.
C. BONDS:In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and,
depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay
the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed
money with interest at fixed intervals.]
Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor),
and the coupon is the interest. Bonds provide the borrower with external funds to finance long-
term investments, or, in the case of government bonds, to finance current expenditure.
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Certificates of deposit (CDs) or commercial paper are considered to be money market
instruments and not bonds.
Bonds and stocks are both securities, but the major difference between the two is that (capital)
stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders
have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds
usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may
be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with
no maturity).
FEATURES OF BONDS:
The most important features of a bond are:
y Nominal, principal or face amount the amount on which the issuer pays interest, andwhich, most commonly, has to be repaid at the end of the term. Some structured bonds
can have a redemption amount which is different from the face amount and can be linked
to performance of particular assets such as a stock or commodity index, foreign exchange
rate or a fund. This can result in an investor receiving less or more than his original
investment at maturity.
y Issue price the price at which investors buy the bonds when they are first issued,which will typically be approximately equal to the nominal amount. The net proceeds that
the issuer receives are thus the issue price, less issuance fees.
y Maturity date the date on which the issuer has to repay the nominal amount. As longas all payments have been made, the issuer has no more obligations to the bond holders
after the maturity date. The length of time until the maturity date is often referred to as
the term or tenor or maturity of a bond. The maturity can be any length of time, although
debt securities with a term of less than one year are generally designated money market
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instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds
have been issued with maturities of up to one hundred years, and some even do not
mature at all.
In the market for U.S. Treasury securities, there are three groups of bond maturities:
o Short term (bills): maturities between one to five year; (instruments withmaturities less than one year are called Money Market Instruments)
o Medium term (notes): maturities between six to twelve years;o Long term (bonds): maturities greater than twelve years.
y Coupon the interest rate that the issuer pays to the bond holders. Usually this rate isfixed throughout the life of the bond. It can also vary with a money market index, such as
LIBOR, or it can be even more exotic. The name coupon originates from the fact that in
the past, physical bonds were issued which had coupons attached to them. On coupon
dates the bond holder would give the coupon to a bank in exchange for the interest
payment.
y The "quality" of the issue refers to the probability that the bondholders will receive theamounts promised at the due dates. This will depend on a wide range of factors:
o Indentures and Covenants An indenture is a formal debt agreement thatestablishes the terms of a bond issue, while covenants are the clauses of such anagreement. Covenants specify the rights of bondholders and the duties of issuers,
such as actions that the issuer is obligated to perform or is prohibited from
performing. In the U.S., federal and state securities and commercial laws apply to
the enforcement of these agreements, which are construed by courts as contracts
between issuers and bondholders. The terms may be changed only with great
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difficulty while the bonds are outstanding, with amendments to the governing
document generally requiring approval by a majority (or super-majority) vote of
the bondholders.
o High yield bonds are bonds that are rated below investment grade by the creditrating agencies. As these bonds are more risky than investment grade bonds,
investors expect to earn a higher yield. These bonds are also called junk bonds.
y Coupon dates the dates on which the issuer pays the coupon to the bond holders. Inthe U.S. and also in the U.K. and Europe, most bonds are semi-annual, which means that
they pay a coupon every six months.
y Optionality: Occasionally a bond may contain an embedded option; that is, it grantsoption-like features to the holder or the issuer:
o Callability Some bonds give the issuer the right to repay the bond before thematurity date on the call dates. These bonds are referred to as callable bonds.
Most callable bonds allow the issuer to repay the bond at par. With some bonds,
the issuer has to pay a premium, the so called call premium. This is mainly the
case for high-yield bonds. These have very strict covenants, restricting the issuer
in its operations. To be free from these covenants, the issuer can repay the bonds
early, but only at a high cost.
o Putability Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates. (Note: "Putable" denotes an
embedded put option; "Puttable" denotes that it may be put.)
o Call dates and put datesthe dates on which callable and putable bonds can beredeemed early. There are four main categories.
A Bermudan callable has several call dates, usually coinciding withcoupon dates.
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A European callable has only one call date. This is a special case of aBermudan callable.
An American callable can be called at any time until the maturity date. A death put is an optional redemption feature on a debt instrument
allowing the beneficiary of the estate of the deceased to put (sell) the bond
(back to the issuer) in the event of the beneficiary's death or legal
incapacitation. Also known as a "survivor's option".
y Sinking fund provision of the corporate bond indenture requires a certain portion of theissue to be retired periodically. The entire bond issue can be liquidated by the maturity
date. If that is not the case, then the remainder is called balloon maturity. Issuers may
either pay to trustees, which in turn call randomly selected bonds in the issue, or,
alternatively, purchase bonds in open market, then return them to trustees.
y Convertible bond lets a bondholder exchange a bond to a number of shares of theissuer's common stock.
y Exchangeable bond allows for exchange to shares of a corporation other than the issuer.
Types of Bonds:
y Secured bonds and unsecured bondsy Perpetual bonds and redeemable bondsy Fixed interest rate bonds and floating interest rate bondsy Zero coupon bondsy Deep discount bondsy Capital indexed bonds
Secured bonds and unsecured bonds The secured bond is secured by the real assets of the
issuer. In the case of the unsecured bond the name of issuer may be the only security.
Perpetual bonds and redeemable bonds Bonds that do not mature or never mature are called
perpetual bonds. The interest alone would be paid. In the redeemable bond the bond is redeemed
after a specific period of time. The redemption value is specified by the issuer.
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Fixed interest rate bondsand floating interest rate bondsIn the fixed interest rate bonds the
interest rate is fixed at the time of the issue. Whereas in the floating interest rate bonds the
interest rates change according to the prefixed norms. For example in Dec 1993 State Bank of
India issued floating interest rate bonds worth Rs 500 Cr. pegging the interest rate with its own
three and five years fixed deposit rates to provide built in yield flexibility to the investors.
Zero coupon bonds These bonds sell at a discount and the face value is repaid at maturity. The
origin of this type of bond can be traced in the U.S. Security Market. The high value of the
U.S.Government security prevented the investors from investing their money in the Government
security. Big brokerage companies like Merril Lynch, Pierce and others purchased theGovernment securities in large quantum and resold them in smaller denomination at a discounted
rate. The difference between the purchase cost and face value of the bond is the gain for the
investor. Since the investor does not receive any interest on the bond, the conversion price is
suitably arranged to protect the interest loss to the investor.
The merit of this bond is that the company does not have the burden of servicing the debt during
the execution period of the project. The repayment could be adjusted to fall after the completion
of the project. This could result in considerable cost savings for the company.
Deep discount bondsDeep discount bond is another form of zero coupon bond. The bonds are
sold at large discount on their nominal value; interest is not paid for them and they mature at par
value. The difference between the maturity value, and the issue price serves as an interest return.
The deep discount bonds' maturity period may range from 3 years to 25 years or more. IDBI was
the first to issue deep discount bonds in India in 1992 with varying maturity period options.
ICICI also issued deep discount bonds with four optional maturity periods in 1997. Early
redemption option is provided at the end of the 6th,12th and 18th year.
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Capital indexed bondsCapital indexed bonds were introduced in 1997. In the capital indexed
bond, the principal amount of the bond is adjusted for inflation for every year. For example, an
investment of Rs.l000 in the inflation indexed bonds earn the investor a semi annual interestincome for the five years' period. The reselling of the principal amount is done semi annually
based on the Wholesale Price Index (WPI) movements. The principal amount of the bond is
adjusted for inflation for each of the years. On the inflation-adjusted principal, the coupon rate of
6 per cent is worked. The benefit of the bond is that it gives the investor an increase in return by
taking inflation into account. The investor enjoys the benefit of a return on his principal, which is
equal to the average inflation between the issue (purchase) and maturity period of the instrument.
To avail the benefit of inflated principal, the investor needs to hold the instrument for the entire 5
year period.
If the investor wants to exit early, he can do it through the secondary market. The value of the
principal repayment will be adjusted by the Index Rate (IR), which will be announced by the
RBI two weeks prior to the repayment of the principal. The IR is worked out as follows
IR = Reference WPI as in Aug 2002/Base WPI (as in August 1997).
In the Indian situation indexed bonds offer more scope since the economy is highly sensitive to
inflation. According to the study conducted by the Development Research Group (DRG) of the
RBI, during the period 1972-93, the real rate of interest was negative for most of the years.
Average value over the period is minus 1.84 per cent.
This situation warrants an inflation hedge. The inflation protection provided by the bond
guarantees real rate of return which means that with the rise in inflation, the return from the
inflation protected bond will rise.
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YIELD TO MATURITY
The Yield to maturity (YTM) orredemption yield of a bond or other fixed-interest security,
such as gilts, is the internal rate of return (IRR, overall interest rate) earned by an investor who
buys the bond today at the market price, assuming that the bond will be held until maturity, and
that all coupon and principal payments will be made on schedule. Yield to maturity is actually an
estimation of future return, as the rate at which coupon payments can be reinvested when
received is unknown.[1] It enables investors to compare the merits of different financial
instruments. The YTM is often given in terms of Annual Percentage Rate (A.P.R.), but more
usually market convention is followed: in a number of major markets the convention is to quote
yields semi-annually (see compound interest: thus, for example, an annual effective yield of
10.25% would be quoted as 5.00%, because 1.05 x 1.05 = 1.1025).
The yield is usually quoted without making any allowance for tax paid by the investor on the
return, and is then known as "gross redemption yield". It also does not make any allowance for
the dealing costs incurred by the purchaser (or seller).
y If the yield to maturity for a bond is less than the bond's coupon rate, then the (clean)market value of the bond is greater than the par value (and vice versa).
y If a bond's coupon rate is less than its YTM, then the bond is selling at a discount.
y If a bond's coupon rate is more than its YTM, then the bond is selling at a premium.y If a bond's coupon rate is equal to its YTM, then the bond is selling at par.
YIELD CURVE
In finance, the yield curve is the relation between the interest rate (or cost of borrowing) and
the time to maturity of the debt for a given borrower in a given currency. For example, the
U.S. dollar interest rates paid on U.S. Treasury securities for various maturities are closely
watched by many traders, and are commonly plotted on a graph such as the one below which
is informally called "the yield curve." More formal mathematical descriptions of this relation
are often called the term structure of interest rates.
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The yield of a debt instrument is the overall rate of return available on the investment. For
instance, a bank account that pays an interest rate of 4% per year has a 4% yield, when the price
of the bond equals its par value. In general the percentage per year that can be earned is
dependent on the length of time that the money is invested. For example, a bank may offer a
"savings rate" higher than the normal checking account rate if the customer is prepared to leave
money untouched for five years. Investing for a period of time t gives a yield Y(t).
This function Y is called the yield curve, and it is often, but not always, an increasing function oft. Yield curves are used by fixed income analysts, who analyze bonds and related securities, to
understand conditions in financial markets and to seek trading opportunities. Economists use the
curves to understand economic conditions.
The yield curve function Y is actually only known with certainty for a few specific maturity
dates, while the other maturities are calculated by interpolation
D. DEBENTURESAccording to the Companies Act 1956, "Debenture includes debenture stock, bonds and any
other securities of company, whether constituting a charge on the assets of the company or not".
Debentures are generally issued by the private sector companies as a long-term promissory note
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for raising loan capital. The company promises to pay interest and principal as stipulated. Bond
is an alternative form of debenture in India. Public sector companies and financial institutions
issue bonds.
CHARACTERISTIC FEATURES OF DEBENTURES:
Form;
It is given in the form of certificate of indebtedness by the company specifying the date of
redemption and interest rate.
Interest:
The rate of interest is fixed at the time of issue itself which is known as contractual or coupon
rate of interest. Interest is paid as a percentage of the par value of the debenture and may be paid
annually, semi annually or quarterly. The company has the legal binding to pay the interest rate.
Redemption:
As stated earlier the redemption date would be specified in the issue itself. The maturity period
may range from 5 years to 10 years in India. They may be redeemed in installment. Redemption
is done through a creation of sinking fund by the company. A trustee in charge of the fund buys
the debentures either from the market or owners. Creation of the sinking fund eliminates the risk
of facing financial difficulty at the time of redemption because redemption requires a huge sum.
Buy back provisions help the company to redeem the debentures at a special price before the
maturity date. Usually the special price is higher than the par value of the debenture.
Indenture:
Indenture is a trust deed between the company issuing debenture and the debenture trustee who
represents the debenture holders. The trustee takes the responsibility of protecting the interest of
the debenture holders and ensures that the company fulfills the contractual obligations. Financial
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institutions, banks, insurance companies or firm attornies act as trustees to the investors. In the
indenture the terms of the agreement, description of debentures, rights of the debenture holders,
rights of the issuing company and the responsibilities of the company are specified clearly.
TYPES OF DEBENTURES;
Debentures are classified on the basis of the security and convertibility
y Secured or unsecuredy Fully convertible debenturey Partly convertible debenturey Non-convertible debenture
Secured or unsecured;
A secured debenture is secured by a lien on the company's specific assets. In the case of default
the trustee can take hold of the specific asset on behalf of the debenture holders. In the Indian
market secured debentures have a charge on the present and future immovable assets of the
company.
When the debentures are not protected by any security they are known as unsecured or nakeddebentures. In the American capital market debenture means unsecured bonds while bonds could
be secured or unsecured in the Indian market. Unsecured debentures find it difficult to attract
investors because of the risk involved in them. Generally debentures are rated by the credit rating
agencies.
Fully convertible debenture;
This type of debenture is converted into equity shares of the company on the expiry of specific period. The conversion is carried out according to the guidelines issued by SEBl. The FCD
carries lower interest rate than other types of debentures because of the attractive feature of
convertibility into equity shares.
Partly convertible debenture;
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This debenture consists of two parts namely convertible and non-convertible. The convertible
portion can be converted into shares after a specific period. Here, the investor has the advantage
of convertibe and non-convertible debentures blended into one debenture. Example: Procter and
Gamble had issued PCD of Rs 200 each to its existing shareholders. The investor can get a share
for Rs 65 with the face value of Rs 10 after 18 months from allotment.
Non-convertible debenture;
Non-convertible debentures do not confer any option on the holder to convert the debentures
into equity shares and are redeemed at the expiry of the specified period.
E. WARRANTSA warrant is a bearer document of title to buy specified number of equity shares at a specified
price. Usually warrants can be exercised over a number of years. The life periods of warrants are
long. Warrants are generally offered to make the bond or preferred stock offering more
attractive. Bonds may bear low interest rate but the warrants offered along with them helps the
investor to enjoy the equity appreciation value. Warrants are detachable. The investor can sell the
warrants separately and they are traded in the market.
The person who is holding the warrant cannot enjoy the benefits of the equity holder before the
conversion of the warrant. The price at which the warrants are converted is called exercise price.
The exercise price is always greater than the current market price of the respective equity at the
time of issue of warrant. When warrants are issued along with host securities and are detachable,
they are known as detachable warrants. In some cases the warrants can be sold back to the
company before the expiry date and is known as puttable warrants. Naked warrants are issued
separately and not with any host securities. The investor has the option to convert it into equity
or bond.
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ADVANTAGES OF WARRANTS:
1) Warrants make the non-convertible debentures and other debentures more attractive and
acceptable.
2) The debentures along with the warrants are able to create their own market and reduce the
company's dependence on financial institutions and mutual funds.
3) Since the exercise of the warrants takes place at a future date, the cash flow and the capital
structure of the company can be planned accordingly.
4) The cost of debt is reduced if warrants are attached to it. Investors are willing to accept lower
interest rate in the anticipation of enjoying the capital appreciation of equity value at a later date.
5) Warrants provide high degree of leverage to the investors. They can sell the warrant in the
market or convert it into stocks or allow it to lapse. But if the conversion is compulsory, even if
there is a fall in the price of the shares, the investors have to shell out money from his pocket.
6) Warrants are liquid and they are traded in the stock exchanges. Hence, the investor can sell the
warrants before exercising them.
Difference Between Share Warrants and Share Certificate
Warrants Share Certificate
1. Issued by public limited
company
Issued by public and private
companies
2. Need for provision in the
Articles of Association
No need for provision in the
Articles of Association
3. Should be approved by the
central Government
Central Government approval is
not needed
4. Transfer of share warrant
requires no registration
Transfer of share would be
complete only if it registration is
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complete
5. Share warrants are issued to fully
paid up shares
Share certificates are issued to fully
and partly paid shares
6. It is considered as a negotiable
instrument
Share certificate is not considered
like that
2. Deposits:Among the non-corporate investments, the most popular are deposits with banks such as savings
accounts and fixed deposits. Savings deposits have low interest rates whereas fixed deposits havehigher interest rates varying with the period of maturity. Interest is payable quarterly or half-
yearly. Fixed deposits may also be recurring deposits wherein savings are deposited at regular
intervals. Some banks have reinvestment plans wherein savings are deposited at regular intervals.
Some banks have reinvestment plans wherein the interest is reinvested as it gets accrued. The
principal and accumulated interests are paid on maturity. Joint stock companies also accept fixed
deposits from the public. The maturity period varies from three to five years. Fixed deposits in
companies have high risk since they are unsecured, but they promise higher returns than bank
deposits. Fixed deposit in non-banking financial companies (NBFCs) is another investment
avenue open to savers. NBFCs include leasing companies, hire purchase companies, investment
companies, chit funds etc. Deposits in NBFCs carry higher returns with higher risk compared to
bank deposits.
3. UTI and other mutual fund schemes:UTI is the oldest and the largest Mutual Fund in the country. It has many investment schemes.
Unit Scheme 1964, Unit Linked Insurance Plan 1971, Master share, Master Equity Plans,
Mastergain etc. are some of the popular schemes of UTI. A number of commercial banks and
financial institutions have set up Mutual Funds. Mutual Funds have been set up in the private
sector also. These Mutual Funds offer various investment schemes to investors.
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4. Post office deposits and certificates:
The investment avenues provided by post offices are generally non-marketable. Moreover, themajor investments in post office enjoy tax concessions also. Post offices accept savings deposits
as well as fixed deposits from the public. There is also a recurring deposit scheme which is an
instrument of regular monthly savings.Six-year National Savings Certificates(NSC) are issued by
post office to investors. The interest on the amount invested is compounded half-yearly and is
payable along with the principal at the time of maturity which is six years from the date of
issue.Indira Vikas Patra and Kissan Vikas Patra are savings certificates issued by post office.
5. Life insurance Policies:The Life Insurance corporation offers many investment schemes to investors. These schemes
have the additional facility of life insurance cover. Some of the schemes of L IC are whole Life
Policies, Convertible Whole Life Assurance Policies, Endowment Assurance policies, Jeevan
Saathi, Money Back Plan, Jeevan Dhara, Marriage Endowment Plan, etc.
6. Provident fund Scheme:Provident fund schemes are compulsory deposit schemes applicable to employees in the public
and private sectors. There are three kinds of provident funds applicable to different sectors of
employment, namely, Statutory Provident Fund, Recognized Provident Fund and Unrecognized
Provident Fund.I
n addition to these, there is a voluntary provident fund scheme which is open toany investor whether employed or not. This is known as the Public Provident Fund (PPF). Any
member of the public can join the scheme which is operated by the post office and the State
Bank ofIndia.
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7. Government and semi-Government securities:The government and semi-government bodies like the public sector undertakings borrow money
from the public through the issue of Government securities and public sector bonds. These are
less risky avenues of investment because of the credibility of the Government and Government
undertakings.
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earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion
of their earnings and pay the remainder as a dividend.
For a joint stock company, a dividend is allocated as a fixed amount per share. Therefore, a
shareholder receives a dividend in proportion to their shareholding. For the joint stock company,
paying dividends is not an expense; rather, it is the division of after tax profits among
shareholders. Retained earnings (profits that have not been distributed as dividends) are shown in
the shareholder equity section in the company's balance sheet - the same as its issued share
capital. Public companies usually pay dividends on a fixed schedule, but may declare a dividend
at any time, sometimes called a special dividend to distinguish it from the fixed schedule
dividends.
Cooperatives, on the other hand, allocate dividends according to members' activity, so their
dividends are often considered to be a pre-tax expense.
Dividends are usually paid in the form of cash, store credits (common among retail consumers'
cooperatives) and shares in the company (either newly created shares or existing shares bought in
the market.) Further, many public companies offer dividend reinvestment plans, which
automatically use the cash dividend to purchase additional shares for the shareholder.
The word "dividend" comes from the Latin word "dividendum" meaning "thing to be divided".
ULIP:
A unit-linked insurance plan (ULIP) is a type of life insurance where the cash value of a policy
varies according to the current net asset value of the underlying investment assets. It allows
protection and flexibility in investment, which are not present in other types of life insurance
such as whole life policies. The premium paid is used to purchase units in investment assets
chosen by the policyholder.
In India investments in ULIP are covered under Section 80C ofIT Act. However, the concept of
having an investment e governed by the Insurance Regulatory and Development Authority
(IRDA).
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INDEX FUNDS:
An index fund or index tracker is a collective investment scheme (usually a mutual fund or
exchange-traded fund) that aims to replicate the movements of an index of a specific financial
market, or a set of rules of ownership that are held constant, regardless of market conditions.
Tracking can be achieved by trying to hold all of the securities in the index, in the same
proportions as the index. Other methods include statistically sampling the market and holding
"representative" securities. Many index funds rely on a computer model with little or no humaninput in the decision as to which securities are purchased or sold and is therefore a form of
passive management.
ACTIVELY MANAGED FUNDS:
Active management (also called active investing) refers to a portfolio management strategy
where the manager makes specific investments with the goal of outperforming an investment
benchmark index
Ideally, the active manager exploits market inefficiencies by purchasing securities (stocks etc.)
that are undervalued or by short selling securities that are overvalued. Either of these methods
may be used alone or in combination. Depending on the goals of the specific investment
portfolio, hedge fund or mutual fund, active management may also serve to create less volatility
(or risk) than the benchmark index. The reduction of risk may be instead of, or in addition to, thegoal of creating an investment return greater than the benchmark.
Active portfolio managers may use a variety of factors and strategies to construct their
portfolio(s). These include quantitative measures such as price/earnings ratio P/E ratios and PEG
ratios, sector investments that attempt to anticipate long-term macroeconomic trends (such as a
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focus on energy or housing stocks), and purchasing stocks of companies that are temporarily out-
of-favor or selling at a discount to their intrinsic value. Some actively managed funds also pursue
strategies such as merger arbitrage, short positions, option writing, and asset allocation.
PASSIVELY MANAGED FUNDS:
Passive management (also called passive investing) is a financial strategy in which an investor
(or a fund manager) invests in accordance with a pre-determined strategy that doesn't entail any
forecasting (e.g., any use of market timing or stock picking would not qualify as passive
management). The idea is to minimize investing fees and to avoid the adverse consequences of
failing to correctly anticipate the future. The most popular method is to mimic the performance
of an externally specified index. Retail investors typically do this by buying one or more 'index
funds'. By tracking an index, an investment portfolio typically gets good diversification, low
turnover (good for keeping down internal transaction costs), and extremely low management
fees. With low management fees, an investor in such a fund would have higher returns than a
similar fund with similar investments but higher management fees and/or turnover/transaction
costs.
Passive management is most common on the equity market, where index funds track a stock
market index, but it is becoming more common in other investment types, including bonds,
commodities and hedge funds. Today, there is a plethora of market indexes in the world, and
thousands of different index funds tracking many of them.
One of the largest equity mutual funds, the Vanguard 500, is a passive management fund. The
two firms with the largest amounts of money under management, Barclays Global Investors and
State Street Corp., primarily engage in passive management strategies
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HEDGING:
A hedge fund is a private investment fund that participates in a range of assets and a variety of
investment strategies intended to protect the fund's investors from downturns in the market while
maximizing returns on market upswings.
Hedge funds are distinct from mutual funds, individual retirement and investment accounts, and
other types of traditional investment portfolios in a number of ways. As a class, hedge funds
undertake a wider range of investment and trading activities than traditional long-only
investment funds, and invest in a broader range of assets, including equities, bonds and
commodities. By taking a long position on a particular asset the manager is asserting that this
position is likely to increase in value. When the manager takes a short position in another asset
they would be asserting that the asset is likely to decrease in value. Most hedge fund investment
strategies aim to secure positive return on investment regardless of overall market performance.
Hedge fund managers typically invest their own money in the fund they manage, which serves to
align their interests with investors in the fund. Investors in hedge funds typically pay a
management fee that goes toward the operational costs of the fund, and a performance fee when
the funds net asset value is higher than that of the previous year. The net asset value of a hedge
fund can be billions of dollars, due to investments from large institutional investors including
pension funds, university endowments and foundations. Worldwide, 61% of investment in hedge
funds is from institutional sources as of February 2011[update].As of 2009[update], hedge funds
represent 1.1% of the total funds and assets held by financial institutions. The estimated size of
the global hedge fund industry is US$1.9 trillion.
Hedge funds are only open for investment to a limited number of accredited or qualified
investors who meet criteria set by regulators. Because hedge funds are not sold to the public or
retail investors its advisers have historically not been subject to the same restrictions that govern
other investment fund advisers, with regard to how the fund may be structured and how
strategies are employed. However, hedge funds must comply with many of the same statutory
and regulatory restrictions as other institutional market participants Regulations passed in the
United States and Europe after the 2008 credit crisis are intended to increase government
oversight of hedge funds and eliminate any regulatory gaps.
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DERIVATIVES:
In finance, a derivative is a contract whose payoff depends on the behavior of some benchmark,
which is known as the "underlying". The underlying is typically a tradable asset, for example, a
stock or commodity, but can be a non-tradable such as the weather (in the case of weather
derivatives). The most common derivatives are futures, options, and swaps.
The most common derivatives have a market value and are traded on exchanges. Among the
oldest of these are rice futures, which have been traded on the Dojima Rice Exchange since the
eighteenth century.
Derivatives are usually broadly categorized by:
y The relationship between the underlying asset and the derivative (e.g., forward, option,swap);
y The type of underlying asset (e.g., equity derivatives, foreign exchange derivatives,interest rate derivatives, commodity derivatives or credit derivatives);
y The market in which they trade (e.g., exchange-traded or over-the-counter); andy Their pay-off profile.
Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For example,
a speculator may sell deep in-the-money naked calls on a stock, expecting the stock price to
plummet, but exposing him to potentially unlimited losses. Very commonly, companies buy
currency forwards in order to limit losses due to fluctuations in the exchange rate of two
currencies.
COMMON DERIVATIVE CONTRACT TYPES
There are three major classes of derivatives:
1. Futures/Forwards :These are contracts to buy or sell an asset on or before a future date at a price specified
today. A futures contract differs from a forward contract in that the futures contract is a
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standardized contract written by a clearing house that operates an exchange where the
contract can be bought and sold, whereas a forward contract is a non-standardized
contract written by the parties themselves.
2. Options :These are contracts that give the owner the right, but not the obligation, to buy (in the
case of a call option) or sell (in the case of a put option) an asset. The price at which the
sale takes place is known as the strike price, and is specified at the time the parties enter
into the option. The option contract also specifies a maturity date. In the case of a
European option, the owner has the right to require the sale to take place on (but not
before) the maturity date; in the case of an American option, the owner can require the
sale to take place at any time up to the maturity date. If the owner of the contract
exercises this right, the counter-party has the obligation to carry out the transaction.
3. Swaps:These are contracts to exchange cash (flows) on or before a specified future date based on
the underlying value of currencies/exchange rates, bonds/interest rates, commodities,
stocks or other assets.
More complex derivatives can be created by combining the elements of these basic types. For
example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or
before a specified future date.
TYPES OF DERIVATIVES:
In broad terms, there are two groups of derivative contracts, which are distinguished by the way
they are traded in the market:
1. Over-the-counter (OTC)OTC derivatives are contracts that are traded (and privately negotiated) directly between two
parties, without going through an exchange or other intermediary. Products such as swaps,
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forward rate agreements, and exotic options are almost always traded in this way. The OTC
derivative market is the largest market for derivatives, and is largely unregulated with respect to
disclosure of information between the parties, since the OTC market is made up of banks and
other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult
because trades can occur in private, without activity being visible on any exchange. According to
the Bank forInternational Settlements, the total outstanding notional amount is US$684 trillion
(as of June 2008). Of this total notional amount, 67% are interest rate contracts, 8% are credit
default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are
equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange,
there is no central counter-party. Therefore, they are subject to counter-party risk, like an
ordinary contract, since each counter-party relies on the other to perform.
2. Exchange-traded derivative contracts (ETD)ETD are those derivatives instruments that are traded via specialized derivatives exchanges or
other exchanges. A derivatives exchange is a market where individuals trade standardized
contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary
to all related transactions, and takes Initial margin from both sides of the trade to act as a
guarantee. The world's largest derivatives exchanges (by number of transactions) are the Korea
Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of
European products such as interest rate & index products), and CME Group (made up of the
2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008
acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in
the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of
derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments
such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges.
Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs
and various other instruments that essentially consist of a complex set of options bundled into a
simple package are routinely listed on equity exchanges. Like other derivatives, these publicly
traded derivatives provide investors access to risk/reward and volatility characteristics that, while
related to an underlying commodity, nonetheless are distinctive.