Session 01

NSE Certified Capital Market Professional (NCCMP)

Topic Date

Session 1 Introduction – Parts 1 & 2 Sep 20

Session 2 Time Value of Money Sep 27

Session 3 Fundamental Analysis - Intro Oct 04

Session 4 Company Analysis Oct 11

Session 5 Financial Statements & Ratio Analysis Oct 18

Session 6 Industry Analysis Oct 25

Session 7 Economy Analysis Nov 01

Session 8 Portfolio Management + Test Nov 08

Introduction

Risk

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Savings Bank Deposits

Short Term Debt Funds

Liquid Funds

Long Term Debt Funds

Gold

Secured Debentures

Bank Fixed Deposits

Fixed Maturity Plans

Unsecured Debentures

Equity Shares

Hybrid Funds Diversified Equity Funds

Sectoral Equity Funds

Spectrum of Retail Investment Products

Derivatives & Commodities

Ris

k -

+

Savings Bank Deposits

Bank Fixed Deposits

Let us begin with the simplest of the

Retail Investment Products

At the very base of the risk scale.

Ris

k -

+

Savings Bank Deposits

Bank Fixed Deposits

Repayment of principal and payment of interest on bank deposits is a contractual obligation of the bank. Therefore, bank deposits carry the least of risk. Since the savings deposits are essentially of a shorter term as compared to the fixed deposits, they carry a relatively lower risk. As time passes the chances of deterioration of financial health of the bank increase; therefore the risk tends to increase with the term of the deposits.

Two types of risk - Default risk

- Market risk

Default risk is the possibility of the principal not being repaid or interest not being paid.

Market risk arises in case of investment products that are traded in a market; it is the risk of the price of the products falling. If the price falls the investor loses.

Bank deposits are not traded; so they do not have “market risk”; they have only “default risk”.

Risk bears an unique relationship with return – risk and return vary in the same direction. That is, as risk increases, return also increases; and vice versa.

To understand the risk – return relationship, we need to look into the composition of return.

Reward for waiting

Compensation for inflation

Reward for risk bearing

Reward for waiting

Every investment requires us to make a choice :

To use the purchasing power in our hands to buy goods and services for consumption.

OR

To save and invest it.

If we use the purchasing power to buy goods and services for consumption, we get satisfaction from it. If we decide to save and invest the purchasing power, we need to postpone this satisfaction. Investment, therefore, involves waiting, sacrificing.

And why should we wait, unless we are sufficiently rewarded for the wait ? That is the “reward for waiting” that the return on investment needs to give us. This is the first component of the return on investment.

But we do not usually reason this out continuously; this time preference is built into our psyche.

As a result we prefer liquidity – we prefer to hold our purchasing power in a liquid form (in a form that lets us deploy it easily for purchase of goods and services), unless we have a reason not to.

That is why, the reward for waiting is also called the “liquidity premium”.

Compensation for inflation

Investment means parting with our purchasing power NOW and getting it back LATER. But the purchasing power we get back later may not be equal to the purchasing power we had parted with, if in the intervening period inflation has eroded the value of money.

Therefore investment can result in loss of purchasing power.

Therefore the return on investment needs to compensate us for this loss, so that the purchasing power we get back is equal to the purchasing power we had parted with.

That is the “compensation for inflation” that the return on investment needs to give us. This is the second component of the return on investment.

But investment also involves risk – of principal not being repaid and / or interest not being paid. When we invest, we have to necessarily bear this risk.

So, we will invest if, and only if, we are rewarded for bearing this risk.

That is the “reward for risk bearing” that the return on investment needs to give us. This is the third component of the return on investment.

Reward for Risk Bearing

The return from those investments which do not carry any risk, will therefore have only two components : reward for waiting and compensation for inflation.

Such investments are called risk free investments and the rate of return from such investments is called the “risk free rate of return”.

Short term investments guaranteed by the government, pay a risk free rate of return.

All other investments pay a rate higher than the risk free rate, depending upon the risk that they carry. Bank deposits pay a rate very close to the risk free rate of return. Weaker the bank, higher will be the rate of interest that it pays.

Compensation

for inflation

Reward for waiting

Risk premium

Compensation

for inflation

Reward for waiting

Risk premium

Compensation

for inflation

Reward for waiting

Risk premium

Risk free rate of return

Higher the risk, higher the risk premium, higher the return.

Total return

The rate of return also bears a relationship to the liquidity of investment.

Liquidity refers to the ease and cost of converting any investment into cash; greater the ease and lower the cost, higher is the liquidity.

Other things remaining the same, higher the liquidity, lower is the rate of return, and vice versa.

This is why, given a bank, the rate of interest on savings deposits is lower than the rate of interest on fixed deposits.

Let us now move further on the risk scale in the investment products spectrum, to products that carry higher levels of risk.

Risk

-

+ Liquid Funds

Fixed Maturity Plans

Liquid Funds Fixed Maturity Plans

Both these products are Mutual Fund schemes.

A mutual fund is a company that pools investment from many investors and invests it in stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these securities.

The combined holdings of securities held by the MF are known as its portfolio.

The total investments collected by a MF from the investors is known as its corpus or AUM ( Assets Under Management).

The total corpus of a MF is divided into units. Each unit represents an investor's proportionate ownership of the portfolio held by the MF. The unit holder has a right to the income those holdings generate; the unit holder also bears the erosion in the value of holdings, if any.

Investor

Investor

Investor

Investor

Investor

Investor

Investor

Investor

Investor

Investor

Investor

Investor

Mutual Fund

Sponsor

Trustees A M C

Custodian

Appoints Appoints

Provides custodial services

Mutual Fund

Supervise the fund on behalf of the unitholders.

Manages the portfolio of the fund.

Provides the initial capital to start the fund.

Risk

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Liquid Funds

Fixed Maturity Plans

Let us now get back to Liquid Funds and FMPs.

Liquid Funds (also called Cash Funds or Money Market Funds) are schemes that invest their corpus in debt instruments of maturity between 1 day and 180 days, but typically around 30 to 60 days; the maturity in some cases may go upto one year.

These securities are highly liquid. The typical investment options for these funds include Treasury Bills (issued by governments), Commercial Papers (issued by companies) and Certificates of Deposit (issued by banks).

* Default risk : Since the liquid funds invest in very short maturity securities they carry a relatively low default risk. Also, as a norm, the liquid funds invest in securities with a high credit quality – that is, they invest in short maturity government securities or financially sound companies/banks.

Liquid Funds have a very low risk profile :

* Market risk : Again, since the liquid funds invest in very short maturity securities they carry a relatively low interest rate risk.

Debt securities, traded in the market, are subject to interest rate risk.

The prices of these securities vary as the general level of interest rates in the market varies – when the interest rates go up, the prices of these securities fall, and vice versa.

The logic is very simple. When new securities paying higher rates of interest come in the market, the older securities paying lower rates of interest become less valuable – the demand for these securities falls. So their prices fall.

When the prices of the securities fall, the value of holdings of the funds falls.

This fall in the value of holdings is reflected in the NAV of the fund.

This is the interest rate risk.

The effect of a change in interest rate on the price of the debt security depends on the term or maturity of the security – longer the term, higher is the effect.

The total corpus of a MF is divided into units. Each unit represents an investor's proportionate ownership of the portfolio held by the MF. The net value of this share of the portfolio is NAV ( Net Asset Value ).

Net value of total portfolio divided by

Total number of units is equal to

N A V

Since the Liquid Funds hold securities with very short maturities, they carry very low interest rate risk.

As we have said earlier, the effect of a change in interest rate on the price of the debt security depends on the term or maturity of the security – longer the term, higher is the effect.

Fixed Maturity Plans (FMPs) are closed ended MF schemes investing in debt securities with medium to long maturities.

Since FMPs are closed ended, and there is no provision for premature redemption, they hold securities with maturities exactly matching their own maturities; that is, if the FMP is of 13 months, they will invest in securities that are going to mature exactly in 13 months or earlier. So they do not have to sell securities in the market. So the market prices of the securities that they hold is of no consequence to them. Therefore they do not carry interest rate risk.

Nevertheless the FMPs carry default risk. The default risk can arise from two factors –

- maturity mismatch

- default by the borrower.

Maturity mismatch arises when the fund invests any part of the FMP corpus in securities whose maturities are longer than those of the FMP. So, when the FMP matures, the fund may have to sell these securities in the market, and the market price may be less than their nominal value. In such a case, the fund may have to default on the redemption of the FMPs.

The default risk on account of this factor can be assessed by comparing the maturities of the FMPs and of the securities in which their corpus is invested.

The second factor which gives rise to default risk in FMPs is the possibility of default by the borrower. Underlying every debt security in which the FMP invests, is a borrowing by a borrower. The possibility of default in repayment of principal and / or payment of interest by this borrower gives rise to the default risk.

The default risk on account of this factor can be assessed from the “credit rating” of the borrower.

• A credit rating agency assesses the credit worthiness of an individual, corporation or even a country. Credit ratings are calculated from financial history and current assets and liabilities.

Why credit rating ?

– Credit rating establishes a link between

risk and return.

– Credit rating aids the investors in taking right investment decisions.

– Credit rating shows the exact worth of an organization.

CREDIT RATING SYMBOLS

A A A : Highest Safety A A : High Safety A : Adequate Safety B B B : Moderate Safety B B : Inadequate Safety B : High Risk C : Substantial Risk D : Default

CRISIL