GOLDEN RULES OF INVESTING IN STOCK MARKET

Warren Buffett once said that the only two rules of successful investing are (1) Never Lose Money
and (2) Never Forget Rule 1. Buying and selling stocks in the share market (share market) is such a
simple activity that almost anyone can do it. But it is not everyone’s cup of to turn a profit. Turning a
profit requires patience, discipline and research.
Buffett’s two rules of investing are simple to understand at the outset but the profound depth of its
meaning is realized after many years of investing and trading. Till you reach that stage, the behaviour
of markets would have left you confused about how to avoid losing money. In this article, we break
it down for you through 10 golden rules. Though there is no sure-shot formula to success, these
rules will ensure that you have a high probability of booking profits in the long run.
1. Don’t follow the crowd
Remember school and college days when you would go for specific tuition classes just because your
seniors had recommended it and all your friends were going there. This is a strategy that can
backfire big time when it comes to investing in stocks. Do not buy a stock just because a lot of
“influencers” are doing so. As Buffett put it: “try to be fearful when others are greedy and greedy
only when others are fearful”. Therefore it is important to conduct your own research. Conducting
both fundamental and technical analysis along with scuttlebutt are critical before choosing to invest
in stocks.
2. Take informed decision
Whether you decide to invest, sell or hold - always make sure that you know why you are taking the
decision. Conduct proper research to ensure that your decisions are reasonable. Your investment
decisions must be data-driven and not sentiment- or reputation-driven. Ensure that you are able to
make a log of all your decisions which can be written down in a diary or saved in an Excel file.
Revisiting these notes throughout your investing journey would help you evolve into a better
investor.
3. Invest only in business that you understand
Remember that you are not investing in a stock, but in the business that stands behind it. When you
choose to invest in a company, you must know how they make money, what their strengths are and
what are the risks that they face. If you don’t - let go of the opportunity. Buffett had an opportunity
to invest in Google before they came out with an IPO , and he let it pass. He had a good reason: he
did not understand how the search engine would make money. Did the decision cost him profits he
could have made? Yes! But remember that this strategy has also saved him from a far greater loss
over the decades. This rule applies to all your investment decisions - for example, if you don’t
understand how bitcoins work, stay away from them.
4. Don’t try to time the market
You should have a good idea on what the right valuation and price level for a stock is. But you should
never try to time when the market will value it correctly. No one can do that - it is impossible to
predict when a shares hit the absolute bottom or top. No one has managed to do this successfully
over multiple market cycles.
5. Be disciplined
Once you have developed an investment strategy and identified companies worth investing in, stick
to it. Once you have decided on a target price and a stop-loss - stick to it. Once you have decided on
how much to invest, and at what pace - follow the plan religiously. When it is your money on the
line, the market volatility will set your emotions racing, it will be difficult to stick to your plan in the
heat of the moment - but trust the decisions you had made with a calm mind. As the saying goes -
get out of the kitchen if you can’t stand the heat.
6. Tame your emotions
“If you cannot control your emotions, you cannot control your money.” You would hear the stories
of very successful investors, and you will hear of the bear ruining someone else. This will set your
heart racing and make you worry about your own investments. When you are watching the share
market live (share market live, you will experience a rush. Don’t take any decision when you are
emotionally disturbed. Let the emotional turmoil pass and then judge based on data you have.
7. Diversify your portfolio
Among the most important ways of keeping the overall risk under control is diversification. Diversify
both in terms of assets and instruments. Remember the adage: don’t put all your eggs in a single
basket.
8. Be objective
While you can hope for the best, all your decisions have to be based on an objective evaluation of
the investment opportunities presented to you. All your plans should be based on realistic
expectations of returns, and not the best case scenario
9. Invest only the surplus
Remember that the markets can be ruthless and take away every paisa you invest in it. So, you
should only invest what you can afford to lose. Make sure you have sufficient low-risk investments
before taking on anything with considerable risk.
10. Track your investments
We are living in times where disruptions to financial markets travel across the globe at great speed.
Monitor the markets and analyse the impact on your portfolio regularly. What was once considered
“safe” may not be safe anymore and you may need to rebalance your portfolio.

Security Analysis requires as a first step the sources of information, on the basis of which analysis is
made. The Securities market is a perfect auction market where demand/supply pressures determine
the price. These demand/supply pressures depend upon the available money and the flow of
information. It is in this context that sources of information become relevant. Besides the market
analysis and estimate of the intrinsic value around which the market price revolves, would also need
an analysis of the flow of information.
Types of Investment Information:
The types of Investment information, which are relevant for our purposes are of the following
categories:
(i) World Affairs:
International factors, which influence domestic income, output and employment and for investment
in the domestic market by F.F.I.s, O.C.B.s, etc. Also foreign political affairs, wars, and the state of
foreign markets affect our markets.
(ii) Domestic Economic and Political Factors:
Gross domestic products, agricultural output, monsoon, money supply, inflation, Govt. policies,
taxation, etc., affect our markets.
(iii) Industry Information:
Market demand, installed capacity, competing units, capacity utilisation, market share of the major
units, market leaders, prospects of the industry, international demand for exports, inputs and capital
goods abroad, import competing products, labour problems and Govt. policy towards the industry
are all relevant factors to be considered in investment decision-making.
(iv) Company Information:
Corporate data, annual reports, Stock Exchange publications, Dept. of company affairs and their
circulars, press releases on corporate affairs by Govt., industry chambers or associations of industries
etc. are also relevant for security price analysis.
(v) Security Market Information:
The Credit rating of companies, data on market trends, security market analysis and market reports,
equity research reports, trade and settlement data, listing of companies and delisting, record dates
and book closures etc., BETA factors, etc. are the needed information for investment management.
(vi) Security Price Quotations:
Price indices, price and volume data, breadth, daily volatility, range and rate of changes of these
variables are also needed for technical analysis.
(vii) Data on Related Markets:
Such as Govt., securities, money market, forex market etc. are useful for deciding on alternative
avenues of investment.
(viii) Data on Mutual Funds:
Their schemes and their performance, N A V and repurchase prices etc. are needed as they are also
investment avenues.
(ix) Data on Primary Markets/New Issues, etc.

The collection of information and its analysis is time consuming and expensive. Besides analysis of
the information also requires expertise which all investors may not have. The available books on the
subject deal with the theoretical aspects and not much practical analysis and down to earth
operational aspects. As such the investors are left to make decisions by hunches and intuition and
not on scientific analysis of the data. Those who have better information use it to make extra
mileage on such information.
It is also possible that insiders who have the information before it becomes public take advantage of
it called Insider trading. At present the SEBI has acquired powers to control insider trading,
malpractices and rigging up of prices in the secondary markets in India, and penalise the offenders.
1. World Affairs:
The day-to-day developments abroad are published in Financial Journals like Economic Times,
Financial Express, Business Line, etc. Some foreign Journals, like London Economist, Far East
Economic Review and Indian Journals like, Business India, Fortune India etc., also contain
developments of economic and financial nature in India and abroad. IMF News Survey, World Bank
and IMF Quarterly Journal (namely, Finance and Development), News Letters of Foreign Banks like
those of Grindlays, Standard, etc., contain all the needed information on world developments.
2. National Economic Affairs:
The daily news papers particularly financial papers referred to above contain all the national
information; Besides Journals like Economic and Political Weekly, Business India, Dataline Business,
Business Today and Fortune India contain the material on economic developments. RBI’s Annual
Reports, Reports on currency and finance and monthly reports and CMIE reports all contain a wealth
of information on the economy and the country. The Economic Survey of the govt. of India and
reports of C.S.O., D.G.T.D. and Dept. of companies, etc. do provide the information on, economy,
industry, trade sectors of the country. The reports of the Planning Commission and annual reports of
various ministries also contain a lot of information.
3. Industry Information:
There are various Associations — Chambers of Commerce, Merchants’ Chamber and other agencies
who publish Industry data. The reports of Planning Commission, govt. of India, publications from
Industry and Commerce Ministries also contain a lot of information. The CMIE publishes various
volumes and update them from time to time containing data on various sectors of the economy and
industries, and the subscribers get these volumes and reports.
Directory of Information published by the B.S.E. also contains information on industries and
companies and this is updated from time to time. Many Daily financial papers bring out regularly
studies on various Industries and their prospects. Industry data at micro level is available in Govt.,
publications, industry wise, but in view of a large time lag involved in their reports, the monthly
reports of various Associations of Industries give more up-to-date and timely information.
4. Company Information:
The information on various Companies listed on Stock Exchanges is readily available in daily financial
papers. Besides the Fort- nightly Journals of Capital Market, Dalai Street, Business India contain a lot
of information on the industries and companies, listed on stock exchanges. Results of equity and
Market Research are also published in these Journals.
The B.S.E. (Mumbai Stock Exchange) publishes Directory of Information on Industries and
Companies, which are listed on Stock Exchanges, and the Journals of Capital Market and Dalai Street
also publish these data. Computer software on these data are available with a number of software
companies. The B.S.E. also publishes weekly Reviews, monthly Reviews giving data on various
aspects of listed companies.
The Annual Reports of companies and their half-yearly unaudited results are another source of
information on the companies. The financial journalists give write ups on various companies after
interviewing their executives and these are published in Economic Times and other financial Dailies,
like Business Line and Financial Express.
5. Security Market Information:
A number of big Broker Firms who have equity research are sending newsletters on Market
Information with Fundamental and Technical analysis, combined in those reports. The Capital
Market, Dalai Street, Business India and few other Stock Market Journals like Fortune India,
Investment Week, etc., contain the information on security markets. The ICFAI also publishes a
monthly called Chartered Financial Analyst, which contains economic data, company information,
and market information, Security analysis, Beta factors and a host of other items, useful for security
analysis.
The data on Trade cycles and settlements, record dates, book closures etc., are contained in financial
papers like Economic Times, Business Line, Financial Express etc., after they are released by stock
exchanges and companies. While the newsletter of Merchant Bankers, brokers’ firms, Investment
Analysts, are available to subscribers or their own clients, others are available for all at stipulated
prices. The collection of information is thus costly and time consuming.
6. Security Price Quotations:
The daily quotations on various Stock Exchanges OTCEI, NSE are published in the daily papers. Each
Stock Exchange is publishing its own daily quotations list, giving out opening, high, low and closing
quotations of all traded securities. They also publish volume of trade for individual securities and
also the total for all securities traded on a daily basis, in terms of shares and value of trades.
The Price indices, for all securities, industry wise, region wise etc., are published by the RBI, B.S.E.
and major Stock Exchanges, in the country. Besides each financial Daily has its own Index published
in its paper. All these indices, daily volumes, highs, lows, advances, declines etc., of well traded
Companies, Gainers and Losers and such similar information, useful for both technical and
fundamental analysis is available from all Stock Exchanges and published in financial Dailies and
Journals. The Capital Market and Dalai Street journals also give Company information regarding their
fundamentals, P/E, EPS, GPM, etc., along with the price data. Daily highs and lows, can be seen as
against yearly highs/lows for each of the securities in financial Dailies.
The patterns of shareholding, distribution schedule, floating stock, past price data are available in all
software and B.S.E. Directory. B.S.E. publishes all the data useful for technical analysis and these
data are compiled by the computer specialists and floppies are available on official Daily quotations
and Technical charts of each of the major companies listed on Stock Exchanges. The computer
software data are also sold by software companies for those who have computer facility. For others,
these data can be collected from daily papers, weekly and fortnightly Journals on Stock Markets, like
Dalai Street and Capital Market.
7. Data on Related Markets:
Data on Money Market, Govt. Securities Market are available in the publications of RBI and D.F.H.I.,
Indian Banks Association, Securities Trading Corporation and banks and NSE. These data are
published on a daily basis on the financial Dailies and journals. The publications who deal with these
markets are however fewer in number compared to those on stock and capital markets.
The information on Forex Market is available in RBI publications, Foreign Exchange Dealers
Association (FEDAI) and foreign banks. These data are published in the form of exchange rates and
cross Currency rates in Financial Dailies regularly. The developments in these markets are reviewed
in the Dailies or weekly and fortnightly Journals.
The data on Bullion market and rates for gold and silver are available on a Daily basis in the financial
press. These data are published in RBI Bulletins and are also available in CMIE reports. Many of these
data on Forex Markets in countries abroad can be obtained from London Economist, Far Eastern
Economic Review, and Wall Street Journal.
8. Data on Mutual Funds, UTI etc.:
These are published in the Daily financial papers — at least once in a week in the Investment Weekly
or Investors’ Guide. They give the Current Schemes, NAV of each scheme if quoted as against the
Market price, if traded, repurchase price, redemption rate, etc. in respect of close ended funds and
daily purchase and sale prices for open ended funds. Besides, however all the journals, magazines
and reports on Stock Markets also contain the relevant information on Mutual funds, as many of
their schemes are quoted and traded on the Stock Exchanges. Thus, the Capital Market, Dalai Street
and Business India also contain information on Mutual Funds.
9. Data on Primary Market:
New Issues in the Pipeline are first known to the SEBI as they get the Draft Prospectus for vetting and
even before that, they would come to know of them from Merchant bankers’ reports. But
consolidation and publications of this information is done by a Magazine called “PRIME” publication.
Prime publishes all information of new issues in the pipe line — industry wise and size wise analysis
and public over subscription and under subscription etc. The performance of companies, Merchant
bankers, underwriters and brokers etc., in the New Issue Market are also analysed by them.
Geographical and centre-wise collection of new issues and other relevant company information is
given by them.
Following them a number of Magazines, merchant bankers, Registrars and Brokers like Karvys are
publishing them. Financial journalists are giving a write up on the forthcoming new issues as also
some cable operators. The RBI and Dept. of Company Affairs in addition to SEBI collect and publish
these data from time to time in their reports once in a quarter, half-yearly and yearly.

Financial Securities
Financial Securities – Definition
Financial security is a document of a certain monetary value.
Traditionally, it used to be a physical certificate but nowadays, it is
more commonly electronic. It shows that one owns a part of a
publicly-traded corporation or is owed a part of a debt issue. In the
most common parlance, financial securities refer to stocks and
bonds which are negotiable. Derivatives are also considered a
common type of financial security, with their growing popularity in
recent years. In current usage, financial securities are no longer an
evidence of ownership. Instead, they refer to the financial product
themselves, i.e., stock, bond, or other product of investment. They
are also known as financial instruments or financial assets.

Features of Financial Securities

One of the most important features of financial securities is that
they are trade-able, i.e., one can convert them into cash quite
easily. Holding financial security gives a right to the holder to
receive future monetary benefits under a stated set of conditions.
Except for derivatives, securities let you own the underlying asset
without physical possession. The price of the securities indicates the
value of an underlying asset. More the price, the higher the value of
the asset.

Types of Financial Securities

What are the Types of Security?
There are four main types of security: debt securities, equity
securities, derivative securities, and hybrid securities, which are a
combination of debt and equity.

Fig. 1. Types of Securities

Let’s first define security. Security relates to a financial instrument
or financial asset that can be traded in the open market, e.g., a
stock, bond, options contract, or shares of a mutual fund, etc. All
the examples mentioned belong to a particular class or type of
Debt Securities
Debt securities, or fixed-income securities, represent money that is
borrowed and must be repaid with terms outlining the amount of
the borrowed funds, interest rate, and maturity date. In other
words, debt securities are debt instruments, such as bonds (e.g., a
government or municipal bond) or a certificate of deposit (CD) that
can be traded between parties.
Debt securities, such as bonds and certificates of deposit, as a rule,
require the holder to make the regular interest payments, as well as
repayment of the principal amount alongside any other stipulated
contractual rights. Such securities are usually issued for a fixed
term, and, in the end, the issuer redeems them.
A debt security’s interest rate on a debt security is determined
based on a borrower’s credit history, track record, and solvency –
the ability to repay the loan in the future. The higher the risk of the
borrower’s default on the loan, the higher the interest rate a lender
would require to compensate for the amount of risk taken.

Bonds
Bonds are debt financial instruments that both public and private sector companies use to
raise funds for their operations. The government agencies, financial institutions as well as
private enterprises issue these instruments to investors. Bonds are secured by their physical
assets. The holder of these bonds is the lender, while the issuer of these bonds is the
borrower. The borrower can issue these bonds to the lender, only by promising to pay back
the loan at a specific maturity date with a fixed interest rate. This interest rate is generally
lower than debentures because the physical assets of a company secure bonds whereas the
debentures are unsecured instruments.

Debentures
Debentures are also debt financial instruments like bonds. Organisations use these
instruments to get funding for their daily needs. They are generally not secured by any
physical assets of the issuers, which makes them riskier than bonds. They also carry a fixed
or floating interest rate. The debenture holders get first preference over shareholders of a
company when it comes to the payment of interests/dividends. The interest rate on debentures
is generally higher than bonds because they are not secured by the physical assets of a
company.

Differences between Bonds and Debentures

The main differences between Bonds and Debentures are as follows:
Bonds Debentures
Definition

Bonds are debt financial instruments issued by large Debentures are debt financial instruments issued
corporations, financial institutions and government by private companies, but any collaterals or
agencies that are backed up by collaterals or physical physical assets do not back them up.
assets.

Owner

The owner of a bond is called a bondholder. The owner of a debenture is called a debenture
holder.

Collateral

Bonds get secured by the collateral or physical assets of Debentures do not get secured by the collateral or
the issuing company. physical assets of the issuing company. Lenders
purchase these instruments solely based on the
reputation of the issuing company.

Tenure

Bonds are long term investments and their tenure is Debentures are generally short to medium term
generally higher than debentures. investments and their tenure is usually lower than
bonds.

Issuer

Large corporations, financial institutions and Private companies generally issue debentures for
government agencies issue these bonds for their long their immediate capital requirements.
term capital requirements.

Rate of Interest

The bonds carry a fixed or floating interest rate that is The debentures carry a fixed or floating interest
generally lower than debentures because they are more rate that is generally higher than bonds because
stable in terms of repayment, and they get backed by they are less stable in terms of repayment, and they
collateral of the issuing company. are also not backed by collateral.

Priority During Liquidation

If the company is on the verge of liquidation, the If the company is on the verge of liquidation, the
bondholders are given priority over debenture holders debenture holders are given second priority over
for repayment of capital and interest amount. bondholders for repayment of capital and interest
amount.

Payment Structure

The payment of interest for bonds is on an accrual basis. The payment of interest for bonds is done on a
The issuing company pays this amount on a monthly, periodical basis and depends on the company’s
half-yearly or yearly basis and this payment is not performance.
dependent on the performance of a company.
Risk

Bonds are less riskier than debentures because they have Debentures are riskier than bonds because they do
the security of the physical assets of the issuing not have the security of the physical assets of the
company. issuing company.

What are the advantages of Bonds?

The major advantages of bonds include fixed returns and regular
interests. Some of the common benefits of purchasing bonds are
listed below.
1. Fixed Returns on Investment
Fixed investment in Bonds yields regular interests at timely
intervals. Also, once a bond matures, you receive the principal
amount invested earlier. The best advantage of investing in
Bonds is that the investors know exactly how much the returns will
be.
2. Less Risky
Although Bonds and stocks are both securities, the clear differences
between the two are that the former matures in a specific period,
while the latter typically remain outstanding indefinitely. Also, the
bondholders are paid first over stockholders in case of liquidity.
3. Less volatile
Investing in bonds is safer than the stock market, which also has
several other risks. Although a bond’s value can fluctuate according
to current interest rates or inflation rates, these are generally more
stable compared when compared to stocks.
4. Clear Ratings
Unlike stocks, bonds are universally rated by credit rating agencies.
This gives further assures investors about the right time for
investing in bonds. Based on the clear ratings, you can choose to
buy bonds of any issuer with a better face value of bonds. However,
it’s still recommended to conduct your own research before
investing.
5. Investor Protection is one of the major advantages of
Bonds
Bondholders are also secured against many failures. Legal
protection is something investors can benefit from investing in
Bonds. If a company goes bankrupt, its bondholders will often
receive some money back in the form of a recovery amount.
What are the Disadvantages of Bonds?
Since it’s the money involved, there are certain Disadvantages of
investing in bonds the investors or issuers may face at times.
Bankruptcy is among the commonly talked disadvantages of Bonds.
1. Larger Investment needed
The cost of purchasing bonds is always among the disadvantages
of Bonds. The cost is directly proportional to a company’s
reputation. Even though some bonds can be purchased for relatively
low sums ($1,000) , you may need a larger investment to buy
some bonds. This means access to some bonds will be impossible
for investors.
2. Bankruptcy
Bondholders may lose much or all their investment in case a
company goes bankrupt. In the economy such as the USA,
bondholders are given much leverage and protection laws in case of
bankruptcy. This means investors are expected to receive some or
all of the invested money. But in many countries, there are no
protection for investors.
3. Less liquid compared to stocks
Most major corporations may have high liquidity, but bonds issued
by a smaller or less financially stable company may be less liquid as
fewer investors are willing to buy them. Bonds with a very high face
value will also be less liquid, but the companies with low face value
won’t find any investors easily.
4. Risks Involved are concerning Disadvantages of Bonds
Fixed-rate bonds are subject to interest rate risk, which means that
their market prices will decrease in value when the generally
prevailing interest rates rise. There are many other risks involved
with Bonds, namely, Credit risk, Inflation risk, Liquidity risk,
and Call risk.
 Credit risk: When the issuer fails to timely make interest or
principal payments and defaults on its bonds.
 Inflation risk: Rise in purchasing power due to inflation puts
a risk for investors receiving a fixed interest rate.
 Liquidity risk: Investors may not find the market for the
bond; this eventually prevents them from buying or selling the
bonds.
  Call risk: Retiring a bond before it reaches the maturity date
is something an issuer might do in case if interest rates dip.
This could be one of the biggest

Debentures can be categorized on the following basis:

A. On the basis of Security:

 Secured Debentures: Debentures that are issued against a

security/collateral are called secured debentures. In other
words, a charge is made against the assets of the issuing
company.
 Unsecured Debentures: Debentures which are issued
without any charge against the issuing company’s assets are
called unsecured debentures.
B. On the basis of Tenure:
 Redeemable Debentures: Such debentures, which are due
to be repaid at the end of a certain period, either in a lump
sum or in installments, either at a premium or at face value,
during the lifetime of the entity are called redeemable
debentures.
 Irredeemable Debentures: Such debentures are not
redeemed or repaid during the lifetime of the company. In the
event of the winding-up of the company, such redemption may
be possible.
C. On the basis of Convertibility:
 Convertible Debentures: Debentures that can be converted
into either equity capital or any other security are called
 convertible debentures. This can be done at the will of the
holders of the company.
 Non- Convertible Debentures: Debentures which cannot be
converted into equity shares or any other form of security are
called non-convertible debentures.
D. On the basis of Coupon Rate:
 Specific Coupon Rate Debentures: These debentures are
issued at a specific rate of interest, called the coupon rate.
This interest is payable to the holders periodically, regardless
of whether the company made a profit that year or not.
 Zero-Coupon Rate Debentures: Such debentures do not
carry any interest rate. To compensate the holders, these are
usually issued at a discount so that the difference between the
face value and the issue price can be treated as the interest
income earned by the holder.
E. On the basis of Registration:
 Registered Debentures: Debentures against which all
information about their holders, like names, addresses, etc.
are kept in a special register at the company’s head office are
called registered debentures. Such debentures cannot be
transferred just by delivery, but require a transfer deed.
 Bearer Debentures: These debentures are transferred via
simple delivery and no special record is kept in the company
register for such documents.
Advantages of Debentures:
1. To Investors:
 Fixed Income for Investors: A company has to pay interest
on the issued debentures, whether it earns profits in a
financial year or not. So, the investors get a fixed income. This
is not the case with equity shareholders, whose dividend
depends solely on the profit earned.
 Secured Investment: Since debt securities are usually
secured by way of a charge against the issuing company’s
assets, the holders can sell off the asset in case of the
company goes bankrupt or insolvent.
 Fixed Return even during Inflation: The rate of interest on
debentures does not fluctuate with the changes in price levels,
thereby ensuring a fixed level of income.
2. To the Company:
 No Dilution of Ownership: Since debenture holders do not
have any voting rights or any participation in company
meetings, the ownership of the company’s management
remains intact, as opposed to companies issuing equity capital
where control is diluted owing to voting rights to the holders.
 Cheaper Source: Flotation costs and listing costs for
debentures are way lesser than those of equity capital, making
them a cheaper source of funds for the company.
Disadvantages of Debentures:
1. To Investors:
 No Voting Rights: Debenture holders are not allowed to
participate in company meetings and do not have voting
rights. Thus they do not have any say in the company matters
or policies.
2. To the Company:
 Rigidity as to Interest Payment: A company issuing equity
capital can fix the dividend rate as per the profit earned, but
the same is not possible for a company issuing debentures,
where the rate of interest is fixed, and interest has to be paid
whether there is profit or not.
 Less control over Mortgaged Assets: Assets against which
charges are made cannot be employed freely for the
company’s uses because they are under the control of the
creditors. This leads to the underutilization of assets and
resources.

It is important to mention that the dollar value of the daily trading

volume of debt securities is significantly larger than stocks. The
reason is that debt securities are largely held by institutional
investors, alongside governments and not-for-profit organizations.

Global debt instrument

Euro Notes: Euro Notes are like promissory notes issued by
companies for obtaining short term funds. They are denominated in
any currency other than the currency of the country where they are
issued. They represent a low-cost funding route. The Euro notes
carry three main cost components: Underwriting fee, One time
management fee for structuring, pricing and documentation; and
Margin on the notes themselves.
Euro Commercial Papers: Another form of short term debt
instrument that emerged during the mid-1980s came to be known
as Euro Commercial Paper. It is a promissory note like the short
term Euro notes although it is different from Euro notes in some
way. ECP came up on the pattern of domestic market commercial
papers that had a beginning in the USA and then in Canada. The
detailed feature of ECPs varies from one country to another. They
involve market-based interest rates, LIBOR. The ECPs are issued
either in interest-bearing form or in a discounted form with interest
built in the issue price itself.
Euro Bonds: A bond underwritten by an international syndicate
banks and marketed internationally in countries other than the
country of the currency in which it is denominated is called a Euro
bond. This issue is not subject to national restrictions. Euro bond
market is almost free of official regulations. The Eurobonds are the
international bonds which is issued in a currency other than the
currency or market it is issued. Generally issued by international
syndicate of banks and financial institutions.

Equity Securities
Equity securities represent ownership interest held by shareholders
in a company. In other words, it is an investment in an
organization’s equity stock to become a shareholder of the
organization.
The difference between holders of equity securities and holders of
debt securities is that the former is not entitled to a regular
payment, but they can profit from capital gains by selling the
stocks. Another difference is that equity securities provide
ownership rights to the holder so that he becomes one of the
owners of the company, owning a stake proportionate to the
number of acquired shares.
In the event a business faces bankruptcy, the equity holders can
only share the residual interest that remains after all obligations
have been paid out to debt security holders. Companies regularly
distribute dividends to shareholders sharing the earned profits
coming from the core business operations, whereas it is not the
case for the debt holders.
Share types explored
Ordinary shares
Ordinary shares are the most common type. They carry one vote
per share and they entitle the owner to participate equally in the
company’s dividends. If the organisation is wound up, the proceeds
are again allocated equally.
Such shares are issued by a company to procure funds to meet
long-term expenses borne by a business. They have associated
ownership benefits provided to an investor, wherein the individual
gains exposure to various management segments involved in
running operations. An individual possessing a large number of
these types of equity shares have substantial voting rights.
Preference Equity Shares –
Preference equity shares are generally issued to an investor as a
guarantee of the payment of cumulative dividend before returns are
distributed among ordinary shareholders. However, preference
shares do not have any associated voting and membership rights
which are provided on common shares.
Classification among preference shares can also be made,
depending upon its participating or non-participating capacity. If an
investor purchases participating preference shares, he/she is
entitled to the stipulated amount of profits, as well as bonus
returns, depending upon the performance of a company during a
particular financial year. Owners of non-participating equity shares
are eligible for no such benefits.
Bonus Shares –
These types of equity shares are issued out of retained earnings of a
business, wherein the profits are distributed among investors in the
form of an additional stake in a company. Contrary to other types of
equity instruments, bonus shares do not increase total market
capitalisation value of a company. It just represents capitalisation of
excess funds generated from production.
Rights Shares –
These shares are issued by a company to premium investors at a
discounted price as an invitation to increase its stake in the
respective business. A firm only sells shares to rights for a
stipulated time to raise the required finances to meet its
expenditures incurred.
Features of Equity Shares
Equity shares have the following characteristics, which make
it one of the most popular investment tools in a stock
market –
1. Most types of equity shares include voting rights to an
investor, allowing him/her to choose individuals
responsible to run the business. Electing efficient
managers allows a company to increase its annual
turnover, thereby increasing investors’ average
dividend income.
2. Equity shareholders are eligible to realise additional
profits generated by a company in a fiscal year. This
increases the total wealth of individual investors having
a considerable investment in equity shares of a
company.
3. Even though equity shares are not repaid until a
business closes down, equity shares already issued can
be traded in the secondary capital market. Thus,
investors can withdraw funds from a company upon
their discretion. This ensures massive wealth creation
through capital appreciation of such shares.

Why Should You Invest in Equity Shares?

Investing in best equity shares have the following benefits, such as
–
 High Income
Equity share market is an ideal segment of the capital market
responsible for the remarkable income of investors. Wealth creation
not only works through capital appreciation of such securities but
also high dividend earnings received by individuals.
 Hedge Against Inflation
Investment in profitable equity shares increases the standard of
living of individuals through asset value appreciation. Money
invested in equity shares offer manifold returns, higher than the
rate of erosion of an individual’s purchasing power due to inflation.
Thus, the real value of investments tends to rise over time.
 Portfolio Diversification
Investors having a low aptitude for risk tend to stick with debt
instruments, as it is less volatile. However, stock and bond market
fluctuations are inversely related when it comes to aggregate
demand. Thus, when the bond market is underperforming, risk-
averse investors can profit from investment in best equity
shares through stock market investments.
What are the Risks Associated with this Investment?
Equity share market tends to be the most volatile segment in a
stock market, profoundly affected by minor fluctuations. Returns on
equity investments are paid out after all other obligations of a
company have been met. During market downturn, production cycle
of a business is affected, thereby reducing profits generated by a
business. This lower share of profit is used up to meet all existing
liabilities before funds are disbursed to as equity investment
returns. Thus equity markets tend to be adversely affected during
market downturn.
Market fluctuations are a part of the business cycle, which has
associated highs and lows as per the prevailing socio-economic
scenario of a country. Even if equity shares demonstrate lower
returns at a certain point of time, it is bound to pick up when the
economy recovers.
Also, equity investments tend to rise in value over time. Thus, if
funds are kept locked-in for an extended period, the value of the
same is bound to increase manifold in the future, thus ensuring
substantial wealth accumulation of investors through capital gains.
Non-voting shares
Non-voting ordinary shares usually carry no right to vote and no
right to attend general meetings. These shares are usually given to
employees so that remuneration can be paid as dividends for the
purposes of tax efficiency for both parties.
Why Have Non-Voting Shares?
A company will typically implement this type of share for individuals
who want to invest in the company’s profitability and success
without the benefit of voting rights or having a say in the
management or control of the company. For example, a company
may issue employees with non-voting shares because they want
them to benefit from dividends or distribution of profits from a sale.
However, they do not want them to participate in decision making.
Non-voting shares often arise when company founders or directors
seek to raise new share capital but do not want to dilute their
control. In such cases, they often issue large numbers of non-voting
shares while keeping control of the original voting stock. Thus,
issuing non-voting shares allows the main shareholders to retain
control of the company whilst multiplying the number of
shareholders.
Rights of Non-Voting Shares
The company constitution will typically set out all share class rights
and any restrictions attached to them. Also, the company or board
resolution may detail further terms of the issue.
Additionally, an incoming shareholder must review the company
constitution to understand the exact restrictions that come with the
class.
A company can also create new classes of shares or vary existing
classes of shares if required. But, again, this will depend on the
rules set out in the company’s constitution or shareholders
agreement.

WHAT IS GDR IN THE STOCK MARKET?

GDRs are negotiable certificates issued by depositary banks that
represent ownership of a specified number of a company’s shares.
These receipts can be listed and traded independently from the
underlying shares. With GDRs, foreign companies can trade in any
country’s stock market except the US stock market. Those holding
GDRs can convert them into shares by surrendering the receipts to
the bank.
They are listed on Non-US stock exchanges like the London Stock
Exchange or the Luxembourg Stock Exchange. The GDR market is
an institutional one and hence offers less liquidity but allows trading
across a more significant number of countries.

For example, if Infosys wants to list its share in Australia, they will
deposit a substantial number of shares with an Australian Bank. The
bank can then issue receipts (GDRs) against these shares to
investors. Each receipt represents a particular number of shares.

GDR IN THE INDIAN MARKET

SEBI came out with a detailed framework for issuance of depository
receipts (DR) in October 2019. The introduced changes allow
increased access to foreign funds through ADRs and GDRs.

Indian companies can now list their GDR at the International

Financial Services Centre in Gujarat. With the new rules in place,
the companies now have an additional source for raising funds. As
per the amended rules, DRs can be issued by way of public offering,
private placement, or in a manner that is accepted in the concerned
jurisdiction. Companies planning to issue GDR need to seek prior
approval of the Ministry of Finance and Foreign Investment
Promotion Board (FIPB).

Examples of companies that have issued GDRs in India include

Aditya Birla Capital listed in the Luxembourg Stock Exchange, GAIL
Indian is listed in the London Stock Exchange, UPL is listed on
Singapore Exchange.

WHAT IS GDR IN THE STOCK MARKET?

Indian businesses can only list on foreign exchanges via a Global
Depositary Receipt (GDR). It is possible to trade the GDR. As a
result, through a GDR, Indian businesses can receive foreign
funding. Global Depository Receipt: A negotiable instrument with a
foreign currency denomination. Indian firms can trade their shares
on markets except the US using a GDR.
On the national stock exchange of that nation, depository receipts
are traded similarly to shares. Investors can afterwards buy & sell
like they would any other share. An intermediary, the Depository
Bank, serves as the guardian of the shares that the Indian business
issues. GDR aids Indian businesses in gaining access to international
capital in this way.

Let's use Microsoft as an illustration. The business desires to float its

stock in Singapore. Microsoft must deposit a sizeable amount of
shares with a Singaporean bank. After that, this bank will provide a
receipt for the shares. As a result, each receipt the bank issues
correspond to a certain amount of stock in the company.

Indian companies can only offer their shares on overseas exchanges

through GDR. As a result, the company may raise money outside of
India using the granted negotiable certificate. Businesses can trade
their shares on international exchanges to enable this.

WHAT IS THE DIFFERENCE BETWEEN ADR & GDR?

The following details highlight the critical distinction between ADR &
GDR:

A) American Depository Receipt is referred to as ADR, & Global

Depository Receipt is referred to as GDR.

B) A US depository bank will issue an ADR in exchange for a certain

quantity of shares of stock in a non-US company that is traded on
the US stock market. An international depository bank will issue a
tradable instrument called a GDR to represent shares of a foreign
company that are traded on the international market.

C) Although GDR can be negotiated anywhere around the globe,

ADR can only be negotiated in America.

D) The American Stock Exchange is where ADR is listed for trading.

In contrast, GDR is listed on stock exchanges outside the US, such
as the London Stock Exchange & the Luxembourg Stock Exchange.

E) The Securities and Exchange Commission's (SEC) strict

guidelines for ADR disclosure are onerous. GDR has less stringent
disclosure obligations.

F) The ADR market is a market for retail investors with substantial

investor activity & where a firm's shares are valued appropriately.
The market is institutional & has less liquidity than the GDR.

WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF

GDRS FOR INVESTORS?
Here is a list of advantages of GDRs for investors:

1) GDRs assist multinational businesses in connecting with many

investors.

2) GDRs give investors the chance to diversify their holdings

globally.

3) They might boost the liquidity of shares.

4) Opening international brokerage accounts and buying equities on

foreign markets are more time-consuming and expensive than using
GDRs.

5) Businesses can carry out a private offering that is both efficient

and affordable.

6) Shares listed on significant international markets can raise the

stature or credibility of a foreign business that would otherwise be
unknown.

7) GDR holders realise any dividends and capital gains in US dollars.

8) GDRs are traded, cleared, and settled in accordance with the

investor's domestic policies.

9) There are no cross-border custody or safekeeping fees for

investors.

Here is a list of disadvantages of GDRs for investors:

1) Administrative costs associated with GDRs could be high.

2) To prevent paying taxes twice on capital gains, US investors may

need to request a credit from the Internal Revenue Service (IRS) or
a refund from the foreign government's taxing body.

3) GDRs may have poor liquidity, which would make it challenging

to sell them.

4) Dividend payments are made after deducting currency exchange

fees and international taxes.

5) The depositary bank makes the necessary deductions for costs

and foreign taxes automatically.

6) Along with liquidity issues, they may also face political and
currency risks.

Derivative Securities
Derivative securities are financial instruments whose value depends
on basic variables. The variables can be assets, such as stocks,
bonds, currencies, interest rates, market indices, and goods. The
main purpose of using derivatives is to consider and minimize risk.
It is achieved by insuring against price movements, creating
favorable conditions for speculations and getting access to hard-to-
reach assets or markets.Formerly, derivatives were used to ensure
balanced exchange rates for goods traded internationally.
International traders needed an accounting system to lock their
different national currencies at a specific exchange rate.
There are four main types of derivative securities:
1. Futures
Futures, also called futures contracts, are an agreement between
two parties for the purchase and delivery of an asset at an agreed-
upon price at a future date. Futures are traded on an exchange,
with the contracts already standardized. In a futures transaction,
the parties involved must buy or sell the underlying asset.
2. Forwards
Forwards, or forward contracts, are similar to futures, but do not
trade on an exchange, only retailing. When creating a forward
contract, the buyer and seller must determine the terms, size, and
settlement process for the derivative.
Another difference from futures is the risk for both sellers and
buyers. The risks arise when one party becomes bankrupt, and the
other party may not able to protect its rights and, as a result, loses
the value of its position.

Difference between forwards futures options and swaps

 Future contracts are always bought and sold or traded
in recognized stock exchange whereas forward
contracts are traded over-the-counter.
 Futures are publicly traded whereas forwards are traded
privately.
 A forward contract is a private and customizable
contract that can be changed depending upon the
mutual understanding of two parties, whereas future
contracts are regulated and standardized by the stock
exchange. The terms and conditions can't be changed
or customized depending upon the two parties.
 Forward contracts are non-standard over-the-counter
contracts and therefore it is harder to find a
counterparty to trade in the forward contracts, whereas
it is easy to buy and sell futures contracts on the stock
exchange.
  In forward contracts, there is a scope of negotiation
whereas future contracts are Quoted and traded on the
Exchange and fixed standards.
 Forward contracts exhibit high counterparty risk as
there is no regulatory body involved in between,
whereas future contracts have very low counterparty
risk as there is a regulatory body (Stock exchange)
involved in between.
 Contracts size in the forward trades is decided and
customized as per the requirements of both parties
whereas in futures contract size is standardized and set
by the stock exchange.
 Another difference between forwards futures options
and swaps is that in the future contract a person has
the right and is obligated to buy or sell a specific asset
at a given time and at a given price, whereas in options
the person has right but not an obligation to buy or sell
a contract.

3. Option
An options contract is a financial instrument that gives you the right but not the obligation to
sell or buy an asset within or towards the end of a specific period. These assets can be shares
of a company or currency. There are two types of options contracts: Call Option and Put
Option.

The call option gives the buyer the right but not the obligation to buy the underlying asset at
the specified strike price (predetermined price). In a put option, the buyer has the right but not
obligation to sell the underlying asset at the strike price. The price at which the option is to be
sold or bought is predetermined. The price to be paid to buy the option is called the premium,
while the price at which the option has to be exercised is called the strike price.

4. Swap
A swap is a type of derivative wherein two parties agree to exchange cash flow or liabilities;
hence, the name swaps. A swap is apt when a company wants to get a variable interest rate
while another opts for a fixed interest rate to curb risks. This is done through a type of swap
called the Interest rate swap, where companies swap payments of interest rates between them.
Another type of swap is the currency swap, which allows the parties to swap the principal and
payments of fixed interest for a loan in a certain currency with the principal and payments of
fixed interest in another currency.

For a better understanding of swaps, consider the following example of a currency swap:

Suppose you need to borrow a certain amount for a fixed period of five years, and your plan
is to opt for a foreign bank. However, what if the value of the rupee drops? Your burden of
debt will shoot up and you will end up paying a huge amount over the principal amount.
Now, imagine you know a foreign businessperson who needs the same amount you need
from the foreign bank, but in Indian currency. This provides you with a chance to swap your
principles because both are equal, and only vary in currency. You will have to give the other
party an interest rate in the foreign currency while receiving the interest rate in Indian
currency. Towards the end of the term, you will exchange principles again.

Similarly, there are commodity swaps as well, where a commodity involves a fixed rate while
another has a floating rate.

Swap Vs Option: What Are The Differences?

 The primary options vs swaps difference is that an option is a right to buy/sell an asset on
a particular date at a pre-fixed price while a swap is an agreement between two
people/parties to exchange cash flows from different financial instruments. The seller or
writer of a call option would however have the obligation to sell the asset that’s
underlying at a pre-set price if the call option is exercised. In a swap, both parties are
obliged for the cash flow exchange.
 Another swap vs option difference is that options involve the trading of securities as per
their actual value and not merely the cash flows as in swap contracts.
 A key difference between swap and option is that a swap is not traded via the
exchanges. A swap is an over-the-counter (OTC) derivative type that is customised and
traded privately between two parties whereas an option can be either an OTC or
exchange-traded derivative.
 Acquiring an option involves premium payment whereas there is no such payment
involved in a swap.
Fig. 2. Risk and Return Profile for Different Securities
Hybrid Securities
Hybrid security, as the name suggests, is a type of security that
combines characteristics of both debt and equity securities. Many
banks and organizations turn to hybrid securities to borrow money
from investors.
Similar to bonds, they typically promise to pay a higher interest at a
fixed or floating rate until a certain time in the future. Unlike a
bond, the number and timing of interest payments are not
guaranteed. They can even be converted into shares, or an
investment can be terminated at any time.
Examples of hybrid securities are preferred stocks that enable the
holder to receive dividends prior to the holders of common stock,
convertible bonds that can be converted into a known amount of
equity stocks during the life of the bond or at maturity date,
depending on the terms of the contract, etc.
Hybrid securities are complex products. Even experienced investors
may struggle to understand and evaluate the risks involved in
trading them. Institutional investors sometimes fail at
understanding the terms of the deal they enter into while buying
hybrid security.

Difference between forwards futures options and swaps

 Future contracts are always bought and sold or traded in recognized stock
exchange whereas forward contracts are traded over-the-counter.
 Futures are publicly traded whereas forwards are traded privately.
 A forward contract is a private and customizable contract that can be changed
depending upon the mutual understanding of two parties, whereas future
contracts are regulated and standardized by the stock exchange. The terms and
conditions can't be changed or customized depending upon the two parties.
 Forward contracts are non-standard over-the-counter contracts and therefore it is
harder to find a counterparty to trade in the forward contracts, whereas it is easy
to buy and sell futures contracts on the stock exchange.
 In forward contracts, there is a scope of negotiation whereas future contracts are
Quoted and traded on the Exchange and fixed standards.
 Forward contracts exhibit high counterparty risk as there is no regulatory body
involved in between, whereas future contracts have very low counterparty risk as
there is a regulatory body (Stock exchange) involved in between.
 Contracts size in the forward trades is decided and customized as per the
requirements of both parties whereas in futures contract size is standardized and
set by the stock exchange.
 Another difference between forwards futures options and swaps is that in the
future contract a person has the right and is obligated to buy or sell a specific asset
at a given time and at a given price, whereas in options the person has right but
not an obligation to buy or sell a contract.
Unit 3
The derivatives are most modern financial instruments for hedging risk. The individuals and
firms who wish to avid or reduce risk can deal with the others who are willing to accept the
risk for a price. A common place where such transactions take place is called the derivative
market.
Initially, derivative started in an unorganized market. But, now, there exists an organized
market as well. Organized market does not mean undeveloped market. It refers to over the
counter market, in which the buyers and sellers come in contract directly with each other or
through an intermediary. They mutually decide about all the terms and conditions of the
contract and both commit to fulfil and abide by the set of terms. Thus derivative market is a
market in which derivatives are traded. In short, it is a market for derivatives. The traders in
the derivative markets are hedgers, speculators and arbitrageurs.

Functions Of Derivatives Markets

 Discovery of price: Prices in an organized derivatives market reflect the perception

of market participants about the future and lead the prices of underlying assets to
the perceived future level. The prices of derivatives converge with the prices of the
underlying at the expiration of the derivative contract. Thus derivatives help in
discovery of future as well as current prices.
 Risk transfer: The derivatives market helps to transfer risks from those who have
them but may not like them to those who have an appetite for them.
 Linked to cash markets: Derivatives, due to their inherent nature, are linked to the
underlying cash markets. With the introduction of derivatives, the underlying market
witnesses higher trading volumes because of participation by more players who
would not otherwise participate for lack of an arrangement to transfer risk.
 Check on speculation: Speculation traders shift to a more controlled environment of
the derivatives market. In the absence of an organized derivatives market,
speculators trade in the underlying cash markets. Managing, monitoring and
surveillance of the activities of various participants become extremely difficult in
these kind of mixed markets.
 Increases savings and investments: Derivatives markets help increase savings and
investment in the long run. The transfer of risk enables market participants to
expand their volume of activity.

Participants In The Derivatives Markets

Hedgers

Hedgers are traders who wish to protect themselves from the risk involved in price
movements. They look for opportunities to pass on this risk to those who are willing to bear
it. They are so keen to rid themselves of the uncertainty associated with price movements
that they may even be ready to do so at a predetermined cost. For instance, let's say that
you possess 200 shares of company Britannia Ltd. and the price of these shares is hovering
at around Rs 3400 at present. Suppose you plan to sell these shares near to Diwali and wish
to utilise the funds to purchase some consumer goods during the season, as you are likely to
get a good deal on the purchase then. However, since Diwali is around a month from today,
you fear that the price of these shares could fall considerably by then. At the same time you
do not want to encash your investment today as you may fritter away the money before
Diwali. You are very clear about the fact that you would like to receive a minimum of Rs
3400 per share and no less. At the same time, in case the price rises above Rs 3400, you
would like to benefit by selling them at the higher price. By paying a small price, you can
purchase an arrangement in the form of a derivative product called an 'option' that
incorporates all your above requirements.

Thus, the derivative market offers products that allow you to hedge yourself against a fall in
the price of shares that you possess. It also offers products that protect you from a rise in
the price of shares that you plan to purchase. And that's only the tip of the iceberg. There
are a wide variety of products available and strategies that can be constructed which allow
you to pass on your risk to other market traders, who are more than willing to take it on.

Speculators

These are risk-takers of the derivative market. They want to embrace risk in order to earn
profits. They have a completely opposite point of view as compared to the hedgers. This
difference of opinion helps them to make huge profits if the bets turn correct.
Speculators, unlike hedgers, look for opportunities to take on risk in the hope of making
returns.

Let's go back to our example, wherein you were keen to sell share of Britannia Ltd. after one
month, but feared that the price would fall below your threshold price. In the derivative
market, there will be a speculator who expects the market to rise. Accordingly, he will enter
into an agreement with you stating that he will buy shares from you at Rs 3400 if the price
falls below that amount. In return for this risk that he will relieve you off, he must be paid a
small compensation. He realises that if his surmise is correct, and the price of Britannia Ltd
rises, you will not want to sell shares to him anymore and he will get to pocket this
compensation. This is only one instance of how a speculator could gain from a derivative
product. For every opportunity that the derivative market offers a risk-averse hedger, it
offers a counter opportunity to a trader with a healthy appetite for risk.
In the Indian markets, there are two types of speculators - day traders and the position
traders. A day trader tries to take advantage of intra day fluctuations and the up and down
movement in prices. They do not leave any position open at the end of the day, i.e., they do
not have any overnight exposure to the markets. On the other hand, position traders greatly
rely on news, tips and technical analysis (the science of predicting trends and prices) and
take a longer view, say a month, in order to realise better profits.

Arbitrageurs

These utilize the low-risk market imperfections to make profits. They simultaneously buy
low-priced securities in one market and sell them at a higher price in another market. This
can happen only when the same security is quoted at different prices in different markets.
Suppose an equity share is quoted at Rs 1000 in the stock market and at Rs 1050 in the
futures market. An arbitrageur would buy the stock at Rs 1000 in the stock market and sell it
at Rs 1050 in the futures market. In this process, he/she earns a low-risk profit of Rs 50.
This is because in the Indian markets, there is no delivery of shares in order to settle
positions in the derivatives segment; the cash and future prices converge on the expiry day,
and a trader merely pays or receives the difference between his purchase price and the
price prevailing in the cash market on the day the contract expires.

Margin Traders

Margin traders are speculators who make use of the payment mechanism, which is peculiar
to the derivative markets. When you trade in derivative products, you are not required to
pay the total value of your position up front. You are only required to deposit a fraction
(called margin) of the value of your outstanding position. This is called margin trading and
results in a high leverage factor in derivative trades, i.e., with a small deposit, you are able
to maintain a large outstanding position. This leverage factor is a multiplier, which allows
the speculator to buy three to five times the quantity that his capital investment would
otherwise have allowed him to buy in the cash market.

For example, let's say a sum of Rs 1.8 lakh fetches you 180 shares of XYZ Ltd. in the cash
market at the rate of Rs 1,000 per share. Under margin trading in the derivatives market, if
you are required to deposit a margin of say 30 per cent of the value of your outstanding
position, you would be able to purchase 600 shares of the same company at the same price,
with your capital of Rs 1.8 lakh i.e., Rs 1.8 lakh / (30 per cent of Rs 1000) = 600 shares. So, in
effect, you are allowed a leverage of 3.33 times in this case (100/30). If the price of XYZ Ltd.
rises by Rs 100, your 180 shares in the cash market will deliver a profit of Rs 18,000, which
would mean a return of 10 per cent on your investment. However, your payoff in the
derivatives market would be much higher. The same rise of Rs 100 in the derivative market
would fetch Rs 60,000, which translates into a whopping return of over 33 per cent on your
investment of Rs 1.8 lakh. This is how a margin trader, who is basically a speculator, benefits
from trading in the derivative markets.

Difference Between Cash Market And Derivative Market

 Ownership: - When you buy shares in the cash market and take delivery, you are the
owner of these shares or you are a shareholder, until you sell the shares. You can
never be a shareholder when you trade in the derivatives segment of the capital
market. This is because you just hold positional stocks, which you have to square-off
at the end of the settlement.

 Holding Period: - When you buy shares in the cash segment, you can hold the shares
for life. This is not true in the case of the futures market, where you have to settle
the contract within three months at the very maximum. In fact, when you buy shares
in the cash segment, they can also be trans-generational, that is they can be
transferred from one generation to the other.

 Dividends: - When you buy shares in the cash segment, you normally take delivery
and are a owner. Hence, you are entitled to dividends that companies pay. No such
 luck when you buy any derivatives contract. This is not only true in the case of
dividends, but, also other corporate benefits like rights shares, bonus shares etc.

 Risk: - Both, cash and futures markets pose risk, but the risk in the case of futures
can be higher, because you have to settle the contract within a specified period and
book losses. In the case of shares bought in the cash market, you can hold onto them
for an indefinite period and can hence sell when prices are higher.

 Investment Objective Differ: - You buy a contract in the derivatives market to hedge
risk or to speculate. Individuals buying shares in the cash market are investors.

 Lots V/s Shares: - In the derivatives segment you buy a lot, while in the cash
segment you buy shares.

 Margin Money: - In the derivatives segment you pay only margin money for
example, if you buy 1 lot of Punjab National Bank (4000 shares) you just pay 15 to 20
per cent of the cost of the 4,000 shares and not the entire amount. That is not true
in the case of cash segment, where you have to pay the entire amount and not only
margin.

Exchange Traded Vs OTC Derivative Market

Derivatives have probably been around for as long as people have been trading with one
another. Forward contracting dates back at least to the 12th century, and may well have
been around before then. Merchants entered into contracts with one another for future
delivery of specified number of commodities at specified price. A primary motivation for
pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to
lessen the possibility that large swings would inhibit marketing the commodity after a
harvest.

As the word suggests, derivatives that trade on an exchange are called exchange traded
derivatives, whereas privately negotiated derivative contracts are called OTC contracts. The
OTC derivatives markets have witnessed rather sharp growth over the last few years, which
has accompanied the modernization of commercial and investment banking and
globalization of financial activities. The recent developments in information technology have
contributed to a great extent to these developments. While both exchange-traded and OTC
derivative contracts offer many benefits, the former have rigid structures compared to the
latter.

Difference Between Exchange Traded and OTC

Types of exchange-traded derivatives

Stock or equity derivatives: Common stock is the most commonly

traded asset class used in exchange-traded derivatives.

As exchange-traded derivatives tend to be standardized, not only does

that improve the liquidity of the contract, but also means that there are
many different expiries and strike prices to choose from.

Global stock derivatives are also seen to be a leading indicator of future

trends of common stock values.

Index derivatives: Not only are you able to transact derivatives in

single-name stocks, but you can also trade derivatives tied to the
performance of a stock index or basket of stocks.

Index-related derivatives are sold to investors that would like to buy or

sell an entire exchange instead of simply futures of a particular stock.
Physical delivery of the index is impossible because there is no such
thing as one unit of the S&P or TSX.

Currency derivatives: Exchange-traded derivatives markets list a

common currency pairs for trading. Futures contracts or options are
available for the pairs, and investors can choose to go long or short.
Interestingly, currency derivatives also allow for investors to access
certain FX markets that may be closed to outsiders or where forward FX
trading is banned. These derivatives, called non-deliverable
forwards (NDF), are traded offshore and settle in a freely-traded
currency, mostly USD. However, NDFs tend to trade OTC rather than on
an exchange.

Commodities derivatives: Derivatives trading in commodities includes

futures and options that are linked to physical assets or commodities.
Most commonly, we see trading in oil and gas futures, agricultural and
metals.

These are very important not only for the producers of commodities,
such as oil companies, farmers and miners, but also a way
that downstream industries that rely on the supply of these
commodities hedge their costs.

Recently, we have even seen the market develop for cryptocurrency

futures on leading tokens such as Bitcoin and Ethereum.

Interest rate derivatives: Another family of commonly traded ETDs

are those related to fixed income products, such as government bond
futures. These bond futures give fixed income traders an efficient and
effective way to manage their interest risk exposure.

While many interest rate derivatives are always available on exchanges,

after the Wall Street Reform and Consumer Protection Act of 2010 (also
known as the “Dodd-Frank Act”) was passed after the Global Financial
Crisis, we have seen more and more OTC derivatives move onto
exchanges, such as credit default swaps (CDS).

Clearing and settlement of exchange-traded derivatives

While an OTC derivative is cleared and settled bilaterally between the

two counterparties, ETDs are not. While both buyer and seller of the
contract agree to trade terms with the exchange, the actual clearing
and settlement is done by a clearinghouse.
Clearing houses will handle the technical clearing and settlement tasks
required to execute trades. All derivative exchanges have their own
clearing houses and all members of the exchange who complete a
transaction on that exchange are required to use the clearing house to
settle at the end of the trading session. Clearing houses are also heavily
regulated to help maintain financial market stability.

Clearing houses ensure a smooth and efficient way to clear and settle
cash and derivative trades. For derivatives, these clearing houses
require an initial margin in order to settle through a clearing house.
Moreover, in order to hold the derivative position open, clearing houses
will require the derivative trader to post maintenance margins to avoid
a margin call.

If the trader cannot post the cash or collateral to make up the margin
shortfall, the clearing house may liquidate sufficient securities or
unwind the derivative position to bring the account back into good
standing.

The clearing house then, is effectively the counterparty for the

transaction that faces the trader and not the other party as would be
the case in an OTC transaction. By stepping in between the buyer and
seller of a derivative contract, the clearing house guarantees that trades
will be successfully completed and more importantly, that traders who
are on the losing end of a derivative transaction have the ability to pay
their obligation. This reduces much of the counterparty credit risk
present in an OTC derivative transaction.

Benefits of exchange-traded derivatives

Highly liquid. Exchange-traded derivatives have standardized contracts

with a transparent price, which enables them to be bought and sold
easily. Investors can take advantage of the liquidity by offsetting their
contracts when needed. They can do so by selling the current position
out in the market or buying another position in the opposite direction.

The offsetting transactions can be performed in a matter of seconds

without needing any negotiations, making exchange-traded derivatives
instruments significantly more liquid.
High liquidity also makes it easier for investors to find other parties to
sell to or make bets against. Since more investors are active at the
same time, transactions can be completed in a way that minimizes
value loss.

Intermediation reduces the risk of default. Exchange-traded

derivatives are also beneficial because they prevent both transacting
parties from dealing with each other through intermediation. Both
parties in a transaction will report to the exchange; therefore, neither
party faces a counterparty risk.

The intermediate party, the clearinghouse, will act as an intermediary

and assume the financial risk of their clients. By doing so, it effectively
reduces counterparty credit risk for transacting parties.

Regulated exchange platform. The exchange is considered to be safer

because it is subject to a lot of regulation. The exchange also publishes
information about all major trades in a day. Therefore, it does a good
job of preventing the few big participants from taking advantage of the
market in their favor.

Disadvantage of exchange-traded derivatives

Loss of flexibility. The standardized contracts of exchange-traded

derivatives cannot be tailored and therefore make the market less
flexible. There is no negotiation involved, and much of the derivative
contract’s terms have been already predefined.

Types of Provident Funds : Tax Implications & Key Points

 Statutory Provident Fund (SPF / GPF)

 These are maintained by Government, Semi Govt bodies, Railways,

Universities, Local Authorities etc.,

 The contributions made by the employer are exempted from income taxes in
the year in which contributions are made.

 The contributions made by the employee can be claimed as tax

deductions under section 80c.
  Interest amount credited during the financial year is not treated as income
and hence it is exempted from income tax.

 The redemption amount at the time of retirement is exempted from tax.

 If an employee terminates the PF account, the withdrawal amount too is

exempted from taxes.

 Recognized Provident Fund (RPF)

 Any establishment (business entity) which employs 20 or more employees

can join RPF. Most of the individuals (who are salaried) generally contribute
to this type of Provident Fund. This is one of the popular types of Employees
Provident Funds (EPF). (Organizations which employ less than 20 employees
can also join RPF if the employer and employees want to do so)

 The business entity can either join the Govt. scheme set up by the PF
Commissioner (or) the employer himself can manage the scheme by creating
a PF Trust. All Recognized Provident Fund Schemes must be approved by The
Commissioner of Income Tax (CIT).

 Employer’s contribution in excess of 12% of salary is treated as income of the

employee and is taxable. In excess of 12%, the contributions are taxable in
the year of contribution.

 Tax Deduction u/s. 80C is available for amount invested by the employee (up
to Rs 1.5 Lakh in a Financial Year).

 Interest amount earned (up to 9.5% interest rate) on PF balance (employee’s

+ employer’s contributions) is tax free. In excess of 9.5%, the interest on
contributions is taxable as ‘salary’ in the year in which it is accrued.

 Accumulated funds redeemed by the employee at the time of retirement /

resignation are exempt from tax if he/she continues the service for 5 years or
more.

 Unrecognized Provident Fund (UPF)

 These are not recognized by Commissioner of Income Tax.

 Employer’s contribution is not treated as income in the year of investment

and hence not taxable in that specific year. So, it is tax free in the year of
contribution.

 Tax deduction under section 80c is not available on Employees contributions.

  Interest earned is not treated as income in the year it is credited and hence
not taxable in the year of accrual.

 At the time of redemption / retirement, the employer’s contributions and

interest thereon is treated as ‘salary income’ and chargeable to tax. However,
employee’s contribution is not chargeable to tax. Interest on Employees
contribution will be charged under income from other sources.

 Public Provident Fund (PPF)

 Under PPF any individual from public, whether is in employment or not may
contribute to this fund.

 The minimum contribution is Rs. 500 p.a. & maximum is Rs 1.5 Lakh Rs. p.a.
The amount is repayable after 15 years.

 PPF can serve as an excellent retirement planning / savings tool, for those
who do not come under any pension scheme.

 The PPF offers tax benefit under section 8OC and the interest earned is also
exempt from tax. All the eligible withdrawals are exempted from taxes.
What is 'Derivatives'

Definition: A derivative is a contract between two parties which derives its value/price from
an underlying asset. The most common types of derivatives are futures, options, forwards
and swaps.

Description: It is a financial instrument which derives its value/price from the underlying
assets. Originally, underlying corpus is first created which can consist of one security or a
combination of different securities. The value of the underlying asset is bound to change as
the value of the underlying assets keep changing continuously.

Derivatives are financial instruments used for trading in the market whose value is dependent upon
one or more underlying assets. It is a security that derived its value from underlying assets such as
stocks, currencies, commodities, precious metals, stock indices, etc. Derivatives represent a contract
that is entered into by two or more parties.

This contract is regarding the money payments and sell/purchase of assets between the
parties. There are certain conditions which are attached to this contract while entering into
such as contractual obligations of parties, date of maturity, notional amount and resulting
values of underlying instruments. Derivative instruments are mainly used for hedging the
risk or earning profit through speculation on value of underlying security.

These instruments are either traded over the counter or via an exchange. Over-the-counter
(OTC) derivatives are one which is traded privately and without any intermediary whereas
exchange-traded derivatives are traded via specialized exchanges such as Bombay stock
exchange. Futures, forwards, options and swaps are four main types of derivative
instruments.

Functions of Derivatives

Price Discovery

Derivative contract helps in determining the prices of the underlying assets. Future and
forward contract prices are used in determining the future spot prices for the commodity.
This way it is beneficial in discovering the prices for underlying assets.
 Functions of Derivatives

Transfer Of Risk

Derivatives are used for transferring the risk from one party to another that is a buyer of a
derivative product to the seller. It is an effective risk management tool that transfers the risk
from those having a low-risk appetite to those having a high-risk appetite.

Hedging Risk

It helps in hedging risk against unfavorable price movements of an underlying asset. By

entering into a forward contract, the buyer and seller agrees to complete the deal at a pre-
decided price at some specific date in the future. Any unexpected price hikes or drop will
not influence the contract value, thereby providing protection against these types of risks.

Lower Transaction Cost

The cost of trading in derivative instruments is quite low as compared to other segments in
financial markets. They act as a risk management tool and thereby lower the transaction
costs of the market.

Provide Access To Unavailable Assets And Markets

Derivative enables business in reaching out to hard to trade assets and markets.
Organizations with the application of interest rate swaps can obtain better interest rates
than available in the current market.

Higher Leverage
Derivatives instruments provide higher leverage than any other instrument available in the
financial market. Capital required to take positions in derivative instruments is very low as
compared to the stock market. In the case of a future contract, only 20-40% of the contract
value is needed whereas, in case of options, only the amount of premium is required for
trading.

Types of Derivatives

Future

Future are the standardized type of contracts enter into by parties for buying and selling of
underlying securities at an agreed price at some future date. These are traded over an
exchange via intermediary and are completely regulated. Future contracts cannot be
customized as per the party needs and carry lower counterparty risk. The value of these
contracts is decided as per the market movement on a daily basis till the expiration date.

Forward

Forward are simply an agreement between two parties for buying or selling an underlying
asset at a specified price at some future date. It is a non-standardized type of contract which
is traded over the counter. These contracts are flexible and can be customized according to
the needs of buyers and sellers. Forward contracts involve large amounts of counterparty
risk as these are unregulated contracts without the involvement of any intermediary.

Options

Options are derivative contracts that provide the buyer a right but not an obligation to buy
or sell an underlying asset. The buyer of an option contract pays a premium to the seller for
buying such right, whereas the seller is under an obligation to discharge his duty in return
for the premium he received. Options are of 2 types: – Call option and Put option. Call
option provides the buyer a right but not an obligation to buy an asset at the pre-decided
price at some future date. On the other hand, the put option provides the buyer a right but
is not under any obligation to sell an asset at some future date at the agreed price.

Swaps

Swaps are the most complicated type of derivative contracts which are entered into for
exchanging cash flows in the future between 2 parties. These are the private agreements
which are done over the counter. Interest rate swaps and currency swaps are the two most
common types of swap contracts. These contracts carry a high amount of risk as the interest
rate and currency are underlying assets in these contracts which are highly volatile.
Advantages of Derivatives
Hedging Risk
Derivative contracts are used for hedging risk arising out of fluctuations in
price movements. Value of these contracts is dependent upon the value of
underlying assets. Investor will purchase those derivative contracts whose
value moves opposite to the value of security the investor owns. Therefore,
losses in underlying commodities may be offset by profit in contracts of
derivatives.

Determine Underlying Asset Price

Derivatives contracts helps in ascertaining the price of underlying assets.
An approximation of commodity prices is known through the spot prices of
future contracts.

Provide Access To Unavailable Market Or Asset

Another important advantage of derivative is that it provides access to
unavailable market and assets to peoples. Individuals can acquire funds at
lower or favorable rate of interest as compared to direct borrowings with the
help of interest rate swaps.

Enhance Market Efficiency

Derivatives plays an efficient role in improving the financial market’s
efficiency. These contracts are used for replicating the assets payoff. It
enables in getting fair and correct economic value of underlying commodity
as these contracts brings price corrections via arbitrage. This way market
becomes price efficient and an equilibrium is attained.

Low Transaction Cost

Trading of these instruments involves low transaction cost which is
beneficial for investors. This acts as a risk management tool and a
protection against price fluctuations. Cost of trading in derivatives is lower
as compared to other securities like shares or debentures.

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options-and-futures