Plan Bond Purchases Well

This article was originally published in Postnoon on August 17th, 2012


http://postnoon.com/2012/08/17/plan-bond-purchases-well/66652

Srikanth was already waiting in the cafeteria when Prof. Nicky walked in for her morning cup of coffee.

Prof. Nicky: Good Morning Srikanth. What pulls you out of your bed at this time?

Srikanth: (Offended), well I am generally awake by this time. But today I am here to show you an sms and ask you about what it means.

Nicky: Alright, let me see the sms.

Srikanth: Here it is- "Shriram Transport Finance Corporation launches the first public issue of Non-Convertible Debentures (NCDs) this financial year from July 26th. The issue closes on August 10, 2012. The bonds offer an annual coupon rate of 10.25% and 10.50% for a period of 36 months and 60 months respectively".

Prof. I know that a bond is an instrument which allows one to invest in a company (corporate bond) or with the government (government bond), for a fixed period of time and with a fixed return. In the case of this sms, a corporate bond is being offered for a fixed period of either 3 years or 5 years and will give a return of 10.25 and 10.5 percent respectively. But I have a few more questions.

First, What is coupon rate? Is it same as return?

Nicky: Let me make a correction in your previous statement, related to your question. 10.25% and 10.5% are not returns. They are coupon rates. Coupon rate is the interest that the bond issuer pays on the face value of a bond.

Srikanth: Face Value?

Nicky: Face Value of the bond is the amount which is returned to the investors by the issuer when the Bond matures. The price or the market value of the bond may be different depending on the attractiveness and demand for the bond.

Let me explain. If the prevailing price of a similar bond, with same coupon rates, in the market is say Rs97. Nobody will be willing to pay more than Rs97 for another bond. Hence the company will have to sell their bond at a discount of 3% on the face value. On the other hand, if the other similar bonds in the market are being sold at Rs105, the company will not be willing to sell their bond at the face value of Rs100. So, they will sell their bond at a premium of 5% on the face value.

Now, if the bond is bought at the face value, and held till maturity, it will give us a return which is equal to the coupon rate. But, if it is bought at a price less than or more than the face value, we will incur a capital loss or gain on maturity. This results in our return from bonds being different from the coupon rate. In finance parlance, the return on a bond is known as yield.

Srikanth: But why will a bond price be Rs97 or Rs105?

Nicky: That's because, a bond need not be held till maturity. It can be traded in the market. Its transferrable. So a bond which is more in demand due to its higher coupon rate, its price increases. Whereas a bond which has a lower coupon rate, its price decreases.

Srikanth: Ah...Demand and Supply at work here too! Economics everywhere!

Nicky: Absolutely. No wonder it is known as the mother of all subjects!

Better Safe than Sorry

This article was originally published in Postnoon on August 11th, 2012

http://postnoon.com/2012/08/11/better-safe-than-sorry/65297

Prof. Nicky had not been to Laxmiamma's house since sometime and on her way to the campus, decided to stop by her house to relish her Irani chai and enquire about her well being. On her advice, Laxmiamma had opened a savings bank account and had also started saving through a recurring deposit. She was happy with this arrangement as it gave her peace of mind and assurance of safety for her money, as against the constant fear of theft when she kept it at home.

There was an agent at the bank who was advising her to invest her money in Systematic Investment Plans (SIP) rather than in a recurring deposit. So as soon as Prof. Nicky came in, after the pleasantries and having settled on the sofa with the chai, Laxmiamma asked him about SIPs.

Laxmiamma: This man at the bank says that SIPs give a much higher return when compared to the recurring deposit. What are SIPs? Is it true that they give more return? Why and how do they give more returns? Why did you ask me to put my money as deposits when SIPs give more return?

Prof. Nicky: Now, now...slow down amma! Let me answer your questions one by one.

What are SIPs

SIPs are instruments which allow you to invest in Mutual Funds on a periodic basis, as against a lump sum. SIPs are to mutual funds, what recurring deposits are to fixed deposits.

Performance of SIPs

When you put your money in a SIP, every month or every quarter, depending on your preference, the money is used to buy the units of mutual fund schemes. The units are bought at the price or the NAV of the fund on a specified date of that month/quarter. In this way, you get more units when the NAV is lower and lesser units when the NAV is higher. So it helps you average out the highs and the lows. This means that is helps reduce risk by spacing out your investments.

But, we cannot say that they will perform better than recurring deposits. Because the performance of the SIPs will depend on the performance of the fund in which you are putting your money. And the performance of the fund depends on where the fund put their money. If it is an equity fund, the performance of the fund will depend on the performance of the stocks in which the fund invested. So yes, they may give more returns than recurring deposits on some occasions and give lesser returns on the other.

Risk and risk taking ability

A person who can take the risk of either getting lesser returns or even losing a part of their principal, should invest in SIPs. They are less risky than investing directly in Mutual funds and even lesser risky that investing directly in the stock markets, yet, they are risky. On the other hand, recurring deposits are safe instruments, with practically no risk, unless the bank goes bankrupt.

Laxmiamma, you are too old to take risk. And you are not so rich that you can afford to lose your hard earned money. That's the reason I asked you to invest in recurring deposit rather than SIPs.

Laxmiamma: Ah...next time that agent bugs me, I can now tell him that I do not have the risk taking ability to buy SIPs. I wonder if he will understand it though (winks)! More chai?

The Village called the Globe

This article was originally published in Postnoon on August 4th, 2012

http://postnoon.com/2012/08/04/the-village-called-the-globe/63760

Pax Indica-India and the World of the 21st Century by Shashi Tharoor, hits the stores at a time when India is struggling with policy making at the domestic front. While our Prime Minister, Dr. Manmohan Singh is heard at International forums, he has been accused (and rightly so) of having lost his voice at home. In an environment which is mired with serious lapses in policy making at the home front, takers for a book on foreign policy may be few.

Having said that, there is no denying that if there is anyone suited to write a book on India’s role in shaping the world’s ‘dreams’, it has to be the former UN Under-Secretary general and the former external affairs minister of state, Shashi Tharoor.
The premise of the book is vasudhaiva kutumbakam and focuses on the relationship of India with the members of the world family, past, present and suggestions for the future. Continuing with his obsession with Pandit Jawahar Lal Nehru, the book starts with a reference to the “tryst with destiny” speech and goes on to establish the role that India has been playing on the ‘global stage’ since the Harappan civilization.

It goes on to give a detailed account of India’s diplomatic relations with Pakistan, China, US and UN, but just offers a glimpse of the relations with the other regional and neighbouring countries, which might go a long way in shaping the policies of an India of tomorrow.

The book lacks the wit and spontaneity of his early books like The Great Indian Novel or Show Business. But it gives a good insight into the foreign policy making process in the country. Heavily advocating the use of social media, Tharoor emphasises on the need for change in the ‘intellectual and institutional infrastructure for foreign policy making in India’.

Name: Pax Indica-India and the World of the 21st Century
Author: Shashi Tharoor
Pages: 449
Publisher: Penguin Books India

Use RTI Superhighway

This article was originally published in Postnoon on August 3rd, 2012 (Co-Author: Anuj Hetamsaria)


http://postnoon.com/2012/08/03/use-rti-superhighway/63511

The Right to Information Act (2005) became effective in October 2005 to empower every citizen to ask questions from the Government. This Act has given the Indian citizens the right to seek information and take copies of government documents on one hand and made the public officers accountable on the other.

The application may be submitted electronically or in a hard copy to the designated Public Information Officer (PIO). Every government department now has a PIO who is responsible to provide the information to any and every applicant.

The application should be accompanied with a payment of Rs10 towards processing charges for the Central Government Departments. The fees may vary from state to state for the departments at the state level. It can be paid in Cash, by a Demand Draft or by a Money Order. You must remember to take a receipt for the application fees paid.

Write or type the application in a clean, white sheet of paper. Frame the questions clearly with the intention for finding out reasons rather than accusing. For example, avoid using words like 'Why did you" and "How could you". Instead use words like "share the process followed" or "would like to know the manner in which...". There is no limit to the number of questions that can be asked. However, it is advisable to keep your list of questions short and queries precise.

The application must contain the name of the person asking for information, his/her signature and application fee details like DD or Cheque Numbers. The reason for seeking information need not be stated as any Indian citizen has the Right to Information.

The application may be rejected if the department is exempt from disclosure or if the disclosure infringes upon the privacy or copyright of a person other than the government.

The upper limit for providing the information is 30 days. However, it is only 48 hours in cases involving life or liberty of a person. It is 35 days if the application is given to the Assistant PIO and 40 days if the information concerns a third party from whom the department might need to get the information before responding to the RTI application. If the information is not provided within these time frames, it is deemed as a refusal to provide information.

One of the reasons for the success of RTI is that if the information is not provided within 30 days of application, it directly penalizes the concerned officer by deducting Rs 250 per day of delay up to a maximum of Rs 25,000 per application, from the salary. If wrong information is provided, a penalty up to Rs 25,000 can be imposed on the officer.

RTI is the right step to make the governance of the country more credible and transparent.

10 Steps to file I-T returns

This article was originally published in Postnoon on June 1st, 2012


http://postnoon.com/2012/07/27/10-steps-to-file-i-t-returns/61691

If you haven't yet filed your income tax returns, you can do it without much hassle at www.incometaxindiaefiling.gov.in. We will take you through the process of filing the income tax returns for a Salaried individual in this article. Once you are on this site, follow the following steps:

Step 1: Left hand corner, first tab says, Download. Click on AY2012-13 which will take you to a table describing the form that you need to use according to your income sources. For example, if you are a salaried person with only interest income apart from your salary, you can download the form ITR-1.

Step 2: Scroll down and download the relevant form on to your computer, that is ITR-1.

Step 3: The downloaded form is in excel format. Fill in the personal details. If you do not know the information about 'Income Tax Ward / Circle', it's okay to leave it blank. Or your Chartered Accountant from previous years may help you.

Step 4: Before going to the section on Income and Deductions, go to the next worksheet called 'TDS'. Fill in the details about the TDS on Salary and other income from Form 16 and Form 16A's. At this point, you must cross check the amounts that you have filled in with the Form 26AS. Form 26AS can also be obtained from the website mentioned above. You just need your PAN number to obtain it. Form 26AS is the statement of all taxes deposited to the Government under your PAN Number. If the amounts that you have filled in the form, exactly match with the Form 26AS, your tax return will sail through. But if they don't, sooner or later, the IT department will come back to you to explain the differences.

Step 5: Go back to the first worksheet and finish the section on Income and Deductions. For Salaried people, most of the items here can be filled in straight from the Form 16 that their employer would have given them. In case you did not give the details about your Life Insurance Policies or other deductible investments to your employer, you can include them here now.

Step 6: If you have made donations to approved institutions, fill in the fourth worksheet.

Step 7: Calculate your tax liability using the 'Calculate Tax' Tab on the right hand corner of the first sheet.

Step 8: Fill the third sheet according to the tax status. If you need to get a refund, you will need to give your bank account details. If you need to pay the tax, you can pay it using your online banking facility or by going to the bank. Obtain the BSR code and the challan details and fill it in Sheet 2.

Step 9: Using tabs on the right hand corner, validate all the four worksheets. If you want you may print the sheets for your records.

Step 10: Generate xml using the tab on the right hand corner of the first sheet, save it on to your computer and then upload it on the website under submit return/AY12-13.

You will get an ITR-V as acknowledgement of your returns filed. You will need to sign it and send it to Bangalore. The address is mentioned in the ITR-V itself.

There are instructions at every step. The income tax department has made it really easy for anyone to file their own returns. In fact, they have also started the facility of getting a Tax Return Preparer (TRP) to come to your house and guide you in the process or you can get help from them online or on the phone at 18001801961.

Bad monsoon- How it will hit key sectors of the economy

Published in the business section of www.rediff.com on 26th July, 2012


http://www.rediff.com/business/slide-show/slide-show-1-bad-monsoon-how-it-will-hit-key-sectors-of-the-economy/20120726.htm

Agriculture in India is majorly rain fed. Hence, monsoons and the rain god attain significance beyond proportions for the Indian farmers. From offering prayers in order to please the rain god to silly things like watching the tail of the cows (they say if the cow lifts its tail upwards, it signals bumper rains), they do it all! And why not? 55% of the Indian population is dependent on agriculture for their livelihoods.

Not just agriculture, monsoons are important for the hydro-electric power generation too, which in turn reduces the consumption of diesel and other forms of fuel. In addition, it also impacts industries like fertilizers, Fast Moving Consumer Goods (FMCG), Electronics etc.

The Indian Meteorological Department (IMD) downgraded its monsoon forecast from 99% of the long period average (LPA) in April to 92%, this week. While this is clearly not in the normal range, the IMD is still cautious about not using the word 'drought'. But clubbed with the disclaimer of errors that come with such forecasts using statistical modeling, gives enough reasons to be worried.

Given that India is currently struggling with below par GDP growth rate, low industrial production, high inflation, high fiscal deficit and weak rupee, the role of monsoons has never been as crucial as in this year. What will be the impact on each of these factors, if the monsoon is any less than normal?

GDP Growth rate: Agriculture contributes to about 15% and the rural economy contributes to about 40% of the GDP in India. Failed crops or lower yields will bring down the GDP further. When the country is still shaken with the fourth quarter GDP growth rate for the year 2011-2012, of 5.3%, a weak monsoon can push it below five. An analysis of the last seventeen years rainfall and GDP data, shows that the effect of rainfall on GDP is generally seen with a lag. For example, in the year 2000-2001, when the rainfall was 12% below normal, the GDP growth rate went down from 5.22% in 2000-2001 to 3.77% in 2001-2002. While there may be other factors as well for the decline in GDP, on an average, a below normal monsoon has resulted in a decline in the GDP in the next year.

Industrial production: Lower crop yield results in lower income for the farmers. This directly translates into low disposable income and hence lower rural demand for FMCG products and white goods.

Inflation: India has been grappling with high inflation since the last two years. Food and fuel comprise of 22% of the Wholesale Price Index. Pulses and Oil seeds are mostly rain fed and will become more expensive, adding to the inflation woes. In general, the price of all food grains, vegetables and fruits would go up too, as the yield would be lower.

Fiscal Deficit: For the financial year 2011-2012, the fiscal deficit of the government of India stood at 5.9% of GDP. Out of which, 2.34% (that is 40% of the total deficit) is accounted for by food, fertilizers and fuel subsidies. The fuel subsidy may go up as the generation of hydro electric power will go down. Also, more diesel will be used for irrigation using ground water.

The food and the fertilizer subsidy may not go up. The food subsidy in India comprises of the Government of India buying excess yield from the farmers at a Minimum Support Price (MSP), providing food at highly reduced prices to people below the poverty line and providing subsidy to the Food Corporation of India (FCI) to cover its costs.

The cost of food distributed at subsidized prices will not go up as the government will use food stored in their warehouses. However, more number of people may avail of this facility and distribution cost may go up marginally. Similarly, the costs of FCI may not go up due to a poor monsoon. But, if the yield is low, there may not be too much excess crop for the Government to buy. This will result in significant decline in the fiscal deficit.

In the case of fertilizers, after the de-control of fertilizers in the year 2010 (except Urea), the demand for fertilizers has been coming down due to 30 to 50% hike in prices of fertilizers. If the monsoons are bad, farmers will become more risk averse to deploying more capital into the farms and will avoid expensive fertilizers. This would hit the fertilizer industry. But the government may not get hit with more farmers seeking subsidies on Urea

Rupee: India is a large importer of pulses and edible oil seeds. A weak monsoon will add further pressure on the Rupee as import of edible oil and pulses will increase to meet the domestic demand for them.

A large scale farmer on the outskirts of Hyderabad quips "If IMD has predicted that the monsoon is going to be weak, then I am not worried! Then it will definitely rain. IMD has a dubious reputation for forecasting!"

IMD uses a statistical model, which takes in account the historical rainfall patterns along with factors like the surface temperatures, warm water volume and sea level pressures, etc. This year, IMD has also experimented with a dynamic model, which are recognized as better weather forecasting tool across the world now. In the dynamic model only the current environmental factors are considered for prediction.

Let's keep our fingers crossed and hope for a good monsoon, for a growing, prosperous India!

It need not be Taxing

This article was originally published in Postnoon on June 20th, 2012

http://postnoon.com/2012/07/20/it-need-not-be-taxing/60180

It is that time of the year again when we scramble to put together our salary slips, investments, collect form 16 and 16A's, run after Chartered Accountants, all in order to meet the deadline for filing our Income Tax returns. Most of us handle pretty complicated decision making scenarios with ease, in our respective work domains. However, this entire process of filing the tax returns seems unfathomable to most of us. The tax rate slabs, the deductions, the exemptions and the sections! This article lays down the basics of Income Tax returns filing for the Assessment Year 2012-13 (that is, financial year 2011-12).

Tax Slabs and Standard Deduction

The tax calculations for an individual depend upon the gender and the age of the person, apart from the income levels. There is a minimum standard deduction of Rs1,80,000 for a male individual below the age of 60. If we are doing the calculation for a woman, the standard deduction will increase by Rs10,000 to Rs1,90,000. Similarly, if the individual is a senior citizen above the age of 60 but below 80 years of age, the standard deduction is Rs2,50,000. For people above 80 years of age, the standard deduction is Rs5,00,000/-.

The Tax rates are 0, 10, 20 and 30%, depending on the level of the income. An illustration of how the tax rates are applicable depending on the income, is presented in Table 1.

For the current Assessment year, the tax slabs and calculations for a male individual or an HUF will be as follows:

Deductions

Various sub-sections of Section 80 specify deductions which can be deducted from the Income, to reduce your tax liability and to encourage people to save in the specified instruments. Once again, this is not an exhaustive list, but covers most of the popular deductions:

The section 80c, 80ccc and 80ccd cover premium paid for Life Insurance policies for self, spouse or child(ren); contributions to Employee or Recognized Provident Funds; Post Office Savings Schemes; Subscriptions to Unit Link Plans of LIC, Annuity Plans or Mutual Fund Plans; Admission Fees for upto two children (this is not an exhaustive list). The upper limit for deductions available under section 80c, 80ccc and 80ccd together is Rs1,00,000/-.

Section 80ccf allows for a deduction of up to Rs20,000 invested in long term infrastructure bonds issued by approved institutions. The investment has to be for a minimum period of 10 years, with a lock in of 5 years. Section 80d is the deduction for premium paid for mediclaim or medical insurance. It is Rs20,000 for senior citizens and Rs15,000 for everyone else. One may also claim for premiums paid for parents who are senior citizens, over and above their own premiums.

Section 80E allows for deduction of interest on loan taken for Higher education, while section 80G allows for deduction of donations paid to approved trusts and NGOs. Section 80 GG allows for deduction of house rent paid (HRA). The amount to be deducted for HRA is the lowest of the:

 the HRA received, or

 50% of salary for people residing in the four Metro cities and 40 % of salary for any other city, or

 rent paid in excess of 10 % of salary

Online Tax Filing

Taxes can be filed through a Chartered Accountant or a Taxation lawyer or one can do it online. If your income is below Rs5,00,000 lakhs, you are not required to file your tax returns if you are a salaried person and receive a Form 16 from your company. On the other hand, according to a notification by the Central Board of Direct Taxes (CBDT), if an individual or a Hindu Undivided Family (HUF) earns more than Rs10 lakhs, it is now mandatory to file the returns online.

You may directly file your returns through the official website of the Income Tax Department: www.incometaxindiaefiling.gov.in or you may file your returns through other sites which may charge you a nominal fees of around Rs200.

It is a good practice to recheck your tax return with the Form 26AS. Form 26AS is a statement of all taxes deducted or collected at source and paid to the Income Tax Department on your behalf, against your PAN number.

Insure Yourself to Skip Worries

This article was originally published in Postnoon on July 13th, 2012

http://postnoon.com/2012/07/13/insure-yourself-to-skip-worries/58783

Having realized the importance of Insurance, Mr. Mukherjee had bought a Life Insurance policy last month. However, he was still a worried man. He caught up with Prof. Nicky near the joggers park in their gated community.

Prof. Nicky: Hello Mr. Mukherjee. Good to see you. What brings you here? I thought you were not the jogging types.

Mukherjee: You are right. I never jog. I came looking for you. I bought a Life Insurance policy last month which will protect my family in the event of my untimely death. But what if something bad happens when I am still alive? What if there is a theft or a fire in my house? What if I meet with an accident and need a lot of money for the hospital? How will my family and me handle such an eventuality financially?

Prof. Nicky: What you need is insurance against these eventualities, for peace of mind.

Mukherjee: Exactly.

Prof. Nicky: There are insurance policies for fire, theft, accident, health, etc. These are together known as General Insurance and are sold by 'Non-Life' Insurance companies. In fact some of these policies are now a day's made mandatory by the Government. For example, the third party liability insurance if you own a vehicle. Many companies provide medical insurance to their employees as part of the compensation. Banks insist on an insurance on property if you are taking a loan against property.

Mukherjee: But what about me? I am a businessman. And I have not taken a loan against my property. Its ancestral!

Prof. Nicky: Then you buy it on your own. You must insure your property against loss or damages. Most of the General Insurance companies determine the premium based on the value of the property and the sum assured. When determining the sum for which you want assurance, you should keep in mind things like anticipated damage in the event of a fire or explosion. How much will it cost to renovate? What all do you want covered-Only the property or the fittings and fixtures as well?

Mukherjee: So you mean that the Insurance company pays for the furniture and fittings as well?

Prof. Nicky: Absolutely. Just your premium will go up. Not only this, they will cover injuries to you as well if you want, under a 'house holders policy'.

Mukherjee: Amazing. How about accident and medical plans?

Prof. Nicky: There are many different types of Medical and Health Insurance Policies. Depending on the terms of the policy, they can cover you expenses from hospitalization to diagnostic tests, to medicines, ambulance and other related expenses. Under accident covers, you may buy policies that cover you and your family for permanent or temporary, total or partial, disability. You may also seek cover for funeral expenses if you wish!

Mukherjee (gets angry): Professor, please don't joke.

Prof. Nicky: Mr. Mukherjee, I am not joking. It's true. I am just trying to tell you that you can buy a policy for anything now a days. It's you who has to decide what is important for you to secure and insure. For example, film stars ensure their body parts, because their fame and success depends on those attributes.

Mukherjee: You finance people are genius! You make a product out of everything!

Rain, Rain Pour Again

This article was originally published in Postnoon on July 6th, 2012


http://postnoon.com/2012/07/06/rain-rain-pour-again/57623

Professor Nicky left for her native village in the Karimnagar district last week. She needed a break from Srikanth and his questions on Derivatives. Nicky loved the smell of the countryside and secretly harbored the desire to retire and live on the farms one day. It is the rainy season and the best time of the year to visit her ancestral farms. The soil is moist and the seeds are sown, the saplings are just sprouting from the soil at this time.

Nicky had heard that the Indian Meteorological Depart¬ment (IMD) had predicted average monsoons this year, though slightly lower than their earlier prediction. For the sake of the country, she was praying for normal monsoons. The economy is as it is showing signs of a slowdown. A weak monsoon will push it further into lower growth path.

The Indian farmers are majorly dependent on the rainfall. They go to any extent to please Indra, the Rain God. In a village, they tie two frogs to a pole and get them married. They say that it brings good rainfall! On her farm, Nicky got into a conversation with Bhasker, the supervisor. Bhasker is more knowledgeable and well read than one would expect a rural farmer to be. Whenever professor visits the farm, he does not miss the opportunity to have a dialogue with her on the economy.

Bhasker: Professor, we farmers are worried about the monsoon. That is understandable. Why is everybody else worried about it? People come on the television and say that if it doesn’t rain, it’s going to be very bad for the economy. Why and how is that?

Nicky: Bhasker, the contribution of agriculture constitutes about 15 per cent of our GDP. In the last quarter of the year 2011-12, our GDP growth rate was only 5.3 per cent. If the monsoons are weak, the contribution of agriculture to GDP will go down further. And other industries like electronics and fast moving consumer goods will also experience a slow down since the rural demand for their products will go down if the farmers don’t make money.

Bhasker: Oh… so the impact is much deeper than what I though.
Nicky: That’s not just it. It’s in fact much more than that. Food inflation would also go up if the monsoon is weak. Lower yield will result in lower supply and hence higher prices. A few necessary food articles might need to be imported as well, driving up the demand for dollars, causing the rupee to weaken further. As it is in the last year, rupee has depreciated close to 25 per cent.
Bhasker: Hmmm…no wonder everyone in India so eagerly tracks the monsoon!
Nicky: Yes. It has a huge impact on the key economic figures like fiscal deficit, growth rate and inflation.
Bhasker: You just explained about growth rate and inflation to me. But what about fiscal deficit?

Nicky: The government has budg¬e¬ted Rs 43,580 crore as fuel subsidy for the year 2012-13. In the event of monsoon being weak, the gene¬ration of hydro-electric power will go down and the use of diesel to pu¬mp water into the fields will increase. Both of these will result in an increase in the import of fuel, causing the fuel subsidies to go up. This in turn will increase the fiscal deficit.

Bhasker: Professor I must run and tell my grandmother to tie two more frogs to the pole and get them married!

Understanding Options

This article was originally published in Postnoon on June 29th, 2012


http://postnoon.com/2012/06/29/understanding-options/56222

Srikanth: Hi Professor! Hope you have some time because I have a ton of questions!

Srikanth: How would buying an option differ from buying a stock?

Prof Nikki: when you buy a call option, you own the right to buy the stock. But you do not own the stock and therefore have no right over dividends. Also, the extent to which the price movement of the option imitates the price movement of the stock depends on the strike price and the stock price.

Also, you own a stock till you sell it, but an option expires. It is an instrument with limited life.

Srikanth: What do you mean by the strike price?

Prof Nikki: Strike price is the price at which you will buy or sell the underlying asset. The current market price, on the other hand, is known as the spot price.

Srikanth: So when would you suggest I buy options?

Prof Nikki: There are several scenarios when buying options would be a good idea. The first case I can think of is when the prices of a stock you own are falling rapidly.

This is a situation that no one likes. And to protect yourself from potentially large losses, you can buy a put option to sell the stock at a certain acceptable price.

Srikanth: A quick question here Prof, can I buy options in such a way that I can make a profit by exercising it right away?

Prof Nikki: Hypothetically, by buying an in the money call, that is, a call with strike price less than market price, you should be able to make instant profit. But in reality, the options are priced to take into account the time value of money. Which means, factors like interest rates, time to expiration, volatility of the stock etc. are taken into account by the market, making it very difficult to make money by exercising the option right away.

Srikanth: Hmmm… so what are the other situation where buying an option would be good for me?

Prof Nikki: Like I said earlier, there are several situations. Before I tell you more, I really need you to understand that options are instruments that offer immense leverage because you are paying only a fraction of the money in the form of the premium. You actually pay for the stock or the commodity when you exercise the option. While this seems like a good strategy, you should always be careful and manage risk.

Srikanth: I understand Professor… Do you think it would be a good idea to buy call options on a stock that I am optimistic about?

Prof Nikki: You are learning fast indeed! It is a good idea. But please remember that if you plan to actually exercise the option, you will need to have enough capital to buy it at the strike price.

As a matter of fact Srikanth, there are several strategies that one can use with different combinations of options. But the more complex strategies need to be managed regularly. It is advisable to take help of a portfolio manager if you are serious about investing in futures and options.

Keeping Your Options Open

Co-Author: AmulyaChirala

This article was originally published in Postnoon on June 22nd, 2012

http://postnoon.com/2012/06/22/keeping-your-options-open/54996

Srikanth owns stocks of ABC Ltd. After he learnt about the concept of futures and hedging from professor Nicky, he used the futures contracts on ABC Ltd. to hedge the risk of a downward slide in the share prices. Unfortunately for him, just a few days after he entered the contract, the company announced its quarterly earnings and the stock prices have gone up steadily ever since.

The value of his stocks are now higher. That’s good news. But he does not intend to sell the stock. On the other hand, his losses are very real! He started getting margin calls from his broker. So he closed out his position in the futures market, before his losses become larger.
However, this led him to think of how it would be great if he could have the good part of futures without the obligation to honor the contract!

“Naah…I guess that would be too good to be true…”, thought Srikanth. Nevertheless, he walked into prof. Nicky’s room to share his experience with futures with the professor.

Prof Nicky: Well, as a matter of fact, such instruments do exist. They are called Options. By buying an option, you can lock in a price but can choose not to exercise your option if the market offers a more advantageous price.

Srikanth: Buying an option?

Prof. Nicky: Perceptive as always Srikanth. Yes, you buy an option. Since you have a right but no obligation to trade your stock at a pre-determined price, you pay a premium. Else it would be like being able to have your cake and eat it too!

Srikanth: Hmmm… though that would be great, I suppose no one would sell options for free, so this situation seems fair enough. So how about if I want to be able to sell a stock? Can I buy an option to sell a stock?

Prof. Nicky: Yes Srikanth, weirdly as it sounds, you can buy an option to sell a stock… It’s pretty interesting actually, there are fundamentally two types of options, a call option which allows you to buy stock and a put option that allows you to sell stocks. Buying an option allows you to, at a cost, transfer risk to the seller of the option. A simple call or a simple put option are also referred to as plain vanilla options.

Srikanth: Professor, in the futures market, we can buy and sell our contracts any time. Can we do the same in the Options market?

Prof. Nicky: Indeed you can buy and sell them anytime at the price (premium) in the market. However, you can exercise your options anytime only if they are American in nature. Now… before you ask… no you don’t need to be in America to be able to trade in American style Options. It’s just nomenclature.

Options which can be exercised anytime up to expiration are called American Options, where as those which can be exercised only on the day of expiration are known as European style options. Both kinds of options are traded all over the world. In India, the index options are European in nature, while the stock options are American!

Srikanth: They don’t seem too plain to me… But why would anyone sell options? The seller seems to take on a lot of risk!

Prof Nicky: Great question! Simple answer — for the premium. The person writing the option believes that the probability of the option being exercised is very low. So he gets to collect and keep the premium.

Srikanth: Wow!… this is information overload for now..but how about we continue this discussion next week and you tell me how someone like me can use options?

Prof Nicky: Sure!

Riding the Leverage Tiger

Co-Author: Amulya Chirala

This article was originally published in Postnoon on June 15th, 2012

http://postnoon.com/2012/06/15/riding-the-leverage-tiger/53754

I had a strange dream last night. I saw a young lad sitting in front of a computer and it’s raining thousand rupee notes. He is soaked in those notes, enjoying every bit of it. I look closer to see what is on the computer screen. I wake up with a start as soon as I realised that the screen was nothing but a derivatives trading platform and the young lad was Srikanth.

I had explained futures to him a few days back. What has been bothering me is that I did not explain the downside risks of investing in futures as profoundly as I should have. Futures are extremely leveraged contracts. And if not used wisely, they can wipe out fortunes. Often people mistake them as magic wands due to this very property of leverage. Let me explain.

Leverage in finance is very much like the leverage we learn about in physics. It amplifies effort, or in this case, the impact of our investment. When one buys a futures contract, she does not need to pay the full amount. For example, if you were to buy 100 shares of Reliance Industries Limited (RIL), you would need to pay a total of Rs72,700 (Rs727 per share times 100).

On the other hand, in the case of Reliance Futures, one contract of 100 shares costs only a small percentage. This amount is known as the initial margin and is calculated based on a system known as Standard Portf¬olio Analysis of Risk (SPAN).This system takes into account the volatility of the underlying stock.

Let us say that according to SPAN, the initial margin should be 10% of the contract value (Rs72,700). This would mean that you end up paying only Rs7,270 to control 100 shares of RIL. That means you are highly leveraged. Now if the stock price goes up, you gain as the price of RIL futures also go up and you can sell them at a profit.

Let’s say you sell them at Rs750 — your profit will be a total of Rs2,300 (750-727 times 100 shares). Hence your profit in percentage is 2,300/7,270 times 100, that is 31% on an investment of Rs7,270 Here is where we need to remember that leverage doesn’t always mean more profits, it merely amplifies things, so in case of a loss, the amount lost is also multiplied by the same factor.

Let’s assume that the stock price goes down by the same Rs23. That is you sell RIL futures at a loss. Once again, your losses are much higher than they would be if you had invested in the stock instead of the futures.

Unfortunately, people forget that the prices can go down. They feel that they can make huge profits with little investment in the case of futures. And I must explain this to Srikanth before he starts dr-eaming of big money and invests recklessly in the futures market. The exchanges do take measures to ensure that the risks are taken care of by adjusting the initial margin on a daily basis.

The investors get margin calls to top up their initial margin accounts in the case of a falling market. This keeps the investors informed of how much they are losing or gaining on a daily basis. The investors can close their positions or take offsetting positions before they end up losing a lot.

But this system of marking to market everyday also means that in addition to profit or loss at the end of your contract, you have to keep track of cash flows needed to stay invested. Otherwise, a sharp move can cause your position to be closed out prematurely when the contract would have been profitable at expiration.

Futures in your portfolio

This article was originally published in Postnoon on June 8th, 2012. Co-Author: Amulya Chirala.
http://postnoon.com/2012/06/08/futures-in-your-portfolio/52603

Srikanth: Hi professor, sorry I had to leave in the middle of our conversation on futures last week. You told me that futures are contracts that help people hedge their portfolios. Please do tell me how people like me can use futures as a part of our investment portfolio.

Prof. Nikki: Futures are very powerful instruments for an investor to manage his risk. But the importance of learning about them before trading in them cannot be overstated because they can also be pretty complex. And even after reading about them, it is best to start small.

Srikanth: How would you suggest we start using futures?

Prof Nikki: I think the best way would be to start with simple contracts to hedge your position on some stock that is experiencing some volatility.

Srikanth: Whoa… That’s a lot of jargon in one sentence… Hedging? And how would you define volatility?

Prof Nikki: Ah! Once a student, always a student. I did explain hedging to you last week. As usual, you did not pay attention! Let me explain again.

Hedging refers to taking a position (or trade) to offset your initial position. Let me try and make it clearer, if you own a stock (you are long stock) , you stand to gain if the stock price goes up, therefore, by entering a trade where you stand to gain when the stock price goes down, you will offset the initial position. You can do this by entering a futures contract to sell (short position) the stock at a certain time and price in future.

Volatility is a measure of variation of prices. A more volatile instrument is one which has more drastic price movements.

Srikanth: So then we would profit both ways? And what if I do not want to sell my stock?

Prof Nikki: Don’t you wish! Unfortunately no, because which¬ever way the stock moves, the gains from one position would be offset by losses from the other.

And you don’t really have to sell your stock if you don’t want to, you can either close out your po¬sition by entering a contract to buy stock (long position) or if the contract allows it, you can settle by paying the equivalent cash value.

Srikanth: Hmmm… So if the losses and gains keep cancelling and doesn’t give me additional gains, why should I go through the effort of entering into a futures contract?

Prof Nikki: One reason could be that you really like a stock that you own, something that has been a good solid company, pays good dividends etc, but is presently experiencing some trouble. In this case, you do not want to sell yet, but want to protect yourself from a very sharp decline in price…so you lock in a price and wait.

Srikanth: That makes sense, I do have a few stocks like that. With the economy in doldrums, the stocks are indeed showing signs of what you call ‘volatility’.

Prof Nikki: Yes. But do remember that futures are financial instruments and not magic wands that eliminate risk. Be sure to read up on them in detail, especially about margins before you put your money in them.

Srikanth: Sure Prof!

Front Running and Bulk Deals in India

http://www.thehindubusinessline.com/features/investment-world/market-strategy/article3483711.ece


Price manipulation and role of unscrupulous brokers in capital markets has historically been a subject of great concern to market participants and Governments since it has an important impact on market efficiency. Price manipulation can occur in many ways, from false information to accounting and earnings alteration to stock price manipulation or what Allen and Gale term “Trade-based manipulation.”

Allen and Gale (1992) confirmed that it is possible for an uninformed speculator to make profits from ‘trade-based manipulation' with large traders frequently buying and then selling substantial blocks of stock.

Evidence

Anecdotal evidence from the Indian capital markets suggest that many such price manipulation strategies exist reducing the market efficiency, and also indicate the existence of front-running by traders primarily before large trades. The fact that SEBI has sent more than 500 show-cause notices in the past four years to various brokers, financial institutions and traders regarding these prohibitive activities support the point furthermore.

Harris (1997) points out that, front- runners are on the lookout for “large traders” who strongly want to complete a trade. Then they make short-term trading profits by front-running these large traders. SEBI defines a “bulk” deal as “all transactions in a scrip (on an exchange) where total quantity of shares bought/sold is more than 0.5 per cent of the number of equity shares of the company listed on the exchange.”
The quantitative limit of 0.5 per cent could be reached through one or more transactions executed during the day in the normal market segment. In an effort to improve transparency in the Indian capital markets, SEBI mandated the disclosure of bulk deals in the year 2004.
An analysis of 80,704 trades over the past six years to see if there is any evidence of “trade-based manipulation” in the context of bulk trades on NSE and BSE, for all NSE listed stocks, by Ms Nupur Pavan Bang (ISB, Hyderabad), Mr Chakrapani Chaturvedula (IMT, Hyderabad), and Mr Nikhil Rastogi (IMT, Hyderabad), shows that there is ample evidence of front running, with significant impact of bulk trades on the share prices.

A person investing in a small-cap stock, ten days before the bulk deal and off loading it the day after the bulk deal can make 9.58 per cent in this 12-day period . Similarly, he can make 4.79 per cent in the case of large-cap stocks in 11 days .
Practical Difficulties

The results are obvious as the finding liquidity for bulk deals in small-cap stocks is more difficult and may signal the presence of more information in the trade. Also, because of liquidity issues, the broker might need more time, and may contact more people to find buyers/ sellers for the small-cap stocks. This results in more information leakage and front running.

Front-running facilitated by information leakage distorts the market integrity and can create adverse selection problems that limit market participation and inhibit efficient capital allocation. Therefore, a much stronger role for Government regulation is required to discourage manipulation in emerging markets.
Behavioural pattern

They also find that while the buyer-initiated trades result in a cumulative return of approximately 4.2 per cent over a 21-day period, but the seller-initiated trades do not see an expected dip in price over the same period.

This is in tune with the proven investor behavior of reacting swiftly to good news (bulk buying indicate good news) and being reluctant to react to bad news (bulk selling indicates bad news).

While there is need for stringent norms to regulate the bulk trades, the regulator must pay special attention to bringing more transparency and liquidity in the small-cap stocks. Due to the illiquidity in the small-cap segment, the intermediaries are able to front run the bulk orders of their customers more easily.
The surveillance activities taken up by SEBI, followed by investigative actions, need to be spruced up.

In a research carried out by Allen and others, published in the year 2007, they find that the ratio between the number of investigative actions taken up by to the number of companies under its jurisdiction was 0.09 for SEBI which is dismal when compared to SEC's (Securities Exchange Commission) 0.52. Things do not seem to have improved in the recent years.

What Futures Mean for Us

This article was originally published in Postnoon on June 1st, 2012 (Co-Authored with Amulya Chirala)

http://postnoon.com/2012/06/01/what-futures-mean-for-us/51486

Prof. Nicky: Srikant, think of a bread factory. They bake hundreds of kilograms of bread every day. This means that they use hundreds of kilograms of wheat every day. The price of wheat fluctuates frequently but the company cannot really change the price of a loaf of bread every time the price of wheat moves up or down. While wheat becoming less expensive may not worry the owner of the factory much, he would constantly worry about rising price of wheat.

Now think of a wheat farmer. He lives in fear of wheat prices dropping when it is finally time to harvest the crop. If they had a mechanism to fix the price of wheat at a certain mutually agreeable price, both of them would be happier people because of the elimination of uncertainty. Sure, the farmer is sacrificing the potential very high profits if the price of wheat were to sky-rocket! Similarly, the bread manufacturer is sacrificing the higher profits he might make if the wheat prices were to nosedive. But they are assured of being in business.

Srikant: Interesting thought. Prof. Nicky, it would indeed be very useful for both of them to enter into such an agreement.

Prof. Nicky: Yes. The elimination of price risk is known as hedging. And it can be done through financial instruments known as ‘Forwards’. Forwards enable the two parties to fix the price, quantity and quality of wheat that will be traded at some point of time in the future. Forwards are highly customisable agreements between two parties, usually via a broker. Since there is not much regulation governing the forwards, there exists a risk of counterparty defaulting on the contract when market prices are more favourable to them.

To eliminate the risk of default, there is a similar class of instruments traded on exchanges. They are known as ‘futures’. The primary difference between futures and forwards is that there is a “margin” or a safety deposit collected by the broker (or clearing house) from the trader which is adjusted daily to reflect the changes in the prices of the asset on which the contract is written (underlying). This process of adjusting the margin is called ‘marking to market’. It is the equivalent of rewriting a forward contract daily.

Srikant: Hold on Professor. Why are you telling me all this? I am neither a farmer, nor a baker.

Prof. Nicky: True. But you are an investor. You recently invested some money in the stock market.

Srikant: Yes. But I am still not able to see the connection between my equity investments and these futures contracts.

Prof. Nicky: You know how volatile the markets are now a days. With the rupee falling, the fiscal deficit increasing, Euro crisis and so on. Wouldn’t it be nice if you could hedge your risk in the stock markets too?

Srikant: Ah! Now I know where you are going!

Prof. Nicky: Just like a farmer and a baker can hedge the price risks involved in their business, an investor too can hedge the risk of her portfolio of stocks being subjected to undue price movements due to external factors. Exchanges like NSE and BSE offer futures contracts on stocks and even the index.

Also, Srikanth, your father owns a jewellery business. You can tell him about futures contracts which can help him hedge the price of Gold. Futures contracts on commodities are traded on exchanges like MCX and NCDEX.

Srikanth: Prof. that reminds me, I’ve got to rush home. Got to take dad for a doctor’s appointment. But this is all very interesting and we’ll continue from where we are leaving, the next week…