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Series on Retail Financial Products
Citation preview
Insurance
Insurance
Insurance
Insurance
Products
Products
Products
Products
Investment
Investment
Investment
Investment
Products
Products
Products
Products
Credit
Credit
Credit
Credit
Products
Products
Products
Products
Risk Risk -+
Savings Bank Deposits
Short Term
Debt Funds
Liquid Funds
Long Term
Debt Funds
Gold
Secured Debentures
Bank Fixed Deposits
Fixed Maturity Plans
Unsecured Debentures
Sectoral Equity Funds
Direct Equity
Hybrid Funds
Diversified Equity Funds
Risk Risk -+
Savings Bank Deposits
Bank Fixed Deposits
Let’s begin with the
sim
plest of the
Retail Financial Products -
At the very base
of the risk scale.
Risk Risk -+
Savings Bank Deposits
Savings Bank Deposits
Bank Fixed Deposits
Bank Fixed Deposits
Repayment of principal and payment of interest
on bank deposits is a contractual oblig
ation of the
bank. Therefore, bank deposits carry the least of risk.
Since the savings deposits are essentially of a
shorter term
as compared to the fixed deposits, they
carry a relatively lower
risk. As time passes the
chances of deterioration of financial health of the bank
increase; therefore the risk tends to increase w
ith the
term
of the deposits.
Two types of risk
Two types of risk
Two types of risk
-Default risk
-Market risk
--Default risk
Default risk
--Market risk
Market risk
Default
risk
is
the
possibility of the principal
not being repaid or interest
not being paid.
Market risk arises in case of investm
ent
products that are traded in a m
arket; it is the
risk of the price of the products falling. If the
price falls the investor loses.
Risk bears an unique relationship
with return –
risk and return vary in the
same
direction.
That
is,
as
risk
increases, return also increases; and
vice versa.
Return
Return
Return
Return
Return
Return
Return
Return
To understand the risk –
return
relationship, we need to look into the
composition of return.
Rew
ard
fo
r
wait
ing
Rew
ard
fo
r R
ew
ard
fo
r
wait
ing
wait
ing
Co
mp
en
sa
tio
n f
or
infl
ati
on
Co
mp
en
sa
tio
n f
or
Co
mp
en
sa
tio
n f
or
infl
ati
on
infl
ati
on
Rew
ard
fo
r
risk b
eari
ng
Rew
ard
fo
r R
ew
ard
fo
r
risk b
eari
ng
risk b
eari
ng
Rew
ard
fo
r w
ait
ing
Rew
ard
fo
r w
ait
ing
Every investm
ent requires us to m
ake
a choice :
To use the purchasing power in our
hands to buy goods and services for
consumption.
OR
To save and invest it.
If w
e use the purchasing power to buy
goods and services for consumption, we get
satisfaction from it.
If we decide to save and invest the
purchasing power, w
e need to postpone this
satisfaction.
Investm
ent, therefore, involves w
aiting,
sacrificing.
And w
hy should w
e w
ait, unless w
e are
sufficiently rewarded for the wait ?
That is the “reward for waiting”that the
return on investm
ent needs to give us. This
is the first
component
of
the return on
investm
ent.
And w
hy should w
e w
ait, unless w
e are
sufficiently rewarded for the wait ?
That is the “reward for waiting”that the
return on investm
ent needs to give us. This
is the first
component
of
the return on
investm
ent.
But we do not usually reason this out
But we do not usually reason this out
continuously; this
continuously; this
tim
e
pre
fere
nce
tim
e
pre
fere
nce
is built
is built
into our psyche.
into our psyche.
As a result we prefer liquidity
As a result we prefer liquidity ––
we
we
prefer to hold our purchasing power in a
prefer to hold our purchasing power in a
liquid form
( in a form
that lets us deploy it
liquid form
( in a form
that lets us deploy it
easily for purchase of goods and services),
easily for purchase of goods and services),
unless we have a reason not to.
unless we have a reason not to.
That is why, the reward for waiting is
That is why, the reward for waiting is
also called the
also called the ““liquidity premium
liquidity premium”” ..
Co
mp
en
sati
on
fo
r in
flati
on
Co
mp
en
sati
on
fo
r in
flati
on
Investm
ent
means parting with our
Investm
ent
means parting with our
purchasing power NOW and getting it back
purchasing power NOW and getting it back
LATER.
LATER.
But the purchasing power we get back
But the purchasing power we get back
later may not be equal to the purchasing
later may not be equal to the purchasing
power
we had parted with,
if in the
power
we had parted with,
if in the
intervening period inflation has eroded the
intervening period inflation has eroded the
value of money.
value of money.
Therefore investm
ent can result in loss
of purchasing power.
Therefore the return on investm
ent
needs to compensate us for this loss, so that
the purchasing power we get back is equal to
the purchasing power we had parted with.
That
is
the
“compensation for
inflation”that the return on investm
ent needs
to give us. This is the second component of
the return on investm
ent.
Therefore investm
ent can result in loss
of purchasing power.
Therefore the return on investm
ent
needs to compensate us for this loss, so that
the purchasing power we get back is equal to
the purchasing power we had parted with.
That
is
the
“compensation for
inflation”that the return on investm
ent needs
to give us. This is the second component of
the return on investm
ent.
But investm
ent also involves risk –
of
principal not being repaid a
nd / o
r interest
not being paid. When w
e invest, w
e have to
necessarily bear this risk.
So, we w
ill invest if, and only if, w
e are
rewarded for bearing this risk.
That is the “reward for risk bearing”
that the return on investm
ent needs to give
us. This is the third component of the return
on investm
ent.
But investm
ent also involves risk –
of
principal not being repaid a
nd / o
r interest
not being paid. When w
e invest, w
e have to
necessarily bear this risk.
So, we w
ill invest if, and only if, w
e are
rewarded for bearing this risk.
That is the “reward for risk bearing
reward for risk bearing”
that the return on investm
ent needs to give
us. This is the third component of the return
on investm
ent.
The return from those investm
ents
which do not carry any risk, will therefore
have only two components : reward for
waiting and compensation for inflation.
Such investm
ents are called risk free
investm
ents and the rate of return from such
investm
ents is called the “risk free rate of
return”. Short term
investm
ents guaranteed by
the government, pay a risk free rate of
return.The return from those investm
ents
which do not carry any risk, will therefore
have only two components : reward for
waiting and compensation for inflation.
Such investm
ents are called risk free
investm
ents and the rate of return from such
investm
ents is called the “ risk free rate of
risk free rate of
return
return”. Short term
investm
ents guaranteed by
the government, pay a risk free rate of
return.
All other investm
ents pay a rate higher
All other investm
ents pay a rate higher
than the risk free rate, depending upon the
than the risk free rate, depending upon the
risk that they carry.
risk that they carry.
Bank deposits pay a rate very close to
Bank deposits pay a rate very close to
the risk free rate of return. Weaker the bank,
the risk free rate of return. Weaker the bank,
higher will be the rate of interest that it pays.
higher will be the rate of interest that it pays.
Compensation
for
inflation
Reward for
waiting
Risk
premium
Compensation
for
inflation
Reward for
waiting
Risk
premium
Compensation
for
inflation
Reward for
waiting
Risk
premium
Risk free rate of return
Higher the risk,
higher the risk premium,
higher the return.
Total return
The rate of
return also bears a
The rate of
return also bears a
relationship to the liquidity of investm
ent.
relationship to the liquidity of investm
ent.
Liquidity refers to the ease and cost of
Liquidity refers to the ease and cost of
converting
any
invetsment
into
cash;
converting
any
invetsment
into
cash;
greater the ease and lower the cost, higher
greater the ease and lower the cost, higher
is the liquidity.
is the liquidity.
Other
things remaining the same,
Other
things remaining the same,
higher
the liquidity, lower
is the rate of
higher
the liquidity, lower
is the rate of
return, and vice versa.
return, and vice versa.
This is w
hy, given a bank, the rate of
This is w
hy, given a bank, the rate of
interest on savings deposits is lower than
interest on savings deposits is lower than
the rate of interest on fixed deposits.
the rate of interest on fixed deposits.
Let
us
now
move further
on the
risk
scale
in
the
investm
ent
products
spectrum, to products
that
carry
higher
levels of risk.
Risk Risk-+
Liquid Funds
Liquid Funds
Fixed Maturity Plans
Fixed Maturity Plans
Liquid Funds
Liquid Funds
Fixed Maturity Plans
Fixed Maturity Plans
Both these products are Mutual Fund
schemes.
A mutual fund is a company that pools
A mutual fund is a company that pools
investm
ent from m
any investors and invests it
investm
ent from m
any investors and invests it
in stocks,
bonds,
short
in stocks,
bonds,
short-- term
money
term
money-- m
arket
market
instruments,
other
securities or
assets,
or
instruments,
other
securities or
assets,
or
some combination of these securities.
some combination of these securities.
The combined holdings of securities held by
The combined holdings of securities held by
the M
F are known as its portfolio.
the M
F are known as its portfolio.
The total investm
ents collected by a MF
The total investm
ents collected by a MF
from the investors is known as its corpus or AUM
from the investors is known as its corpus or AUM
( Assets U
nder Management).
( Assets U
nder Management).
The total corpus of a MF is divided into
The total corpus of a MF is divided into
units.
Each
unit
represents
an
investor's
units.
Each
unit
represents
an
investor's
proportionate ownership of the portfolio
held by
proportionate ownership of the portfolio
held by
the M
F. The unit holder has a right to the income
the M
F. The unit holder has a right to the income
those holdings generate; the unit holder
also
those holdings generate; the unit holder
also
bears the erosion in the value of holdings, if any.
bears the erosion in the value of holdings, if any.
Investo
rIn
vesto
r
Investo
rIn
vesto
r
Investo
rIn
vesto
r
Investo
rIn
vesto
r
Investo
rIn
vesto
r
Investo
rIn
vesto
rIn
vesto
rIn
vesto
r
Investo
rIn
vesto
r
Investo
rIn
vesto
r
Investo
rIn
vesto
r
Investo
rIn
vesto
rIn
vesto
rIn
vesto
r
Mutual
Mutual
Fund
Fund
SECURITIES AND EXCHANGE BOARD OF INDIA
MUTUAL FUNDS REGULATIONS,
1996
SECURITIES AND EXCHANGE BOARD OF INDIA
MUTUAL FUNDS REGULATIONS,
1996
7.
For the purpose of grant of a certificate of
registration, the applicant has to fulfill the
following conditions, namely :
(a) the sponsor should have a sound track record
and general reputation of fairness and integrity in
all his business transactions;
(e) appointm
ent of trustees to act as trustees for
the mutual fund in accordance with the provisions
of the regulations;
(f) appointm
ent of asset management company to
manage the mutual fund and operate the schemes
of such funds in accordance with the provisions of
these regulations;
(g) appointm
ent of a custodian in order to keep
custody of the securities or gold and gold related
instruments and carry out the custodian activities
as may be authorised by the trustees.
Sponsor
Sponsor
Trustees
Trustees
A M C
A M C
Custodian
Custodian
Appoints
Appoints
Provides custodial
services
Mu
tual
Mu
tual
Fu
nd
Fu
nd
Supervise the fund on
behalf of the unitholders.
Manages the portfolio of
the fund.
Provides the initial
capital to start the fund.
14.
A mutual fund shall be constituted in the form
of a
trust and the instrument of trust shall be in the
form
of a deed, duly registered under the provisions
of the Indian Registration Act, 1908 (16 of 1908),
executed by the sponsor in favour of the trustees
named in such an instrument.
20.
The sponsor or, if so authorised by the trust deed,
the trustee, shall appoint an asset management
company, which has been approved by the Board.
26.
The mutual fund shall appoint a Custodian to
carry out the custodial services for the schemes of
the fund.
16(4). No person who is appointed as a trustee of a
mutual fund shall be eligible to be appointed as a
trustee of any other mutual fund.
16(5).
Tw
o-t
hir
ds
of
the
tru
stee
sshall be independent
persons and shall not be associated with the
sponsors or be associated with them in any manner
whatsoever.
21(1)(d). The board of directors of such asset management
company shall have a
t le
ast
fif
ty p
er c
ent
dir
ecto
rs,
who are not associate of or associated in any
manner with, the sponsor or any of its subsidiaries
or the trustees.
Sponsor
Sponsor
Trustees
Trustees
A M C
A M C
Custodian
Custodian
The purpose of these regulations
is to keep an “arms length”distance
between the different entities in the
mutual fund structure;
so that they do not collude to harm
the investor’s interest.
Risk Risk -+
Savings Bank Deposits
Short Term
Debt Funds
Liquid Funds
Long Term
Debt Funds
Gold
Secured Debentures
Bank Fixed Deposits
Fixed Maturity Plans
Unsecured Debentures
Sectoral Equity Funds
Direct Equity
Balanced Funds
Diversified Equity Funds
At
the e
nd
of
sessio
n 1
,
we h
ave r
each
ed
here
on
th
e
sp
ectr
um
of
Investm
en
t P
rod
ucts
.
We still need to look deeper
into Liquid funds and FMPs.