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Friday, October 31, 2008
Write Down
A Write down in banking terminology means, deducting a portion of the banks assets from its net worth because they have become non collectible.
For e.g., when a bank grants a loan to a person A for Rs. 10 lacs and he declares bankruptcy after paying the first 3 EMI's then the remaining principal amount of the loan would become non collectible. Hence it would have to be written down from the banks assets.
Write Downs in the current US Financial Crisis:
With the ongoing economic crisis in the US, a lot of companies have had to write down a lot of illiquid MBS and Sub Prime Loans.
A MBS refers to Mortgage Backed Securities. To know more about MBS click here.
A Sub Prime loan is a loan granted to a non creditworth customer. The customer may not have enough income to even pay back the EMI. To know more about Sub prime loans click here.
Some Major write downs in the US:
1. Citigroup = $39 billion (Approximately INR 2 lac Crores)
2. Merryl Lynch = $29 billion (Approximately INR 1.5 lac Crores)
3. Morgan Stanley = $ 11.5 billion (Approximately INR 57000 Crores)
Some Major write downs in UK:
1. HSBC = $20 billion (Approximately INR 1 lac Crores)
2. Barclays Capital = $3.1 billion (Approximately INR 15000 Crores)
Write downs in India:
1. ICICI Bank = $0.264 billion (Approximately INR 1200 Crores)
$ - US Dollar
INR - Indian Rupee
Monday, October 27, 2008
Saving Income Tax through Investments
Every Indian who earns an income in India is entitled to pay tax on his income. As per the Indian tax laws we the tax payer is allowed to save his income tax by using the provisions under Sec 80C of the tax laws. To know more about the Indian Income tax laws and the options using which we can reduce our tax pls refer to this link. Income Tax
In this article we will be checking out some investment options that would help us save some cash for our future.
Why do we need to invest?
This is one big question that most of us have but we do not know the best answer. The most common answer is "To Save Income Tax".
Yeah that too is an answer but that is not the first of the reasons. There are a few other compelling reasons why we should invest.
1. Inflation - The Inflation rate of our country is currently at 11%. This means that anything you buy this year for Rs. 100 would be worth Rs. 111 next year. Next year our income would rise but so would our commitments. So if our money is not growing at least at the rate at which the inflation is going, then effectively the worth of our money is going down.
2. Future Income - Today we are in a good job and earning a decent income. After 20 or 30 years we would have to retire some time. After that we would not want to compromise on the life style we are used to. Nor would we want to be dependent on our children to support us. So what is the only option? We must save up some cash that we can use after our retirement. This is possible only by investment.
3. Financial Security - Financial security is something all of us would want to have. If anyone asks us what would make us feel financially secure what would we say? A bank balance of 10 lacs? Yeah that sounds nice. But how would we get such lump sum amounts? The answer is simple. If we start investing now, once our income earning days are over we would be able to sit on a pool of cash that would make us feel financially secure...
4. Saving Income Tax
I have intentionally placed Saving Income tax as the last option because, we must not invest just for the sake of saving tax. We must invest sincerely because we are the ones who is going to enjoy the fruits in future.
In my article on Income tax i have mentioned about 9 options that are available for us under Sec 80C to save tax. Out of these I am going to consider the investment options available. We would not be considering Life Insurance and Home loans because they are not investments but a protection and an asset for us. We will be looking at them one after the other in the increasing order of risk and also the increasing order of Returns.
Remember - "The Greater the Risk, Greater are the Returns" This doesn't mean that we must only in high risk instruments. Definitely not. We must have exposure to safe avenues of investment too because after all it is our hard earned money and we do not want it to go waste. We must maintain a good balance between risky investments and safe investments so that our principal is intact and at the same time our money must grow and beat at least the Inflation rate.
1. Provident Fund
All of us know what Provident Fund is. This is a portion of our salary that our employer deducts every month. This money is remitted to the government of India's PF trust. This money is used by our government for its cash needs. Once we retire or close our PF account, the money that has accumulated against our name would be given back to us. The money in our PF account grows at the rate of 8.5% per annum compounded every year.
Safety = Very high because backed by the government
Returns on Investment = Average - Our Inflation is 11% and the returns on PF is only 8.5%
Investment Strong points:
a. Extremely Safe
b. A small amount every month can help us make up a good corpus over the long run.
Downside:
a. Only average returns.
Note: Ever wondered why the government of India has made PF mandatory for all employers? Even the government wants us to save some money for our future. The best way is to make it mandatory at the source which gives us the income. We should be thankful to our government for doing at least some good things for us :-)
2. Public Provident Fund
PPF is similar to PF with the only difference being, anyone can open a PPF account by visiting the nearest State Bank of India branch. PPF is also managed by the government of India. Once we open a PPF account we can deposit cash in our PPF account anytime. There is one restriction here. We must deposit at least Rs. 500/- every year to keep our PPF account active. The maximum amount we can remit in our PPF account every year is Rs. 70,000/- Our PPF account remains active for 15 years and if we want we can extend it by a further 5 years. We cannot encash the entire amount in our account before the tenure of 15 years. Of course we can do partial withdrawals from our account but we cannot take out the entire corpus.
Safety = Very high because backed by the government
Returns on Investment = Average - Our Inflation is 11% and the returns on PPF is only 8%
Investment Strong points:
a. Extremely Safe
b. A decent amount deposited every year can help us make up a good corpus over the long run.
Downside:
a. Only average returns.
b. Very long lock in period. We cannot take out our cash before 15 years
c. We need to deposit at least Rs. 500/- every year to keep the account active.
3. National Savings Certificate
NSC certificates are certificates of deposits issued by the government of India. Any Indian can deposit cash in NSC. This money would be used by the government for its cash needs. NSC gives us a return of 8% per annum compounded every half year and we can get our amount inclusive of the interest at the end of 6 years. 6 years is the lock in period on NSC certificates. Since these certificates are issued by our government they are extremely safe.
Safety = Very high because backed by the government
Returns on Investment = Average - Our Inflation is 11% and the returns on NSC is only 8%
Investment Strong points:
a. Extremely Safe
b. A decent amount deposited every year can help us make up a good corpus over the long run.
Downside:
a. Only average returns.
b. Long lock in period. We cannot take out our cash before 6 years
c. The Interest earned on NSC is taxable
4. Bank 5 year Fixed Deposits
The latest addition to the tax saving investment options is the Bank 5 year fixed deposit. We can deposit our cash in this special scheme of fixed deposits in any bank. Most banks give us returns as high as 10% for these deposits. The money we deposit is locked in with the bank for 5 years after which we can take back our money. We can opt for periodic interest payments or we can get the interest along with the principal at the end of 5 years.
Safety = High because backed by the RBI
Returns on Investment = Average - Our Inflation is 11% and the returns on FD's is only 9% or 10% max
Investment Strong points:
a. Very Safe
b. A decent amount deposited every year can help us make up a good corpus over the long run.
Downside:
a. Only average returns.
b. Long lock in period. We cannot take out our cash before 5 years
c. The Interest earned on Bank FD's is taxable if it is more than Rs. 10,000/- per annum.
5. Equity Linked Savings Scheme (ELSS)
ELSS mutual funds are a category of Mutual funds that are exempt from Income tax. To know more about Mutual funds Click Here
ELSS mutual funds are special funds that invest predominantly in Large cap stocks (Companies that are very large with exceedingly high capability of profit making, that have been successful for a number of years) ELSS funds have a lock in period of 3 years after which we can take our money if we want. Since the money we invest is invested in the Share market, the returns are not constant. In years in which our market performs well we can expect exceptional returns but at the same time it carries a risk. If our markets perform poorly we may incur losses. But over the years, the Indian share market has been able to give a returns of at least 15-20% year on year.
Safety = Low, because the money is linked to the share market.
Returns on Investment = Very high - If the share market goes up, our returns may exceed 20%. In the past 2 years until Jan 2008, our markets have dished out returns as high as 50%
Invest Strong Points:
a. High returns
b. A small amount investment every month can help us accumulate wealth over the years.
c. Short lock in period. ELSS is the only investment option that has a lock in period of only 3 years.
d. Returns on ELSS are tax free. Both Dividends and the maturity amount.
Downside:
a. High risk because it is linked to the stock market
The most important point:
This is the most important point of this article. "Starting Early"
Starting Early means, starting investing at a young age. Assuming two friends A & B start investing. A is 25 years old and invests Rs. 50,000/- every year for the next 20 years. B is 35 years old and invests Rs. 1 lac every year for the next 20 years. Who do you think will have more cash by the time they are 60 years old?
If you said B then you are wrong. A would have more money because he started early. His investments were able to earn an income on themselves for 35 years which was 10 years more than B's investments.
Assuming you can invest Rs. 1 lac every year for the next 25 years in an instrument that gives you a returns of 10% per annum. By delaying your investment by one year your corpus would fall short by Rs. 3.5 lacs at the end of 25 years. That is the power of compounding. The interest you earn this year would earn interest for you next year. So Start Early :)
Happy Investing...
In this article we will be checking out some investment options that would help us save some cash for our future.
Why do we need to invest?
This is one big question that most of us have but we do not know the best answer. The most common answer is "To Save Income Tax".
Yeah that too is an answer but that is not the first of the reasons. There are a few other compelling reasons why we should invest.
1. Inflation - The Inflation rate of our country is currently at 11%. This means that anything you buy this year for Rs. 100 would be worth Rs. 111 next year. Next year our income would rise but so would our commitments. So if our money is not growing at least at the rate at which the inflation is going, then effectively the worth of our money is going down.
2. Future Income - Today we are in a good job and earning a decent income. After 20 or 30 years we would have to retire some time. After that we would not want to compromise on the life style we are used to. Nor would we want to be dependent on our children to support us. So what is the only option? We must save up some cash that we can use after our retirement. This is possible only by investment.
3. Financial Security - Financial security is something all of us would want to have. If anyone asks us what would make us feel financially secure what would we say? A bank balance of 10 lacs? Yeah that sounds nice. But how would we get such lump sum amounts? The answer is simple. If we start investing now, once our income earning days are over we would be able to sit on a pool of cash that would make us feel financially secure...
4. Saving Income Tax
I have intentionally placed Saving Income tax as the last option because, we must not invest just for the sake of saving tax. We must invest sincerely because we are the ones who is going to enjoy the fruits in future.
In my article on Income tax i have mentioned about 9 options that are available for us under Sec 80C to save tax. Out of these I am going to consider the investment options available. We would not be considering Life Insurance and Home loans because they are not investments but a protection and an asset for us. We will be looking at them one after the other in the increasing order of risk and also the increasing order of Returns.
Remember - "The Greater the Risk, Greater are the Returns" This doesn't mean that we must only in high risk instruments. Definitely not. We must have exposure to safe avenues of investment too because after all it is our hard earned money and we do not want it to go waste. We must maintain a good balance between risky investments and safe investments so that our principal is intact and at the same time our money must grow and beat at least the Inflation rate.
1. Provident Fund
All of us know what Provident Fund is. This is a portion of our salary that our employer deducts every month. This money is remitted to the government of India's PF trust. This money is used by our government for its cash needs. Once we retire or close our PF account, the money that has accumulated against our name would be given back to us. The money in our PF account grows at the rate of 8.5% per annum compounded every year.
Safety = Very high because backed by the government
Returns on Investment = Average - Our Inflation is 11% and the returns on PF is only 8.5%
Investment Strong points:
a. Extremely Safe
b. A small amount every month can help us make up a good corpus over the long run.
Downside:
a. Only average returns.
Note: Ever wondered why the government of India has made PF mandatory for all employers? Even the government wants us to save some money for our future. The best way is to make it mandatory at the source which gives us the income. We should be thankful to our government for doing at least some good things for us :-)
2. Public Provident Fund
PPF is similar to PF with the only difference being, anyone can open a PPF account by visiting the nearest State Bank of India branch. PPF is also managed by the government of India. Once we open a PPF account we can deposit cash in our PPF account anytime. There is one restriction here. We must deposit at least Rs. 500/- every year to keep our PPF account active. The maximum amount we can remit in our PPF account every year is Rs. 70,000/- Our PPF account remains active for 15 years and if we want we can extend it by a further 5 years. We cannot encash the entire amount in our account before the tenure of 15 years. Of course we can do partial withdrawals from our account but we cannot take out the entire corpus.
Safety = Very high because backed by the government
Returns on Investment = Average - Our Inflation is 11% and the returns on PPF is only 8%
Investment Strong points:
a. Extremely Safe
b. A decent amount deposited every year can help us make up a good corpus over the long run.
Downside:
a. Only average returns.
b. Very long lock in period. We cannot take out our cash before 15 years
c. We need to deposit at least Rs. 500/- every year to keep the account active.
3. National Savings Certificate
NSC certificates are certificates of deposits issued by the government of India. Any Indian can deposit cash in NSC. This money would be used by the government for its cash needs. NSC gives us a return of 8% per annum compounded every half year and we can get our amount inclusive of the interest at the end of 6 years. 6 years is the lock in period on NSC certificates. Since these certificates are issued by our government they are extremely safe.
Safety = Very high because backed by the government
Returns on Investment = Average - Our Inflation is 11% and the returns on NSC is only 8%
Investment Strong points:
a. Extremely Safe
b. A decent amount deposited every year can help us make up a good corpus over the long run.
Downside:
a. Only average returns.
b. Long lock in period. We cannot take out our cash before 6 years
c. The Interest earned on NSC is taxable
4. Bank 5 year Fixed Deposits
The latest addition to the tax saving investment options is the Bank 5 year fixed deposit. We can deposit our cash in this special scheme of fixed deposits in any bank. Most banks give us returns as high as 10% for these deposits. The money we deposit is locked in with the bank for 5 years after which we can take back our money. We can opt for periodic interest payments or we can get the interest along with the principal at the end of 5 years.
Safety = High because backed by the RBI
Returns on Investment = Average - Our Inflation is 11% and the returns on FD's is only 9% or 10% max
Investment Strong points:
a. Very Safe
b. A decent amount deposited every year can help us make up a good corpus over the long run.
Downside:
a. Only average returns.
b. Long lock in period. We cannot take out our cash before 5 years
c. The Interest earned on Bank FD's is taxable if it is more than Rs. 10,000/- per annum.
5. Equity Linked Savings Scheme (ELSS)
ELSS mutual funds are a category of Mutual funds that are exempt from Income tax. To know more about Mutual funds Click Here
ELSS mutual funds are special funds that invest predominantly in Large cap stocks (Companies that are very large with exceedingly high capability of profit making, that have been successful for a number of years) ELSS funds have a lock in period of 3 years after which we can take our money if we want. Since the money we invest is invested in the Share market, the returns are not constant. In years in which our market performs well we can expect exceptional returns but at the same time it carries a risk. If our markets perform poorly we may incur losses. But over the years, the Indian share market has been able to give a returns of at least 15-20% year on year.
Safety = Low, because the money is linked to the share market.
Returns on Investment = Very high - If the share market goes up, our returns may exceed 20%. In the past 2 years until Jan 2008, our markets have dished out returns as high as 50%
Invest Strong Points:
a. High returns
b. A small amount investment every month can help us accumulate wealth over the years.
c. Short lock in period. ELSS is the only investment option that has a lock in period of only 3 years.
d. Returns on ELSS are tax free. Both Dividends and the maturity amount.
Downside:
a. High risk because it is linked to the stock market
The most important point:
This is the most important point of this article. "Starting Early"
Starting Early means, starting investing at a young age. Assuming two friends A & B start investing. A is 25 years old and invests Rs. 50,000/- every year for the next 20 years. B is 35 years old and invests Rs. 1 lac every year for the next 20 years. Who do you think will have more cash by the time they are 60 years old?
If you said B then you are wrong. A would have more money because he started early. His investments were able to earn an income on themselves for 35 years which was 10 years more than B's investments.
Assuming you can invest Rs. 1 lac every year for the next 25 years in an instrument that gives you a returns of 10% per annum. By delaying your investment by one year your corpus would fall short by Rs. 3.5 lacs at the end of 25 years. That is the power of compounding. The interest you earn this year would earn interest for you next year. So Start Early :)
Happy Investing...
Securities and Exchange Board of India - SEBI
SEBI is the primary governing/regulatory body for the securities market in India. All transactions in the securities market in india are governed & regulated by SEBI.
The SEBI Governs the following
1. New Issues (Initial Public Offering or IPO)
2. Listing agreement of companies with Stock Exchanges
3. Trading Mechanisms
4. Investor Protection
5. Corporate disclosure by listed companies etc.
The SEBI is headquartered in Mumbai, India and has regional offices in the 4 metros.
The reason for creation of SEBI is to take care of these three group of people.
1. The Issuers of Securities (The companies)
2. The Investors (Us)
3. The Market Intermediaries (The brokers, DEMAT providers etc)
The Following are some of the main functions of SEBI:
1. The business that happens in the Indian stock exchanges and other securities markets in India
2. Registering and monitoring of Intermediaries like Brokers who may participate in the securities market
3. Registering and monitoring the work of depository participants, custodians of securities, FII's etc
4. Prohibiting unfair trade practices and fraudulent practices in the markets
5. Promoting Investor education
6. Training of Intermediaries
7. Prohibiting Insider trading
8. Regulating substantial acquisitions and take overs of companies.
FII's - Foreign Institutional Investors
The SEBI has been vested with a lot of powers and it is the most important governing body that regulates the equity, debt, derivatives segment and also the trading mechanisms in the stock exchanges.
Thursday, October 23, 2008
Stock Exchanges in India
A Stock Exchange is the place where investors go to buy/sell their shares. You know what an Equity share is. Pls refer to Equity Shares for more details.
Once a company's public offering is complete, it gets listed in a stock exchange. After listing it would be available for trading to all investors in the stock exachanges where they are listed. In India we have two major stock exchanges. They are:
1. The National Stock Exchange (NSE) &
2. The Bombay Stock Exchanges (BSE)
National Stock Exchange:
The NSE is India's largest and the worlds third largest stock exchange in terms of Transaction volumes & amounts. The NSE is based out of Bombay. The NSE has set up its trading platform as a nation-wide, fully automated screen based system. This enables anyone in any part of the country to trade on shares listed in the NSE.
The NSE is based on a demutualized model wherein the ownership, management & trading rights are managed by three different group of people. This is to ensure that there is no conflict of interest among the stake holders.
NSE was set up with the objectives of:
1. Establishing a nationwide trading facility for all types of securities
2. Ensuring equal access to all investors across the country through an appropriate telecommunication network
3. Providing fair, efficient & transparent securities market using electronic trading system
4. Enabling shorter settlement cycles and book entry settlements
5. Meeting International benchmarks and standards
NSE Index or NIFTY:
The NSE Index or the Nifty Index as it is popularly known, is the index of the performance of the 50 largest & most profitable, popular companies listed in the index. Each company that is part of the index has its own weightage in the value of the Index. The value of the Nifty Index is the weighted average of the prices of these 50 companies.
To know about the 50 company's that comprise this Nifty Index "Click Here"
Bombay Stock Exchange:
The BSE is the oldest stock exchange in Asia. It is situated in Dalal Street in Mumbai. It is the third largest stock exchange in south Asia and the tenth largest in the world. BSE has over 5000 companies that are listed in it. The objectives of the BSE are similar to that of the NSE. BSE also uses the latest technologies in the IT field to provide a single place where traders from across the world can buy/sell shares in the Indian share market.
BSE Index or SENSEX:
The BSE Index or the Sensex as it is popularly known, is the index of the performance of the 30 largest & most profitable, popular companies listed in the index. Each company that is part of the index has its own weightage in the value of the Index. Since the number of companies is lesser, the index variations are higher when compared to the Nifty index.
To know about the 30 company's that comprise this Sensex Index "Click Here"
Hope you got a basic idea about the two major stock exchanges in India. Happy reading...
Once a company's public offering is complete, it gets listed in a stock exchange. After listing it would be available for trading to all investors in the stock exachanges where they are listed. In India we have two major stock exchanges. They are:
1. The National Stock Exchange (NSE) &
2. The Bombay Stock Exchanges (BSE)
National Stock Exchange:
The NSE is India's largest and the worlds third largest stock exchange in terms of Transaction volumes & amounts. The NSE is based out of Bombay. The NSE has set up its trading platform as a nation-wide, fully automated screen based system. This enables anyone in any part of the country to trade on shares listed in the NSE.
The NSE is based on a demutualized model wherein the ownership, management & trading rights are managed by three different group of people. This is to ensure that there is no conflict of interest among the stake holders.
NSE was set up with the objectives of:
1. Establishing a nationwide trading facility for all types of securities
2. Ensuring equal access to all investors across the country through an appropriate telecommunication network
3. Providing fair, efficient & transparent securities market using electronic trading system
4. Enabling shorter settlement cycles and book entry settlements
5. Meeting International benchmarks and standards
NSE Index or NIFTY:
The NSE Index or the Nifty Index as it is popularly known, is the index of the performance of the 50 largest & most profitable, popular companies listed in the index. Each company that is part of the index has its own weightage in the value of the Index. The value of the Nifty Index is the weighted average of the prices of these 50 companies.
To know about the 50 company's that comprise this Nifty Index "Click Here"
Bombay Stock Exchange:
The BSE is the oldest stock exchange in Asia. It is situated in Dalal Street in Mumbai. It is the third largest stock exchange in south Asia and the tenth largest in the world. BSE has over 5000 companies that are listed in it. The objectives of the BSE are similar to that of the NSE. BSE also uses the latest technologies in the IT field to provide a single place where traders from across the world can buy/sell shares in the Indian share market.
BSE Index or SENSEX:
The BSE Index or the Sensex as it is popularly known, is the index of the performance of the 30 largest & most profitable, popular companies listed in the index. Each company that is part of the index has its own weightage in the value of the Index. Since the number of companies is lesser, the index variations are higher when compared to the Nifty index.
To know about the 30 company's that comprise this Sensex Index "Click Here"
Hope you got a basic idea about the two major stock exchanges in India. Happy reading...
Wednesday, October 22, 2008
Derivative Categories
A Derivative is a financial product that is derived out of the value of an underlying asset. Derivatives are very popular and are widely used financial instruments.
Derivative products can be classified into the following main types:
1. Forwards
2. Futures
3. Options
4. Swaps
5. Warrants
6. Leaps &
7. Baskets
Out of these Futures & Options are actively traded on organized stock exchanges whereas Forwards are traded in OTC Exchanges.
Forwards Contract:
A forward contract is the simplest of the Derivative products. It is a mutual agreement between two parties, in which the buyer agrees to buy a quantity of an asset at a specific price from the seller at a future date. The Price of the contract does not change before delivery. These type of contracts are binding, which means both the buyer and seller must stay committed to the contract. This means they are bound to deliver or take delivery of the product on which the forward contract was agreed upon. Forwards contracts are very useful in hedging.
Important Characteristics of Forwards Contracts:
1. They are Over the counter (OTC) contracts
2. Both the buyer and seller are bound by the contractual terms
3. The Price remains fixed
Limitations of Forwards contracts:
1. Lack of centralized trading. Any two individuals can enter into a forwards contract
2. Lack of Liquidity
3. Counterparty risk - The case wherein either the buyer or seller does not honour his end of the contract.
Futures Contract:
A futures contract is an agreement to buy or sell an asset at a certain time in the future at a specific price. The Contractual terms of the futures contracts are very clear. The Futures market was designed to solve the shortcomings in the forwards contracts. Unlike forwards, futures are traded in organized exchanges. They also use a clearing house that provides the necessary protection to both the buyer and the seller. The price of the futures contract can change prior to delivery. Hence, both participants must settle daily price changes as per the contract values.
An Example of a futures contract would be an agreement to 100 tonnes of Steel at Rs. 10000/- per tonne at some date say in December 2008. If no interim payments are made and if the price of Steel moves violently, a considerable credit risk could build up. To avoid this a margin system is used by the exchanges. As per the margin system, both parties must deposit a small sum with the exchange. This amount will be a small percentage of the total contract. This amount is called the initial margin. As the steel value changes, the contract value also changes. If the contract value changes, the margin must be topped up by an amount corresponding to the change in price of steel. The margin money is the property of the person who deposits it and would be returned to them if the contract gets cancelled/completed.
Characteristics of Futures contract:
1. They are traded in organized exchanges
2. Credit risk is eliminated with the margin system. Both parties deposit a portion of the contract with the clearing house.
3. Both the buyer and seller are bound by the contract terms and are expected to honour their end of the contract.
Options Contract:
An options contract is nothing but the right to buy or sell something at a specified price within a period of time. The feature of the options contract for a buyer is that, the buyer has the right to buy, but he may choose to buy or may even choose to cancel the contract. Hence the buyers maximum loss is only the initial amount that was paid to gain the rights. Unlike buyers, the options contracts for sellers is an obligation. If a seller enters into an agreement, he has to deliver the asset on the specified date and the price agreed upon. Thus the loss for a seller could be much worse.
The right to buy is called a "CALL" option while the right to sell is called a "PUT" option. Please note that an option is only a right to do something. It is not an obligation to carry out the action. For a buyer it is only a right and not an obligation, but for a seller it is an obligation.
For Example, you want to buy Gold. You form an options contract with a Gold merchant to buy 1000 grams of Gold at the rate of say Rs. 1000/- per gram of gold on December 1st 2008. The total value of the contract would sum up to 10,00,000/- (10 lacs) As part of getting into the contract you make an initial payment of say 2% of the contract value to the merchant. You make a payment of Rs. 20 thousand (Rs. 20,000/-) and the contract gets formed. Now you are the buyer and the merchant is the seller.
Now there could two possible scenarios:
1. Assuming on 1st December the price of gold is Rs. 1050/- per gram, then to buy thousand grams of gold you would need Rs. 10,50,000/- rupees which is Rs. 50,000/- more than your options contract. Hence if you exercise your right to buy, you stand to make a profit of Rs. 50,000/- At the same time, the seller has an obligation since he has agreed on the contract and he has to sell the gold to you at a loss of Rs. 50,000/- when compared to the market rate.
2. Assuming on 1st December the price of gold is Rs. 950/- per gram, then to buy thousand grams of gold you would need Rs. 9,50,000/- which is Rs. 50,000/- less than your options contract. Hence if you exercise your right to buy, you stand to lose Rs. 50,000/- You can buy the same quantity of gold in the market at a lesser price. Hence you can choose to let your contract expire and limit your losses to only Rs. 20,000/- The Seller on the other hand does not make any transaction but still stands to keep the Rs. 20,000/- you paid him to form the contract.
This 1000 rupees per gram that you agreed upon with the merchant is called the "Strike" Price.
The initial deposit of Rs. 20,000/- you paid him is called the "Option premium".
Partcipants in an Options market:
1. Buyers of Calls
2. Sellers of Calls
3. Buyers of Puts
4. Sellers of Puts
People who buy options are called "Holders" and those who sell options are called "Writers"
Call Holders and Put Holders (The Buyers) are not obligated to buy or sell. They have the right to do so if they wish. Similarly Call writers and Put Writers (The Sellers) are obliged to buy or sell. This means that they need to buy or sell if the Call holder decides to exercise his right to buy.
Characteristics of Options Contracts:
1. Unlike other derivative products that are price fixing contracts, options are price insurance type of contracts
2. Options have been basically OTC products. But of late, due to its popularity, exchange traded options are also being widely used.
3. The options are very favourable to the Holders or the Buyers.
Widely used terms in Options contracts:
In-the-Money - An ITM option is one that would lead to a positive cash flow to the holder if it were exercised immediately. For e.g., If you have an options contract to buy shares of XYZ limited at Rs. 100/- per share and it is currently trading at Rs. 120/- per share then your options contract is said to be In the Money.
At-the-Money - An ATM option is when the prevailing price of the asset and your option price are more or less same.
Out-of-the-Money - An OTM option is when the prevailing price of the asset is lesser than the option price.
An Example call Option with respect to the Share Market:
You buy 10 call options for the company XYZ pvt ltd, at the strike price of Rs. 325/- at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008.
Two things can happen here:
1. You can make a profit:
Say on the date of expiry the share of XYZ pvt ltd is trading at Rs. 380/- per share, then you can opt to exercise your call option. Hence you would be getting 10 shares of XYZ ltd at Rs. 325/- which you can sell at Rs. 380/-
Your Input cost per share = 325
Premium per share = 10
Market value during Selling = 380
Your Profit per share = 380 - (325+10) = Rs. 45 /-
Net Profit = Rs. 450/-
Here Rs. 325 is the Strike price and Rs. 380 is the spot price.
2. You can incur a Loss:
Say on the date of expiry the shares of XYZ pvt ltd is trading at Rs. 275/- per share, then you can opt to let the contract expire. Since you are the buyer or the call holder you can opt to either buy or let the contract expire. Since the share is available in the market at a lesser price than the strike price, it is not wise to exercise the option. Hence you ignore it.
Your input cost = Rs. 10/- (The premium you paid per option)
Loss incurred = Rs. 100/- (Because you do not make any other payment apart from the premium)
Loss you would have incurred if you had exercised the option:
Cost per share = 325
Premium per share = 10
Market value during selling = 280
Your loss per share = (325+10) - 280 = Rs. 55/-
Net Loss: Rs. 550/-
Incurring a loss of Rs. 100/- is better than incurring a loss of Rs. 550/- hence your decision of letting the contract expire was a wise decision.
An Example Put Option with respect to the Share Market:
You buy 10 put options for the company XYZ pvt ltd, at the strike price of Rs. 300 per share at a premium of Rs. 10 per option. The option is valid till 30th Oct 2008.
Two things can happen here:
1. You can make a profit:
Say on the date of expiry, the shares of XYZ is trading at Rs. 265/- per share, then you can opt to exercise your contract. You can buy 10 shares of XYZ from the market and then sell your shares to the option writer since he has an obligation to buy if you intend to sell.
Your premium = 10
Your input cost per share = 265
Price at which the Put option is exercise = 300
Profit per share = 300 - (265 + 10) = 25
Net Profit = Rs. 250/-
2. You can make a Loss:
Say on the date of expiry, the shares of XYZ is trading at Rs. 325/- per share, then you can opt to let the contract expire. Since the share is trading at a price more than the option price, you can choose to let the contract expire.
Your premium = 10
Loss incurred = Rs. 100/- (The premium paid)
Even in this case, this loss would be compensated by the fact that you can sell off the shares that you have in the market at a higher price than the option strike price.
Swaps:
A Swap is an agreement between two parties to exchange future cash flows according to a predefined formula. These streams of cash flow are called the "Legs" of the swap. Usually, when the swap contract is formed at least one of these series of cash flows are determined by a random or uncertain value like interest rate or equity price etc.
Most swap contracts are traded OTC which are tailor made for the counterparties. Some are also traded in organized exchanges. The five generic types of swaps are:
1. Interest rate swaps
2. Currency swaps
3. Equity swaps &
4. Commodity swaps
Interest Rate Swaps:
In Interest rate swaps, each party agrees to pay either a fixed or a floating rate in a particular currency to the other party. The fixed or floating rate is multiplied with the Notional Principal Amount (NPA) say Rs. 1 lac. This notional amount is not exchanged between the parties involved in the Swap. This NPA is used only to calculate the interest flow between the two parties.
The most common interest rate swap is where one party 'A' pays a fixed rate to the other party 'B' while receiving a floating rate which is pegged to a reference rate like LIBOR.
LIBOR - London Inter Bank Offer Rate
For e.g., a Swap arrangement between two people could be like, 'A' pays a fixed rate of 3% to 'B' on a principal of Rs. 1 lac every month and 'B' in turn would pay 'A' at the rate of LIBOR + 0.5%. The cash flow that 'B' can expect from 'A' is fixed whereas the value that 'A' would receive would vary based upon the LIBOR. If the LIBOR that month is 2% then 'A' would receive an interest of 2.5% that month. The fixed rate of 3% is termed as the 'Swap Rate'
Note: The LIBOR is taken as just an example. The swaps may be pegged with any reference rate that is common to both parties.
At the point of Initiation of the Swaps the swap is priced in such a way that the "Net Present Value" is '0'. If one party wants to pay 50 bps (Basis points or 0.5%) above the Swap rate, then the other party may have to pay the same 50 bps above LIBOR
Net Present Value - NPV is defined as the total present value of a series of cash flows. The term NPV is used widely in the financial terms and it is used by people to decide on whether to invest in an instrument or not. A NPV > 0 indicates a good investment opportunity and a NPV < style="font-style: italic;font-size:130%;" >Currency Swaps:
The Currency Swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps also are motivated by comparative advantage. Unlike Interest rate swaps, currency swaps include payment of Principal amount as well. For e.g.,
- Party 'A' Receives a 8% rate of interest on Rs. 1 crore every 6 months
- Party 'B' Receives a 11% interst on USD $25,00,000/-
- Cash flow is exchanged every 6 months for 5 years
- Principal amount is exchanged at both the beginning and end of the contract.
Equity Swaps:
An Equity Swap is a special type of swap where the underlying asset is a stock or a group of stocks or even a stock market index. The key differentiator in equity swaps is the fact that the floating leg of the payment is dependent on the performance of the underlying stock. One party would receive fixed amounts regularly while the other would receive a payment depending on the performance of the Stock upon which the Equity swap is created.
Commodity Swaps:
A commodity swap is similar to Equity swaps wherein the floating payment would depend on the price of the underlying commodity. for e.g., A commodity swap may be created on Gold. Party 'A' would receive fixed payments from 'B' every month, whereas the payment 'B' received would vary every month based on the price movement of Gold in the market. A vast majority of commodity swaps use "OIL" as the underlying commodity.
Warrants:
Options generally have a life of upto One year. Most options that are traded on exchanges have a life of 9 months. Longer dated options are called Warrants and are generally traded OTC. A Warrant is a certificate issued to a buyer who is entitled to buy a specific amount of securities at a specific price (Usually greater than the current market price) for an extended period which may range from a few years to more...
In the case where the price of the security is more than the Warrant's exercise price, the holder of the warrant can exercise his right to buy it and sell it in the open market and make a profit. If the warrant does not get used, it would just expire or remain unused until the life of the Warrant.
LEAPS:
Leaps stand for - Long Term Equity Anticipation Securities. These are options that have a maturity of upto 3 years. Usually the Equity Leaps would expire in January. For e.g., if you want to buy an equity leap this month Oct 2008, it may expire in Jan 2009, 2010 or 2011. Here the contracts that expire in 2010 and 2011 may be considered as Leaps due to the maturity duration. The further the expiration date, the costlier the Leap.
Baskets:
A Basket is an economic term for a group of several securities created for the purpose of simultaneous buying/selling. For e.g., Index funds can be considered as a basket of all securities that are listed in a particular Exchange weighted appropriately.
Friday, October 17, 2008
Derivatives
We would have heard a lot about Derivatives & Derivatives Trading. But not many of us are very sure about what a Derivative is. This article is an attempt to help you learn about Derivatives.
The word 'Derivative' in Financial terms is similar to the word Derivative in Mathematics. In Maths, a Derivative refers to a value or a variable that has been derived from another variable. Similarly a Financial Derivative is something that is derived out of the market of some other market product. Hence, the Derivatives market cannot stand alone. It has to depend on a commodity or an asset from which it is derived. The price of a derivative instrument is dependent on the value of the asset from which it is derived. The underlying asset can be anything like stocks, commodities, stock indices, currencies, interest rates etc.
As you know, the financial markets come with a very high degree of risk/volatility. By using the derivative products, it is possible for us to partly or fully reduce the risk and to reduce the impact of fluctuations in the asset prices.
Let me explain how derivatives are used with a real time example...
Say, you go to an electronics shop to buy a TV. After searching around you decide on a model which costs Rs. 25000/-. The shop owner says that he would be able to deliver the TV to your house in one week if you place an order with a small initial amount today. Once the shop owner delivers the TV you are expected to pay the full amount. This is effectively a "Forward" contract where you are agreeing to the terms of delivery and a payment in a future date.
Say, I go to another electronics shop to buy a TV. After searching around I decide on a model that costs Rs. 26000/- Though I like the model I am not too sure if this is the best model for me and at the same time I am predicting the price of TV sets to come down in one week. Along with this I am also worried that if I do not buy this TV, somebody else may buy it. Thus, I talk to the salesman to put aside this TV for two weeks so that I can arrange cash and come for purchase. The salesman in return asks for a small non refundable deposit which I pay to block the TV in my name. If the price of the TV falls then I may not opt to buy the same TV but if I want I can always walk in to the shop after a few days make the payment and take the TV. This is effectively an "Options" contract, wherein I have the option of executing it at my will and wish. The shop owner took a non refundable deposit, which is to compensate for the few days that he may have to hold on to his item without selling it. Even if I do not go to buy the TV he would have made a meager profit.
The Important Categories of Derivatives:
The Derivative products can be categorized into the following main types:
1. Forwards
2. Futures
3. Options
4. Swaps
5. Warrants and
6. Leaps & Baskets
Use of Derivatives:
Hedging:
One main use of Derivatives is as a tool for transferring/reducing risk on a commodity/item. Say you are a manufacturer who uses Rice as the ingredient in your product. You would not want the price or availability of Rice to affect your production in any way. You can decide to enter into a contract with a Rice farmer to buy a specified quantity of Rice in a future date say after 3 months at a specified price. Here you are hedging to reduce your risk of availability. The farmer would also be avoiding a risk of lack of prospective buyers. By entering into agreement with you, he has reduced that risk and he has a buyer who would be buying his product on the agreed date at the agreed price. Of course there are some external factors that may cause the agreement to become null. For e.g., if due to a flood all his crops are destroyed, you cannot expect the farmer to honour the agreement. Similarly if you go bankrupt the farmer would have to find a new buyer for his products. So Derivatives can act as a tool to mitigate risk but it cannot help us avoid it altogether. Also this risk reduction will happen only between the two parties who are entering into the agreement. Any other manufacturer may end up without rice supplies or any other farmer may end up without buyers.
Types of Derivatives:
1. OTC (Over The Counter) OTC Derivatives are contracts that are traded/negotiated directly between the contracting parties. The OTC Derivative market is the largest market for derivatives and it is also the most unregulated. There is always an inherent risk of either of the parties not honouring the agreement.
2. ETD (Exchange Traded Derivatives) ETD are those that are traded via regulated/specialized trading exchanges. A derivative exchange acts as the intermediary for all transactions and requires an initial margin to be put up by both the parties of the trade to serve as a guarantee. In India NSE is one of the largest ETD exchange.
Problems with Derivatives:
1. Possibility of Huge Losses - The unregulated use of Derivatives can result in huge losses due to the use of Leverage or Borrowing. It is a well known fact that Derivatives allow investors to gain huge sums of money from small movements in the underlying asset's price. However, investors can lose huge amounts of money if the asset moves in the opposite direction. There have been a lot of instances where investors have lost significant amounts of money due to Derivatives.
2. Counterparty Risk - This is the risk that arises if either of the contracting parties fails to honour his end of the contract. This is very common in OTC Derivative products.
3. Posing high risk to small/inexperienced investors - Since the Derivative markets give an opportunity for an individual to earn huge profits, its often lucrative to small/inexperienced investors as well. Speculation in the Derivatives market requires great knowledge of the market and the future price movements on the asset over which the derivative is formed to ensure profit. This is the reason why small investors are generally advised to stay away from them...
There are a large number of Derivative categories. Covering all that in this article would make this too big to read. Hence I would be posting a new article that explains only about those categories.
Click Here to know about Derivative Categories...
Hope you found this useful. Happy Reading.
The word 'Derivative' in Financial terms is similar to the word Derivative in Mathematics. In Maths, a Derivative refers to a value or a variable that has been derived from another variable. Similarly a Financial Derivative is something that is derived out of the market of some other market product. Hence, the Derivatives market cannot stand alone. It has to depend on a commodity or an asset from which it is derived. The price of a derivative instrument is dependent on the value of the asset from which it is derived. The underlying asset can be anything like stocks, commodities, stock indices, currencies, interest rates etc.
As you know, the financial markets come with a very high degree of risk/volatility. By using the derivative products, it is possible for us to partly or fully reduce the risk and to reduce the impact of fluctuations in the asset prices.
Let me explain how derivatives are used with a real time example...
Say, you go to an electronics shop to buy a TV. After searching around you decide on a model which costs Rs. 25000/-. The shop owner says that he would be able to deliver the TV to your house in one week if you place an order with a small initial amount today. Once the shop owner delivers the TV you are expected to pay the full amount. This is effectively a "Forward" contract where you are agreeing to the terms of delivery and a payment in a future date.
Say, I go to another electronics shop to buy a TV. After searching around I decide on a model that costs Rs. 26000/- Though I like the model I am not too sure if this is the best model for me and at the same time I am predicting the price of TV sets to come down in one week. Along with this I am also worried that if I do not buy this TV, somebody else may buy it. Thus, I talk to the salesman to put aside this TV for two weeks so that I can arrange cash and come for purchase. The salesman in return asks for a small non refundable deposit which I pay to block the TV in my name. If the price of the TV falls then I may not opt to buy the same TV but if I want I can always walk in to the shop after a few days make the payment and take the TV. This is effectively an "Options" contract, wherein I have the option of executing it at my will and wish. The shop owner took a non refundable deposit, which is to compensate for the few days that he may have to hold on to his item without selling it. Even if I do not go to buy the TV he would have made a meager profit.
The Important Categories of Derivatives:
The Derivative products can be categorized into the following main types:
1. Forwards
2. Futures
3. Options
4. Swaps
5. Warrants and
6. Leaps & Baskets
Use of Derivatives:
Hedging:
One main use of Derivatives is as a tool for transferring/reducing risk on a commodity/item. Say you are a manufacturer who uses Rice as the ingredient in your product. You would not want the price or availability of Rice to affect your production in any way. You can decide to enter into a contract with a Rice farmer to buy a specified quantity of Rice in a future date say after 3 months at a specified price. Here you are hedging to reduce your risk of availability. The farmer would also be avoiding a risk of lack of prospective buyers. By entering into agreement with you, he has reduced that risk and he has a buyer who would be buying his product on the agreed date at the agreed price. Of course there are some external factors that may cause the agreement to become null. For e.g., if due to a flood all his crops are destroyed, you cannot expect the farmer to honour the agreement. Similarly if you go bankrupt the farmer would have to find a new buyer for his products. So Derivatives can act as a tool to mitigate risk but it cannot help us avoid it altogether. Also this risk reduction will happen only between the two parties who are entering into the agreement. Any other manufacturer may end up without rice supplies or any other farmer may end up without buyers.
Types of Derivatives:
1. OTC (Over The Counter) OTC Derivatives are contracts that are traded/negotiated directly between the contracting parties. The OTC Derivative market is the largest market for derivatives and it is also the most unregulated. There is always an inherent risk of either of the parties not honouring the agreement.
2. ETD (Exchange Traded Derivatives) ETD are those that are traded via regulated/specialized trading exchanges. A derivative exchange acts as the intermediary for all transactions and requires an initial margin to be put up by both the parties of the trade to serve as a guarantee. In India NSE is one of the largest ETD exchange.
Problems with Derivatives:
1. Possibility of Huge Losses - The unregulated use of Derivatives can result in huge losses due to the use of Leverage or Borrowing. It is a well known fact that Derivatives allow investors to gain huge sums of money from small movements in the underlying asset's price. However, investors can lose huge amounts of money if the asset moves in the opposite direction. There have been a lot of instances where investors have lost significant amounts of money due to Derivatives.
2. Counterparty Risk - This is the risk that arises if either of the contracting parties fails to honour his end of the contract. This is very common in OTC Derivative products.
3. Posing high risk to small/inexperienced investors - Since the Derivative markets give an opportunity for an individual to earn huge profits, its often lucrative to small/inexperienced investors as well. Speculation in the Derivatives market requires great knowledge of the market and the future price movements on the asset over which the derivative is formed to ensure profit. This is the reason why small investors are generally advised to stay away from them...
There are a large number of Derivative categories. Covering all that in this article would make this too big to read. Hence I would be posting a new article that explains only about those categories.
Click Here to know about Derivative Categories...
Hope you found this useful. Happy Reading.
Wednesday, October 15, 2008
Equity Shares
If you watch any news channel or listen to any of your colleagues talking you would have invariably heard the term "Shares". The term shares used here refers to "Equity Shares". "Equity Shares" are the most common types of shares and are the most widely traded stock market instruments.
"Equity" means ownership. Anyone who holds one share of XYZ company owns a portion of the company.
How are Equity Shares formed?
Any company that satisfies the conditions laid down by SEBI (Securities and Exchange Board of India) can issue equity shares. SEBI is the governing body for all market related instruments in India.
Let us say XYZ company wants to go public. (Going public is the word used in market terminology to refer to the event of a company issuing equity shares for the first time) It would file an application with SEBI. If it is filing a request to raise a capital of say Rs. 1 crore, it would be issuing 10 Lac equity shares of face value 10 each.
The terms Face value and Market value would be used through this article. Let us first understand what they are.
Face Value - The Face Value of the share refers to the intrinsic value of a share. This is the value at which the company issues its shares to the common public.
Market Value - Once a share is issued to the public, it would be bought and sold through recognized exchanges like the NSE or BSE. The price at which a particular share is being bought /sold is termed as Market Value.
Net capital Raised by the company = 1,00,00,000/-
No. of Shares issued through the public offering = 10,00,000 (Out of these 10 lac shares, the company would be holding at least 51% that is 5,10,000 shares with itself. The remaining 4,90,000 shares would be available for the public)
When XYZ files its application, based on the profit making capability, its revenue etc the company and SEBI would decide on the market value at which the share would be available for the public to buy. Say for e.g., the share with the face value of Rs. 10/- could be available at the price of Rs. 50/- for purchase through the public offering.
Net Amount raised by the company through the public offering = 4,90,000 * 50 = Rs. 2,45,00,000/-
Every individual who wants to buy the shares of XYZ limited would be filling in forms and paying the amount corresponding to the number of shares they want to buy. Say you want to buy 100 shares of XYZ you would be paying them Rs. 5000/- to buy those 100 shares.
Once the process of issuing shares is over the shares would be allotted to the people who had placed the purchase request. Based on the credibility of the company, the no. of people who place requests to buy its shares would vary. Sometimes the issue could be oversubscribed and sometimes it could be under subscribed. If the issue of XYZ limited was oversubscribed, then you may not get the exact 100 shares that you wanted. You may get a certain
number of shares based on the number of times the issue was oversubscribed.
Say you get 60 shares, then the remaining Rs. 2000/- would be returned to you.
Whatever we have discussed about till now is termed as the "PRIMARY MARKET". The Market in which fresh share offerings given by companies are bought.
Once the public issue is over, the share would get listed in any of the two or both of the Registered stock exchanges in India. The National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). Once the companies shares are listed in the NSE/ BSE it would be available for the public to buy/sell. Say at the end of the first trading day the share closes at a
price of Rs. 53/- then the total market capitalization of XYZ limited is = 10,00,000 * 53 = 5,30,00,000/- The Market capitalization of the company would keep varying everyday based on its share price movement.
This Trading that happens everyday on the shares of companies that are listed in registered stock exchanges is termed as "SECONDARY MARKET"
What are the benefits of holding a company's share?
1. If you hold shares of a company, you are one of the owners of that company. Every year the company would send you its annual statement, its profit & loss accounts etc. Also if they have made a good profit, they would even declare a Dividend. A Dividend is something like Interest that you receive from a bank for holding a deposit with it. The only difference is
that you may or may not get Dividends. Assuming you hold 100 shares of XYZ limited and they declare a dividend of 50% per equity share it means you would be getting Rs. 5/- per share that you hold in the company. The Dividend % that any company declares is on the Face value of its share. That is you would be getting Rs. 500/- as a dividend.
2. Whenever the company takes any major decisions like change of the CEO or Acquisition of another company etc, you would be communicated. There would be a share holders meeting and only if at least 51% of the company's share holders approve the corporate action would happen.
3. As you know, the shares of the company would be traded in the secondary market everyday. Say after 3 months the Market value of the share of XYZ limited has become Rs. 70 per share, you can sell the shares of XYZ and make Rs. 7000/- which is a profit of Rs. 2000/- in 3 months.
Note: The last point about profit is the main reason why people tend to trade in the Secondary Market. The price of a share can go either ways. It can both increase & decrease. People who buy the shares of a company whose Market price is increasing make profits and similarly people who hold shares of a company whose market price is decreasing make losses.
Hope you were able to get a basic idea of what an equity share is and how it is used in the Stock Markets.
Sunday, October 12, 2008
Repo Rate
When we are short of cash, we go to a bank to take a loan. Ever wondered where a bank in India would go for cash?
When a bank in India needs cash when it is short of funds, they would go to the Reserve Bank of India. As you know the RBI is the central bank in india that governs the banking operations in our country.
When you take a loan from a bank, it charges you an interest. Does the RBI charge any interest on the amount it lends to our banks?
Yes of course it does. The rate of interest at which the RBI gives loans to other banks is called the REPO Rate. When RBI reduces the Repo rate, the banks in India can get money at a cheap rate, similarly if the RBI increases its Repo rate, then getting cash from RBI becomes costlier.
The Repo rate, the Cash Reserve Ratio and some other factors influence the rate at which banks lend loans to customers like us...
Saturday, October 11, 2008
Subprime Mortgage Crisis
The Subprime Mortgage Crisis is an ongoing economic problem that has become more apparent in 2008 and has resulted in reduced liquidity in the global credit market and also the banking & financial systems. This crisis has exposed the weakness in the global financial system and also the regulatory framework that is overlooking them.
Some of the reasons for this crisis are:
1. The US Real estate market crash
2. High default rates on Subprime loans &
3. Subprime Mortgage backed securities
A Subprime loan is a loan that is granted to a borrower who does not qualify for loans owing to a variety of risk factors like low income level, bad credit history etc. For more details on Subprime loans refer to: SubPrime Loans
How it all started:
In the past few years, due to high liquidity and low interest rates on mortgage loans, the demand for housing properties started increasing. After the advent of the subprime lending practices, people who were, not so creditworthy began to buy homes using these loans. This resulted in a heavy demand for houses which in turn fuelled the increase in residential property prices. The prices increased exponentially and people who already owned homes, opted for refinance at lower interest rates.
At the same time, Banks were lending mortgage loans to everyone who asked for it, considering the property price hike. On one hand, they would get their money back even if the borrower doesn’t repay the loans and on the other hand the banks were selling their loan products to investment companies who packaged them into MBS and sold them in the open market. This resulted in the bank getting back almost their entire loan amount which they started lending to further subprime customers.
An MBS refers to Mortgage backed Securities. For more details on MBS refer to: MBS
What went wrong?
Trying to cash in on the heavy demand for residential properties, real estate majors started promoting a huge number of residential projects. This led to overbuilding. This resulted in a surplus inventory of homes which eventually caused the real estate prices to decline by the end of 2006.
Ease of availability of loans coupled with the assumption that property prices would continue to move upwards prompted a lot of subprime borrowers to buy houses. Once the housing prices started to fall, the interest rates on loans started to rise. Most of the borrowers were unable to make their payments on time and also due to unavailability of refinance options default on loans started to increase. For most home owners, their outstanding amount on the mortgage loan was much more than the value of their houses. This motivated home owners to walk away from their property in spite of the fact that it would impact their credit ratings. People were not ready to pay hefty mortgage amounts when their property wasn’t worth that much. If our home loan was worth 10 lacs and our home was worth only 6 lacs would we continue to pay our EMI on the home loan? :-)
This resulted in a surplus supply of houses which were available for Sale. The only way banks could reclaim their amount was by selling these homes. With the availability of so many homes, the prices of residential property fell further. The losses & Non Performing Asset’s for banks started to increase.
The high rate of default on subprime loans & downward movement of housing prices resulted in lower demands for the MBS products created out of subprime loans. The banks & financial institutions were unable to generate the liquidity that they were expecting to which resulted in an overall credit crunch. The Banks were left with too many houses with too little buyers and similary the financial institutions had lots of MBS products with very little takers.
The Billion Dollar Question:
Due to the subprime crisis, only banks should have received huge losses. Why have large financial institutions like Lehmann or Meryll Lynch have posted even bigger losses or even gone bankrupt?
The Answer: Once the banks finish lending subprime loans, the loan products would be bought by financial institutions and packed into MBS. These financial institutions are responsible for the money invested by investors on these securities. When the loans are defaulted, the payments received by the bank on them would dwindle, which would impact the payment to the investors in these MBS. Even if the bank does not make the payments, the financial institution which sold them has to incur losses and make the payments to the investors. The limit to which these institutions could manage was reached and one by one they started to fall.
What is the Impact?
1. Banks have incurred huge losses. Their earnings came down.
2. Financial institutions have gone bust or have been taken over by bigger organizations
3. The housing prices have plummeted
4. The liquidity in the financial system has come down etc.
Some other Questions:
1. When Banks were able to manage, why weren’t the financial institutions able to?
Banks receive customer deposits which they used to leverage their financial position and continue to operate whereas financial institutions do not receive any customer deposits. This is the reason why they were unable to survive under such dire circumstances.
2. Don’t banks know that lending to subprime borrowers is risky? Why did they still continue to do so?
The Banks do know that lending to subprime borrowers come with its inherent risks. They were confident of the US Real estate market and did not expect it to crash. Moreover the leverage provided by the MBS ensured a continuous supply of liquidity which they continued to lend to other borrowers.
3. We hear the names of even Insurance companies that are facing issues due to this crisis. What is the relationship of the insurance companies to this problem? How did they get impacted?
Some insurance providers have products that are intended to protect lending agencies against credit defaults in exchange for a premium or a fee. They are required to post a certain amount of collateral (either cash or any other highly liquid assets) to be in a position to provide payments in the event of loan defaults. This amount of capital is based upon the credit rating of the insurance company. Lower the credit rating greater is the amount that they need to place as collateral. Due to the financial crisis, the credit ratings of such insurance companies that provided credit default insurance products were brought down. Some of them were unable to manage that increase in capital which resulted in their downfall.
4. What happened to the investors who bought these MBS products?
The financial institutions were not able to repay everyone who bought those products from them. So they too incurred losses.
5. What is Next?
The US Federal Reserve and the US Government has announced a $700 billion bailout package using which the US Treasury department is going to purchase MBS units to infuse liquidity and stability into the market. The success of this scheme is very vital to stop the global economy from going down further...
Hope the explanation about sub prime crisis was clear... Happy Reading.
Thursday, October 9, 2008
Cash Reserve Ratio
Cash Reserve Ratio or CRR in India is the amount of money that every bank has to deposit with the RBI per customer. Every time a customer deposits cash to the bank, the bank has to correspondingly deposit a portion of that cash to the RBI. RBI decides this percentage of money that each bank has to deposit with it. The RBI holds the control on the CRR because, the CRR can influence the credit conditions in our country. If the CRR is increased, the amount of liquid cash in circulation in the country would come down and similarly if the CRR is decreased, the cash circulation in the country would increase.
Say if the CRR of the country is 10%, and you go to a bank to deposit Rs. 1000/- the bank will have to deposit at least Rs. 100/- with RBI. The remaining funds can be used by the bank to grant loans to other customers and earn an income for itself.
The purpose of having a CRR is to satisfy withdrawal demands and also as a shield to protect the depositors money atleast to a certain extent.
The CRR % would determine the amount of cash in circulation in the country. If the RBI reduces the CRR then the banks would have extra surplus cash which they would lend out and create a positive influence in the economy...
Recently on Oct 6th 2008, the RBI reduced the CRR by 50 basis points. The current CRR in India is 8.5%. This reduction of 50 basis points has infused nearly Rs. 20,000/- crores into the Indian market. This would help ease the extreme credit crunch the country is facing as a result of the US and global economic slow down.
Mortgage Backed Securities
We would have heard of the term Mortgage Backed Securities being used in any article that talks about the US Subprime mortgage crisis. This article will be explaining what an MBS is and how it is created & used. Mortgage backed securities are very common & famous in the United States, hence this article would be covering about the MBS in the US Market.
Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization.
Most MBS are issued by the Government National Mortgage Association (Ginnie Mae), a U.S. government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments.
We saw the theoretical explanation of what an MBS is. Let me explain what and how a MBS is created in simpler terms:
Hope you know what a Mortgage loan is. If not Pls refer to this link on what a Mortgage loan is. Mortgage Loan
Let us take into consideration the following entities that would be used during the explanation.
Bank ‘B’ - The Bank that is issuing mortgage loans
Customer ‘C’ - The person who has taken the mortgage loan from the bank
Agency ‘A’ - The Agency that is going to create the MBS
Investor ‘I’ - The person who is going to purchase the MBS
Customer ‘C’ approaches Bank ‘B’ with the request to issue a mortgage loan of Rs. 1,00,000/-. After all the scrutinizing process ‘B’ decides to grant a loan of Rs. 1,00,000/- to ‘C’.
Agency ‘A’ buys the mortgage loan that was granted to ‘C’ at the rate of say Rs. 90,000/- and then packages it into a bunch of securities each with a face value of say Rs. 100/- each. Which means ‘A’ would be creating 1000 units of the MBS. These MBS units would be available for sale in the open securities market for investors to buy. Our Investor ‘I’ decides to buy these MBS units. He makes a payment of Rs. 1,00,000/- to ‘A’ and purchases the units. In many cases 'A' may opt to retain a portion of these units based on the loan mixture to generate revenue for itself.
‘B’ can now use this Rs. 90,000/- for granting fresh loans to other customers.
This is how a typical MBS gets created and sold in the open market.
There could be a lot of Questions on MBS that may arise after reading this article. I have tried to cover as many of them as possible. If you have any further doubts kindly leave a comment and I would try to post the answer to your question as well.
1. What is the use for Investor ‘I’ after purchasing these MBS Units?
As you know, each loan would have loan tenure and an EMI fixed while disbursement of the loan. Every month when the bank receives the EMI, it would deduct a small portion of the EMI as its margin and would be remitting the remaining to Investor ‘I’ through the Agency ‘A’. Because ‘I’ has invested the amount in purchasing the MBS, he would be getting a regular income as long as the Customer ‘C’ repays his EMI properly.
2. What is the Rate of returns on ‘I’s investment?
The Return on the investment made by ‘I’ would be dependent on the rate of interest charged by ‘B’ to the customer 'C'
3. Why are MBS so famous?
From the Bank perspective - When the loan amount disbursed to a customer is packaged into an MBS, the Bank gets almost all its amount back. This they can use to grant fresh loans.
From the Agent perspective - When the loan is packaged into an MBS the agency gets a commission based on the amount of loan packaged. Also it retains a portion of the MBS units, which would generate regular income for them.
From the Investor perspective - As long as the MBS units are held by the investor, he would be receiving regular payments from the bank. This is definitely better than the money being idle in the savings account.
4. What happens if the loan customer does not repay the EMI properly or forecloses the account?
The agency ‘A’ is responsible for taking care of this. Almost all agencies give a guarantee to its investors about protection of their funds that are invested in MBS. (This is the reason why the Investment banks & Brokerage firms that create and sell MBS were the most affected by the US Subprime Mortgage Crisis)
5. What kinds of MBS are famous?
The MBS that give maximum return on investment are famous. Examples are MBS created out of subprime loans.
6. What is a subprime MBS?
Pls Refer to this link for what a subprime loan is. Subprime Loan An MBS that is created out of a bunch of subprime loans is called a subprime MBS.
7. Why are subprime MBS famous?
The Rate of Interest charged for subprime customers is far higher than that charged to prime customers. As the ROI is higher on these loans, the subprime MBS generate a better return on investment when compared to the prime MBS.
Hope this article was able to give you an introduction of what an MBS is.
Tuesday, October 7, 2008
What is a Mutual Fund
A Mutual Fund is nothing but a common pool of money collected from a lot of people which is used by an experienced fund manager who invests the money in the Share market. Not many of us are experienced in investing directly in the Equity market. Mutual funds are a boon to the investor who doesnt have enough knowledge to invest directly in the market but wants to take a risk and gain higher returns from the market.
A Mutual fund works as follows. (I am not getting into the technical terms. This is a very simple explanation)
Mr. X who has a lot of experience in the share market decides to start a MF. He calls for prospective investors. Say investors A, B, C, D & E decide to invest Rs. 10000/- each, Mr. X would be starting his MF with a corpus of Rs. 50000/- X would be creating MF units of face value Rs. 10/- each and distribute it to all the investors. So each A, B, C, D & E would get 1000 units each.
Inv amount = 10000 & Unit Face Value (NAV) = 10
==> No. of units given = 1000 (I have not taken into account the entry load since this is only a theoritical example)
Using this Rs. 50000/- X would buy/sell shares and make profit. At the end of each trading day X would calcuate the total net worth of the initial investment. Say after 1 month of trading, the total value of the investment is Rs. 58000/- then the current NAV of the fund would be Rs. 11.60/- which means each of the investors has made a profit of Rs. 1.60 per unit they bought from Mr. X.
Note: This 58000 would be the amount that is arrived at after subtracting the profit margin that Mr. X would take for using his expertise in forming this MF and making profit. This profit margin would vary from fund to fund but has an upper cut off set by SEBI.
Say after one succesful year of operation the Net assets in the MF stands at Rs. 1,00,000/- then the NAV on that day would be Rs. 20/-
There are three different ways in which MF houses share their profit.
1. Dividend scheme - At the end of the year the MF house has posted a brilliant return of 100%. So the MF house would decide to declare a dividend of say 50% per unit. Which means the investors A, B, C, D and E would be getting Rs. 5000/- each for staying invested with the fund. Plus each of their 1000 units is still invested with the fund and would continue to earn income for them. The most important point to note here is that once a MF house declares a dividend, the funds NAV drops by an equivalent amount. Here since the MF house has declared a 50% dividend the NAV would fall from Rs. 20/- to Rs. 15/-
2. Growth scheme - Unlike the Dividend scheme, there are no intermittent payments in the growth scheme. The 1000 units held by the investors would stay intact and would continue to grow for as long as they want.
3. Dividend Re-investment - In the Dividend Re-investment scheme, once the MF house declares a dividend say 50% in our example, each investor is eligible for Rs. 5000/- The MF house would allocate extra units to the investors at the current market NAV of the fund. In our example our investors would be getting approximately 250 units extra. So at the end of the first year the investors make a gain of 250 units. In the Dividend Re-investment scheme also the NAV would drop in accordance to the declared dividend units. In spite of the drop in NAV the investors dont stand to lose because they have got extra units.
Each scheme has its own pro's and con's. If you want a regular income on your MF investments go for Dividend option. If you do not want to disturb your investment for a long time and allow it to grow go for the Growth option.
Each MF would have its own locking period after which the investors can surrender their units and get cash. We will check the returns of 2 investors A & B. A was invested in Dividend scheme and B was invested in Growth Scheme.
NAV on date - Dividend Plan - Rs. 25.
NAV on date - Growth Plan - Rs. 30. (The NAV of growth plans are always more than that of Dividend plans)
No. of Units held by both A & B = 1000
Surrender Value for A = 25000 (He would have got a dividend of Rs. 5000 at the end of his first year in staying invested)
Surrender Value for B = 30000 (He hasnt got any dividend and the entire corpus he invested had grown to this amount)
Usually the returns of the Dividend plan and the Growth plan are not exactly the SAME. I have taken an ideal scenario and explanined so the returns work out to be the same.
Happy Investing!!!!!
A Mutual fund works as follows. (I am not getting into the technical terms. This is a very simple explanation)
Mr. X who has a lot of experience in the share market decides to start a MF. He calls for prospective investors. Say investors A, B, C, D & E decide to invest Rs. 10000/- each, Mr. X would be starting his MF with a corpus of Rs. 50000/- X would be creating MF units of face value Rs. 10/- each and distribute it to all the investors. So each A, B, C, D & E would get 1000 units each.
Inv amount = 10000 & Unit Face Value (NAV) = 10
==> No. of units given = 1000 (I have not taken into account the entry load since this is only a theoritical example)
Using this Rs. 50000/- X would buy/sell shares and make profit. At the end of each trading day X would calcuate the total net worth of the initial investment. Say after 1 month of trading, the total value of the investment is Rs. 58000/- then the current NAV of the fund would be Rs. 11.60/- which means each of the investors has made a profit of Rs. 1.60 per unit they bought from Mr. X.
Note: This 58000 would be the amount that is arrived at after subtracting the profit margin that Mr. X would take for using his expertise in forming this MF and making profit. This profit margin would vary from fund to fund but has an upper cut off set by SEBI.
Say after one succesful year of operation the Net assets in the MF stands at Rs. 1,00,000/- then the NAV on that day would be Rs. 20/-
There are three different ways in which MF houses share their profit.
1. Dividend scheme - At the end of the year the MF house has posted a brilliant return of 100%. So the MF house would decide to declare a dividend of say 50% per unit. Which means the investors A, B, C, D and E would be getting Rs. 5000/- each for staying invested with the fund. Plus each of their 1000 units is still invested with the fund and would continue to earn income for them. The most important point to note here is that once a MF house declares a dividend, the funds NAV drops by an equivalent amount. Here since the MF house has declared a 50% dividend the NAV would fall from Rs. 20/- to Rs. 15/-
2. Growth scheme - Unlike the Dividend scheme, there are no intermittent payments in the growth scheme. The 1000 units held by the investors would stay intact and would continue to grow for as long as they want.
3. Dividend Re-investment - In the Dividend Re-investment scheme, once the MF house declares a dividend say 50% in our example, each investor is eligible for Rs. 5000/- The MF house would allocate extra units to the investors at the current market NAV of the fund. In our example our investors would be getting approximately 250 units extra. So at the end of the first year the investors make a gain of 250 units. In the Dividend Re-investment scheme also the NAV would drop in accordance to the declared dividend units. In spite of the drop in NAV the investors dont stand to lose because they have got extra units.
Each scheme has its own pro's and con's. If you want a regular income on your MF investments go for Dividend option. If you do not want to disturb your investment for a long time and allow it to grow go for the Growth option.
Each MF would have its own locking period after which the investors can surrender their units and get cash. We will check the returns of 2 investors A & B. A was invested in Dividend scheme and B was invested in Growth Scheme.
NAV on date - Dividend Plan - Rs. 25.
NAV on date - Growth Plan - Rs. 30. (The NAV of growth plans are always more than that of Dividend plans)
No. of Units held by both A & B = 1000
Surrender Value for A = 25000 (He would have got a dividend of Rs. 5000 at the end of his first year in staying invested)
Surrender Value for B = 30000 (He hasnt got any dividend and the entire corpus he invested had grown to this amount)
Usually the returns of the Dividend plan and the Growth plan are not exactly the SAME. I have taken an ideal scenario and explanined so the returns work out to be the same.
Happy Investing!!!!!
What is a Mortgage Loan?
Mortgage Loan is a kind of Loan that is available to customers who are ready to pledge their property in lieu of a loan. Let me explain how a loan process works out and then we will go to mortgage lending.
When you approach a bank for a loan, they will check your income/expenditure details and decide how much you can repay and what is your financial strength. This would help the bank decide on how good a customer you are. There are some extra things that can help improve your credit worthiness. They are:
1. A Guarantor - A Guarantor is a person who provides a guarantee to your loan. In case you default on your payments he takes responsibility of repaying it.
2. A Collateral - A Collateral is a property that the bank would take possession of, if you default on your payments.
Once the bank is confident of your financial strength they would lend you the loan.
Mortgage lending would come under the category of Loans that are disbursed if you provide a collateral. If you have a house or gold jewels or any other property that has a standing asset value you can pledge them in the bank. The bank would disburse a loan that is approximately 75 - 80% of the collateral value. This value would vary from bank to bank. You can opt to repay the amount as EMI or opt to pay only the interest amount every month and repay the principal loan amount in one shot and take back your property.
Since you are pledging your property for the loan, the bank would relax a bit on the Interest rate as well since the risk of lending to you is greatly reduced due to the collateral you have provided.
Banks do not have any major restrictions on giving mortgage loans because they can make enough money out of your property that to mortgage to them if you default on your payments.
When you approach a bank for a loan, they will check your income/expenditure details and decide how much you can repay and what is your financial strength. This would help the bank decide on how good a customer you are. There are some extra things that can help improve your credit worthiness. They are:
1. A Guarantor - A Guarantor is a person who provides a guarantee to your loan. In case you default on your payments he takes responsibility of repaying it.
2. A Collateral - A Collateral is a property that the bank would take possession of, if you default on your payments.
Once the bank is confident of your financial strength they would lend you the loan.
Mortgage lending would come under the category of Loans that are disbursed if you provide a collateral. If you have a house or gold jewels or any other property that has a standing asset value you can pledge them in the bank. The bank would disburse a loan that is approximately 75 - 80% of the collateral value. This value would vary from bank to bank. You can opt to repay the amount as EMI or opt to pay only the interest amount every month and repay the principal loan amount in one shot and take back your property.
Since you are pledging your property for the loan, the bank would relax a bit on the Interest rate as well since the risk of lending to you is greatly reduced due to the collateral you have provided.
Banks do not have any major restrictions on giving mortgage loans because they can make enough money out of your property that to mortgage to them if you default on your payments.
Monday, October 6, 2008
What is a Sub Prime Loan
When someone goes to a bank or to any financial institution for a loan his credibility and financial strengths are reviewed. Based on his financial status he would be rated. A customer who is very credit worthy and has a consistent cash flow with which he can meet out his loan obligations is termed as a "PRIME" customer and such a loan would be termed as a Prime Loan.
On the other hand when the credit worthiness of the customer is not too good and he is not in a strong financial status he is termed as a "Sub Prime" Customer. When banks disburse loans to such customers, it is termed as a "Sub Prime Loan"
Usually the rate of interest charged by banks to sub prime customers is very high in comparison to Prime customers.
On the other hand when the credit worthiness of the customer is not too good and he is not in a strong financial status he is termed as a "Sub Prime" Customer. When banks disburse loans to such customers, it is termed as a "Sub Prime Loan"
Usually the rate of interest charged by banks to sub prime customers is very high in comparison to Prime customers.
What is meant by Bailout?
With the current US Financial Crisis Looming at large, we are frequently hearing the term Bail Out. A Bail out is a form of corporate action that happens between two companies or institutions.
The term bail out in financial terms is almost similar to the term out on bail as per legal law. If someone has committed a crime and is jailed they need a bail to come out of jail. Until a Bail is issued the convict has to serve his term in Jail.
Similarly if a company is in a financial crisis and is about to go bankrupt they would be looking out prospective buyers or people who can help them manage the crisis. At such a situation, some other company may opt to help them out of the crisis by either buying a stake in the company or by taking that company over. This process would require the approval of all the share holders of both the companies and would take a lot of time to materialize. Once it is approved by the share holders and also by the law makers the buying company would infuse fresh capital into the bought company and help stabilize the financial position of that company.
In some cases like AIG which is a very famous Insurance company in the US, the country’s government may opt to help it out.
Such a scenario would be termed as bailing out.