Equity Linked Savings Scheme
Definition: Equity Linked Savings Scheme refers to ELSS. ELSS as the name clearly suggests is a savings scheme linked to equity markets. It is a type of mutual fund, which additionally offers tax benefits to the investors.
Key Features and benefits of ELSS are:
ELSS is a fund with a lock-in period of 3 years.
It offers tax benefit to the investors under section 80c of the income tax Act up to a maximum limit of 1 Lac per annum.
Investment has to be for long term, any expectation of short term gains is not appropriate.
Involves a little bit of risk because of equity allocation.
ELSS helps an investor to get addicted to investments and savings by offering systematic investment option.
ELSS is very beneficial to salaried people.
Up to March 31,2005 an investor could claim only rebate under Section 88 if invested in ELSS and the maximum amount that could be invested in ELSS was only Rs.10,000/-. But from March 31, 2006 the investment limit in ELSS has been increased to Rs.1, 00, 000/- and this entire investment is eligible for deduction under sec 80C of Income tax Act, 1961.
Comparison between ELSS and ULIPs:
ULIPs and ELSS works almost in the similar way as both offers tax benefit. Money will be mostly invested in the equity markets in both the cases. I would like to put before few points which differentiates ULIPs and ELSS.
ELSS plans are offered by Asset Management Companies, where as ULIPs are mostly offered by Life Insurance Companies.
ELSS plans does not offer switching facility, but ULIPs offers switching facility to the investors, which helps an investor to safe guard his money in the time of market fluctuations by allowing the switch over of funds from equity to debt instruments.
The fund management charges in ELSS would always be higher than ULIPs.
SIP in ELSS is not convenient to investors, as money invested on monthly basis has to be locked for three years from the date of investment of the respective monthly investment. Where as in case of ULIPs investment amount and its return can be taken back after completion of 3 years from the date of first monthly investment made.
The Investment strategy of ELSS is not that strong when compare to the ULIPs as the investment strategy of ULIPs are governed by law.
Advantages of ELSS over NSC and PPF
Main advantage of ELSS is its short lock-in period. Maturity period of NSC is 6 years and PPF is 15 years.
Since it is an equity linked scheme earning potential is very high.
Investor can opt for dividend option and get some gains during the lock-in period.
Investor can opt for Systematic Investment Plan.
Some ELSS schemes also offer personal accident death cover insurance.
Provides 30 to 40% returns compared to 8% in NSC and PPF.
Market risk is also there in ELSS
Sunday, December 28, 2008
Different Interest Rates
Different Interest Rates
1. Repo (Repurchase) Rate2. Reverse Repo Rate3. Bank Rate4. Call Rate5. CRR6. SLR
1. Repo (Repurchase) Rate
Repo rate is the rate at which banks borrow funds from the RBI to meet the gap between the demands they are facing for money (loans) and how much they have on hand to lend. If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate. Hence, if repo rate is increased, banks would hesitate to borrow money from RBI. Hence, there would be less cash and less liquidity in the market.
2. Reverse Repo RateThis is the exact opposite of repo rate. The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the reverse repo rate. The RBI uses this tool when it feels there is too much money floating in the banking system.
If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk). Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy. Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is injected.
3. Bank RateThis is the rate at which RBI lends money to other banks or financial institutions. The bank rate signals the central bank’s long-term outlook on interest rates. If the bank rate moves up, long-term interest rates also tend to move up, and vice-versa.
Banks make a profit by borrowing at a lower rate and lending the same funds at a higher rate of interest. If the RBI hikes the bank rate (this is currently 6 per cent), the interest that a bank pays for borrowing money (banks borrow money either from each other or from the RBI) increases. It, in turn, hikes its own lending rates to ensure it continues to make a profit.
4. Call RateCall rate is the interest rate paid by the banks for lending and borrowing for daily fund requirement. Since banks need funds on a daily basis, they lend to and borrow from other banks according to their daily or short-term requirements on a regular basis. A lower call rate means banks frequently borrow money from other banks. A lower call also shows health and confidence of the economy and banking system.
5. CRRAlso called the cash reserve ratio, refers to a portion of deposits (as cash) which banks have to keep/maintain with the RBI. This serves two purposes. It ensures that a portion of bank deposits is totally risk-free and secondly it enables that RBI control liquidity in the system, and thereby, inflation by tying their hands in lending money.
6. SLRBesides the CRR, banks are required to invest a portion of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements. What SLR does is again restrict the bank’s leverage in pumping more money into the economy.
1. Repo (Repurchase) Rate2. Reverse Repo Rate3. Bank Rate4. Call Rate5. CRR6. SLR
1. Repo (Repurchase) Rate
Repo rate is the rate at which banks borrow funds from the RBI to meet the gap between the demands they are facing for money (loans) and how much they have on hand to lend. If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate. Hence, if repo rate is increased, banks would hesitate to borrow money from RBI. Hence, there would be less cash and less liquidity in the market.
2. Reverse Repo RateThis is the exact opposite of repo rate. The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the reverse repo rate. The RBI uses this tool when it feels there is too much money floating in the banking system.
If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk). Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy. Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is injected.
3. Bank RateThis is the rate at which RBI lends money to other banks or financial institutions. The bank rate signals the central bank’s long-term outlook on interest rates. If the bank rate moves up, long-term interest rates also tend to move up, and vice-versa.
Banks make a profit by borrowing at a lower rate and lending the same funds at a higher rate of interest. If the RBI hikes the bank rate (this is currently 6 per cent), the interest that a bank pays for borrowing money (banks borrow money either from each other or from the RBI) increases. It, in turn, hikes its own lending rates to ensure it continues to make a profit.
4. Call RateCall rate is the interest rate paid by the banks for lending and borrowing for daily fund requirement. Since banks need funds on a daily basis, they lend to and borrow from other banks according to their daily or short-term requirements on a regular basis. A lower call rate means banks frequently borrow money from other banks. A lower call also shows health and confidence of the economy and banking system.
5. CRRAlso called the cash reserve ratio, refers to a portion of deposits (as cash) which banks have to keep/maintain with the RBI. This serves two purposes. It ensures that a portion of bank deposits is totally risk-free and secondly it enables that RBI control liquidity in the system, and thereby, inflation by tying their hands in lending money.
6. SLRBesides the CRR, banks are required to invest a portion of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements. What SLR does is again restrict the bank’s leverage in pumping more money into the economy.
Derivatives
Derivatives
There is a whole world of financial securities other than stocks and bonds. One of such securities is Derivatives, which are financial instruments whose “value” are derived from the value of the underlying. Hence, they are called “derivative” i.e. derive from something else. The underlying on which derivative is based could be: Asset: e.g. stocks, bonds, mortgages, real estate, commodities, real estate properties. Index: e.g. stock market indices, Consumer Price Index, Foreign Currencies and interest rates other items: e.g. Weather (yes- you will derivatives written on rain!!)
For example – a derivative on a stock derive its value from the value of underlying stock! There are three main types of derivatives: Forwards (similar to Futures), Options and Swaps. Futures are very similar to Forwards except for the fact that Futures are traded on exchange while Forwards are traded over the counter (OTC). We will be going to concentrate only on Futures (F) and Options (O). So whenever you come across any article on F&O or any reference to it, remember it means Futures & Options.
Why do we need derivatives?
Derivatives are used to either
1. Hedge the risk i.e. lessen the risk which may arise due to changes in the value of underlying – This is known as “hedging”
2. Increase the profit arising from the changes in the value of underlying in the direction they expect or guess – This is known as “speculation”.
Hence, there should not be any misconception that derivatives or F&O are used only by speculators to make money. These are extremely useful financial instruments which are used by corporate or individuals to mitigate their risk. But unfortunately same instruments can be used by speculators to make money. One simple example is nuclear energy. People can use it to generate 1000s of MW of energy for peaceful purpose whereas others can use the same nuclear energy to make nuclear bombs for mass destruction. Is it fair to blame nuclear energy for this? We cannot. So if you want to blame someone, blame speculators and not derivatives.
How hedging works?
Assuming that our readers are not speculators, I will focus on how futures or future contracts are used for hedging. Suppose I am a petroleum distributor whose job is to sell petroleum products such as Petrol and Diesel in the market while you are an airline owner, I am in the business of selling petroleum while you are a say Mr. Vijay Mallya net buyer of petroleum products. I will be concerned with drop in prices of petroleum because that would hurt my revenues and profit margin. This is because I am selling petrol, right? While you, an airline owner, would be concerned with any increase in prices of petroleum because it would increase your costs. Thus we two have a common concern – uncertainty in the price of petroleum products.
To reduce our risk and buy a peace of mind, we will sit together and fix a price of petroleum to be sold in the future. Thus, I have reduced the risk of prices going down while you have reduced the risk of prices going up. This is called hedging.
F&O Market in the US and India
You would be surprised to know that the volume of F&O trade is much more than volume of stocks trade in the world. This shows the sheer popularity of F&O instruments among investors. In the US futures are traded primarily on CME (Chicago Mercantile Exchange), which is the largest financial derivatives exchange in the United States and most diversified in the world. CME’s currency market is the world’s largest regulated marketplace for foreign exchange (FX) trading. In the US Options are traded on CBOE (Chicago Board Options Exchange).
In India Futures and Options are traded on both BSE and NSE. The market hasn’t developed to its potential yet due to lot of political and regulatory issues. Hence, the size of derivatives market is much smaller in India as compared to those in developed worlds.
Forward Contract vs. Futures Contract
While futures and forwards are both contracts to deliver an asset at a fixed (pre-arranged) price on a future date, they are different in following respects:
Features
Forward Contracts & Future Contracts
Operational Mechanism
Forward Contracts :Traded Over The Counter (OTC) and NOT on exchange while Future Contracts are Traded on exchange
Contract Specifications
Forward Contracts :Extremely customized; differs from trade to trade while Future Contracts are Standardized contracts
Counterparty Risk
Forward Contracts: High because of default risk while Future Contracts are Less risky because only margins are settled
Liquidation Profile
Forward Contracts: Poor liquidity due to customized products while Future Contracts are Very high because contracts are customized
Price Discovery
Forward Contracts: Poor; as markets are fragmented while Future Contracts are Better because market is on a common platform of an exchange
Futures Let us now focus only on Future contracts, which are an agreement between two parties to buy or sell an asset (underlying) at a given point of time in the future. They are standardized contract i.e. an agreement, traded on a futures exchange, to buy or sell a standardized quantity of a specified commodity of standardized quality at a certain date in the future, at a price (the futures price) determined by the parties involved. The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day\'s trading session on the exchange is called the settlement price for that day of business on the exchange.
I have assumed that no cash settlement was done between the two parties. A futures contract gives the holder the obligation to make or take delivery under the terms of the contract. Also both parties of a futures contract must fulfill the contract on the settlement date – it is legally binding. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. Money lost and gained by each party on a futures contract are equal and opposite. In other words, a future trading is a zero-sum game.
Future prices are not definitive statements of prices in the future. In fact they are not even necessarily predictions of the future. But they are important pieces of information about the current state of a market, and futures contracts are powerful tools for managing risks.
Terminology
I will discuss a few terms that are often associated with derivatives. They are following:
Underlying: It is the asset or index on which a derivative is written. For example a futures index has the underlying as an index.
Delivery Date: This is the date at which the underlying will be delivered by the seller to the buyer. It is also known as final settlement date.
Future Price: This is the agreed upon or prearranged price determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. Simply, the price prearranged between the seller and the buyer.
StandardizationFutures contracts ensure their liquidity by being highly standardized, usually by specifying:
Ø The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate.
Ø The type of settlement, either cash settlement or physical settlement.
Ø The amount and units of the underlying asset per contract. This can be the notional (fictional) amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.
Ø The currency in which the futures contract is quoted.
Ø The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies the quality of the underlying goods
Ø The delivery month
Ø The last trading date
Types of Futures Contracts
There are a large number of futures contracts trading on future exchanges around the world. I have highlighted characteristics of each major group of contracts:
Agricultural Commodities
This category is the oldest group of futures contracts. It includes all widely used grains such as wheat, soybeans, corn and rice. Additionally, futures are traded actively on Cocoa, coffee, orange juice, sugar, cotton, wool, wood, and cattle.
Equities
Futures are actively traded on individual stocks as well as index. These are generally cash settled i.e. no exchange of stocks happens between the contracted parties; only the party which loose (prices of stocks move against them) gives money to the party which wins. Stock index futures have been quite popular in the market. These contracts are generally indices of a combination of stocks.
Natural Resources
Futures contracts are actively traded on metals and natural resources. Metals include gold, silver, copper, aluminum etc while natural resources include crude.
Foreign Currencies
There is a very large market of futures contract traded on foreign currencies because a large number of multinational companies are concerned about the volatility (changes) in the value of currencies of different countries where they sell or buy their products. Most popular currencies are Japanese Yen (¥), British Pound (£), Euro (€) and Swiss Franc (CHF).
Disadvantages of futures or derivatives
Remember, I gave you an example of Petroleum distributor (me) and airline owner (you). I will be concerned with the drop in prices of petro products while you will be worried about a rise in the prices. Let’s say the current price of petro is Rs. 50 per liter. I think the prices will fall further from Rs. 50 to 40 while you think US might attack Iran and hence prices will go up from Rs. 50 to 60. So you want to fix a price little higher from today’s price (but less than what you expect it to be in 3 months) which is favorable to both of us as per our own calculations and predictions. Two of us decide to exchange 100 liters of petro 3 months later on March 24, 2009 at a price of Rs. 55.
Now, imagine US didn’t attack Iran and global economy sink further. Hence, on May 24, 2009 price of petro products drop to Rs. 45. Here, I, the seller, will sell you petro at a price of Rs. 55 even though the market price is Rs. 45 per liter. Thus, I will make money while you lose it.
Hence, the biggest disadvantage of futures is that one of the parties involved will not be able to take advantage of favorable movement in price i.e. if you have not entered into a futures contract with me, you could have bought petro at Rs. 45 (market price) instead of Rs. 55.
There is a whole world of financial securities other than stocks and bonds. One of such securities is Derivatives, which are financial instruments whose “value” are derived from the value of the underlying. Hence, they are called “derivative” i.e. derive from something else. The underlying on which derivative is based could be: Asset: e.g. stocks, bonds, mortgages, real estate, commodities, real estate properties. Index: e.g. stock market indices, Consumer Price Index, Foreign Currencies and interest rates other items: e.g. Weather (yes- you will derivatives written on rain!!)
For example – a derivative on a stock derive its value from the value of underlying stock! There are three main types of derivatives: Forwards (similar to Futures), Options and Swaps. Futures are very similar to Forwards except for the fact that Futures are traded on exchange while Forwards are traded over the counter (OTC). We will be going to concentrate only on Futures (F) and Options (O). So whenever you come across any article on F&O or any reference to it, remember it means Futures & Options.
Why do we need derivatives?
Derivatives are used to either
1. Hedge the risk i.e. lessen the risk which may arise due to changes in the value of underlying – This is known as “hedging”
2. Increase the profit arising from the changes in the value of underlying in the direction they expect or guess – This is known as “speculation”.
Hence, there should not be any misconception that derivatives or F&O are used only by speculators to make money. These are extremely useful financial instruments which are used by corporate or individuals to mitigate their risk. But unfortunately same instruments can be used by speculators to make money. One simple example is nuclear energy. People can use it to generate 1000s of MW of energy for peaceful purpose whereas others can use the same nuclear energy to make nuclear bombs for mass destruction. Is it fair to blame nuclear energy for this? We cannot. So if you want to blame someone, blame speculators and not derivatives.
How hedging works?
Assuming that our readers are not speculators, I will focus on how futures or future contracts are used for hedging. Suppose I am a petroleum distributor whose job is to sell petroleum products such as Petrol and Diesel in the market while you are an airline owner, I am in the business of selling petroleum while you are a say Mr. Vijay Mallya net buyer of petroleum products. I will be concerned with drop in prices of petroleum because that would hurt my revenues and profit margin. This is because I am selling petrol, right? While you, an airline owner, would be concerned with any increase in prices of petroleum because it would increase your costs. Thus we two have a common concern – uncertainty in the price of petroleum products.
To reduce our risk and buy a peace of mind, we will sit together and fix a price of petroleum to be sold in the future. Thus, I have reduced the risk of prices going down while you have reduced the risk of prices going up. This is called hedging.
F&O Market in the US and India
You would be surprised to know that the volume of F&O trade is much more than volume of stocks trade in the world. This shows the sheer popularity of F&O instruments among investors. In the US futures are traded primarily on CME (Chicago Mercantile Exchange), which is the largest financial derivatives exchange in the United States and most diversified in the world. CME’s currency market is the world’s largest regulated marketplace for foreign exchange (FX) trading. In the US Options are traded on CBOE (Chicago Board Options Exchange).
In India Futures and Options are traded on both BSE and NSE. The market hasn’t developed to its potential yet due to lot of political and regulatory issues. Hence, the size of derivatives market is much smaller in India as compared to those in developed worlds.
Forward Contract vs. Futures Contract
While futures and forwards are both contracts to deliver an asset at a fixed (pre-arranged) price on a future date, they are different in following respects:
Features
Forward Contracts & Future Contracts
Operational Mechanism
Forward Contracts :Traded Over The Counter (OTC) and NOT on exchange while Future Contracts are Traded on exchange
Contract Specifications
Forward Contracts :Extremely customized; differs from trade to trade while Future Contracts are Standardized contracts
Counterparty Risk
Forward Contracts: High because of default risk while Future Contracts are Less risky because only margins are settled
Liquidation Profile
Forward Contracts: Poor liquidity due to customized products while Future Contracts are Very high because contracts are customized
Price Discovery
Forward Contracts: Poor; as markets are fragmented while Future Contracts are Better because market is on a common platform of an exchange
Futures Let us now focus only on Future contracts, which are an agreement between two parties to buy or sell an asset (underlying) at a given point of time in the future. They are standardized contract i.e. an agreement, traded on a futures exchange, to buy or sell a standardized quantity of a specified commodity of standardized quality at a certain date in the future, at a price (the futures price) determined by the parties involved. The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day\'s trading session on the exchange is called the settlement price for that day of business on the exchange.
I have assumed that no cash settlement was done between the two parties. A futures contract gives the holder the obligation to make or take delivery under the terms of the contract. Also both parties of a futures contract must fulfill the contract on the settlement date – it is legally binding. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. Money lost and gained by each party on a futures contract are equal and opposite. In other words, a future trading is a zero-sum game.
Future prices are not definitive statements of prices in the future. In fact they are not even necessarily predictions of the future. But they are important pieces of information about the current state of a market, and futures contracts are powerful tools for managing risks.
Terminology
I will discuss a few terms that are often associated with derivatives. They are following:
Underlying: It is the asset or index on which a derivative is written. For example a futures index has the underlying as an index.
Delivery Date: This is the date at which the underlying will be delivered by the seller to the buyer. It is also known as final settlement date.
Future Price: This is the agreed upon or prearranged price determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. Simply, the price prearranged between the seller and the buyer.
StandardizationFutures contracts ensure their liquidity by being highly standardized, usually by specifying:
Ø The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate.
Ø The type of settlement, either cash settlement or physical settlement.
Ø The amount and units of the underlying asset per contract. This can be the notional (fictional) amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.
Ø The currency in which the futures contract is quoted.
Ø The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies the quality of the underlying goods
Ø The delivery month
Ø The last trading date
Types of Futures Contracts
There are a large number of futures contracts trading on future exchanges around the world. I have highlighted characteristics of each major group of contracts:
Agricultural Commodities
This category is the oldest group of futures contracts. It includes all widely used grains such as wheat, soybeans, corn and rice. Additionally, futures are traded actively on Cocoa, coffee, orange juice, sugar, cotton, wool, wood, and cattle.
Equities
Futures are actively traded on individual stocks as well as index. These are generally cash settled i.e. no exchange of stocks happens between the contracted parties; only the party which loose (prices of stocks move against them) gives money to the party which wins. Stock index futures have been quite popular in the market. These contracts are generally indices of a combination of stocks.
Natural Resources
Futures contracts are actively traded on metals and natural resources. Metals include gold, silver, copper, aluminum etc while natural resources include crude.
Foreign Currencies
There is a very large market of futures contract traded on foreign currencies because a large number of multinational companies are concerned about the volatility (changes) in the value of currencies of different countries where they sell or buy their products. Most popular currencies are Japanese Yen (¥), British Pound (£), Euro (€) and Swiss Franc (CHF).
Disadvantages of futures or derivatives
Remember, I gave you an example of Petroleum distributor (me) and airline owner (you). I will be concerned with the drop in prices of petro products while you will be worried about a rise in the prices. Let’s say the current price of petro is Rs. 50 per liter. I think the prices will fall further from Rs. 50 to 40 while you think US might attack Iran and hence prices will go up from Rs. 50 to 60. So you want to fix a price little higher from today’s price (but less than what you expect it to be in 3 months) which is favorable to both of us as per our own calculations and predictions. Two of us decide to exchange 100 liters of petro 3 months later on March 24, 2009 at a price of Rs. 55.
Now, imagine US didn’t attack Iran and global economy sink further. Hence, on May 24, 2009 price of petro products drop to Rs. 45. Here, I, the seller, will sell you petro at a price of Rs. 55 even though the market price is Rs. 45 per liter. Thus, I will make money while you lose it.
Hence, the biggest disadvantage of futures is that one of the parties involved will not be able to take advantage of favorable movement in price i.e. if you have not entered into a futures contract with me, you could have bought petro at Rs. 45 (market price) instead of Rs. 55.
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