Chapter 3- Debentures, Securities, IPO, Futures & Options & Mutual Funds

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Debentures & Bonds

Debentures are portions of debt to the company against which the company returns a fixed rate of Interest. A debenture would typically return fixed payments at scheduled intervals of time. Debentures are different from other loans in that they are backed only by the borrower’s integrity – which means one can lose the amount if the company shuts its doors. That explains why debentures would typically have higher rates of interest in return as compared to Banks. A Debenture is another instrument of raising funds used by companies. A debenture is defined as an unsecured bond that is backed by the issuer’s legally binding promise to pay interest and principle when due. A debenture works like a loan with no collateral guarantee. So when we buy debentures, we become creditors for the company. Buying debentures amounts to lending money to the company, against which the company guarantees payment in the form of interest at a predefined fixed rate. 

Debentures are also referred to as Bonds. In the Share Market, another term used frequently by Analysts and Media persons alike is “Securities”. Securities are just a Broad term covering all financial instruments, usually stocks, bonds, money market instruments, or mutual fund shares that are issued by corporations; municipalities; state, local, or national governments; or investment companies to raise or borrow money or give the public an opportunity to participate in the growth of a company.

Hence Debentures are Creditorship securities, where as Equity Shares are Ownership Securities. Therefore a debenture holder does not have any voting rights and gets a fixed rate of return per year where as the Shareholder gets varying returns in the form of dividends. Since Debentures are riskier than Bank Loans, it is easy to understand why the rates of return are also higher than returns from a Bank.

Another term you will often hear during Analysis of a Company is the Debt:Equity ratio. This just states the ratio of the amount of initial capital of the company has been raised through Equity (ownership of other people) and the amount that has been raised through Debt (through Debentures or Financial Loans).

What are Mutual Funds ?

A Mutual Fund is a financial company that brings together a group of people and invests their money in stocks and bonds. Each investor owns shares in this Mutual Fund, which represents a portion of the holdings of the fund. The Mutual Fund earns through Dividends on the Shares it invests in, through Interest in Debentures bought and through Capital Gains (profit earned through appreciation of the Shares that were invested in).

When we invest in a mutual fund, we are actually buying shares (or portions) of the Mutual Fund and therefore become a shareholder of the fund. By pooling money together in a mutual fund, investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on their own. However, they do include the cost of running the company and paying the Fund Managers and the experts who decide where to invest and how much to invest.
Mutual Funds are generally good for people who neither have the time nor the inclination to watch and follow the market and want to leave it to people who are more experienced. However, if you want to learn and follow what is going on in the Share Market, you might want to stay away from Mutual Funds for some time.

There are many different types of Mutual Funds and the names would give you a good indicator to the sort of companies these funds would be investing in – e.g. Equity Funds, Index Funds, Sector Funds, Tax Savings Funds, Balanced Funds etc.

NAV (Net Asset Value)

NAV or Net Asset Value is the ratio that is used to measure the Performance of a Mutual Fund. The NAV of a Mutual Fund is the Ratio of its total Assets (market value of Shares plus Cash reserves) minus its Operation Expenses to the No of Units issued by the fund.

If we were to draw a parallel, NAV of a Mutual Fund would be like the Market Value of the Share of a Company. NAV fluctuates on Market Value fluctuation of the Market Value of the Shares that it has invested in. It is calculated at the end of each Trading day and reported next day as the latest NAV of that Mutual Fund.

IPO (Initial Public Offering)

IPO is an abbreviation for “Initial Public Offering” which signifies a company’s first sale of shares to the public. When a company declares an IPO, it is on its way to becoming a “Public” company, hence the term “going public.” With an IPO, a company raises money from the public for the first time through sale of Shares and Debentures. These Shares and Debentures are called New Issues. At an IPO, a company can sell the shares at Par (at Nominal or Face Value) or at a Premium (above Nominal or Face value) depending on how long the company has been in existence, its profitability, current Assets and many other factors.
If we apply for an IPO and are allocated some New Issues, we are said to be purchasing from the Primary Market. However, if we purchase shares or debentures already listed and trading at the Stock Exchange through Brokers, we are said to be purchasing from the Secondary Market.

When a company decides to raise capital through an IPO, there is generally a widespread publicity about the IPO through Print and Media Ads. These advertisements highlight the important facts about the issue and also mention the list of brokers and bankers through which you can apply for the IPO. The prospectus and application form to the IPO are usually available Free of cost from these Brokers. Applying to an IPO does not guarantee allotment of shares. Very often the issue gets oversubscribed several times and then there are various ways in which the companies figure out the list of final allotees. When an IPO is issued through a Book Building Process reservations are made for FIs(Financial Institutions) , HNIs (High Networth Individuals) and Retail Investors( who apply for less than Rs. 50,000 worth of shares). Companies cannot allot shares arbitrarily. They need to do so in consultation with the Stock Exchange Authorities. The principles of allotment usually favour the larger applicants.

What are Derivatives ?

Derivatives, as the name suggests. Are financial instruments whose value is dependent on another underlying asset. The underlying security in the case of equity derivatives is an equity share. Or the widely followed nifty and sensex indices. A share of equity can only provide an unhedged position whether long or short, and the entire risk of the transaction lies with the trader on investor.

There are two types of derivatives. One is the futures product and the other is the options product and trading strategies can be created using them individually or in combination. Derivatives add a lot of flexibility to a trader’s tools. They can be used for two purposes, namely speculation and hedging.

What is Speculation ?

Contrary to what many people believe, speculation is not gambling speculation is the skill of analysing data and taking positions an the various market situations to profit from favourable price movements. In the stock market arena. This activity is also called trading. Throughout the remainder of this book, speculation in the stock market will be referred to as trading. Which includes going both long and short an the market. Also contrary to popular opinion, trading is neither about predicting the direction of the stock market nor is it about predicting prices. The most important aspect of trading is money
Management there is a complete chapter later in this book which deals with the issue of money management ( Chapter 12 )

Briefly, money management involves risking a particular amount of money to make several times the amount risked. There are various situation, called setups on the technical charts, which increase the probability of successful trades. But and I want to state this loud and clear. Since no one can predict the stock market. The key to making money in trading an a sustained basis is to make big profits when you are right and limit your losses when you go wrong. Also important is the size of your trading positions in proportion to the overall size of your trading capital ; correct position sizes enable you to stay in the game for the longest possible time and hence increase the chances of making money.

Anyone who has bought this book in the hope of making easy money can stop reading it right now. Trading is a skill that is learnt over a period of time. No one is born with this talent. No one has a holy grail which can predict stock price consistently over any length of time. This is the most important lesson of this book. Once you stop chasing the otherwise wasted in trying to find the perfect system. I often see people predicting prices in the media which can lead novice traders to believe that this is a skill which can be acquired. I will only say that if these experts had any such magical knowledge. They would not be sharing it on television with the rest of us for free but, instead, be sitting on beach in California.

trading in fact, is a skill that can be learnt and once learnt you can make huge amounts of money. To do so traders should get used to the notion of losses at the very outset. Trading is both about profits and losses. The key is to keep losses small and profit big.

What is Hedging ?

The idea of hedging is more important in the commodities and currency market. In the equity market, hedging can be an expensive exercise. Often people think they will be fully protected if they take a position which profits if the market starts moving in the reverse direction. True they will protect themselves but not totally because hedging comes at a cost, for while hedging can reduce losses but it also lowers your profits. In my experience, it is not worthwhile for trader to hedge their positions. Instead, when a trade starts moving contrary to we hear recommendations about buying stock futures and hedging it by buying a put. This strategy sounds great but the put comes at a cost which is deductible from the profits that you earn on futures, assuming that the profit an your futures position is higher than the cost of the put.

What are Futures ?

A equity futures product is a derivative of either an underlying stock, or a stock index. In other words, the value of futures depends on that of its underlying stock or index, as the case may be.

During the rest of this book we will distinguish the stock market consisting of all the listed stocks by calling it the cash market. The term derivatives market, or futures market, will be used to refer to the futures and options market.

Here it is important to understand how a futures contract is different from the underlying stock:
· when you buy a stock you pay the full value of the transaction (i.e. the number of shares multiplied by market price of ach share).
· There is no time component, you own the stock for all times to come.
· You make a loss or profit only when you sell the shares you own.
· You may or may not have a long – term view on the stock.
· You can go long an a stock only if you own it ( because of rolling settlement). You cannot short sell unless you borrow the stock, something which is neither cheap nor convenient.
· There is no way of taking a position an the index through the cash market.
· The cash market has a market lot of one, i.e. you can buy any stock in the multiples of one unit.

When you trade Futures : 

· Long is the equivalent of initiating a futures position by buying a futures contract and then squaring up by selling it.
· Short is the equivalent of initiating the position by first selling a futures contract and then up by buying it back.
· You pay only the margin which is a fractional portion of the total transaction value, generally about 15 % in the case of index futures, and up to 50 % in the case of individual stock futures.
· All futures contracts are dated. For example, Indian futures and options settlements currently take place on the last Thursday of every month. So the current month’s futures expire on the month’s last Thursday. If a trader has to carry his position to the next month, he has to shift his position to the next month’s futures.
· Futures are generally traded using technical analysis because the product facilitates speculation ; futures are not an investment product.
· You can go long or short on the futures depending on your short-term view of the market, or a particular stock.
· The futures market helps you take a variety of views on the market and a particular stock.
· A futures contract is the smallest unit which you can trade in the futures market. A contract consists of different numbers of shares for each underlying stock. The futures market lots are decided an the basis that the minimum market lot should be worth at least Rs. 2 lakh. For example one contract of reliance futures is worth 600 shares. When you trade reliance futures, you can do so only in lots of 600 shares of reliance, which is one futures contract

Theoretically,

Futures Price = Cash Price + ( Monthly ) Cost Of Carry

In theory, the cost of carry should always be positive because of futures trade is really a carry forward product similar to the erstwhile badla. But just as badla rates sometimes became negative when the market sentiment was bearish, the cost of carry can also similarly be negative when the sentiment is poor.
Presently in India the current month’s stock or index futures are the only futures products which can really be traded. Futures for the succeeding months are usually not liquid enough for trading.
For example, during January, only the January futures would be liquid enough to be traded during most of the month. The February and March futures are unlikely to be liquid for active trading for most of January. Only in the last week of January might the February futures become liquid. This is because the futures and options settlement takes place on the last Thursday of January.

What are Options ?

Options are the second type of derivative instrument. An option is available in its most basic forms in two versions, namely :

· Call option and
· Put Option.

A Call option is the right to buy a certain asset at an agreed price, and before a certain date, by paying a premium. Put option is the right to sell a certain asset at an agreed price, on or before a certain date, by paying a premium.

A lot of Indian investors will relate to options as being akin to the advance or bayana given or received at the time of sale or purchase if a property. A better understanding of options is gained by seeing how these differ from futures.

· An option is a non – linear product where the loss is limited and the profit is unlimited. A future is a linear product where profits and losses are both unlimited.
· An option has two components built into its premium. A time component and an intrinsic value component. The value of a future is the cash price added to the cost of carry per month.
· One an option is bought, the only loss can be the premium. In the case of futures, mark to market losses need to be paid at the end of each trading session.
· Options depend more on the availability of a buyer and a seller and are not necessarily liquid at every price point. Most futures contracts are liquid enough to ensure excellent price discovery.

Categories: Debentures & Bonds

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