Chapter 3- Debentures, Securities, IPO, Futures & Options & Mutual Funds
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 ?
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.
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)
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.
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 ?
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 ?
What are Futures ?
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 trade Futures :
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.
What are Options ?
· Call option and
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.