advance financial planning study notes part 1

Advance Financial Planning- Study Notes Part - 1

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Roots Institute of Financial Markets 1197 NHBC Mahavir Dal Road. Panipat. 132103 Haryana.

Ph.99961-55000, 0180-2663049 email: [email protected]

Website: www.rifm.in

Roots Institute of Financial Markets

RIFM

Study Notes-Part 1

Advanced Financial Planning


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Forward

Welcome To RIFM Thanks for Choosing RIFM As Your Guide To Help You In CFP/NCFM Certification. Roots Institute Of Financial Markets Is An Advanced Research Institute Promoted By Mrs. Deep Shikha CFPCM. RIFM Specializes In Financial Market Education And Services. RIFM Is Introducing Preparatory Classes And Study Material For Stock Market Courses Of NSE , NISM And CFP Certification. RIFM Train Personals Like FMM Students, Dealers/Arbitrageurs, And Financial Market Traders, Marketing Personals, Research Analysts And Managers. We Are Constantly Engaged In Providing A Unique Educational Solution Through Continuous Innovation. Wish You Luck…………… Faculty And Content Team, RIFM


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Our Team

Deep Shikha Malhotra CFPCM

M.Com., B.Ed.

AMFI Certified For Mutual Funds

IRDA Certified For Life Insurance

IRDA Certified For General Insurance

PG Diploma In Human Resource Management

CA. Ravi Malhotra

B.Com.

FCA

DISA (ICA)

CERTIFIED FINANCIAL PLANNERCM

Vipin Sehgal CFPCM

B.Com.

NCFM Diploma In Capital Market (Dealers) Module


Neeraj Nagpal CFPCM

B.Com.



NCFM Diploma In :

Capital Market (Dealers) Module

Derivatives Market (Dealers) Module

Commodities Market Module

Kavita Malhotra

B.Com.



Certification In Following Modules Of CFPCM Curriculum (FPSB India)

Risk Analysis & Insurance Planning

Retirement Planning & Employees Benefits

Investment Planning

Tax Planning & Estate Planning



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Exam Pattern Pattern of Questions in a Case Study

Module I Module II Module III Module IV Module V

No_Item

s Mark

s No_Item

s Mark

s No_Item

s Mark

s No_Item

s Mark

s No_Item

s Mark

s

Marks Categor

y

2 2 4 1 2 0 0 1 2 1 2

3 1 3 1 3 1 3 0 0 1 3

4 0 0 1 4 0 0 1 4 0 0

5 0 0 0 0 1 5 2 10 1 5

Total 3 7 3 9 2 8 4 16 3 10

A student who scores 50% or more will pass the examination and anyone who scores below 50%

(exclusive) will fail the examination.

There is no negative marking in the Examination.

Successful students in the CFPCM Certification examination are not given their scores or ranks as

practiced in most international professional certification examinations. However, given the

aspiration needs of the students, grades will be provided to the successful students. Unsuccessful

students shall get their marks in percentage terms along with the result.

The following grading system will be used to provide grades.

Grade Score (Percentage)

A Equal and above 75%

B Equal and above 60% and less than 75%

C Equal and above 50% and less than 60%

Fail Less than 50%


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Syllabus


COURSE DESCRIPTION: This module builds upon the foundations in Financial Planning and the

knowledge requirements in Modules 2 to 5 to enable the CFP professional to construct a comprehensive

Financial Plan for a client. Miscellaneous topics are also covered in this module.

LEARNING OBJECTIVES: At the end of this module, a student should be able to:

1. Determining the client’s financial status by analyzing and evaluating the client's information.

2. Developing and preparing a client-specific Financial Plan tailored to meet the goals and

objectives of client, commensurate with client’s value, temperament, and risk tolerance.

3. Implement and monitor the Financial Plan.

DETAILED CLASS OUTLINE:

Financial Planning Process

1. Establishing client- planner relationships

a. Explain issues and concepts related to overall Financial Planning process, as appropriate to the

client

b. Explain services provided, the process of planning, documentation required

c. Clarify client’s and certificant’s responsibilities

2. Gathering client data and determining goals and expectations

a. Obtain information from client through interview/ questionnaire about financial resources and

obligations

b. Determine client’s personal and financial goals, needs and priorities

c. Assess client’s values, attitudes and expectations

d. Determine client’s time horizons

e. Determine client’s risk tolerance level

f. Collect applicable client records and documents

3. Determining the client’s financial status by analyzing and evaluating the client's information

A. General

a. Current financial status (e.g., assets, liabilities, cash flow, debt management)

b. Capital needs

c. Attitudes and expectations

d. Risk tolerance

e. Risk management


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f. Risk exposure

B. General Needs

a. Emergency funds

b. Children’s education

c. Children’s marriage

d. Buying real assets like home, car, durables, etc.

e. Future lifestyle needs

C. Special needs

a. Divorce / remarriage considerations

b. Charitable planning

c. Adult dependent needs

d. Disabled child needs

e. Education needs

f. Terminal illness planning

g. Entrepreneurial needs planning

D. Risk management

a. Life insurance needs and current coverage

b. Disability insurance needs and current coverage

c. Medical insurance needs and current coverage

d. Long – term care insurance needs and current coverage

e. Homeowners insurance needs and current coverage

f. Auto insurance needs and current coverage

g. Commercial insurance needs and current coverage

h. Other liability insurance needs and current coverage (e.g., umbrella, professional, errors and

omissions, directors and officers)

E. Retirement

a. Current retirement plan tax exposures

b. Current retirement plans

c. Retirement strategies

F. Employee benefits

a. Available employee benefits

b. Current participation in employee benefits

G. Investments


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a. Current investments

b. Current investment strategies and policies

H. Taxation

a. Tax returns

b. Current Tax strategies

c. Tax compliance status (e.g., estimated tax )

d. Current tax liabilities

I. Estate planning

a. Estate planning documents

b. Estate planning strategies

4. Analyze Client Objectives, Needs and Financial Situation

a. Analysis of relevant information

b. Need for specialist advice

c. Issues that require further clarification

5. Developing and presenting the Financial Plan

A. Developing and preparing a client-specific Financial Plan tailored to meet the goals and objectives of

client, commensurate with client’s value, temperament, and risk tolerance, covering:

1. Financial position

a. Current statement

b. Projected statement

c. Projected statement with recommendations

2. Cash flow

a. Projections

b. Recommendations

c. Projections with recommendations

3. Capital needs at retirement

a. Projections

b. Recommendations


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c. Projections with recommendations

4. Capital needs projections at death

a. Recommendations

b. Projections with recommendations

5. Capital needs: disability

a. Recommendations


6. Capital needs: General needs

a. Recommendations


7. Capital needs: special needs

a. Recommendations


8. Income tax

a. Projections

b. Recommendations

c. Projections with strategy recommendations

9. Employee benefits

a. Projections

10. Asset allocation

a. Statement

b. Strategy recommendations

c. Statement with recommendations

11. Investment

a. Recommendations

b. Policy statement


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c. Policy statement with recommendations

12. Risk

a. Assessment

b. Recommendations

13. List of prioritized action items

a. Presenting and reviewing the plan with the client

b. Collaborating with the client to ensure that plan meets the goals and objectives of the client,

and revising as appropriate

6. Implementing the Financial Plan

a. Assist the client in implementing and recommendations

b. Coordinate as necessary with other professionals, such as accountants, attorneys, real estate

agents, investment advisors, stock brokers and insurance agents

7. Monitoring the Financial Plan

a. Monitor and evaluate soundness of recommendations

b. Review the progress of the plan with the client

c. Discuss and evaluate changes in client’s personal circumstances, (e.g., birth/ death, age, illness,

divorce, retirement)

d. Review and evaluate changing tax law and economic circumstances

e. Make recommendations to accommodate new or changing circumstances

Miscellaneous Topics

8. Internet Resources

a. Internet usage and application

b. Transactions over the net

c. Issues of security

d. Financial Planning using the Internet

9. Foreign exchange issues for individuals

a. Foreign Exchange Management Act (FEMA)

b. Currency risk management

10. Financial Planning for special needs and clients


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a. Individual life cycle

b. Financial Planning for unmarried clients, single parents, widows/widowers, etc.

c. Financial Planning for returning Non Resident Indians

d. Other special needs and options (e.g., divorce, bankruptcy)


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Index

Advanced Financial Planning Part 1

Conents Page No. Unit 1 Introduction to financial Planning A. Financial planning process B. Time value of money C. Cash flow management D. Code of Ethics E. Financial Ratios F. Financial Calculator Operations G. Excel Applications Unit 2 Risk Analysis and Insurance Planning A. Risk analysis B. Review of life insurance C. Life insurance need analysis D. Review of non life insurance E. Settlement of claims in insurance Unit 3 Investment Planning A. Risk return analysis B. Asset allocation C. Derivatives D. Mutual fund E. Equity valuation F. Small saving schemes G. Bond return & valuation

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8-14 15-17 18-35 36-40 41-43 44-61

65-74 75-109

110-122 123-144 145-153

157-173 174-183 184-205 206-211 212-220 221-228 229-235


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UNIT 1

INTRODUCTION TO FINANCIAL PLANNING

A. Financial planning process

B. Time value of money

C. Cash flow management

D. Code of Ethics

E. Financial Ratios

F. Financial Calculator Operations

G. Excel Applications


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A. TIME VALUE OF MONEY

Calculate and interpret time value of money

Money has time value. A rupee today is more valuable than a rupee a year hence. Why? There are several reasons:

Individuals, in general, prefer current consumption to future consumption. Capital can be employed productively to generate positive returns. An investment of

one rupee today would grow to (1+r) a year hence (r is the rate of return earned on the investment.)

In an inflationary period a rupee today represents a greater real purchasing power than a rupee a year hence.

Most Financial problems involve cash flows occurring at different points of time. These cash flows have to be brought to the same point of time for purposes of comparison and aggregation. Hence you should understand the tolls of compounding and discounting which underlie most of what we do in finance-from valuating securities to analyzing projects, from determining lease rentals to choosing the right financing instruments, from setting up the loan amortization schedules to valuing companies, so on and so forth. Calculation of future value Future value measures the nominal future of money that a given sum of money is „worth‟ at a specified time is the future assuming a certain interest rate. Formula used FV= PV (1+R) 1(1+R)2 … (1+R)N FV= PV (1+R)N Where, FV= Future Value PV= Present Value R= rate of interest/Return N= Term Period

ON FC-200V Press CMPD N= Enter Value I = Enter Value PV= Enter Value FV = Solve

Example 1 Calculate the maturity amount of Rs. 18,000 if invested at 8% per annum for 5 years.

a. Rs. 26448 b. Rs. 26500 c. Rs. 25100 d. Rs. 16541 Solution Press CMPD Set: End, N= 4, I% = 8, PV= -18000, FV=Solve= 26448 Calculation of Present value Present value is the value on a given date of future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk.


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Formula used FV= PV (1+R) 1(1+R)2 … (1+R)N FV= PV (1+R)N

PV= FV/(1+R)n

Where, FV= Future Value PV= Present Value R= rate of interest/Return N= Term Period PV= Future Amount/ (1+ Interest Rate) term

ON FC-200V Press CMPD N= Enter Value I = Enter Value PV= Solve FV= Enter Value

Example 2 How much must be invested today, at 9% p.a. to accumulate enough to retire a Rs. 100000 debt due seven years from today?

a. Rs. 32650 b. Rs. 54704 c. Rs. 61230 d. Rs. 87950 Solution Press CMPD, Set: End, N= 7, I-9, PV= Solve= -54703.42, FV=100000

Calculation of Interest & term Interest Interest is a fee, paid on borrowed capital. Assets lend include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements. The interest is calculated upon the value of the assets in the same manner as upon money. Interest can be thought of as „rent on money‟. For example, if you want to borrow money from the bank, there is a certain rate you have to pay according to how much you want loaned to you. The fee (interest) is compensation to the lender for foregoing other useful investments that could have been made with the loaned money. Instead of the lender using the assets directly, they are advanced to the borrower. The borrower then enjoys the benefits of using the assets ahead of the effort required to obtain them, while the lender enjoys the benefit of the fee paid by the borrower for the privilege. The amount lent, or the value of the assets lent, is called the principal. This principal value is held by the borrower on credit. Interest is therefore the price of credit, not the price of money as it is commonly and mistakenly-believed to be. The percentage of the principal that is pad as a fee (the interest), over a certain period of time, is called the interest rate. On FC-200V, Press CMPD, N= Enter Value, I= Solve, PV= Enter Value, FV= Enter Value Term Term is defined as a limited period of time, a point in time at which something ends, or a deadline, as for making a payment.


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Thumb Rule This rule is just like a quick calculation. It might not give you the exact answers but will give you the closest answer. Rule of 72: To estimate the number of periods required to double an original investment, divide the most convenient “rule-quantity” by the expected growth rate, expressed as a percentage. Steps Involved: 1. Find out your interest rate

2. Second…….do the math 72/interest rate= Years Rule of 69: A rule stating that an amount of money invested at r percent per period will double in 69/r (in percent) + 3.5 periods. 69/interest rate+0.35= years For example, if interest rate is 9%, the investment will double in a little over 8 years 69/9+0.35= 8.016 years. Rule of Tripling Investments Rule of 115: To estimate how long it takes to triple your money, divide 115 by your expected interest rate (or rate of return) 115/interest rate= years For instance, an investment will triple in approximately 11.5 years, if rate of interest is 10% Example 3 An analyst estimates that Mars Software‟s earning will grow from Rs.3 per share to Rs. 4.50 per share over the next eight years. The rate of growth in Mars Software‟s earning is closest to:

a. 4.9% b. 5.2% c. 6.7% d. 7.0% Set: End, N= 8, I=Solve= 5.2, PV= -3, FV= 4.5 Example 4 If Rs. 5000 is invested in a fund offering a rate of return of 12 percent per year, approximately how many years will it take for the investment to reach Rs. 100000?

a. 4 years b. 5 years c. 6 years d. 7 years Solution 72/12= 6 years

Calculation of annuities Annuity: The term annuity is used in reference to any terminating stream of fixed annuity payments over a specified period of time. Some examples of annuity are: Rent Loan EMI‟s Pension, etc. Following are the various types of annuities-


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Ordinary Annuity/ Annuity in Arrears: An ordinary annuity is essentially a level

stream of cash flows made at the end of each period for a fixed period of time. Straight bond coupon payments are normally referred to as ordinary annuities.

Annuity Due: An annuity whose payment is to be made immediately rather than at

the end of the period.

Annuity certain: Annuity certain is a plan which makes payments for a specified period of time regardless of whether the annuitant is alive or dead during that period.

Deferred Annuity: A type of annuity contract that delays payment of income,

installments or a lump sum until the investor elects to receive them. This type of annuity has two main phases, the savings phase in which you invest money into the account, and the income phase in which the plan is covered in to an annuity and payments are received.

Perpetuity Annuity Forever: Perpetuity forever is an annuity whose payments

continue forever.

Growing Annuity: A growing annuity is a finite number of cash flows growing at a constant rate. The formula for the present value of a growing annuity is:

PV= CF0 (1+g)/(k-g)*[1-(1+g)/(1+k)N ]

Where, CF= Cash flows, G= Growth Rate, K= Interest Rate, N= Number of years FV= PMT [{(1+r)n - (1+g)n }]/(1+r)-(1+g)

Payment (PMT) The payment is an equal cash flow that occurs each sub period in

an annuity Faculty Comment: Always assume an annuity is an ordinary annuity unless the facts clearly indicates otherwise. Important Note: Always use begin Mode on your calculator if it is Annuity due. Example 1 Find the present value of an annuity of Rs. 1000 payable at the end of each year for 8 years, if rate of interest is 5% p.a.

a. Rs. 6463 b. Rs. 3231 c. Rs. 4265 d. Rs. 1614 Set: End, N= 8, I= 5, PV= Solve= 6463.21, PMT= -1000 Example 2 Alfa add Rs. 7000 per year to an account for 10 years. If rate of interest is 6% per year on the money. What is the worth of the account at the end of the 10 years? Rs. 64622 b. Rs. 92266 c. Rs. 72550 d. Rs. 80124 Set: End, N=10, I= 6, PMT= -7000, FV=Solve=92266

Loan repayment schedule The present value annuity formula can be applied in a variety of contexts. Its important applications are discussed below.


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How much can you borrow for a Car After reviewing your budget, you have determined that you can afford to pay Rs. 12,000 per month for 3 years toward a new car. You call a finance company and learn that the going rate of interest on car finance is 1.5 percent per month for 36 months. How much can you borrow? To determine how much you can borrow, we have to calculate the present value of Rs. 12000 per month for 36 months at 1.5 percent per month. Since the loan payments are an ordinary annuity, the present value interest factor of annuity is: PVIFAr, = 1-1/(1+r)n /r = (1-1/(1.015)36 /.015= 27.1 Hence the present value of 36 payments of Rs. 12,000 each is: Present value= Rs. 12000*27.7= Rs. 332400 You can, therefore borrow Rs. 332400 to buy the car.

Period of Loan Amortization You want to borrow Rs. 1,080,000 to buy a flat. You approach a housing finance company which charges 12.5 percent interest. You can pay Rs. 180000 per year toward loan amortization. What should be the maturity period of the loan? The present value of annuity of Rs. 180000is set equal to Rs. 1000,000 180000*PVIFAn,r = 1,080,000 180,000*PVIFAn=? r=12.5%= 1,080,000 180,000[1-1/ (1.125) n /0.125] = 1080000 Given this equality the value of n is calculated as follows: 1-1/ (1.125)n /0.125= 1,080,000/180,000=6 1-1/ (1.125)n = 0.125*6= 0.75 1/ (1.125)n = 0.25 1.125n = 4 N log 1.125= log 4 N*0.0512= 0.6021 N= 0.6021/0.0512= 11.76 years You can perhaps request for a maturity of 12 years. Determining the loan Amortization Schedule Most loans are repaid in equal periodic installments (monthly, quarterly, or annually), which cover interest as well as principal repayment. Such loans are referred to as amortized loans. For an amortized loan we would like to know (a) the periodic installment payments and (b) the loan amortization schedule showing the break-up of the periodic installments payment between the interest component and the principal repayment component. To illustrate how these are calculated, let us look an example. Suppose a firm borrow Rs. 1,000,000 at an interest rate of 15 percent and the loan is to be repaid in 5 equal installments payable at the end of each of the next 5 years. The annual installment payment A is obtained by solving the following equation.


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Loan Amount= a *PVIFAn=5,r=15%

1,000,000 = A*3.3522 Hence A= 298,312 The amortization schedule is shown following table. The interest component is the largest for year 1 and progressively declines as the outstanding loan amount decreases. Loan Amortization Schedule

Year Beginning Amount (1)

Annual installment (2)

Interest Principal Repayment 2-3=4

Remaining Balance 1-4= 5

1 1,000,000 298,312 150,000 148,312 851,688 2 851,688 298,312 127,753 170,559 681,129 3 681,129 298,312 102,169 196,143 484,986 4 484,986 298,312 727,482 225,564 259,422 5 259,422 298,312 38,913 259, 399 23

Interest is calculated by multiplying the beginning loan balance by the interest rate.

Principal repayment is equal to annual installment minus interest

Due to rounding off error a small balance is shown Inflation- adjusted interest rates Inflation Adjusted Rate of returns: Inflation adjusted rate of return is a measure that accounts for the return periods inflation rate. Inflation adjusted returns reveals the return on an investment after removing the effects of inflation. It is calculated as follows: Inflation Adjusted Return = (1+Return)/(1-Inflation Rate)-1 Example A bond that pays interest annually yields a 7.25 percent rate of return. The inflation rate for the same period is 3.5 percent. What is the real rate of return on this bond?

a. 3.62% b. 3.75% c. 10.75% d. 8.50% Solution: Real rate= 1+nominal rate/1+inflation rate-1*100= 1.0725/1.0350-1*100= 3.62%


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Compound Interest calculation Most of the banks and person dealing with funds use the word compounding interest annually, semi-annually or quarterly etc. to understand better compound interest would mean calculating the interest on interest also. The mathematical formula shall be as follow:

C.I. = P [ ( 1+ r/100) -1] , where C.I. = compound interest

If the interest rates for the successive fixed periods are r1%, r2%, r3% ..., then A (Amount) is given by

A=P ( 1 +r1/100) (1+r2) (1+ r3)………………… where A= amount & principal , P= principal For example An amount of 5000/- is borrowed at the rate of 9% per annum for 3 years, CI would be

C.I. =5000 x {(1+ .09)³-1} = 1475.145 A =5000 + 1475.145 = 6475.145

Operation Press CMPD key Input the following using scroll and exe keys

Set : begin / end select End using scroll and exe key N : press 3 and enter exe key I% : press 9 and enter exe key PV : press 5000 and enter exe key PMT : leave blank or press 0 and enter exe key* FV : Press solve key, see the answer appears as -6475.145

Note : Using scroll key please enter the P/Y = 1 and C/Y = 1 as the same represents the Installments per year and Compounding per year respectively. If the compounding is semi annually then C/Y should be selected as 2 and for quarterly the same should be selected as 4. Note: Press ESC key to come back to previous screen Note: To clear variables from the memory is to press SHIFT key and 9 key and EXE key and chose the correct option to clear either setup, memory or all variables from the memory


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EMI calculation CMPD continues…. A very important tool for finance companies having the business of lending money and all those also borrowing money and in the need to know that how much monthly installment need to be paid for a particular loan. Typically a person needs to know the present value of amount borrowed/lend and the interest rate to be paid also the total number of installments to be used while returning the amount borrowed. i.e. PV = amount borrowed or lend i.e. INR 50000 I% = interest rate i.e. 12% p.a. i= I%/12/100 = 0.010 N = number of installments per year i.e. 15 years = 180 times A typical way of calculating the EMI shall be taking the help of computer or a long sheet of paper and lot of time in computing and yet not very sure about the way of doing. The formula shall be as follows: PV x i x (1+ i)ⁿ = (1+ i)ⁿ-1 = 50000 x 0.01 x (1.01) (1.01) 180 -1 = 600.08 EMI calculation without a calculator having the solving power like this is just impossible and doing little simulations and variations in interest, principal etc, the working becomes very tough, but the use of FC 200V is very simple, faster and economical, let‟s see Press CMPD key and using the scroll and exe key enter the following data

Set = End key N = Press 180 and enter Exe key (15 years x 12 months) I% = Press 12 and enter Exe key PV = 50000 exe key PMT = Solve key FV = Press 0 and enter Exe key P/Y =12 as the installments per year is 12 the duration of loan is 15 years C/Y =12 as the compounding also is monthly so in a year 12 compounding

Scroll back to PMT key and enter solve key as the answer flashes -600.08. Now we can use variation just like mortgage calculators available on the web and computer spreadsheets e.g.

1. Calculate the PV if we know how much maximum EMI can be paid


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Set = End key N = 180 periods (15 years x 12 months) I% = 12 PV = solve key PMT = -600.08 FV =0 P/Y =12 as the installments per year is 12 the duration of loan is 15 year C/Y =12 as the compounding also is monthly so in a year 12 compounding

2. Calculate the maximum Rate of interest can be borne if EMI, period and PV is

known

Set = End key N = 180 periods (15 years x 12 months) I% = Solve key PV = 50000 MT = -600.08 FV =0 P/Y =12 as the installments per year is 12 the duration of loan is 15 years C/Y =12 as the compounding also is monthly so in a year 12 compounding

3. Calculate the Number of periods (i.e years) wherein loan can be repaid if PV, I%

and EMI is known

Set = End key N = Solve key I% = 12 PV = 50000 PMT = -600.08 FV =0 P/Y =12 as the installments per year is 12 the duration of loan is 15 years C/Y =12 as the compounding also is monthly so in a year 12 compounding

4. Example

Just in simple way skip the term we want to know and enter the data in rest of the terms as before, using the scroll key come back to the term we want to know and press solve key and result is available.


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G.Excel Application

PV

Returns the present value of an investment. The present value is the total amount that a series of future

payments is worth now. For example, when you borrow money, the loan amount is the present value to the

lender.

PV(rate,nper,pmt,fv,type)

Rate is the interest rate per period. For example, if you obtain an automobile loan at a 10 percent annual

interest rate and make monthly payments, your interest rate per month is 10%/12, or 0.83%. You would enter

10%/12, or 0.83%, or 0.0083, into the formula as the rate.

Nper is the total number of payment periods in an annuity. For example, if you get a four-year car loan and

make monthly payments, your loan has 4*12 (or 48) periods. You would enter 48 into the formula for nper.

Pmt is the payment made each period and cannot change over the life of the annuity. Typically, pmt includes

principal and interest but no other fees or taxes. For example, the monthly payments on a $10,000, four-year car

loan at 12 percent are $263.33. You would enter -263.33 into the formula as the pmt. If pmt is omitted, you must

include the fv argument.

Fv is the future value, or a cash balance you want to attain after the last payment is made. If fv is omitted, it is

assumed to be 0 (the future value of a loan, for example, is 0). For example, if you want to save $50,000 to pay

for a special project in 18 years, then $50,000 is the future value. You could then make a conservative guess at

an interest rate and determine how much you must save each month. If fv is omitted, you must include the pmt

argument.

Type is the number 0 or 1 and indicates when payments are due.

Set type equal to If payments are due

0 or omitted At the end of the period

1 At the beginning of the period

Remarks


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Make sure that you are consistent about the units you use for specifying rate and nper. If you make

monthly payments on a four-year loan at 12 percent annual interest, use 12%/12 for rate and 4*12 for

nper. If you make annual payments on the same loan, use 12% for rate and 4 for nper.

The following functions apply to annuities:

CUMIPMT PPMT

CUMPRINC PV

FV RATE

FVSCHEDULE XIRR

IPMT XNPV

PMT

An annuity is a series of constant cash payments made over a continuous period. For example, a car

loan or a mortgage is an annuity. For more information, see the description for each annuity function.

In annuity functions, cash you pay out, such as a deposit to savings, is represented by a negative

number; cash you receive, such as a dividend check, is represented by a positive number. For

example, a $1,000 deposit to the bank would be represented by the argument -1000 if you are the

depositor and by the argument 1000 if you are the bank.

Microsoft Excel solves for one financial argument in terms of the others. If rate is not 0, then:

If rate is 0, then:

(pmt * nper) + pv + fv = 0

Example


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1

2

3

4

A B

Data Description

500 Money paid out of an insurance annuity at the end of every month

8% Interest rate earned on the money paid out

20 Years the money will be paid out

Formula Description (Result)

=PV(A3/12, 12*A4, A2, , 0) Present value of an annuity with the terms above (-59,777.15).

The result is negative because it represents money that you would pay, an outgoing cash flow. If you are asked

to pay (60,000) for the annuity, you would determine this would not be a good investment because the present

value of the annuity (59,777.15) is less than what you are asked to pay.

NOTE The interest rate is divided by 12 to get a monthly rate. The years the money is paid out is multiplied by

12 to get the number of payments.


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PMT

Calculates the payment for a loan based on constant payments and a constant interest rate.

MT(rate,nper,pv,fv,type)

For a more complete description of the arguments in PMT, see the PV function.

Rate is the interest rate for the loan.

Nper is the total number of payments for the loan.

Pv is the present value, or the total amount that a series of future payments is worth now; also known as the

principal.

Fv is the future value, or a cash balance you want to attain after the last payment is made. If fv is omitted, it is

assumed to be 0 (zero), that is, the future value of a loan is 0.

Type is the number 0 (zero) or 1 and indicates when payments are due.

Set type equal to If payments are due

0 or omitted At the end of the period

1 At the beginning of the period

Remarks

The payment returned by PMT includes principal and interest but no taxes, reserve payments, or fees

sometimes associated with loans.

Make sure that you are consistent about the units you use for specifying rate and nper. If you make

monthly payments on a four-year loan at an annual interest rate of 12 percent, use 12%/12 for rate and

4*12 for nper. If you make annual payments on the same loan, use 12 percent for rate and 4 for nper.

Tip To find the total amount paid over the duration of the loan, multiply the returned PMT value by nper.

Example 1

A B


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1

2

3

4

Data Description

8% Annual interest rate

10 Number of months of payments

10000 Amount of loan


=PMT(A2/12, A3, A4) Monthly payment for a loan with the above terms (-1,037.03)

=PMT(A2/12, A3, A4, 0, 1)

Monthly payment for a loan with the above terms, except payments are due at the beginning of the period (-1,030.16)

Example 2

You can use PMT to determine payments to annuities other than loans.

1

2

3

4

A B

Data Description

6% Annual interest rate

18 Years you plan on saving

50,000 Amount you want to have save in 18 years


=PMT(A2/12, A3*12, 0, A4) Amount to save each month to have 50,000 at the end of 18 years (-129.08)

NOTE The interest rate is divided by 12 to get a monthly rate. The number of years the money is paid out is

multiplied by 12 to get the number of payments.


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UNIT

2

RISK ANALYSIS & INSURANCE PLANNING

A. Risk analysis

B. Review of life insurance

C. Life insurance need analysis

D. Review of non life insurance

E. Settlement of claims in insurance


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Communication

& Learning

A. RISK ANALYSIS Meaning and objective of risk management The combination of perils and hazards creates risks to which an individual is vulnerable every day in life. These range in severity from the risk of dying to something as minor as the risk of getting ill with a common flu bug. They also vary in likelihood from high frequency to low-frequency risks. The chances of getting the flu at some point in the life are obviously much greater than the chances of perishing in an airplane tragedy. But whatever its likelihood or possible severity, every risk carries the potential for some type and degree of loss. If an individual doesn‟t have medical insurance, even the risk of the flu can produce financial losses in the form of doctors‟ visits and prescription drugs. In effect, if an individual wants to minimize the losses associated with different kinds of risks, he needs to develop a plan for dealing with risk. This plan should treat each specific risk on an individual basis while simultaneously addressing them all together as a total package of risks. This is where risk management comes into play. Objective of risk management Given the number and variety of risks that exist in the everyday world, the basic objective of risk management should be fairly obvious. Risk management is simply intended to combat the risks an individual faces in life and, in so doing, to minimize the financial and other losses potentially associated with those risks. Steps in personal risk management Identifying Exposure to Loss Identifying exposures is a vital first step to risk management; until you know the scope of all possible losses, you won't be able to develop a realistic, cost-effective strategy for dealing with them. It is not easy to recognize the hundreds of hazards or perils that can lead to an unexpected loss.

Identifying

Risks

Reviewing

&Reporting

Risks

Assessing

Risks

Managing &

Controlling

Risks


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For example,' unless one has experienced a fire, he may not realize how extensive fire losses can be. Damage to the building and its contents are obvious, but also consider

I. Smoke and water damage. II. Damage to employees' personal property and to others' property (e.g., data-

processing equipment on' lease or customers' property) left on the premises. III. The amount of business one‟ll loses during the time it takes to return business to

normal. IV. The potential permanent loss of customers to competitors.

The process of identifying exposures begins by taking a close look at each of the client‟s business operations and assesses what could cause a loss. If there are dozens of exposures one will find dozens of answers. For each exposure that is identified, ask how serious that loss is. This question focuses on the possible severity of each exposure, e.g., what would that loss cost? The purpose here is not to determine the source of replacement or repair funds, but the full cost of the loss. Many business owners use a risk analysis questionnaire or survey, available from insurance agents, as a checklist. Agents and financial planners are expected to help analyze the situation; with their expertise and experience, they are less .likely to overlook any exposures. A loss exposure is the possibility of financial loss that a particular entity faces as a result of a particular peril striking a particular thing of value. Probably the most important step in the risk management process is the identification or finding of risks that need to be treated. If one is not aware of the existence of a risk, one certainly cannot make plans for handling it. In order to consider the identification of risks, it is necessary to classify them in some sort of orderly manner. Although various methods for classifying risk can be devised, it is common to classify risks in a manner similar to that used by the insurance industry. This system has the advantage of making it easier to relate risks to insurance coverage‟s like Personal risk Property Risk Liability Risk Personal Risk As the name suggests these are risks associated with an individual and below mentioned are some of the process of looking at personal risks

I. Lifestyle In terms of lifestyle, if an individual participates in dangerous activities such as hang gliding or mountain climbing, he is exposing himself to risks that most individuals don't have. Since these activities put the individual at increased risk for injury and premature death, the individual needs to be especially concerned about the financial losses for the dependents if something happened to him. Other lifestyle issues that may raise similar concerns include smoking, alcohol consumption, and occupational hazards.

II. Existing insurance

An individual's existing insurance may make it easy to pinpoint the areas where he is vulnerable to loss and other areas and where he is not insurance is specifically designed to safeguard against the risk of loss. Assuming the individual has carefully chosen the type(s), coverage and amount(s) of insurance he needs and may already have enough protection against certain kinds of losses. If so, his chance of loss in those areas is minimal, so he can forget about them and move on to other areas, if


30




any, where the protection is 'not as adequate. Let's say an individual has Rs. 500,000 of life insurance coverage but no health insurance. While he may not need to worry about how his family will get by if he prematurely dies, he should consider how he‟ll pay the medical bills if he is suddenly down with a serious illness that's expected to drag on for years.

Advisor relationship(s) Equally important in identifying potential risks and losses is the relationship with financial planner and any other advisors. The reason is simply that the better the individual and the advisor know each other, the more familiar he or she will be with the finances, lifestyle, and other circumstances. This greater familiarity will make it easier for the advisor to identify the risks and potential losses that apply to a client's situation. It should also make for a more comfortable relationship that will allow the two to candidly discuss particularly sensitive matters (e.q., spouse's aversion to handling money) that might come into play come into play at this stage of the risk-management process. Property Risk Property risks of several types are created by the possibility of property being damaged or destroyed. The first task involves identifying that property and then determining what perils might damage it. Losses can be divided into three categories.

Direct Loss

Indirect loss

Contingent loss

Direct Loss A direct loss is incurred by the owner of property or the party responsible for property when it is damaged by a peril. The property may be real property or personal property. A loss is sustained if expenditure must be made to repair or replace the damaged or destroyed property. Property damage can be caused by many common perils, such as fire, windstorm, lightning and vandalism. To cope effectively with the possibility of physical damage to property, the business owner should consider more than just damage to or destruction of a building. Contents may be even more susceptible. Manufacturers might lose raw materials and finished goods, and merchants, valuable inventories and fixtures. Any business miglit lose valuable accounting records, making it difficult to bill or collect from customers. Vital machinery or equipment may become inoperable, and, if replacements can't be found and installed immediately, the business may even be forced to temporarily shut down.

Indirect Loss Damage to real or personal al property may cause indirect or consequential losses. These are losses which occur when, as a result of damage to real or personal property, income is reduced or additional expenses are incurred other than for the repair or replacement of damaged property.

Contingent Loss A contingent loss may be suffered by a party who is dependent upon the activities of another party owning or operating the property that is damaged. For example, if a major supplier's facility is damaged, or access ·to the individual's facilities is not possible because of a storm or other catastrophe, individual may lose income, or incur additional expenses as a result of the storm.


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Liability Risk Liability Risk indicates losses caused by injuries to persons or liability for injuries to persons or damage to property of others. Workers Compensation, General Liability, Auto, and similar losses are considered casualty losses inviting liability of the person responsible. Liability Losses Every business faces exposure to liability losses. A business may become legally liable (i.e. responsible for payment) for bodily injury suffered by another person or persons, or for damage to or destruction of the property of others. This liability may be the result of

A court decision (as in a lawsuit charging negligence).

Statutory provisions (such as a state's workers' compensation law). Violation of contract provisions (a contract that makes one party responsible for certain kinds of losses).

Public Liability A business may be held liable for injuries or other losses suffered by a member of the general public as the result of the firm's (or its employees') negligence or fault. Examples include

A customer in a firm's building falls on a broken step.

A defective product causes injury to its user.

Improper installation of a product causes injury to a customer. A daily newspaper provides dozens of other examples. A firm that is found legally liable for harming a third party must pay damages to compensate the injured party. Sometimes the court also imposes punitive damages and, in cases involving violation of statutes designed to protect the community, the court may levy fines in order to discourage future violations. Liability to Employees India has enacted workers' compensation laws. These laws require most employers to compensate employees for loss of income or medical expenses resulting from work-related disease or injury (except for certain self-inflicted injuries). Should an employee die as a result of a job-related accident or disease, the employee's family also collects a specified amount. Evaluation of Risks Once identified, the next step in the risk management process is to evaluate risks. In order to evaluate a risk, one must determine the probability of loss by considering the following:

a) Frequency b) Severity c) Variation d) Impact

a. FREQUENCY Frequency is a measure of how often a particular type of loss occurs or will occur. Generally, what we experience in our life is that smaller losses occur more frequently and larger losses less frequently, that is very much an admitted fact in all spheres.


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But then each risk has to be measured and a probable frequency must be anticipated to decide on the risk management.

Table 1: Assessing the Likelihood of the risk occurring Likelihood level

Rare Unlikely Possible Likely Almost certain

May occur only in exceptional circumstances Is unlikely to occur, but could, at some time Fairly likely to occur at some time, or in some circumstances Will probably occur at some time, or in most circumstances Is excepted to occur in most circumstances

1 2 3 4 5

b. SEVERITY When considering the degree of risk involved, we must also consider severity-the amount of loss that is to be sustained. To predict future losses, prior occurrences should be reviewed to determine how often losses of a certain type have taken place, and the range in cost of those losses. Various "trending factors" are applied to recognize such things as inflation, changes in laws, delay in reporting claims, increased activity, etc.

High Frequency Area of Priority Concern Low Severity High Severity Low Frequency

c. Variation When surveying exposures to risk and considering prior loss experience as an indication of probable future, loss experience cannot be emphasized too strongly. The fact that one did not had a fire at a location during the last five years does not mean that the location will not have a fire next year. However, a high frequency of small losses may be an indication of carelessness or poor management.

d. Impact

While risks are commonly evaluated in terms of frequency, severity and variation, the possible impact of a loss is also an important consideration. When dealing with risks involving damage or destruction of property, it is common to consider severity and impact in terms of maximum possible loss (the worst that could happen) or maximum probable toss (the worst that is likely to happen). Usually, maximum probable loss is a more realistic measure, but this can be very difficult to determine when large, highly valued properties are involved. Not only is it sometimes difficult to determine the extent to which a particular property would be damaged-by a peril, But it can also be extremely difficult to .determine the extent to which business will be interrupted or the extra expenditures that would be required to conduct operations at another location and expedite reconstruction of the damaged facility.


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Evaluation of liability risks is much more difficult. For the most part, the amount of a liability claim is a matter of pure chance, although smaller losses do occur more frequently than large losses.

For example, even though the potential losses resulting from an earthquake would probably be far more severe than the losses associated with a shattered car windshield, one may opt to have glass coverage on auto insurance but no earthquake coverage on homeowners insurance. Particularly if he lives in an area where earthquakes rarely occur, one might base these decisions on the fact that the probability of damage to the car windshield is much higher than the probability of earthquake damage to the home. Of course, other types of risks with the potential for high-severity losses may be evaluated very differently than earthquakes based on the greater likelihood that they will occur.

Alternative Risk Management Techniques After risks have been identified and evaluated, the next step in the risk management process is a determination of what to do about them. Risk management involves either

Stopping losses from happening (RISK CONTROL) or

Paying for those losses that inevitably do occur (RISK FINANCING)

OBJECTIVE-To travel from A to B in time for an important meeting

Owner Inherent assessment Controls in place

Residual Assessment

Action Planned

Target date

Myself Risk Impact Likelihood

Impact Likelihood

Missing a train makes me late for the important meeting

High High Catch train one earlier than I actually need

High Low No further action planned

Another

Severe weather prevents the train from running

High Low Cannot control

High Low Telephone conferencing facility to be installed as a contingency

August


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Myself Engineering works make the train late

High Medium Check for engineering works and arrange flexibility with people I am meeting

High Low No further action planned


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B. Life insurance need analysis What amount of life insurance should an individual own? A number of methods are used to determine the proper amount of life insurance. The difference is that the simple rule of thumb approach may be applied by the clients and individuals of their own to get an approx idea of their requirement, but a financial planner will be expected to work on the needs analysis employing more scientific method and industry accepted methods to find the same. The rules of thumb are simple basic calculations. There are more specific calculations industry adopted methods, such as the family needs approach, income replacement approach, capital retention approach, and capital liquidation approach, whatever approach is used, life insurance is important to provide the needed cash to meet financial needs. Some simple rules of thumb

Human life Approach

Need Approach

Capital Needs analysis Approach Rules of thumb A rule of thumb is a simple guideline that can be easily applied to a situation. It gives an instant answer to the basic need for life insurance, there are some rules of thumb that may be used to calculate a basic amount of insurance coverage. The rules of thumb are simplistic and do not consider many of the factors used in other methods of insurance-need determination. They are however, easy to use and provide a starting point insurance-need evaluation. Common rules of thumb for determining amounts of life insurance coverage Income rule The most basic guideline for determining an insurance requirement is six to eight times of the gross annual income. Under this rule, a person earning a gross salary of Rs. 60,000 per annum, should have between Rs. 360,000 and Rs. 480,000 of life insurance

Gross Salary X6 X8 60,000 360,000 480,000 80,000 480,000 640,000 100,000 600,000 800,000

Income Plus expenses This rule is considers gross annual income along with cash needs at death and any special funding needs, such as private school or college tuition. Under this rule, the insurance requirement is five times gross income plus the total of any mortgage, personal debt, final expenses, and special funding needs, such as college funding. For example, assume the following expenses and debt:

Expense/Cash Need Amount

Mortgage 80,000

Personal Debt 15,000


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Estimated Final Expenses 15,000

Estimated College Expenses 50,000

Total 160,000

Using the expenses assumed above, insurance requirements using this rule at various gross salary amounts are as shown:

Gross Salary

Gross Salary X 5 Expenses Insurance Required: Gross Salary X 5+Expenses

60,000 80,000 100,000

300,000 400,000 500,000

160,000 160,000 160,000

460,000 560,000 660,000

Premiums as percentage of Income This rule calculates the amount to be spent on premiums instead of the amount of life insurance coverage. Under this rule, 6 percent of the earning member‟s gross income plus an additional 1 percent for each dependent should be spent on life insurance premiums. Assuming a earning member with a nonworking spouse and two dependents, the insurance premium allocations are as shown for various salaries:

Salary Basic Allocation 6% of Salary

Dependent Allocation (3 Dependents X 1%)X

Premium

60,000 80,000 100,000

3,600 4,800 6,000

1,800 2,400 3,000

5,400 7,200 9,000

This rule of thumb, determines the percentage of the annual income to be spent on life insurance premiums and then an individual can buy as much life insurance as he can get for that premium amount. When considering term insurance, the percentage of income allocated for premiums is often calculated at 2 percent or 3 percent instead of 6%. Multiples of Salary Method The multiples of salary method require the use of multiples of salary chart and are based on the assumptions that the family has one income provider and that the average family can live adequately on 75 percent of the income provider‟s salary. Advantage of rules of thumb for determining life insurance requirement The rules of thumb are simple and calculations can be done using a basic calculator immediately. They are useful as a rough starting point and can point a framework to start assessing the insurance need of an individual. Disadvantages of rules of thumb for determining life insurance requirement While the rules of thumb are helpful starting point, they fail to consider the needs and circumstances of the individual. There are no considerations of the ages of the insured or the dependents or whether the family is provided for with one income or two. There are also no adjustments made for special circumstances, such as the expenses associated with a special needs child or the need for liquidity for estate planning. There are several more comprehensive methods used to calculate life insurance need. Overall, these methods are more detailed than the rules of thumb and provide a more complete view of total insurance needs.


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[A] HUMAN LIFE APPROACH The human life value approach aims to replace the expected future income of the insured in case of death. Here, the insurance purchased is based on the value of the income the insured breadwinner can expect to earn during his or her lifetime. By focusing only on a family breadwinner's expected future earnings stream, the human life value provides a fairly rough estimate of life insurance needs. To help make the insurance needs estimate more accurate, the income replacement approach allows for some adjustments to the human life value. Therefore, the Human life value approach projects an individual's income through his remaining working life expectancy, and then the present value is determined by means of a discount rate. A demonstration would help understand the calculation involved in determining the human life value of an insured. It has various steps involved in it. Step 1: Determine the insured person's after-tax earnings The first step is to take the insured‟s current after-tax earnings, essentially after-tax salary. We use after-tax rather than gross earnings because that is the amount actually available to spend on the family's needs. Example: Let Mr. Kumar's current annual gross salary be Rs.1 00, 000. The income tax liability is 30 percent of the gross salary; hence his after-tax salary is Rs.70, 000. This is the amount Mr. Kumar currently provides to his family. Step 2: Deduct the personal expenses of the insured In the Human life value approach, we include only that portion of the anticipated future income that would be devoted to the family. Since a part of the insured's earnings are spent on self-maintenance (e.g., clothing, food, and individual transportation expenses), that part of the future income is not available to the family. The frequent assumption is that 25 percent of the after-tax income goes for personal expenses and the remaining 75 percent goes for family living expenses. Thus, we multiply the expected total earnings by a family support ratio of 75 percent (or some other amount according to the actual available percentage in each case) to reflect the percentage of income that actually supports the family. Example: Mr. Kumar's gross salary is Rs.1, 00,000 and his after-tax salary is Rs. 70,000. If we go by the 25%-75% assumption, the amount devoted to his personal expenses would be 25% of Rs.70, 000. Thus we subtract Rs.17, 500 (Rs.70, 000 * 0.25) from his after-tax salary to arrive at the amount available to the family i.e. Rs.52, 500. Alternately, we can take the family support ratio i.e. 75% of Rs.70, 000 as well to arrive at the amount available to the family (Rs.70, 000 * 0.75). If the personal expenses ratio is say 30%, then you use a 70 percent family support ratio instead (Rs.70, 000 * 0.70). Step 3: Consider the number of years for which income stream is required The future earnings stream you want to protect reflects the income that the insured will earn over the number of future years he or she expects to work until retirement.


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Example: Mr. Kumar is 35 years old and anticipates retiring at the age 60. His expected future economic life is 25 years. The lost income stream if he died today would be for 25 years. Step 4: Consider anticipated salary growth and inflation The insured's income will rarely stay the same over time. Inflation and merit increases, promotions, or other salary growth, separate from inflation are factors that will affect the salary increase. Therefore, we need to factor in an earnings growth factor (sum of these effects) to account for these effects on the future earnings stream. While considering inflation, one can take the long term average inflation rate, and for salary increases, consider the average increase in the particular industry or in general. We can use the future inflation rate estimate for the growth factor as well. Example: Mr. Kumar works in the software industry. Let's say, he chooses an inflation rate of 5%. The software field sees annual salary increases ranging from 10-20%, so he takes 10% as the inflation adjusted salary growth rate. Hence the growth factor would be 15% percent (5% + 10%). Note that if Mr. Kumar's family wanted to just maintain the current standard of living and not account for future merit, seniority, or other increases unrelated to inflation, he would just use the 5 percent inflation factor as the growth factor. Step 5: Determine the total anticipated future income for supporting the family We can calculate the expected future income stream using the following figures:

Current after-tax earnings multiplied by the family support ratio

Number of years the insured expects to work

Earnings growth factor (accounting for inflation and salary raises)

This future income needs to be discounted in order to arrive at the present value, or the human life value.

Step 6: Determine a discount rate for the insurance proceeds and calculate the present value The discount rate should reflect the after-tax investment return on the insurance proceeds over the years. The investment of the life insurance proceeds should provide returns over time that equal the income stream calculated in the previous step. Various investments like stocks, bonds, post office schemes etc. offer varying average rates of return. Figures are available for short-, medium-, and long-term average rates of return for the different types of investments. Stocks generally offer the highest rates of return, and significant variations exist among the different types of stock. Similarly, different types of bonds offer different average rates of return. Step 7: Determine the present value of the expected income stream, using the discount rate. In order to find the present value of the expected income, we can utilize either a formula for calculating present value or the easier-to-use present value tables. The present value tables give the present value of Re 1 at various rates of return for different numbers of years that you invest. You simply take the number of years and percentage that apply to you, find the


39




present value in the table, and multiply it by the expected income stream figure you determined above. Example: Mr. Kumar has an expected income stream of Rs. 17, 28,245 for a 25-year period and he has chosen inflation adjusted discount rate of 4%. The present value table gives a figure of 0.375 for a 25-year investment at 4 %. Then multiply Rs.17, 28,245 by 0.375 to come up with a human life value of Rs. 6, 48,092. Step 8: Making adjustments to the human life value As discussed, the human life value is not a very precise estimate of the family's actual life insurance needs. It sometimes tends to over estimate the family's insurance needs by not considering other family assets and sources of income that can help support the family if the insured dies. It does not consider other investments, savings accounts etc. that can offset some of your family's life insurance needs. Again, it fails to account for certain large lump-sum expenses that will come up only after the insured's death, such as final medical expenses, funeral and burial costs, estate settlement expenses, mortgage and other debt repayment costs, and college education costs. Step 9: Add in large lump-sum expenses There may be huge expenses in future that are not taken into account by projecting an income stream based on the family's current standard of living. There may be medical costs associated with the insured's death, personal debts such as credit card debts, college loan, automobile loans, and home loans etc. Also children may have future education costs that aren't necessarily part of your current income needs. The income replacement approach can adjust for these expenses by adding them on to your human life value figure. Step 10: Considering differences in income replacement needs during different future periods The amount of income needed for family support may differ over time. The time after the insured's death can be divided into different periods:

Readjustment period

Dependency period

Blackout period

Retirement period We need to make allowances for the varying family support needs during these periods. To account for differing family income needs during these periods, we can estimate a percentage of the insured's income that would be necessary during the different periods. Differences in children's dependency needs and the availability of income from the surviving spouse .factor into the various estimates a you make. Advantages More accurate than the rules of thumb The Human life value approach considers factors like inflation, salary increases, and several factors unique to the family's situation including the breadwinner's remaining work years. Moreover, the income replacement method provides a more accurate estimate of life insurance needs by considering other available assets and sources of income, and some major lump-sum expenses. Relatively easy to understand conceptually


40




Although the calculations involve a number of steps, they are relatively easy to understand conceptually. The idea of maintaining a stream of income is more straightforward than accounting for a long list of expenses in the family needs approach. Disadvantages Requires more involved calculations than some other approaches The income replacement approach calculations involve more steps than the very straightforward rules of thumb and some other methods. Fails to consider family's financial needs in depth The income replacement approach generally assumes that it is sufficient to consider that percentage of income that currently goes towards family support when anticipating the family's future financial needs. There are some adjustments made but it does not examine the future expenses in depth. Thus, this approach is generally less precise than the family needs approach. The life insurance needs analysis is only the initial part of understanding and taking life insurance coverage. The next step is to evaluate which type of policy has to be taken considering each person's requirement and family situations. The first decision has to be made whether a temporary or a permanent life insurance is required. Choice has to be made from term life insurance and its various options or whole life insurance, universal life insurance, endowment plans etc. Choosing the right kind of life insurance policy also involves understanding each individual and his family's needs and goals of taking life insurance coverage. A careful and well throughout decision will give the best benefits to the insured's family.


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UNIT 3

INVESTMENT PLANNING

A. Risk return analysis

B. Asset allocation

C. Derivatives

D. Mutual fund

E. Equity valuation

F. Small saving schemes

G. Bond return & valuation


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Sharpe Ratio Sharpe's performance index gives a single value to be used for the performance ranking of various funds or portfolios. Sharpe index measures the risk premium of the portfolio relative to the total amount of risk in the portfolio. This risk premium is the difference between the portfolio‟s average rate of return and the riskless rate of return. The standard deviation of the portfolio indicates the risk. The index assigns the highest values to assets that have best risk-adjusted average rate of return.

St = Rp – Rf δp Sharpe index = Portfolio average return – Risk free rate of interest Standard deviation of the portfolio return The details of two hypothetical funds A and B are given below Table 1 risk and return for funds A and B

Fund Average Annual Return

Riskless Rate of interest

Standard Deviation

St

A B

0.0879 0.1347

0.05 0.05

0.829 0.1982

0.0879 – 0.05 0.0829 = 0.457 0.1347 - 0.05 0.1982 = .0427

Risk and return of funds A and B

R


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Fund „A‟ Fund “B” δp Fig. 1 The larger the St Better the fund has performed. Thus, A ranked as better fund because its index .457 > .427 even though the portfolio B had a higher return of 13.47 per cent. It is shown in Figure 1. The reason is that the fund 'B's managers took such a great risk to earn the higher returns and its risk adjusted return was not most desirable. Sharpe index can be used to rank the desirability of funds or portfolios, but not the individual assets. The individual asset contains its diversifiable risk. ,.- Treynor Measure To understand the Treynor index, an investor should know the concept of characteristic line. The relationship between a given market return and the fund's return is given by the characteristic line. The funds performance is measured in relation to the market performance. The ideal fund's return rises at a faster rate than the general market performance when the market is moving upwards and its. rate of return declines slowly than the market return, in the decline. The ideal fund may place its fund in the treasury bills or short sell the stock during the decline and earn positive return. The relationship between the ideal fund's rate of return and the market's rate of return is given by the figure 2.

Fund's Rate of Return F U 30 N D Ideal fund S R E 20 T U R


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N 10 -20 -10 0 10 20 30 Market Return Fig. 2 The market return is given on the horizontal axis and the fund's rate of return on the vertical axis. When the market rate of return increases, the fund's rate of return increases more than proportional and vice-versa. In the figure 2 the fund's rate of return is 20 per cent when the market's rate of return is 10per cent, and when the market return is -10, the fund's return is 10per cent. The relationship between the market return and fund' return is assumed to be linear. This linear relationship is shown by the characteristic line. Each fund establishes a performance relationship with the market. The characteristic line can be drawn by plotting the fund‟s rate of return for a given period against the market's return for the same period. The slope of the line reflects the volatility of the fund's return. A steep slope would indicate that the fund is very sensitive to the market performance. If the fund is not so sensitive then the slope would be a slope of less inclination. All the funds have the same slope indicating same level of risk. The investor would prefer A fund, because it offers superior return than funds C and B for the same level of risk exposure. This is shown in [Figure 3] With the help of the characteristic line Treynor measures the performance of the fund. The slope of the line is estimated by Rp = ά + β Rm + ep Rp = Portfolio return Rm= the market return or index return

ep = The error term or the residual ά,β = Co-efficient to be estimated


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Market return and funds return 40 Funds return A 30 B 20 C 10 -30 -20 -10 10 20 30 40 50 60 Market return -10 -20 -30 -40 Fig. 3 Beta co-efficient is treated as a measure of undiversifiable systematic risk. Tn = Portfolio average return- riskless rate of interest Beta co- efficient of portfolio Tn = Rp - Rf

βp Treynor's risk premium of the portfolio is the difference between the average return and the riskless rate of interest. The risk premium depends on the systematic risk assumed in a portfolio. Let us analyse two hypothetical funds. Table 2 Funds A and B

Fund Average return

Beta Risk return Rf Tn


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A B

0.0879 0.1347

0.499 1.2493

0.0379 0.0847

0.05 0.05

0.0879 – 0.05 .499 =0.076 .1347 - .05 1.2493 =0.0678

Performance of Funds ‘A’ and ‘B’ Fund „A‟ 8 0.76 Fund „B‟ 0.68 Rf 5.0 4 0.5 1.0 1.5 δp Fig. 4

The fund 'A' is more desirable than B because it earned more risk premium per unit of systematic risk i.e Tn of A .076 > .0678 of 'B's.


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A. Derivatives

A. Essential Features

Hedging We have seen how one can take a view on the market with the help of index futures. The other benefit of trading in index futures is to hedge your portfolio against the risk of trading. In order to understand how one can protect his portfolio from value erosion, let us take an example. Stocks carry two types of risk- Company specific and market risk. Company specific risk can be reduced through diversification while market risk is reduced through hedging. Beta is the measure of market risk. Beta measures the relationship between movements of the index to the movement of the stock. The beta measures the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, the beta would be 1:1. When the index increases by 10%, the value of the portfolio increases 11%. The strategy of hedging is resorted to with the objective of reducing portfolio beta to zero and reducing the market risk. Hedging involves protecting an existing equity portfolio from future adverse price movements in the stock market. In order to hedge the portfolio, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta. Assuming you have a portfolio of Rs. 20 lacs, which has a beta of 1.2, you can factor a complete hedge by selling Rs. 24 lacs of S&P CNX Nifty Futures. Steps in hedging:

1) Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1.

2) Short sell the index in such a quantum that the gain on a unit decreases in the index would offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings.

Therefore in the above scenario, we have to short sell 1.2*20 lacs-24 lacs worth of Nifty. Now, lets us study the impact on the overall gain/loss that accrues:

Index goes up by 10% Index goes down by 10%

Gain/(loss) in portfolio 2,40,000 (2,40,000)

Gain/(loss) in futures (2,40,000) 2,40,000

Net effect NIL NIL

As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment. But as a cost, one has to forego any gain that arises out of improvement in the overall sentiment. Then, why does one invest in equities in all the gains will be offset by losses in future market? The idea is that everyone expects his portfolio to outperform the market. Irrespective of whether the market goes up or not, his portfolio value would increase. The same methodology can be applied to a single stock by deriving the beta of eh scrip and taking a reverse position in the futures market.


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Thus, we have seen how one can use hedging in the futures market to offset losses in the cash market. Speculation Speculations are those who do not have any position in which they enter in futures and options market. They only have a particular view on the market, commodity, etc. In short, speculations put their money at risk in the hope of profiting from an anticipating price change. They consider various factors such as demand supply, market positions, open interests, economic fundamentals and other data to take their positions. Example: Kirti is a trader but has no time to track and analyze stocks. However, he fancies his chances I predicting the market trend. So, instead of buying different stocks he buys nifty features. On September 1, 2009 he buys 100 nifty futures @3400 on expectations that the index will rise in future. On September 16, 2009 Nifty rises to 3460 and at that time he sells Nifty futures and squares his position. Selling price: 3460*100= Rs. 346000 Less: Purchase cost: 3400*100= Rs. 340000 Net gain= Rs. 6000 Kirti has made a profit of Rs. 6000 by taking a call on the future value of the Nifty. However, if Nifty had fallen he would have made a loss. Similarly, if Kirti had a bearish view on the market he could have sold Nifty futures and bought the same back after the expected market fall and made a profit from a falling market. Arbitrage An arbitrage is basically risk averse. He enters into those contracts where he can earn risk less profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives risk less profit. Arbitrageurs are always on the look out for such imperfections. In the future market, one can take advantages of arbitrage opportunities by buying from lower prices market and selling at the higher priced market. In index futures, arbitrage is possible between the spot market and the future market (NSE has provided special software for buying all 50 Nifty stocks in the spot market)

Take the case of the NSE Nifty.

Assume that Nifty is at 3400 and 3 month‟s Nifty futures is at 3500.

The futures price of Nifty futures can be worked out by taking the interest cost of 3 months into account.

If there is a difference then arbitrage opportunity exists.

If we assume 8% interest rate then Nifty three months futures should be quoting at Rs. 3468 but is actually quoting at Rs. 3500, which is higher than the correct price thus providing an arbitrageur an opportunity-he will sell 3 months futures at 3500 and buy spot at 3400 and


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should make Rs. 32 per Nifty because of the difference between the actual price and the correct price. These kinds of imperfections continue to exist in the markets but one has to be alert to the opportunities as they tend to get exhausted very fast. Pricing of index futures The index futures are the most popular futures contracts as they can be used in a variety of ways by various participants in the market. The cost of carry Model The cost of carry model where the price of the contract is defined as: F= S+C Where, F= Future price, S= Spot price, C= Holding costs or carry costs If F< S+C or F>S+C, arbitrage opportunities would exist i.e. whenever the future prices moves away from the far value, there would be chances for arbitrage. If Nifty is quoting at Rs. 3400 and the 3 months future of Nifty is Rs. 3500 then one can purchase Nifty at Rs. 3400 in spot by borrowing @ 8% per annum for 3 months and sell Nifty future for 3 months at Rs. 3500. Here F= 3400+68= 3468 and is less than prevailing future price and hence, there are chances of arbitrage. Sale= 3500 Cost= 3400+68= 3468 Arbitrage Profit= 32 However, one has to remember that the components of holding cost vary with contracts on different assets. Futures pricing in case of dividend yield We have seen how we have to consider the cost of finance to arrive at the futures index value. However, the cost of finance has to be adjusted for benefits of dividends and interest income. In the case of equity futures, the holding cost is the cost of financing minus the dividend returns. Example Suppose a stock portfolio has a value of Rs. 100 and has a annual dividend yield of 3% which is earned throughout the year and finance rate is 12%.The fair value of the stock index portfolio after one year will be: F= Rs. 100+Rs. 100* (0.12-0.03) Future price-Rs. 109


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If the actual future price of one year contract is Rs. 112 an arbitrageur can buy the stock at Rs. 100, borrowing the fund at the rate of 12% and simultaneously at Rs. 112. At the end of the year, the arbitrageur would collect Rs. 3 for dividends, deliver the stock portfolio at Rs. 112 and repay the loan of Rs. 100 and interest of Rs. 12. The net profit would be Rs. 112+Rs. 3-Rs. 100-Rs. 2= Rs. 3 Thus, we can arrive at the fair value in the case of dividend yield Options The markets are volatile and huge amount of money can be made or lost in very little time. Derivatives products are structured precisely for this reason- to curtail the risk exposure of an investor. Index futures and stock options are instruments that enable an investor to hedge his portfolio or open positions in the market. Options contracts allow an investor to run his profits while restricting his downside risk. Apart from risk containment, options can be used for speculation and investors can create a wide range of potential profit scenarios. What are options? Some people remain puzzled by options. The trust is that most people have been using options for some time, because options are built into everything from mortgages to insurance. An option is a contract, which gives the buyer the right, but not the obligations to buy or sell shares of the underlying security at a specific price on or before a specific date. „Option‟ as a word suggest, is a choice given to the investor to either honour the contract; or not if the chooses to walk away from the contract. To begin, there are two kinds of options; Call option and put options. A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, call options are like security deposits. If for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you have no other liability. Call options usually increases in value as the value of the underlying instrument rises. When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium. Put options are options to sell at a specific price on or before a certain date. In this way, put options are like insurance policies. If you buy a new car and then buy auto insurance on the car, you pay a premium and are, hence, protected if the car is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains as the value of the underlying instrument decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.


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With a Put option, you can “issue” a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, “damages” your asset, you can exercise your option and sell it at its “insured” price level. If the price of your stock goes up, and there is no “damage”, then you do not need to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed options to allow investors ways to manage risk. Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. The seller accepts an obligation for which he receives a fee. Example Now let us see how one can profit from buying an option. Mr. Shah Feels that the market will go up. He is bullish on Nifty but he does not want to lose money if he is turned wrong and if the market goes down.

He buys an options contract September 2006 Nifty for a strike price of 3450 paying a premium of Rs. 50.

In about 15 days time Nifty goes up and therefore he sell the option for Rs. 75 making a profit of Rs. 25 per Nifty.

The contract size being 100, he will make a profit of Rs. 25*100= Rs. 2500/-.

If he had not sold and if the Nifty had gone up further, he would have made ever more profits.

If the Nifty were to fall, his maximum loss would have been restricted to Rs. 50*100= Rs. 5000/- which is the premium paid by him for having bought the cal, option.

Thus, you can see that the profit potential in a call option is unlimited while the loss is limited to the actual premium paid.

Call Options –Long & short Positions When you expect prices to rise, then you take a long position by buying calls. You are bullish. When you expect prices to fall, then you take a short position by selling calls. You are bearish. Put Options A put option gives the holder the right to sell a specific number of shares of an agreed security at a fixed price for a period of time. Example Mr. Dutt purchases one contract of infoysys technologies September 2006 1800 put-premium Rs. 50 (contract size 100 Shares) This contract allows Mr. Dutt to sell 100 shares infoysys technologies at Rs. 1800 share at any time between the current date and the expiry of September 2006 series. To have this privilege, Mr. Dutt pays a premium of Rs. 5000 (Rs. 50 a share for 100 shares). He will make a profit if the share price of infoysys technologies falls during this period. He has the potential to make high profits as there is a potential for the stock price to fall by any


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amount but in case the price of the share goes up, he will suffer a loss but the loss will be limited to Rs. 5000/- premium paid by him. For purchasing the right to sell (buy a put option). The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell. Put Options- Long & Short Positions When you expect prices to fall, then you take a long position by buying puts. You are bearish. When you expect prices to rise, then you take a short position by selling puts. You are bullish. The following table wills summaries the actions to be taken depending upon your view on the stock price:

Your view/Type of option Call option Put Option

You expect fall in prices (bearish)

Sell Buy

You expect fall in prices (bullish)

Buy Sell

Summary:

CALL OPTION BUYER CALL OPTION WRITTER (SELLER)

Pays the premium Receives the premium

Right to exercise and buy the shares Obligation to sell shares if exercised

Profits from rising prices Profits from falling prices or remaining stable premium

Limited losses potential to earn unlimited premium profits

Potentially unlimited losses, limited gains

PUT OPTION BUYER PUT OPTION WRITTER (SELLER)

Pays the premium Receives the premium

Right to exercise and buy the shares Obligation to sell shares if exercised

Profits from falling prices Profits from falling prices or remaining stable

Option Styles Settlement of options is based on the expiry date. However, there are three basic styles of options you will encounter which effect settlement. The styles have geographical names, which have nothing to do with the location where a contract is agreed. The styles are: European: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument only on the expiry date. This means that the option cannot be exercised early. Settlement is based on a particular strike price at expiration. Currently, in India only index options are European nature.


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Example: Mr. Dutt. Purchases 1 Nifty September 2006 6450 call-premium 20. The exchange will settle the contract on the last Thursday of August. Since there are no shares for the underlying, the contract is cash settled. American: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument on or before the expiry date. This means that the option can be exercised early. Settlement is based on a particular strike price at expiration. Options in stocks that have been recently launched in the Indian Market are “American Options” while the options on the index are “European Options.” Example: Mr. Patel purchases 1 Tata Steel September 06-520 call, premium 20 Here Mr. Patel can close the contract any time from the current date till the expiration date, which is the last Thursday of September American style options tend to be more expensive than European style because they offer greater flexibility to the buyer. Option Class& Series Generally, for each underlying, there are a number of options available: For this reason, we have the terms “class” and “series”. An option “class” refers to all options of the same type (call or put) and style (American or European) that also have the same underlying. Example: All Nifty call options are referred to as one class. An option series refers to all options that are identical: they are the same type, have the same underlying, the same expiration date and the same exercise price. Example: ACC SEP 2006 900 refers to one series and trades take place at different premiums


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B. Small Savings Schemes Small is big, at least with small savings in India. Over the years, small savings schemes have become a favorite of Indian household. Such is the popularly of these schemes that it will probably be difficult to find an investing household not having any investment is small savings schemes. Small savings schemes are designed to provide safe & attractive investment options to the public and at the same time to mobiles resources for development. Traditionally schemes like public provident fund and National Saving Certificate have been associated with attractive returns and tax benefits. Most importantly these schemes offer assured returns thereby appealing to a large section of the investor community. National Savings Organization (NSO) is responsible for national level promotion of small savings scheme. Over the years small savings scheme has grown big. These schemes are primarily meant for small urban and rural investors. Institutions are not eligible to invest in major small savings schemes. Non- residential Indians (NRIs) are also not eligible to invest in savings schemes. The following schemes come under small savings schemes:-

Post office Savings Account Post office time Deposit Account 5 years post office Recurring Deposit Account Kisan Vikas Patra National Savings Certificate (VIII issue) Post office Monthly Income Account 15 years Public Provident Fund Account Deposit Scheme for retiring Govt. Employees. Deposit Scheme for Retiring Employees of public Sector Companies 1991

1. Post office Savings Account

Post office savings accounts can be opened by any of the following:

a. For a single account any individual who is 18 years and above, a minor who has attained the age of 10 years, a guardian on behalf of a minor and guardian of a person of unsound mind.

b. A joint account of two-three adults jointly. c. A pensioner to receive/credit his monthly pension. d. Group Accounts by provident fund, Superannuation fund or gratuity fund. e. Public accounts by a local authority/body. f. An employee, contractor, or agent of a government company or of a university for

depositing security amounts. g. A Gazettled officer or an officer of a government company or corporation of

Reserve Bank of India or of a local authority in his official capacity. h. A corporative society or a cooperative bank for payment of pay, leave salary,

pension contribution of government servants on deputation with such society or bank.

It can be opened at any Head/Sub post office. Account can be opened with a minimum of Rs. 20. However, the balance that can be

kept is the maximum of rupees one lakh for single holder and Rs. Two lakhs for joint holders. If depositors have more than one account (single, pension or joint), the


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balances or shares of balances in all such accounts taken together should not exceed Rs. One lakh for each of the depositors.

There is no lock-in/maturity prescribed. Withdrawals can be for any amount subject to keeping a minimum balance of Rs. 50

in simple and Rs. 500 for cheque facility accounts. No withdrawal or deposit can be for a sum of less than Rs. 5.

Interest according to the rate (s) as decided by the central Government from time to time is calculated on monthly balances and credited annually.

Interest rate applicable w.e.f. 1.3.2001 is 3.5 per cent/per annum for general public. Interest income exempted from Income tax u/s 10 of IT Act 1961.

2. Post office time Deposit Account

The following are permitted to open post office time deposit accounts: a. A single adult or two adults jointly. b. A pensioner to receive/credit his monthly pension. c. Group accounts by provident fund, Superannuation fund or Gratuity fund,

Authority controlling funds of the Sanchakiya. d. Public account by a local authority/body. e. Institutional Accounts by the treasurer of charitable Endowments for India, Trust

Regimental fund & Welfare Fund. f. A corporative society. Cooperative bank or scheduled bank on behalf of its

members, clients or employees. g. Gazetted officer in his official capacity.

It can be opened in any head/ sub post office. The size of the deposit is minimum of Rs. 200 with no maximum limit. The maturity period can be for any of the following tenors; 1 year, 2 years, 3 years, or

5 years. Interest is calculated on quarterly compounding basis but is payable annually. At present the rate of interest per annum as per the period of deposit is as follows:

Period of Deposit Rate of Interest/annum

One year 6.25%

Two year 6.50%

Three year 7.25%

Five Year 7.50%

Premature withdrawals from all types of post office Time Deposit accounts are

permissible after expiry of 6 months with certain conditions. Post maturity interest “at the rate applicable to the post office savings from time to

time”, is payable for a maximum period of 2 years. There is no tax deduction at source. Income tax benefit is available under section 80C.

3. Post office Recurring Deposit Account

The following can open a post office recurring deposit account:- a. A single adult or two adults jointly. b. A guardian on behalf of a minor or a person of unsound mind. c. A minor who has attained the age of ten year, in his own name.


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It can be opened at any head/sub post office. The period of maturity of an account is five years. Sixty equal monthly deposits shall be made in an account in multiples of Rs. Five

subject to a minimum of ten rupees. Accounts with not more four defaults in deposits can be regularized within a period of

two months on payment of a default fee. Accounts become discontinued after more than four defaults. To a subscriber of Rs. 10 per month the maturity amount inclusive of interest shall be

Rs. 728.90 (accounts opened after 1st March 2003). Premature closure of accounts is permissible after expiry of three years provided that

interest at the rate applicable to the post office savings account shall be payable on such premature closure of account.

After maturity the maximum it can be extended for five years.

4. Post office Monthly Income Account

Can be opened by a single adult or 2-3 adults jointly. More than one account can be opened subject to maximum deposit limits. Can be opened at any head/sub post office. The period of maturity is 6 years. Only one deposit can be made in an account. Minimum size of a deposit is Rs. One thousand and the maximum is rupees three

lakhs in case of single and rupees six lakhs in case of joint account. Deposits in all accounts taken together shall not exceed Rs. Three lakhs in single account and Rs. Six lakhs in joint account. The depositor‟s shares in the balances of joint accounts shall be taken as on half or one third of such balance according as the account is held by 2 or 3 adults.

Interest @ 8 per cent/per annum, payable monthly in respect of the accounts opened on or after the 1st march, 2003. In addition, bonus equal to five per cent of the deposited amount is payable at the time of repayment on maturity.

Premature closure facility is available after one year subject to condition. Account shall be closed after expiry of 6 years; bonus equal to five per cent of

deposits shall be paid along with principal amount.

5. National Savings Certificate (VIII issue)

National Savings certificate can be purchased by the following classes of persons: a. An adult in his own name or on behalf of a minor. b. A minor c. A trust d. Two adults jointly e. Hindu undivided family.

It is available for purchase/issue at post offices. The period of maturity of a certificate is six years. Nomination facility is available. Certificates can be transferred from one post office to any other post office. Transfer from one person to another person permissible in certain conditions. Certificates are available in denominations (face value) of Rs. 100, Rs. 500, Rs.

1000, Rs. 5000 & Rs. 10000. There is no maximum limit for purchase of the certificates.

With effect from 1st March, 2003, Maturity value of a certificate of Rs. 100 domination is Rs. 160.10. Maturity value of a certificate of any other denomination shall be at proportionate rate. The stated rate of interest is 8% p.a.


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Interest accrued on the certificates every year is liable to income tax but deemed to have been reinvested. The investment is eligible for rebate u/s 80C of IT Act. Annual accrued interest is also eligible for rebate U/s 80C of IT Act 1961.

Premature encashment of the certificate is not permissible except at a discount in the case of death of the holder(s), forfeiture by a pledge and when ordered by a court of law.

In can be encashed/discharged at the post office where it is registered or any other post office.


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C. BOND RETURN AND VALUATION Debt instruments are the cherished conduit for investor's money. An assured return and high interest rate are responsible for the preference of bonds over equities. The year 1996-97 witnessed hectic trading in the debt market, as resource mobilisation reached a record level of almost Rs 25,000 crores which is much above the equity segment. In the first seven months of the fiscal year 1998-99, the funds mobilised by ICICI (Four debt issues) and IDBI have accounted for 90 per cent of Rs. 3175 crores mopped in primary market. Financial institutions, banks and corporate bodies are offering attractive bonds like retirement bonds, education bonds, deep discount bonds, encash bonds, money multiplier bonds and index bonds. In this chapter the risk, the yield to maturity the duration and bond immunization is given in detail. BOND BASICS A bond is a contract that requires the borrower to pay the interest income to the lender. It resembles the promissory note and issued by the government and corporate. The par value of the bond indicates the face value of the bond i.e. the value stated on the bond paper. Generally, the face values of bonds are Rs 1, 000, 2000, 5,000 and alike. Most of the bonds make fixed interest payment till the maturity period. This specific rate of interest is known as coupon rate. Coupons are paid quarterly, semi-annually and annually. At the end of maturity period, the value is repaid. Bond risk Generally stocks are considered to be risky but bonds are not. This is not fully correct. Bonds do have risk but the nature and types of risks may be different. The risks are interest rate, default, marketability, and callability risks. Interest rate risk Variability in the return from the debt instruments to investors is caused by the changes in the market interest rate. This is known as interest rate risk. Changes that occur in interest rate affect the bonds more directly than the equity. There is a relationship between the coupon rate and market interest rate. If the market interest rate moves up, the price of the bond declines and vice versa. For example, If one holds a 14.50 per cent bond and the market interest rate falls, from 14per cent to 13 per cent, the bond value would be higher. In contrast, if the market interest rate goes upto 15 per cent, the price would decline to offer the buyer a yield that is proximate to the market interest rate. Default risk The failure to pay the agreed value of the debt instrument by the issuer in full, on time or both are the default risk. Treasury bills and bonds issued by the Central Government are devoid of this risk. The same cannot be assured of bonds/debentures issued by any other corporate bodies. The default risk occurs because of macro economic factors or firm specific factors. The macro economic factors affect the overall system. A number of small firms found the going difficult in 1995-96 because of high interest rates in 1994 and 1995. In the case of CRB Capital Market, the bankruptcy had more to do with the firm specific factors - inefficient management rather than macro economic factors. In order to avoid the default risk, the capacity to serve the debt by the company is rated by rating agencies. Regulators like: Reserve Bank of India and Securities and Exchange Board of India often use credit rating to determine the eligibility of the fixed income instruments. Credit Rating Information Services of India Limited (CRISIL), Investment Information and Credit Rating Agency of India Limited (ICRA) and Credit Analysis and Research Limited


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(CARE) are rating the bonds and other fixed income securities. In the international bond market, Moody's Investor Service and Standard and Poor's ratings are famous. Marketability risk Variation in return caused by the difficulty in selling the bonds quickly without having to make a substantial price concession is known as marketability risk. This risk is different from the market risk that affects all securities in the market but, marketability risk is a specific risk. The marketability or liquidity of the particular bond depends on the corporate who issues the bond. There is a possibility of a particular company's bond becoming illiquid due to the down-grading of bond's rating by the rating agencies. The managerial inefficiencies and fall in the profits may create a fear in the minds of the investors and they may not be willing to buy such bonds in the secondary market. Sometimes, a particular instrument of a company whose other instruments enjoy good liquidity may be illiquid. If an investor has to sell such illiquid investments, he may be forced to sell it at a high discount. For example, the bonds/debentures issued by Reliance Industries enjoy high liquidity, but the same may not be true of the debentures issued by the smaller companies. Thus liquidity of the particular bond or debenture depends on the corporate image. Callability risk The uncertainty created in the investor's return by the issuer's ability to call the bond at any time is known as call ability risk. Debt instruments used to carry call option. The call option provides the issuer the right to call back the instruments by redeeming them. This facility provides a way out for the issuer if the interest rate declines. The issuer can call the bond with high interest rate and again raise funds at a lower interest rate. Since, the bond or debenture can be called at any time there is an uncertainty regarding the maturity period. This feature of the bond may depress the price level of the bond and the uncertainty element attached with the callable bonds make the investors to ask for higher yields. THE TIME VALUE CONCEPT The time value concept of money is that the rupee received today is more valuable than a rupee received tomorrow. The investor will postpone current consumption only if he could earn more future consumption opportunities through investment. Individuals generally prefer current consumption to future consumption. If there is inflation in the economy, a rupee today will represent more purchasing power than a rupee at a future date. Interest is the rent paid to the owners to part their money. The interest that the borrower pays to the lender causes the money to have future value different from its present value. The time value of money makes the rupee invested today grow more than a rupee in the future. To quantify this concept mathematically compounding and discounting principles are used. The one period future time value of money is money is given by the equation: Future value= Present Value (1 + interest rate). If hundred rupees are put in a savings bank account in a bank for one year, the future value of money will be:

Future Value = Rs 100 (1.0+6%) = 100 x 1.06 = Rs 106.

If the deposited money is allowed to cumulate for more than one time, the period exponent is added to the previous equation.

Future Value = Present Value (1 + interest rate) t t - the number of time periods the deposited money accumulates as interest. Suppose Rs 100 is put for two years at the 6% rate of interest, money will grow to be Rs 112.36.


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Future value = (Present Value) (1 + interest rate) 2

= 100 (l + .06)2 = 100 (1.1236) = 112.36.

To find out the values in a simple manner, the compound sum of Re.1 at the end of a period FVIF1, /K, n and compound sum of an annuity of Re.1 per period FVIFA tables are given in the appendix 1. THE PRESENT VALUE The present value of money can be found simply by reversing the earlier equation.

Present value X (1 + interest rate) = Future value Present value=Future value 1+ interest rate Here, the discounting principle is used. Today's worth of Rs 100 to be received after a year at 10 per cent interest would be:

Present value =Future value 1+ interest rate

Here, the discounting principle is used. Today‟s worth of Rs. 100 to be received after a year at 10% interest would be:

Present value =Future value 1+ interest rate =100__ = 100 1+.10 1.1

=Rs.90.90 The multiple period of present value equation takes in to account of the multiple periods.

Present value=Future value (1+ interest rate) t To make the calculation easier, the present value ofRe.1: PVIF ==1/ (1 +K) t and present value of annuity of Re.1 per period. BOND RETURN Holding period return An investor buys a bond and sells it after holding for a period. The rate of return in that holding period is:

Price gain or loss during the holding Holding period return = Period + Coupon Interest rate , if any Price at the beginning of the holding period


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The holding period rate of return is also called the one period rate of return. This holding period return can be calculated daily or monthly or annually. If the fall in the bond price is greater than the coupon payment the holding period return will turn to be negative. Example 10.1

a) An investor 'A‟ purchased a bond at a price of Rs 900 with Rs 100as coupon payment and sold it at Rs 1000. What is his holding period return?

b) If the bond is sold for Rs 750 after receiving Rs 100 as coupon payment, then what is the holding period return?

Solution (a) Holding period return = Price gain + coupon payment = Purchase price

=100 + 100 = 200 = .2222

900 900 Holding period return =22.22 % (b)

Holding period return = Gain or loss + Coupon payment Purchase price

= -150+100 = -50 =-.0555

900 900 Holding period return = -5.5%. The current yield The current yield is the coupon payment a~ a percentage of current market price,

Annual coupon payment Current yield =-----------------------------------------

Current market price With this measure the investors can fmd out the rate of cash flow from their investments every year. The current yield differs from the coupon rate, since the market price differs from the face value of the bond. When the bond's face value and market price are same, the coupon rate and the current yield would be the same. For example, when the coupon payment is 8% for Rs.l00 bond with the same market price, the current yield is 8%. If the current market price is RS.80 then the current yield would be 10%.


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Roots Institute of Financial Markets

(RIFM)

“Every effort has been made to avoid any errors or omission in this book. In spite of this error may creep in. Any mistake, error or discrepancy noted may be brought to our notice, which, shall be taken care of in the next printing. It is notified that neither the publisher nor the author or seller will be responsible for any damage or loss of action to anyone of any kind, in any manner, therefrom. ROOTS Institute of Financial Markets, its directors, author(s), or any other persons involved in the preparation of this publication expressly disclaim all and any contractual, tortuous, or other form of liability to any person (purchaser of this publication or not) in respect of the publication and any consequences arising from its use, including any omission made, by any person in reliance upon the whole or any part of the contents of this publication. No person should act on the basis of the material contained in the publication without considering and taking professional advice.

Helpful Books from RIFM NCFM Modules Practice Books (about 500 Questions per Module)


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Cost ` 600 Per Module 1. FINANCIAL MARKETS: A BEGINNERS MODULE

2. SECURITIES MARKET (BASIC) MODULE

3. CAPITAL MARKET (DEALERS) MODULE

4. DERIVATIVES MARKET (DEALERS) MODULE

5. COMMODITIES MARKET MODULE

6. INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

7. OPTION TRADING STRATEGIES

NISM Modules Practice Books (about 500 Questions per Module) Cost ` 600 Per Module

1. MUTUAL FUND DISTRIBUTORS CERTIFICATION EXAMINATION

2. CURRENCY DERIVATIVES CERTIFICATION EXAMINATION

CFP Certification Modules ---Study Notes (Detailed Study notes as per FPSB syllabus) Cost ` 1000 Per Module

1. INTRODUCTION TO FINANCIAL PLANNING

2. INVESTMENT PLANNING

3. RISK ANALYSIS OF FINANCIAL PLANNING

4. RETIREMENT PLANNING

5. TAX PLANNING

CFP Certification Modules ---Practice Books (about 800 Questions per Module) Cost ` 1000 Per Module

1. INTRODUCTION TO FINANCIAL PLANNING

2. INVESTMENT PLANNING

3. RISK ANALYSIS OF FINANCIAL PLANNING

4. RETIREMENT PLANNING

5. TAX PLANNING

Advance Financial Planning Module---

Practice Book & Study Notes (Cost ` 5000/-)

Roots Institute of Financial Markets (RIFM) 1197 NHBC Mahavir Dal Road. Panipat. 132103 Haryana.


Web www.rifm.in

http://nseindia.com/content/ncfm/ncfm_nism_modules.htm#5

http://nseindia.com/content/ncfm/ncfm_nism_modules.htm#1

advance financial planning study notes part 1

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