NISM SERIES XB - INVESTMENT

ADVISER LEVEL 2 EXAM

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NISM XB – INVESTMENT ADVISER (LEVEL 2)

CERTIFICATION EXAMINATION

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I. Understanding Securities Market and Performance

Working of the Equity Markets

Primary Markets

Primary market refers to the market where equity shares of a company are issued for the first time to the public for
raising resources for the company. New shareholders are able to contribute to the capital of a company by
participating in the primary issue of shares by a company. A public offer is open to three categories of investors:

 QIB (Qualified Institutional Buyers): Mutual Funds, FPIs, Pension Funds, Insurance Funds
 HNI (High Net worth Individuals): Buyers investing more than Rs.2 Lakhs
 Retail Investors: Buyers investing up to Rs.2 Lakhs

Modes of Issue:

 IPO: Fresh issue of shares

 FPO: Additional shares are offered to the public
 Rights Issue: Shares are offered to existing investors
 OFS: Shares held by existing investors are offered to public shareholders

Primary Market Regulations

1. Book building versus Fixed Price Issue

Fixed Price Issue: A public issue of shares may be made at a fixed price decided by the issuer and the lead manager.
The rationale for the price so decided is clearly explained in the offer document and will include qualitative factors
Book Building Issue: the issuer indicates the price band or a base or floor price and investors bid for the desired
quantity of shares at a price within the specified band. On closure of the issue, the cut-off price is determined as the
price at which the issue gets fully subscribed.

2. A public issue has opening and closing dates, and is expected to garner the stipulated minimum subscription.
An initial public offer shall be kept open for at least three working days and not more than ten working days.
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3. The registrars to an issue process applications from investors in an issue; keep proper record of applications
and money received from investors; and assist the issuer in creating investor records, executing the
allotment of shares into the demat account of investors, and sending refund orders for partial allotment, and
non-allotment.

4. The price at which shares list and trade on the secondary markets may be at a premium or discount to the
issue price.

Leveraged investing in an IPO is a short-term investing practice of using borrowed funds to invest with the
expectation of making immediate short-term gains from the shares being listed at a premium to the issue price.
There is however no assurance of a higher listing price. IPOs can list at a premium or discount to the issue price.

Secondary Markets

The secondary market or the stock exchange is the place where shares once issued can be bought or sold between
investors. Secondary markets provide liquidity to equity investments so that investors may sell the equity shares
they hold or buy more equity shares, at any time. Secondary market transactions by investors involve executing the
trade and settling the obligations that arise from the transaction. The obligations will involve transfer of funds and
securities between the parties to the trade.

Electronic Trading: Modern stock markets are electronically enabled for convergence of investors. Buyers and sellers
enter their trades on the trading terminals of their broker which transmits it to the entire trading network of the
stock exchange. The system electronically matches buy and sell orders so that buy orders are executed at the price
specified or lower and sell orders at the price specified or higher. A price-time priority is followed in executing
orders. The order can be a market order, a limit order or an immediate or cancelled order.

Start from clearing corporation: Buyers of shares are expected to provide funds for their purchase and sellers are
expected to deliver the shares they have sold. After the pay-in is completed the pay-out takes place when the buyer
receives the securities and the seller receives the funds for shares sold. A clearing corporation (CCP) takes care of
this process of exchange of funds and shares which is called settlement.

Interoperability: SEBI has allowed ‘interoperability’ which addresses the current suboptimal utilization of margin and
capital resources in the securities market, by linking the CCPs and allowing market participants to consolidate their
clearing and settlement function at a single CCP, irrespective of the stock exchange on which the trade is executed.
This would lead to efficient allocation of capital for the market participants, thereby saving on cost as well as provide
better execution of trades.

Settlement Calendar: Securities can be settled in rolling settlement, institutional segment or on a trade-for-trade
(TT) basis. Institutional and TT segments settle in T+2 days, on a trade basis. This means every trade has to be settled
and positions will not be netted. Most trades are settled on a rolling basis

Margin Trading: Margin trading is a facility provided by members of stock exchanges to their clients to leverage their
short term investments in the secondary markets, by providing a borrowing facility for funds. It allows investors to
take a larger position than what their own resources would allow, thus increasing their profits if their expectation of
price movements came true.
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Equity Market Indicators

A market index is a basket of equity shares whose price is weighted by market capitalization, and tracked for changes
in price level of the stocks included in it. An index enables an overall understanding of the direction of equity
markets. They are often used as performance benchmarks. In India, the benchmark indices. There are several indices
that have been constructed to track equity markets.

 Narrow Belt Weathers: These are indices made up of a few large listed shares, but serve as a quick
barometer of market movement. Ex: Nifty 50, Sensex
 Broad Indices: These indices track a large basket of stocks. Ex: BSE 500
 Sectorial Indices: These are indices created to track various industry sectors such as technology, banking,
metals, finance, real estate, consumer durables, media and the like.
 Other Market Indicators: Other market indicators that provide information on liquidity and trading activity
in the stock market are:

1. Volume Traded or Turnover

2. Top gainers and Losers
3. 52 Week High or Low
4. Circuit Breakers
5. Price bands

Valuation Indicators

PE Ratio: The most common stock valuation measure used by analysts is the price to earnings ratio, or P/E. To
compute this figure, take the stock price and divide it by the EPS figure. Historical or trailing P/Es are computed by
taking the current price divided by the sum of the EPS for the last four quarters. A company with a high P/E ratio will
eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will need to
drop.

PEG Ratio: This stands for Price Earnings to Growth Ratio. This valuation measure takes three factors into account -
the price, earnings and earnings growth rates. This ratio may be used to express the extent to which price that an
investor is willing to pay for a company, is justified by the growth in earnings.

PEG Ratio: PE Ratio/EPS

Price to Book Value Ratio: Price to Book Value (P/BV) is a valuation ratio used by investors, which compares a stock's
price per share (market value) to its book value (shareholders' equity). The P/BV ratio is an indication of how much
shareholders are paying for the net assets of a company.

P/BV Ratio: Stock Price per Share/ Shareholders’ Equity per Share

Dividend Yield: Dividend is declared as a percentage of the face value of the shares. The dividend yield of a share is
inversely related to its share price. If the price of equity shares moves up, the dividend yield comes down, and vice
versa. Dividend yields are also used as broad levels with which to measure market cycles.
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Thumb Rules and their Limitations

High Dividend Yield: Stocks with high dividend yield appeal to investors who are income seeking and are averse to
risky investments. Companies with good growth prospects may be wary of paying high dividends, but may instead
like to use the profits for funding their growth.

Low Price Earnings Multiples: Stocks with low PE multiples are seen as being cheap, mispriced or undervalued.
However, the low PEs may reflect the higher risk associated with the earnings, or lower expected growth rate in
earnings, or both.

Low Price Book Value: Stocks whose market price is lower than book value are considered cheap, because
accounting measures of book value may be conservative. Therefore conceptually, a stock can sell at a discount to its
book value only if its return on equity is lower than the cost of equity, or the expected earnings growth rate is too
low.

Fundamental Analysis

Fundamental analysis is about understanding the quantitative and qualitative factors that impact earnings of a
company and make an estimate of future earnings based on this analysis. Analysts follow two broad approaches to
fundamental analysis – top down and bottom up.
Fundamental Analysis takes the following factors into consideration:
 Economic Factors like GDP, interest rates, Consumption, Global Factors etc.
 Industry Factors like Regulations, Entry Barriers, Cost, Seasonal Factors etc.
 Company Factors like Cost, Margins, Management, and Business strength

Technical Analysis

Technical analysis involves studying the price and volume patterns to understand how buyers and sellers are valuing
a stock and acting on such valuation. The three essentials of technical analysis are history of past prices, volume of
trading and time span. Technical analysis integrates these three elements into price charts, points of support and
resistance in charts and price trends. By observing price and volume patterns, technical analysts try to understand if
there is adequate buying interest that may take prices up, or vice versa.

Options used while investing in Equity Instruments

1. Direct Investments: The research and evaluation is done by the investor who decides on what to invest in
and the timing for entry and exit. The stocks are bought in the name of the investor and held in their demat
account. The costs of transaction and taxes are borne directly by the investor. Managing a portfolio may
require time and skills beyond most investors.

2. Investment through Portfolio Management Services: Investors can choose to invest through a Portfolio
Management Service (PMS) offered by banks, broking houses, mutual funds and others. The service can
either be a discretionary PMS, where the portfolio manager manages the portfolio in alignment with the
investor’s requirement or a non-discretionary PMS where the portfolio manager will provide advice and
information to the investor who will themselves take the decisions on investment choices and timing of the
investment.
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3. Investment through Equity Mutual Funds: Mutual funds are portfolios that are created and managed
according to stated investment objectives. Equity funds invest in equity instruments to meet the objective of
growth. The construction of the portfolio is as per the regulations that ensure a minimum level of
diversification and risk mitigation. It is managed by professional fund managers who make and monitor the
investment decisions.

Debt Markets

Short-term debt markets enable lending and borrowing funds up to a tenor of one year. Instruments in the short-
term market can be classified under two heads:

 Money Market Instruments

 Short-Term Instruments

Collateralized Borrowing and Lending Obligation: Collateralized Borrowing and Lending obligation (CBLO) is a short-
term instrument used to lend or borrow for periods ranging from overnight to one year against the collateral of
eligible debt securities. CBLOs were introduced in order to accommodate participants without access to the call
money market. Mutual funds are among the biggest lenders in the CBLO segment.

Treasury Bills: Treasury bills are short-term instruments issued by the RBI on behalf of the government. T-bills are
issued by the RBI every week through an auction. They are issued at a discount and redeemed at par value. They are
currently issued for maturities of 91-days, 182-days and 364-days.The government issues T-bills for two broad
purposes:
 To meet short-term requirements for funds.
 As part of the Market Stabilisation Scheme (MSS).

Certificates of Deposits: CDs are predominantly issued by banks, to meet short-term requirements of funds. They
can be issued for maturities up to 364 days. Rates on CDs are similar to bank deposit rates of the same tenor, except
that they are not transactions between the bank and the depositor, but a security issued by the bank and bought by
the customer.

Commercial Paper: Commercial Papers (CPs) are issued to meet the short term funding needs of companies, primary
dealers and financial institutions. They can be issued for maturities between a minimum of 7 days and a maximum of
one year from the date of issue, but the 90-day CP is most commonly issued.

Bonds with residual maturities less than a year: When longer-term bonds are close to their maturity dates, they no
longer exhibit fluctuations in price. The duration of such bonds is low and so is the price sensitivity to changes in
discount rates.

Securitized Instruments: There are several lenders in the market who receive periodic cash flows from their
borrowers. These primary lenders are usually finance companies and banks who receive repayments of car loans,
home loans, truck loans and other loans in the form of equated monthly installments (EMIs). These installments
include both principal and interest.

Government Securities: Government securities are issued by the RBI on behalf of the government. The government
resorts to market borrowings as a means to bridge the fiscal deficit. An estimate of the market borrowing of the
government is announced along with the deficit numbers. The market borrowing program has grown significantly
over the years. Gross borrowing refers to the total borrowings of the government.
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Inflation Indexed Bonds: Inflation Indexed Bonds (IIB) is a category of government securities issued by the RBI which
provides inflation protected returns to the investors. These bonds have a fixed real coupon rate which is applied to
the inflation adjusted principal on each interest payment date. On maturity, the higher of the face value and inflation
adjusted principal is paid out to the investor. Thus, the coupon income as well as the principal is adjusted for
inflation.

Inflation Indexed National Savings Securities: Inflation Indexed National Savings Securities (IINSS) are inflation
indexed bonds with a tenor of 10 years that are indexed to the Consumer Price Index (CPI). They are available for
investment by retail investors. The interest rate on these securities will have two parts: a fixed rate of 1.5% per
annum and the inflation rate (based on the Consumer Price Index -CPI).

Corporate Bonds: The market for long-term corporate debt is made up of two segments:
 Bonds issued by public sector units, including public financial institutions.
 Bonds issued by the private corporate sector.
PSU bonds can be further classified into taxable and tax-free bonds. Tax free bonds are mainly issued by PSUs in the
infrastructure sector. Corporate bonds with embedded options, floating-rate interest, conversion options and a
variety of structured obligations are issued in the markets.

Debt Market Concepts

Valuing Cash-flows: A set of cash flows can be evaluated at any point on the time line, by using the principles of time
value of money. If a set of cash flows accrues in the future, their value at any point in the present is the sum of the
discounted values of the future cash flows. The rate, at which the cash flows of a bond are discounted, is called the
yield.

Changes to Bond Value: The time to maturity of a bond changes virtually every day, as the bond moves towards its
maturity date. When we value a bond, we measure the distance of each cash flow to the valuation date. This also
means that the value of a bond will change with change in tenor, even if everything else is constant. The discounting
rate is the yield determined by the market forces.

Rate and Price: In the bond markets, what traders care about is whether the price reflects their expectations for the
yield. Bonds are valued given such expectations and bought or sold on that basis. Therefore bond prices reflect the
expectations for future interest rates just as stock prices reflect expectations for future earnings.

Yield to Maturity: The rate that equates the present value of the future cash flows of a bond to its current value is
called the Yield to Maturity (YTM) of a bond. The YTM of a bond is the discount rate that is implied in the value of
the bond at a given point in time.

Yield and Yield Curve: In the bond market, what is quoted and observed is the price of a bond. Since the cash flow of
the bond is known, this price can be used to find the yield of the bond. The yields of all bonds traded in the market
can thus be computed from their market prices. The curve that links the yields of traded bonds at a point of time is
the yield curve.

Bond Price Sensitivity: Changes in the rate of discounting (yield) create changes in bond prices. The inverse
relationship between price and yield of bonds implies that every change in yield would bring about a change in price
in the opposite direction. Interest rates are determined by market forces, and can therefore change continually.
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Factors impacting sensitivity: Price sensitivity is evidently unequal across bonds. This is directly related to the
valuation principles just discussed. The value of a bond is the sum of the present value of future cash flows. Even if
two bonds were trading for the same price in the market, they differ in structure and therefore will differ in their
response to interest rate changes. Sensitivity can be measured in the following two ways:

 Duration
 Modified Duration

Risk and Return from Investing in Debt

Risks
 Inflation/ Purchase Power Risk: Inflation or purchasing power risk is the risk that though returns may be
fixed and predictable in absolute terms, they may be lower and risky after adjusting for inflation.
 Default Risk: Default or credit risk refers to the risk that debt issuers may default on interest and/or
principal payments.
 Re-investment Risk: Reinvestment risk is the probability that an investor will be unable to reinvest cash
flows at a rate comparable to the current investment's rate of return.
 Call Risk: Call risk exists in callable debt securities. The investor may have planned to stay invested until
bond maturity, but the issuer may exercise the option to call the security earlier.
 Liquidity Risk: liquidity risk stems from the lack of marketability of an investment that can't be bought or
sold quickly enough to prevent or minimize a loss.

Benefits
 Fixed Income
 Fixed Tenor

Debt Products

1. Deposits and Saving Schemes: Savings schemes such as the Post Office Savings schemes, National Savings
Certificate (NSC), Public Provident Fund (PPF), deposits with banks, Non-Banking Financial Companies
(NBFCs) and others are designed only to provide defined income over the term of the scheme. They do not
provide any appreciation in value.

2. Debt Securities: Debt securities such as bonds and debentures may be listed and traded on stock exchanges.
This enables investors to earn periodic coupon as well as gains from appreciation in the price when interest
rate movements are favorable.

3. Debt Mutual Funds: Debt schemes of mutual funds create portfolios out of debt securities to meet defined
objectives such as liquidity and market returns from investing in short term securities, periodic income from
a portfolio of bonds or total returns from the price movements in debt securities.
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Derivative Markets- Futures

A futures contract refers to the purchase of an underlying for delivery on a future date. A futures contract enables a
buyer or a seller to buy or sell a stock, commodity or interest rate, for delivery on a future date. Futures are
exchange traded instruments. The features of the contract are specified by the exchange. Futures contracts trade
online and are matched automatically. Futures contracts trade online on the electronic trading screens of the
exchange and orders are matched automatically. Apart from the trading lot, exchanges also specify price steps, base
prices and price bands for futures contracts.

Pricing a derivative contract: The pricing of a futures contract is based on the simple principle of carry cost. The logic
for such pricing is that given the same amount of information about the stock at a point in time, there is no arbitrage
profit to be made between the spot and the futures market. The law of one price stipulates that if the same good is
traded in two markets, the price has to be the same, unless there are costs involved in buying in one market and
selling in another. The presence of these costs makes it impossible to make money by buying the same good in one
market and selling it at another.

Spot: Future Arbitrage: Sometimes the spot price and the futures price for the same stock vary much more than
what is justified by a normal rate of interest (cost of carry). There is then the scope to create equal but opposite
positions in the cash and futures market (arbitrage) using lower cost funds.

Derivative Markets- Options

Various Positions in Option Contracts:

 Long on Option: If an investor is long on options, it means that the investor has bought and owns those
shares of stocks
 Short on Option: if the investor has short positions, it means that the investor owes those stocks to
someone, but does not actually own them yet.
 Long Call: A long call gives you the right to buy the underlying stock at strike price.
 Short Call: Short Call means selling of a call option where you are obliged to buy the underlying asset at a
fixed price in the future.
 Long Put: A long put gives you the right to sell the underlying stock at strike price.
 Short Put: Short Put means selling of a put option where you are obliged to sell the underlying asset at a
fixed price in the future.
 Time Decay: Time decay is a measure of the rate of decline in the value of an options contract due to the
passage of time.
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A convenient way to envision what happens with option strategies as the value of the underlying asset changes is
with the use of a profit and loss diagram, known as a “payoff diagram”. A Payoff diagram is a graphical
representation of the potential outcomes of a strategy. Results may be depicted at any point in time, although the
graph usually depicts the results at expiration of the options involved in the strategy.

Note: Please refer the pay-off diagrams given in the NISM book to understand them better

Use of Derivatives:

1. Hedging: When an investor has an open position in the underlying, he can use the derivative markets to
protect that position from the risks of future price movements. This is particularly true when the underlying
portfolio has been built with a specific objective in mind, and unexpected movements in price may place
those objectives in risk. Hedging can be done with futures and option contracts both.

Futures v/s options in Hedging

 The option premium reduces the net position value, even if the market price did not move. Option comes at
a specific cost by way of premium.
 The loss is limited to the premium amount if the underlying moves against the option position (markets
moving up when the investor has bought a put option).
 The futures hedge keeps the net position value constant, irrespective of market movement. What is lost in
portfolio value is gained in futures and vice versa.
 In the options hedge, the gain if the market price moved up depends on how much the portfolio position is
participating in the upside, after accounting for the option premium.
 The gain if the market price moved down depends on the option position paying off on the downside after
accounting for the option premium.

Speculation: A speculative trade in a derivative is not supported by an underlying position in cash, but simply
implements a view on the future prices of the underlying, at a lower cost. A buyer of a futures contract has the view
that the price of the underlying would move up and he would gain having bought it at a lower price, much earlier.
Speculative positions are about implementing a view and a buyer can close his position any time between purchase
and expiry date, to book a profit or loss.

Arbitrage: The strategy to exploit the difference by borrowing and buying in the cash market, and selling in the
futures market is called Arbitrage. Given the “one-price” rule (the underlying is the same), the interest costs should
be equal to the difference in prices. If that holds true always, there would be no arbitragers. The Law of One Price
stipulates that this difference in prices should represent the cost. In the futures market, we call this the carry cost.

Derivative Market Indicators

 Open interest (OI) shows the volume of open positions that have not been squared up.
 Implied volatility (IV) is a key indicator in option markets. Changes to IV alter the value of options.
 Put-call ratio (PCR) is computed by dividing the number of puts (contracts) by the number of calls
(contracts).
 Rollover is the process of carrying over a futures position from one contract period to the next.
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Foreign Exchange Market

The foreign exchange market is the market to determine the price of different currencies in terms of one another in
order to enable trade between countries and to provide a way to transfer currency associated risks arising from
economic transactions. The legal framework for the conduct of foreign exchange transactions in India is provided by
the Foreign Exchange Management Act, 1999. Foreign exchange transactions in India happens both on an OTC
market and an exchange traded market. The authorized dealers are the market makers who give buy and sell quotes
for different currency pairs. The brokers act as intermediaries who find the best quotes for their clients who may be
the end users of the currency.

Market Segments

OTC Sport Market: The spot market has an interbank market and a retail or merchant market. Interbank market is
the market for trade between banks, which is the largest segment in the spot market. The banks quote prices for
both buying and selling the currency. This is called market making.

Currency Derivatives Market: A currency derivative is a contract that derives its value from the spot currency prices.
The terms of trade such as the price, volume and settlement date are decided on the trade date. The primary
function of the derivative market is to enable risk transfer by providing a way to hedge the currency risk arising from
a transaction.

OTC Derivatives Market: The OTC markets for derivatives deal in forward contracts, foreign exchange swaps and
options. The most widely used instruments are the forward contracts and the foreign exchange swaps. In the
forward OTC market, the terms of the contract are agreed upon on the trade date for execution at a future date,
decided between the parties to the contract.

Exchange Traded Derivatives: Futures and options are the exchange traded derivatives available on recognized stock
exchanges permitted to deal in currency derivatives by SEBI and the RBI. Exchange traded currency derivatives can
be used to hedge a currency position, speculate on the future direction of the market and to benefit from arbitrage
opportunities.

Terminologies

 The price at which the underlying asset trades is the spot Price.
 The current price of the specified futures contract is the Futures Price
 Contract cycle is the period over which a contract trades.
 The last business day of the month will be termed as the Final Settlement date of each contract.
 Expiry Day is the day on which trading ceases in the contract; and is two working days prior to the final
settlement date
 The amount of asset that has to be delivered under one contract is the contract size/ lot size
 Initial margin is the amount that must be deposited in the margin account at the time a futures contract is
first entered into,
 In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's
gain or loss depending upon the futures closing price. This is called marking-to-market.
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Options

Option is a contract between two parties to buy or sell a given amount of asset at a pre-specified price on or before a
given date.

 The right to buy the asset is called call option and the right to sell the asset is called put option.
 The pre-specified price is called as strike price and the date at which strike price is applicable is called
expiration date.
 The difference between the date of the contract and expiration date is called time to maturity.
 The party which buys the rights but not obligation and pays premium for buying the right is called as option
buyer and the party which sells the right and receives premium for assuming such obligation is called option
seller/ writer.
 The price which option buyer pays to option seller for the right is called as option premium
 The asset which is bought or sold is also called as an underlying or underlying asset.

Interest Rate Parity:

Interest rate parity (IRP) is a theory in which the interest rate differential between two countries is equal to the
differential between the forward exchange rate and the spot exchange rate. Interest rate parity plays an essential
role in foreign exchange markets, connecting interest rates, spot exchange rates and foreign exchange rates.
Forward exchange rates for currencies are exchange rates at a future point in time, as opposed to spot exchange
rates, which are current rates. An understanding of forward rates is fundamental to interest rate parity, especially as
it pertains to arbitrage (the simultaneous purchase and sale of an asset in order to profit from a difference in the
price).

Factors that affect exchange Rate:

The foreign exchange rates constantly respond to a number of economic variables, both domestic and global, which
have an impact on the demand and supply of foreign currency in the short-term and long term. Some of the factors
that affect the value of a currency in the foreign exchange market include the gross domestic product (GDP) growth
rate, balance of payment situation, deficit situation, inflation, interest rates, policies related to inflow-outflow of
foreign capital. It is also a function of factors like price of crude oil, value of other currency pairs and geopolitical
situation. These economic indicators, not only of the Indian economy but also of other countries, determine the
exports and imports of the country, its attractiveness as a destination for investment through FDI as well as portfolio
flows and the risks that are seen in the economy. The flow of foreign currency in and out of the country as a result of
the economic situation will determine the exchange rate. The exact impact would be a function of relative health of
other economies, global risk appetite among investors and market expectations.

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II. Knowing Operational Aspects Of Financial Transactions

Investor Types

 Resident Individuals
 Hindu Undivided family (HUF)
 Minors through guardians
 Registered societies and clubs
 Non-resident Indians (NRI)
 Persons of Indian Origin (PIO)
 Banks
 Financial institutions
 Association of persons
 Companies
 Partnership firms
 Trusts
 Foreign portfolio investors (FPIs)
 Insurance companies
 Pension funds
 Mutual funds

Acquisition Process

Terms of Offer: The offer document of a financial product specifies the conditions to be fulfilled by a prospective
investor and the documentation needed. Conditions may be laid down in terms of who can invest and how much can
be invested in the scheme. Investment instruments may also have a certain minimum threshold amount for
investment which may exclude small ticket investors from it, or there may be a ceiling on the maximum amount.

Regulatory Requirements: Investors must have a Permanent Account Number (PAN) issued by the Income Tax
Authorities to be eligible to invest in most financial products in India. Exemptions may be given to certain category of
investors or types of transactions. Similarly, the ‘Know Your Customer’ process has to be undergone by all investors
in compliance with the regulations of the Prevention of Money Laundering Act, 2002.

Mandatory Investor Information: An application for buying a financial product or subscribing to a financial service
must be complete with respect to certain mandatory fields in the application form, without which the application
can be deemed invalid and is liable to be rejected. It generally includes:
 Name
 Signature
 Address
 Bank Account Information
 PAN
 KYC Compliance

Investor Folio or Account: A folio number or account number, customer identity number or certificate number is
allotted to the investor at the time of the initial purchase or investment or account opening. It is created by the
investment product or service provider or their agent, such as the registrar and transfer agent, on receipt of a valid
application. The information provided in the application form is captured to create a unique customer record.
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PAN and KYC Process

PAN: Permanent Account Number (PAN) is an identification number issued by the Income Tax authorities. Form 49A
issued is the prescribed form to apply for a PAN. Section 114 B of the Income Tax Rules lists the transactions that
mandatorily require the PAN to be quoted. Most financial market transactions require the PAN details to be
provided for all categories of investors, including NRIs and guardians investing on behalf of minors. There are certain
mutual fund transactions which are exempt from the requirement for submitting PAN. These are micro investments,
i.e. investments up to Rs.50,000 in aggregate under all schemes of a fund house.

Know Your Customer (KYC) Process: In order to ensure that illegal funds are not routed into Indian markets, the
government has promulgated the Prevention of Money Laundering Act (PMLA). According to this Act, the identity of
those entering into financial transactions must be known and verified. The procedure to do this is known as Know
Your Customer (KYC) norms. The KYC process involves verification of proof of identity and proof of residence of the
customer. The KYC procedures require the intermediary with whom the client conducts the Know Your Customer
formalities to do, an ‘In Person Verification (IPV)’ of the client.

SEBI has mandated a uniform KYC procedure for compliance by clients from January 1, 2012. This means that an
investor who has undergone a KYC procedure with any of the specified intermediaries can use the same to invest
with a mutual fund and vice versa.

Dematerialisation and Re-materialisation of Securities

A depository is an institution that offers the service of holding the securities of the investors in electronic form. The
Depositories Act was passed in 1996 which allow companies and investors to issue, hold and transact in securities
through a depository. There are currently two depositories operational in India, National Securities Depository Ltd.
(NSDL) & Central Depository Services (I) Ltd. (CDSL). As per the Depositories Act, 1996, the physical securities that
are dematerialised are required to be destroyed by the R&T agent and a credit entry is made in the electronic
records of the depository.

Dematerialisation is the process of converting physical securities into electronic form. It involves the investor, the
DP, the issuer/R&T agent and the depository. The DP sends the request through the electronic system to the
issuer/R&T agent and the depository. The Dematerialisation Request Number (DRN) that is generated by the system
is entered on the DRF and sent along with the physical documents and a standard covering letter to the R&T agent.

Rematerialisation of securities is the process of converting the electronic holding of a security to physical form.
Confirmation of the rematerialisation will be electronically sent to the depository and the DP will be informed of the
same.

Power of Attorney (POA)

Individual investors can empower someone they trust to do transactions on their behalf, by granting and executing a
Power of Attorney (PoA).

General Power of Attorney: A General Power of Attorney gives the agent the authority to handle all the affairs
during a period of time when the investor is unable to do so. A General Power of Attorney is typically very broad,
giving the agent extensive powers and responsibilities.
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Specific Limited Power of Attorney: A Specific Power of Attorney gives the agent the authority to conduct a specific
act or acts on the investor. Because this type of POA is limited to the act designated in the document, it is especially
important to be clear about the powers one wishes to give to the agent.

Account Opening Process for Non-Residents

An individual is said to be non-resident in India if he is not a resident in India and an individual is deemed to be
resident in India in any previous year if he satisfies any of the following conditions:
1. If he is in India for a period of 182 days or more during the previous year; or
2. If he is in India for a period of 60 days or more during the previous year and 365 days or more during 4 years
immediately preceding the previous year.
However, condition No. 2 (mentioned above) does not apply where an individual being citizen of India or a person of
Indian origin, who being outside India, comes on a visit to India during the previous year.
A person shall be deemed to be of Indian origin if he, or either of his parents or any of his grand-parents, was born in
undivided India.

KYC for NRIs: NRIs have to be KYC compliant in order to make investments in India. A soft copy of the KYC form is
widely available at the websites of mutual funds, brokers, service providers and KRAs. It has to be completed and
submitted along with the necessary documents to a point of service (PoS) in person, or mailed to the KRA agency
directly.

KYC for Foreign Portfolio Investors: Persons eligible to invest a Foreign Portfolio Investor under the SEBI (Foreign
Portfolio Investors), Regulations 2014 has to undergo the KYC process. Eligible FPIs are categorized as
 Category I: Includes Government and Government related organizations such a foreign central banks,
Government agencies, Sovereign wealth funds and International/Multilateral agencies
 Category II: Includes appropriately regulated broad-based funds such as mutual funds, investment trusts,
insurance/re-insurance companies, asset management companies, banks, investment managers, portfolio
managers, university funds and pension funds
 Category III: Includes all others not eligible under categories I or II such as individuals, trusts, charitable
societies, corporate bodies and family offices.

Portfolio Investment (NRI) Scheme (PINS) Account

The Portfolio Investment (NRI) Scheme (PINS) is a scheme of the Reserve Bank of India (RBI) and is mandatory for
Non Resident Indians (NRIs) and Persons of Indian Origin (PIOs) who like to purchase and sell shares and convertible
debentures of Indian companies or units of domestic mutual funds on a recognized stock exchange in India. All
purchase and sale transactions in listed securities of NRIs are routed through their PINS account. Only an NRI/PIO
can open a PINS account. PINS account with the bank is identical to the NRE account. PINS account can be opened
only in designated branches of banks (authorized dealers) as authorized by RBI under the Portfolio Investment
Scheme.

NRI Demat and Trading Account

 NRIs can open a demat account with any Depository Participant in India. NRI’s needs to mention the type
(‘NRI’ as compared to ‘Resident’) and the sub-type (‘Repatriable’ or ‘Non- Repatriable’) in the account
opening form.
 NRI investors can open a trading account with a registered broker of a stock exchange. NRIs can have two
separate trading accounts linked to NRE & NRO accounts.
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Maintenance of Investment Records

 Investor accounts require maintenance of changes to the details provided at the opening an account.
 The change in address of Investor has to be intimated to the provider for updating in the records.
 Investors willing to, can request a change of name in their investment records or folio.
 Investors who undergo a change in status from resident to non-resident or vice versa have to inform the
change of status to the investment companies and financial service providers.
 Investors may pledge their investments such as shares to borrow money from, financial institutions, or non-
banking finance companies (NBFCs).
 Transmission means 'an act of passing on something'. In the context of investments it refers to passing on
the investments on the death of the investor to another person.

Change in Status of Special Investor Categories

Minor to Major

Minors are investors who are less than 18 years of age on the date of investment. Minors cannot enter into contracts
on their own and if they, then such contracts are null and void by law. Therefore, the financial transactions of minors
are conducted by adults on their behalf. Those transacting on behalf of the minor child are called guardians. Parents
are the natural guardians of their minor children. If the application form identifies the status of the investor as a
minor, then the date of birth of the minor investor becomes mandatory information that has to be provided along
details of the guardian.

Once the minor become major, financial transactions are disallowed in their account. No debits or redemptions can
be made in accounts; mutual funds folios or demat account of minors-turned-major. Minors are not eligible to sign
documents, enter into contracts, or issue third party cheques. However, after a minor becomes major, they can
conduct such transactions, only after their signature is attested.

NRI to Resident Indian

Bank Account: Once an NRI becomes a RI, he cannot operate his NRO/NRE/FCNR accounts. He needs to inform to
the bank about the change of status and needs to open a Resident Rupee Account. This account can hold foreign
currency and continue to receive funds in foreign currency from abroad.
Demat Account: Just like bank account, the returning NRI needs to inform change of status to the designated dealer
which the investor had made investments in the PIS, as well as the DP with whom he has opened a demat account. A
new demat account with ‘Resident’ status needs to be opened.
Trading Account: If the NRI was operating an online trading account, the broker also needs to be informed about the
change. The trading account with NRI status will get closed and a new trading account with resident status needs to
be opened.
Mutual Fund Investments: Respective AMC with whom the NRI holds mutual fund investments needs to be
informed about the status change. KYC change form needs to be sent to the KYC registration agency for change of
status, address and bank details.

Resident to NRI

Different rules apply for Resident Indian when his status changes to a Non Resident Indian. On becoming an NRI, a
person needs to carry out certain formalities with respect to his existing investments and bank accounts.
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Other Operational Aspects

1. An investment may be held jointly by up to a maximum of three holders.

2. Nomination is a facility provided to the holder of an investment to designate the person who will be entitled
to receive the investments, in the event of the death of the investor.
3. There are several accepted modes of payment for making investments. These include:
 Demand drafts, Cheques, Post-dated cheques, for SIP transactions in mutual funds
 Electronic and digital payment modes such as ACH, RTGS, NEFT,
 Cash is an accepted mode of payment for some
 ASBA for New Fund Offer and initial public offer purchases

III. Personal Financial Planning

Evaluating the financial position of clients

The personal financial situation of an individual or a household primarily refers to its ability to manage its current
and future needs and expenses. Typically, assets are created to meet the future expenses of the household, and
financial planning helps apportion the available current income to immediate expenses and savings for the future.
Loans are used to meet expenses and to create assets, if the income is inadequate to meet all the needs. Meeting
income needs in retirement is an important concern and financial goal for all households.

Savings Ratio & Expenses Ratio: Savings Ratio is the percentage of annual income that a person is able to save. It is
calculated as Savings per year/Annual Income. The Savings to Income ratio measures the total accumulated savings
of the individual relative to the annual income. It is calculated as Total Savings/Annual Income. This ratio measures
the preparedness to meet long term goals such as retirement. The current value of the investments and assets, after
accounting for any outstanding loans taken to acquire the same, is taken to compute the total savings. Self-occupied
home is typically not included when calculating the savings level. A low expense ratio and high savings ratio is
desirable for an individual’s financial security and stability.

Total Assets: Savings of the individual are deployed in various forms of physical and financial assets such as shares,
debentures, mutual funds, real estate, gold, provident fund, superannuation fund, and others over a period of time.
The current value of these assets constitutes the investor’s total assets. Physical assets such as real estate are
typically acquired with a combination of savings and loans.

Total Liablities: Liabilities include loans and different forms of credit taken to meet expenses or to acquire assets.
These may be taken from institutional sources, such as banks and financial institutions, or from personal sources
such as friends and relatives.

Leverage Ratio: This is a measure of the role of debt in the asset build-up of the investor. It is calculated as Total
Liabilities ÷ Total Assets. Higher the leverage, more risky it is for the individual’s financial situation. A ratio greater
than 1 indicates that the assets will not be adequate to meet the liabilities.

Net Worth: A strong asset position is of no use, if most of these are acquired through loans that are outstanding.
Similarly, liability is not bad, if it has been used for creating an asset, such as real estate, which has the potential to
appreciate in value. It is therefore normal to monitor any investor’s financial position through the net worth. It is
calculated as Total assets – Total liabilities.
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Solvency Ratio: Despite having assets, a person may be insolvent, if the liabilities are higher than the assets held. A
critical benchmark is that the individual’s net worth should be positive. The extent of the investor’s solvency can be
determined through the solvency ratio, which is Net Worth ÷ Total Assets. For the same asset position, higher the
solvency ratio, stronger the investor’s financial position.

Liquid Assets: Liquid assets are those assets that can be easily converted into cash at short notice to meet expenses
or emergencies. Investors need to balance their liquidity and return needs. Keep enough in liquid assets to meet
liquidity requirements, and invest the balance in longer term assets with a view to earning superior return.

Liquidity Ratio: The role of liquid assets is to meet the near-term liquidity needs of the individual. Liquidity ratio
measures how well the household is equipped to meet its expenses from its short-term assets. It is calculated as:
Liquid Assets/Monthly Expenses.

Financial Assets Ratio: Financial assets have the advantage of greater liquidity, flexibility, convenience of investing
and ease of maintaining the investments. They are primarily income generating investments, though some of them,
such as equity-oriented investments are held for long-term capital appreciation. A higher proportion of financial
assets are preferred especially when goals are closer to realization and when there is a need for income or funds to
meet the goals.

Debt to Income Ratio: Debt to income ratio is an indicator of the individual’s ability to manage current obligations
given the available income and a parameter used by lenders to determine eligibility for additional loans. It is
calculated as Monthly Debt Servicing Commitment ÷ Monthly Income. Debt servicing refers to all payments due to
lenders, whether as principal or interest.

Contingency Planning

Investment advisers need to prepare the client for various contingencies that might come up. The family’s financial
strategy needs to provide for these risks. The following are typical contingencies to provide for:
 Death of earning member of the family
 Sudden Healthcare costs
 Loss of job for the earning member
 Separation (Divorce)
 Inadequacy of Emergency Fund

Estimating Financial Goals

Most aspirations of a family have a financial implication like purchase of house, buying a car. Thus, a financial goal
can be quantified for each of these aspirations. An estimate of these future expenses (the financial goals) requires
the following inputs:

 How much would be the expense, if it were incurred today?

 How many years down the line will the expenses are incurred?
 During this period, how much will the expenses rise on account of inflation?
 If any of these expenses are to be incurred in foreign currency, then how would changes in exchange rate
affect the financial commitment?

The costs mentioned above, in today’s terms, need to be translated into the rupee requirement in future. This is
done using the formula A = P X (1 + i) n where A= Future Value, P= Present Value, i= Inflation Rate, n= No. of Years.
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IV. COMPREHENSIVE FINANCIAL PLANNING

Role of Debt

Debt is used to finance goals when available funds are inadequate. For example, most people cannot buy a house
without a loan. Debt comes at a cost and imposes a repayment obligation on the borrower. The decision on whether
or not to use debt will depend upon the ability of the available income to bear the additional charge of interest cost
and repayment. Debt is not always bad. In some cases, the decision to use borrowed funds over own funds, also
called leverage, may actually increase the return made on an investment.

While some debt is good and may even be recommended, how much debt is good depends upon the financial
situation of each household. A good indicator is the debt to income ratio discussed in the previous chapter that
measures the ability to meet the obligations arising from debt with the available income.

Debt Counseling

Purpose of Debt: Debt should ideally be taken for acquiring appreciating assets such as real estate. Or, debt may be
recommended to meet an expense that will increase the value of an asset, say an education loan to up skill, so that
the income generating ability of the person goes up. If a person starts borrowing to meet expenses, then he is
clearly living beyond his means and likely to be in a debt trap.

Cost of Debt: Higher the rate of interest at which money is borrowed, more will be the outgo in servicing the debt.
Secured loans, such as mortgages, and education loans are relatively cheaper. Unsecured loans such as personal
loans and credit card debt are very expensive and must be used with caution.

Maturity of Debt: Shorter the tenor of the loan; more will be the periodic repayment putting pressure on available
income. Even if the cost of debt is low, short loan tenor can put financial pressures in repayment.

Debt Re-scheduling: If the borrower is unable to manage the debt repayments, then it helps to work out a solution
as soon as possible. Potential solutions are as follows:

 Rank Debt
 Pre-payment of Debt
 Debt Re-financing
 Extending the tenor of the debt

Credit Score

Credit score is a number assigned to each individual by a credit information bureau based on their credit behavior
and history. A credit bureau is licensed by the RBI and governed by the Credit Information Companies (Regulation)
Act, 2005. The credit and financial health of the individual is assessed on the basis of the outstanding loans and
credit facilities used, repayment behavior exhibited, utilization of credit limits, type of loans i.e. the proportion of
credit card out standings, personal loans and other unsecured loans, and other factors that may affect the ability to
service loans. A good credit score and credit report can be built by dealing with debt responsibly. Always pay dues on
loans, credit cards and others on time. Credit utilization relative to credit available should be kept low.
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Investments for Liquidity and Financial Goals

Liquidity needs are short-term in nature. For example, household expenses over the next 6 months. Investments for
liquidity should be in avenues that can be easily liquidated without much concern about capital erosion. Financial
goals are typically long-term in nature. Savings towards financial goals too can be deployed in liquid assets. However,
liquidity comes at a price in the form of lower yields on the investment. Growth assets should not be used to
provide for liquidity needs, because, in the short term, there is risk of significant capital erosion; however, equity can
be used to support long term financial goals of the investor, provided the investor is comfortable with the risk. Every
investor needs to have a mix of liquid assets and growth assets in the portfolio.

Prioritizing Financial Goals

 Goals such as retirement and education of children are important financial goals for which adequate
provision of funds have to be made. Long-term goals such as retirement often get lower priority for
allocation of savings because it has time on its side.
 While this may be acceptable for shorter-term goals that are also important, such as accumulating funds for
down payment on a home, it may not be right to prioritize consumption goals, such as holidays and large
purchases, over long-term important goals. The delay in saving for such goals will affect the final corpus,
since it loses the longer saving and earning benefits including that of compounding.
 Some outflows, like providing education to children, may appear to be consumption expenditure. But they
may be a useful investment, if the children do well and are able to raise the family’s income.
 Some common errors that make it seem as if savings are not possible include not being clear if an expense is
an essential living expense or discretionary in nature, incorrect (higher) allocation for expenses, not ‘paying
self’ before allocating for discretionary expenses, not tracking expenses regularly and hence going over-
budget, among others. Very often, clients do not realize how much money goes in various avoidable
expenses.
 The monthly summary of outflows helps in understanding the current prioritization. If unusual expenses are
kept out (for instance, a hospitalization that was not covered by insurance), the balance outflows can be
categorized as mandatory contributions to provident fund and other retirement savings, loan servicing,
essential expenses and lifestyle expenses.
 Goals are prioritized on the basis of their importance to the individual’s financial wellbeing. Other financial
goals may have to be deferred to ensure that the critical financial goal is not compromised.
 Clients occasionally earn a windfall such as unexpectedly high annual bonus, inheritance, winning a lottery,
etc. A healthy portion of such unexpected income should be set apart for the future, since the family is used
to living without that windfall. These are also situations to take a look at the outstanding loans and consider
pre-paying some of them.

Risk Profiling

The funds allocated to various goals are invested in different investment avenues. Different investment products
have various levels of inherent risk. Similarly, there are differences between investors with respect to the levels of
risk they are comfortable with. At times there are also differences between the level of risk the investors think they
are comfortable with, and the level of risk they ought to be comfortable with. Risk profiling is an approach to
understand the risk appetite of investors. This is an essential pre-requisite to advice investors on their investments.
The investment advice is dependent on understanding both aspects of risk:
 Risk appetite of the investor
 Risk level of the investment options being considered.
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Asset Allocation

‘Don’t put all your eggs in one basket’ is an old proverb. It equally applies to investments. Return from asset classes
at any point in time will not be the same in direction or magnitude but will vary depending upon the impact of the
prevalent economic conditions on their performance. The distribution of an investor’s portfolio between different
asset classes is called asset allocation. An efficient asset allocation is one which includes asset classes that have low
or negative correlation so that the returns from the investments do not rise and fall together.
Strategic Asset Allocation is allocation aligned to the financial goals of the individual. It considers the returns
required from the portfolio to achieve the goals, given the time horizon available for the corpus to be created and
the risk profile of the individual.
Tactical Asset Allocation is the decision that comes out of calls on the likely behavior of the market. An investor who
decides to go overweight on equities i.e. take higher exposure to equities, because of expectations of buoyancy in
industry and share markets, is taking a tactical asset allocation call.
Dynamic Asset Allocation uses pre-defined models to allocate assets among different asset classes. Triggers for
reallocation may be defined in terms of asset class valuations or portfolio performance.

Fundamental Principles of Insurance

Utmost Good Faith (Uberrimae Fidei): Since the insured party is better informed about himself or herself than the
insurer, there is an information asymmetry between the two parties. The insurer agrees to enter into the insurance
contract based on utmost good faith in the insured. The obligation is on the insured to disclose all relevant
information truthfully.

Insurable Interest: The insurer will cover the risk only if the insured has an insurable interest in the subject matter of
insurance. The test of insurable interest is that the insured should be better off if the risk does not materialize, but
will be adversely affected if the risk materializes.

Model Portfolios

Since investors’ requirement from their investments varies, a single portfolio cannot be suggested for all. Investment
advisers often work with model portfolios – the asset allocation mix that is most appropriate for different
investment objectives, return expectations, risk appetite levels and liquidity needs. The list of model portfolios, for
example, might read something like this:

Young call center / BPO employee with no dependents

50% diversified equity schemes (preferably through SIP); 20% sector funds; 10% gold ETF, 10% diversified debt fund /
fixed deposits, 10% short-term debt funds and liquid schemes / savings bank account / current account.

Other model portfolio examples may include:

 Young married single income family with two school going kids
 Single income family with grown up children who are yet to settle down
 Couple in their seventies, with no immediate family support
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Role of Insurance Advisor

Identify the insurance required based on:

 Income Replacement Method: Earning ability of an asset, which includes the life of an individual as an asset
generating income.
 Income protection need: This is the need to protect the available income from an unexpected charge.
 Asset Protection needs: Here, the need is to protect assets created. Insurance against theft or destruction of
goods is an example of insurance product that covers the risk.

Identify the most suitable insurance product:

 Optimize the Insurance Premium
 Monitor the Insurance coverage

Life Insurance Products:

 Term Insurance (Pure Risk Policy)
 Endowment Plan (Fixed term with an embedded savings component)
 Whole Life Policy (Used for Estate Building)
 Unit-Linked Products- ULIPS (Includes Insurance and Investment components)
 Variable Insurance Products (Includes all other plans)

Mortgage Insurance is a special kind of insurance policy, where the sum assured keeps going down with time. This is
suitable when the insurance policy is taken to cover a housing loan, which will keep reducing with loan repayments.

Non-Life Insurance Products:

 Health Insurance (Covers Medical expenses)
 Personal Accident Insurance (Covers any accidents)
 Travel Insurance (Covers travel related risks like loss of baggage)
 Motor Insurance (Third party Insurance for motor accidents)
 Property Insurance (Covers Loss of property)
 Fidelity Insurance (protects employers against losses caused by infidelity of their employees)
 Directors and Officers Insurance (Covers various claims arising out of their employment)
 Keyman Insurance (Protection for the company against death of a key person in the company)

Retirement Planning:

The two relative phases in the financial life of people are the accumulation and distribution phase.
Accumulation phase is the earning years of a person’s life, when a person accumulates savings.
Distribution phase is the retirement years, when some of the savings will fund the living expenses.

Note: Please refer to the calculation of Retirement Corpus in the NISM book
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Philanthropy

The world over, more and more people are getting philanthropic i.e. they want to devote time and / or money for
larger social good. Earlier, the approach was to set apart some money in their Will for philanthropic purposes.
Increasingly, people want to give away part of their wealth during their life time and see the positive change around
them. Thus, philanthropy is becoming a part of everyone’s life.

Broadly, there are two approaches to financial planning viz. goal-specific planning and comprehensive financial
planning. In goal specific planning, each financial goal is looked at in isolation, and a dedicated investment plan is
made to realize the financial goal. Comprehensive financial planning takes a consolidated view of all the financial
goals of the person. Accordingly, the investment plan too is a consolidated one – not a separate plan for each goal.

V. Product Analysis and Selection

Risk, Return and Portfolio Construction

Return on Investment: Measuring return on investment involves comparing the capital outflow with the inflows
from the investment. Return on investment can be positive or negative. When market price is different from face
value, the return is represented by yield. The yield depends on the purchase price (or market price) of the
investment. Another type of return from an investment may be an appreciation or depreciation in its value that is
not paid out to the investor which is similar to capital gain/loss. These capital gains may be notional or booked. Using
the current market price to estimate the value of an investment is called 'marking to market’ or MTM. If an
investment generates both types of return – regular income and capital gains – it is preferable to measure its total
return.

Risk in investments: Risk in investments refers to the possibility that the expected return from an investment or the
capital invested may be eroded in some manner. Whenever there are returns, there will be risk; so all investments
are exposed to risk to some extent. Risk refers to both positive and negative deviations of actual returns from
expected returns. Investments are subject to some risk or the other, only the nature and extent of risk may vary.
Economic activities are exposed to differing risks.
 Inflation Risk: Inflation risk is the chance that the cash flows from an investment won't be worth as much in
the future because of changes in purchasing power due to inflation.
 Default Risk: Default risk, also known as credit risk, refers to the probability that borrowers could default on
the commitment to pay interest and may not repay the principal on the due dates. Debt instruments are
subject to default risk as they have pre-committed payouts.
 Re-investment Risk: It is the risk of fall in the returns when cash flows from investments are reinvested. Since
income received shall be invested at the prevailing rates, there is a possibility that these cash flows may be
invested at a lower return as compared to the original investment.
 Call Risk: Debt instruments are often issued with an embedded call option in them which allows issuers to
redeem the bond before maturity. Such investments are exposed to call risk. Call risk refers to the possibility
that the issuer of a bond may choose to redeem it before maturity. Early redemption brings down the tenor
of the bond, and forces the investor to find alternate investments to invest the funds received.
 Liquidity Risk: Liquidity refers to the ease at which an investment can be bought/sold in the market. Liquidity
risk implies that the investor may not be able to sell his investment when desired, or it has to be sold below
its fair value.
 Market Risk: Market or price risk is the risk from adverse movements in the price of the investments.
Investment options such as equity, bonds, mutual funds, ULIPs, gold and property are subject to market risks
because their value depends on the current price in the market where they are traded. Investments such as
bank deposits and saving schemes are not subject to market risks.
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Every investment is subject to one kind of risk or the other. Some investments may be subject to more than one type
of risk. Investors should first be aware of the various risks they are exposed to and be sure whether they are able
and willing to bear those risks. The most common measure of risk is standard deviation. It is the average deviation
of actual returns from the average return over a time period. It is computed using a statistical formula. Total risk
consists of two parts i.e. systematic risk and unsystematic risk. The part that affects the entire system is known as
systematic risk, and the part that can be diversified away is known as unsystematic risk.

Portfolio Construction Principles: Asset classes differ in their risk-return features. The potential return from each
asset class varies. The holding period that is suitable for each asset class is also different. Cash equivalents are
suitable for short-term holding periods, since they offer protection of capital. The primary reason for grouping
investments under an asset class is to recognize the similarity in risk-return features. Sub-categories within asset
classes are groupings based on risk and return, within the broad asset class. All of things have to be considered while
constructing a portfolio.

 The performance of an asset class can be captured in a benchmark index. This enables investors to track the
performance of an asset class over time. The creation of benchmark indices further confirms the
categorization and acceptance of an asset class among investors.
 Return is the reward to investors for bearing risk in an investment. Investors require a higher level of return
to invest in assets that are risky as compared to assets with lower levels of risk. Thus higher risks are
associated with higher returns. There is thus a trade-off between risk and return
 The higher return that a risky asset has to provide to motivate investors to invest is known as risk premium.
 Investing across asset classes provides the benefit of diversifying risk. This is because asset classes in
themselves may be risky, but since they are affected differently by different factors, they generally do not
move together. They cancel out the risks of one another to some extent, creating a benefit of lower overall
risk, called the diversification benefit.

Return Target, Risk Profiling and Optimization

A portfolio generally does not provide a higher return from the addition of an asset, without a corresponding
increase in risk. The extent to which risk is reduced by combining assets depends upon the ‘correlation’ between
various asset class returns. Correlation is a statistical measure of the extent of co-movement exhibited in the return
of two asset classes. Measuring correlation provides two kinds of information: whether the asset class returns are
moving in the same or opposite direction over a long term and what is the extent to which they co-move. Correlation
between two asset series ranges from -1 to +1.
 A correlation of -1 means that they move exactly in opposite directions. Investing equally in both brings risk
to zero.
 A correlation of +1 means that they move exactly in the same directions. Investing equally in both does not
modify the risk of the portfolio at all.
A portfolio leads to diversification benefits in the form of enhanced risk-adjusted return. The investor is able to:
 Reduce the level of risk, at the same level of return
 Earn a higher level of return at the same level of risk, or
 Earn a higher return at a lower level of risk. However, after a certain level, a higher return can be earned
only by taking on additional risk.
Diversification does not eliminate risk or guarantee a return; it reduces the volatility of a portfolio. While
constructing an investment portfolio, the focus is always on generating a better risk-adjusted return. This means, a
manager will look out for asset classes that have a lower correlation with what he holds in the portfolio, so that he
can achieve better return at a lower risk. Risk and return of various investment options can be estimated from
historical data, modified to consider current dynamic market situations, and used to generate expectations about
how these investments may perform in the future. The return from a portfolio depends upon the return of the asset
classes included in the portfolio and the weighting to each asset class. A portfolio’s return is simply the weighted
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average return of all assets included in it, the weights being the proportions invested in each asset. Unlike portfolio
return, portfolio risk cannot be simply calculated as the weighted average of the risk of investments in the portfolio.
This is because in addition to the risk of each investment and its weight in the portfolio, portfolio risk will also
depend on the correlation between the assets classes included in it.

Portfolio Constraints: Risk Tolerance and Investment Horizon

The selection of assets in a portfolio is primarily driven by the portfolio objectives and return requirements of the
investor. The proportion to be invested in various assets to achieve the stated return however depends on the
constraints of the investor. Thus the key constraints in portfolio construction are the risk tolerance of the investor
and investment horizon. In asset allocation, risk profiling is a key process. Risk profiling is an exercise that
determines the level of risk that an investor can take. It is an assessment of an investor’s risk tolerance. Financial
Risk tolerance depends upon risk capacity and risk attitude. Risk attitude is a preference of the investor towards risk.

Risk attitude, or the willingness to assume risk, is a subjective factor which is difficult to assess. Risk capacity is the
ability to take risk, which relates to an individual’s financial circumstances and investment knowledge. This can be
objectively measured by financial parameters such as total wealth, income, savings ratio and net worth. Allocation
based on the risk profiling exercise may be unsuitable to the investor if due consideration is not given to both ability
(capacity) and willingness (attitude) to take risk. The risk profile of an investor tends to change over time.

Impact of market cycles on asset allocation and product selection

The dynamics of asset class performance makes it a challenge in managing asset allocation for the long run. Different
asset classes perform well in different market conditions. While it may be tempting to try and forecast asset class
returns for the future, it may be risky to do so. All asset classes are impacted by economic cycles and their
performance can vary significantly at different phases of the market cycle. Stocks are expected to do well during the
growth and recovery phase, while commodities may do well during a period of inflation and interest rate hikes.
Money market securities may do well during a period of low growth, high inflation and high interest rates. Asset
allocation that has been made with a view of the investor’s needs may require tuning, depending on the economic
cycle.

Core and Satellite Portfolios: The core-satellite strategy is a method of portfolio construction that allows investors
to focus on long term financial goals while minimizing volatility, costs and taxes. In this approach, investors
differentiate between two segments in their portfolio. The core should ideally consist of passive investments that
track major market indices, such as index funds. The satellite portfolio should include actively managed investments.
These investments are tactical in nature and form a smaller part of the total asset allocation of the investor. The core
portfolio provides stability and long term appreciation. The satellite portfolio offers an extra risk-adjusted return that
pushes up overall portfolio returns. The suggested allocation has been 75% in a core portfolio of debt-oriented
investments and 25% in a satellite portfolio that is actively managed to benefit from macro-economic and other
factors that impact asset classes. The funds allocated for active management are held in short and ultra-short term
investments if they are not allocated to the satellite portfolio.
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Evaluating and Selecting Mutual Funds

Principles of Fund Selection

 Asset Classes and Funds
 Investment Objective
 Portfolio Features of a Fund
 Returns of the Fund
 Portfolio Composition
 Relative Return
 Risk in the fund

Equity Funds

Equity funds invest in equity instruments, such as shares, derivatives and warrants. Most equity funds are created
with the objective of generating long-term growth and capital appreciation. All equity funds are subject to market
risk. An investor investing in equity funds must be prepared for some volatility.

 Equity Linked Savings Scheme (ELSS): Equity Linked Savings Schemes (ELSS) is a special category of diversified
equity funds, designated as ELSS at the time of launch. Investment in ELSS to the extent of Rs.1.5 lakh in a
year enjoys a tax deduction under Section 80C of the Income Tax Act. Investors can buy the units to claim tax
deduction at any time of the financial year.
 Diversified v/s concentrated Funds: Diversified equity funds invest across various sectors, sizes and
industries, with the objective of beating a broad equity market index. Thematic equity funds invest in
multiple sectors and stocks falling within a specific theme. Themes are chosen by the fund managers, who
believe these will do well over a given period of time, based on their understanding, of macro trends and
developments. Sector funds are available for sectors such as information technology, banking, pharmacy and
FMCG. We have learnt that sector performances tend to be cyclical.
 Index Funds v/s ETFs: Index funds invest in a portfolio of securities that replicates the composition of a
market index. The index that the fund will track is stated upfront and the assets are invested in the same
securities and in the same proportion as they appear in the index. Exchange Traded Funds (ETF) are also
mutual fund products linked to an underlying index, but listed and traded on a stock exchange. The portfolio
of the ETF will reflect the specific index and the value of each unit of the ETF will be linked to the value of the
underlying index.

Debt Funds
 Debt funds can be segmented in terms of tenor as short, medium and long tenor funds or on the basis of
interest rate risk as low, medium and high interest rate volatility funds.
 FMPs or Fixed Maturity Plans are closed-end schemes that invest in a portfolio of debt securities which
mature on or before the maturity of the scheme. The bonds are held to maturity and intervening changes in
price does not affect the yield at maturity. This limits the interest rate risk in the fund. The yield from the
fund will depend on tenor and credit quality of the securities held in the portfolio.

Other Products

 Gold ETFs have gold as the underlying asset so as to provide investment returns that, closely track the
performance of domestic prices of gold. Each ETF unit typically represents one gram of gold.
 International funds invest in markets outside India, in foreign securities.
 Real Estate Mutual Funds invest in real estate either in the form of physical property or in the form of
securities of companies engaged in the real estate business.

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Performance and Evaluation of Investment Alternatives

ELSS vs. other Tax saving instruments: The tenure is fixed for PPF, NSC and Bank deposits. In the case of ELSS, it
could be 10-years closed end, or an open ended fund. However, 3-years are the minimum lock in period. ULIPs have
a minimum subscription for a 5-year period. Investors generally prefer traditional debt instruments for tax saving.
While these may provide safety and stability, they fall short of generating higher inflation-adjusted returns over the
long run. Instruments that earn a fixed rate of interest when average inflation is high will yield low real rate of
return. Along with tax deduction, ELSS funds provide scope for long-term capital appreciation and higher inflation-
adjusted returns. ELSS offers an opportunity to gain from market-linked returns from equity. Investments in ELSS
are, however, subject to market risk and must be made taking into consideration age and risk taking ability. A young
investor may have the capacity to bear some volatility in order to gain from the significant capital appreciation that
ELSS funds seek to deliver. Regular income in the form of dividends is also tax-free.

PPF vs. Mutual Funds: The biggest advantage of mutual funds is that they allow the benefit of diversification across
asset classes. An investor may diversify using various schemes and products. Diversification is also possible within a
particular product. PPF, on the other hand, is a pure debt investment with tenure of 15 years, which can be further
extended in blocks of 5 years each for any number of blocks. In that sense, PPF can prove to be a very rigid
investment, especially in case of an emergency when funds are required at short notice. Mutual funds on the other
hand are very liquid. PPF is popular with a certain category of risk-averse investors who do not want to subject their
investments to any market risk and are content with fixed and guaranteed return provided by the PPF.

Direct Equity vs. Equity Mutual Funds: Mutual funds are professionally managed by qualified fund managers, who
continuously monitor companies, have access to market data and company reports and can take appropriate
decisions on whether to buy, sell or hold a particular stock in the portfolio. Direct equity investor needs to
independently research and track the prospects and potential of companies in the portfolio in order to make buy,
sell or hold decisions.

Physical Gold vs. Gold ETF: An investor seeking exposure to gold as an asset class may buy a gold fund, or a gold ETF
instead of buying physical gold as the advantages are many. The impurity risk in gold ETF is absent. Gold ETF allows
investors to buy gold in quantities as low as 1gm.This is done in form of demat units, where each unit approximately
represents the value of 1 gm of gold. Physical gold may not be available in such small quantities. Hence, investors
can even use small amounts to invest in gold. Transaction costs are low in case of gold ETFs, as only the brokerage is
payable. Expense ratio on Gold ETFs is also quite low, as it is passively managed.

Equity Fund Evaluation Parameters:

 Relative Return: Comparison with benchmark index
 Relative Volatility of the fund
 Risk Adjusted Return: The risk- adjusted returns is computed in order to assess whether the fund has
justified taking on a higher risk by generating higher returns.
 Allocation to cash: The extent of cash holding in an equity fund or debt holding in case of hybrid funds, tells
whether the fund manager is taking an aggressive or defensive stance
 Portfolio Diversification
 Sector Allocation
 Valuation Ratios: A valuation ratio is a measure of how cheap or expensive a security is compared to some
measure of profit or value. If a fund has a preference for certain types of stocks, it may be visible in the
fund’s valuation ratios.
 Market Cap
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Risk and return move together. A fund may have posted a higher return, but that would have also come with a
higher level of risk. The risk- adjusted returns is computed in order to assess whether the fund has justified taking on
a higher risk by generating higher returns. The Sharpe ratio compares the excess return a fund makes over and
above a risk-free rate, with its risk as measured by the standard deviation. The Treynor ratio is a measurement of
the returns earned in excess of that which could have been earned on a risk-free investment per each unit of risk
measured by its beta coefficient.

 Sharpe Ratio = (Return of the fund – Risk-free Rate) / Standard Deviation of the fund
 Treynor Ratio = (Return of the fund – Risk free Rate) / Portfolio Beta

Debt Fund Evaluation Parameters:

Debt Fund Composition
Credit Profile: The credit risk assumed by a debt portfolio can be discerned from the summary rating profile. Rating
profile indicates the percentage allocation to the various rating categories.
Maturity Profile: Average maturity, duration and modified duration are the measures of interest rate risk. Higher the
numbers, greater is the risk.

Average maturity is the weighted average of the maturities of the individual holdings. Duration is the weighted
average maturity, weighted by the cash flows of a security. They are weighted by the market value of the securities
to the total net assets of the fund.

Elements of Macro Economic Policy

 Gross Domestic Product (GDP) is the final value of all goods and services produced by a country in a given
time period. Rate of growth in GDP is a widely used measure of economic growth.
 The business cycle is the cyclical pattern of expansion and recession in economic growth around the path of
trend growth. GDP is at its trend level when an economy’s productive capacity is being fully or highly utilized
to achieve maximum output.
 Industrial performance is estimated mainly on the basis of the index of industrial production. IIP measures
changes in industrial activity with reference to a base year (currently 2011-12).
 The sum of total expenditures provides an estimate of how much was demanded and consumed, which by
corollary represents how much was produced is called aggregate demand.
 The current account balance is the difference between total exports and total imports of goods and services.
The difference between exports and imports of goods is known as trade balance.
 Inflation is the rate at which the general level of prices for goods and services is rising from one period to
another. Headline inflation refers to the change in the value of all goods in the basket. Core inflation
excludes food and fuel items, because the prices of these items tend to be more volatile, and thus create
‘noise’ in the headline inflation number.

Behavioral Biases in Investment Decision Making

Optimism or Confidence Bias: Investors cultivate a belief that they have the ability to outperform the market based
on some investing successes. Such winners are more often than not short-term in nature and may be the outcome of
chance rather than skill.
Familiarity Bias: This bias leads investors to choose what they are comfortable with. This may be asset classes they
are familiar with, stocks or sectors that they have greater information about and so on.
Anchoring: Investors hold on to some information that may no longer be relevant, and make their decisions based
on that. New information is labeled as incorrect or irrelevant and ignored in the decision making process.
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Loss Aversion: The fear of losses leads to inaction. Studies show that the pain of loss is twice as strong as the
pleasure they felt at a gain of a similar magnitude.
Herd Mentality: This bias is an outcome of uncertainty and a belief that others may have better information, which
leads investors to follow the investment choices that others make.
Recency Bias: The impact of recent events on decision making can be very strong. This applies equally to positive
and negative experiences.
Choice Paralysis: The availability of too many options for investment can lead to a situation of not wanting to
evaluate and make the decision.

VI. Regulatory and Compliance Aspects

SEBI (Investment Advisers) Regulations 2013

Definitions:
 Financial planning shall include analysis of clients’ current financial situation, identification of their financial
goals, and developing and recommending financial strategies to realize such goal.
 Investment advice means advice relating to investing in, purchasing, selling or otherwise dealing in securities
or investment products, and advice on investment portfolio containing securities or investment products,
whether written, oral or through any other means of communication for the benefit of the client and shall
include financial planning
 Investment adviser means any person, who for consideration, is engaged in the business of providing
investment advice to clients or other persons or group of persons and includes any person who holds out
himself as an investment adviser, by whatever name called.
 Representative means an employee or an agent of an investment adviser who renders investment advice on
behalf of that investment adviser.

No person shall act as an investment adviser or hold itself out as an investment adviser unless he has obtained a
certificate of registration from SEBI under the SEBI (Investment Adviser) Regulations, 2013. The certificate of
registration granted by SEBI shall be valid till it is suspended or cancelled by SEBI.

 Certain people do not require seeking registration, subject to the fulfillment of the conditions stipulated. Ex:
Any advocate, solicitor or law firm, who provides investment advice to their clients, incidental to their legal
practice.
 An individual registered as an investment adviser under these regulations and partners and representatives
of an investment adviser registered under these regulations offering investment advice shall have the certain
minimum qualifications as prescribed by SEBI at all times.
 Investment advisers which are body corporate shall have a net worth of not less than twenty five lakh
rupees. Investment advisers who are individuals or partnership firms shall have net tangible assets of value
not less than rupees one lakh.
 The certificate of registration granted under SEBI (Investment Adviser) Regulations, 2013 shall be valid till it
is suspended or cancelled by SEBI. (Note- these notes are prepared by www.pass4sure.in – the most trusted
question bank to clear NISM exams)
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Disclosure to clients:

 An investment adviser shall disclose to a prospective client, all material information about itself including its
business, disciplinary history, the terms and conditions on which it offers advisory services, affiliations with
other intermediaries and such other information as is necessary.
 An investment adviser shall disclose to its client, any consideration by way of remuneration or compensation
or in any other form whatsoever, received or receivable by it or any of its associates or subsidiaries for any
distribution or execution services in respect of the products or securities for which the investment advice is
provided to the client.
 An investment adviser shall, before recommending the services of a stock broker or other intermediary to a
client disclose any consideration by way of remuneration or compensation or in any other form whatsoever,
if any, received or receivable by the investment adviser, if the client desires to avail the services of such
intermediary.
 An investment adviser shall disclose to the client its holding or position, if any, in the financial products or
securities which are subject matter of advice.
 An investment adviser shall disclose to the client any actual or potential conflicts of interest arising from any
connection to or association with any issuer of products/securities, including any material information or
facts that might compromise its objectivity or independence in the carrying on of investment advisory
services.
 An investment adviser shall, while making an investment advice, make adequate disclosure to the client of
all material facts relating to the key features of the products or securities, particularly, performance track
record.
 An investment adviser shall draw the client’s attention to the warnings, disclaimers in documents,
advertising materials relating to an investment product which it is recommending to the client.

Other Duties:

 Maintenance of Records
 Appointment of Compliance Officer
 Redressal of Client Grievances
 Segregation of Execution Services

Code of Conduct for Investment Advisers

 Honesty and Fairness

 Diligence
 Capabilities
 Information about clients
 Information to its clients
 Fair and reasonable charges
 Conflicts of Interest
 Compliance
 Responsibility of Senior Management
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Regulation Relating to Insurance

The insurance sector in India is governed by the Insurance Regulatory and Development Authority Act, 1999, the
Insurance Act, 1938, the Life Insurance Corporation Act, 1956 and the General Insurance Business (Nationalization)
Act, 1972. Under the act, Intermediary" or "insurance intermediary" includes insurance brokers, reinsurance brokers,
insurance consultants, corporate agents, third party administrator, surveyors and loss assessors and such other
entities, as maybe notified by the Authority from time to time.

Regulation Relating to Pension Funds

The Workbook for NISM-Series-X-A: Investment Adviser (Level 1) Certification Examination discusses the role of the
Pension Fund Regulatory and Development Authority (PFRDA), the structure of National Pension System (NPS) and
its various products. The Pension Fund Regulatory and Development Authority Bill (PFRDA), 2011 was passed in
Parliament and became an Act in September 2013. This has given statutory power to PFRDA as regulator of the
pension sector in the country. The PFRDA is the authority entrusted with the following responsibilities under the
PFRDA Act, 2013:

 To promote old age income security by establishing, developing and regulating pension funds.
 To protect the interests of subscribers to schemes of pension funds and related matters.

Regulation Relating to Alternative Investment Schemes

Mutual Funds are regulated by the SEBI (Mutual Funds) Regulations, 1996. With a view to regulate other funds SEBI
introduced the Securities and Exchange Board of India (Alternate Investment Funds) Regulations, 2012.
Category I Alternative Investment Fund which invests in start-up or early stage ventures or social ventures or SMEs
or infrastructure or other sectors or areas which the government or regulators consider as socially or economically
desirable and shall include venture capital funds, SME Funds, social venture funds, infrastructure funds and such
other Alternative Investment Funds as may be specified.
Category II Alternative Investment Fund which does not fall in Category I and III and which does not undertake
leverage or borrowing other than to meet day-today operational requirements and as permitted in SEBI (Alternative
Investment Funds) Regulations, 2012.
Category III Alternative Investment Fund which employs diverse or complex trading strategies and may employ
leverage including through investment in listed or unlisted derivatives.

Redressal in Capital Market

SEBI as regulator of the capital market has put in place various measures for investor protection. Delegated redressal
mechanisms have been put in place. For instance, investors having a grievance related to a transaction in a stock
exchange can approach the Investor Services Centre (ISC) of the stock exchange. Various types of complaints are
registered against members of the stock exchange such as non-receipt of funds or securities, execution of trades
without investor consent, higher brokerage than what is permissible and other issues related to trading. Similarly
various types of complaints are registered against the listed companies such as non-receipt of securities or refunds
or interest related to offers made in the primary market, non-receipt of dividends, bonus or rights shares, interest
and redemption amount on debentures, or complaints related to the dematerialisation or transfer of securities.
Complaints can be filed online or physically.
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Redressal in Banking

Reserve Bank of India has set up the Banking Codes and Standards Board of India (BCSBI) as an independent
autonomous watchdog to ensure that customers get fair treatment in their dealings with Banks. The BCSBI has
published the “Code of Banks’ Commitments to Customers “which sets minimum standards of banking practice and
benchmarks in customer service for banks to follow.

Banking Ombudsman: The Banking Ombudsman is a person appointed by the RBI to address the complaints of
banking customers related to the services offered by banks. They also hear complaints related to credit cards issued
by banks and Non-banking Finance Companies (NBFC).

Redressal in Insurance

A complainant would first approach the grievance redressal mechanism of the insurance company. If the grievance is
not addressed satisfactorily then it can be escalated to IRDAI through the IGMS. IRDAI also offers the facility of
online registration of policy holders’ complaints through its Integrated Grievance Management System (IGMS) in its
website. A complainant would first approach the grievance redressal mechanism of the insurance company. If the
grievance is not addressed satisfactorily then it can be escalated to IRDAI through the IGMS. IRDAI also offers the
facility of online registration of policy holders’ complaints through its Integrated Grievance Management System
(IGMS) in its website.

VII. Case Studies In Comprehensive Financial Advice

The cases in comprehensive financial advice will address different topics covered in the Workbook. Examinees are
advised to get comfortable with the kind of MS Excel working illustrated in the cases provided.

Readers are thereby advised to refer the NISM Book to get a complete understanding of the case study provided

PLEASE NOTE, THESE ARE SHORT IMPORTANT NOTES EXTRACTED FROM THE NISM BOOK. ITS ADVISABLE
TO READ THE NISM BOOK TO GET FULL KNOWLEDGE.

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