Introduction to Investing

Investment is a must for everyone. Investing is to make your money grow for long-term financial goals. It is a means of saving money for some thing in the future. There are different ways of making an investment. This includes depositing money into stocks, bonds, mutual funds, real estate and gold. The purpose of investment is to put your money to work so that it earns you an additional profit.

For an average person investing is the only way to maintain same standard of living even after retirement.

The main reasons to invest are:

• Achieve financial goals
• Beat inflation
• Plan for retirement

Time Value of Money: Time value of money principle says that the value of money at a date in future is more than the value of the money today.For example 1000 rupees of today’s money held at 5 percent interest is worth 1050 rupees after a year, therefore 1000 rupees paid now and 1050 paid exactly one year from now is the same amount of payment of money with that given interest at the given amount of time.

The TVoM is calculated using the Compound interest formula:

FV = PV (1+r) ⁿ

Where,

FV = Future Value

PV = Present Value

r = Interest rate

n = Number of periods (No. Of years)

Introduction to Financial Market: Buyers and sellers come together and determine price in a market. The buyer and seller are two basic participants in a market. In a Financial market, firms and individuals enter into contracts to buy or sell a specific product such as stock or bond.

Funds or capital is essential for a company to grow and expand. A company can raise capital in two ways

• By issuing equity (Shares)
• By raising debt (Loans from Banks or financial intuitions)

Financial system is broadly divided into 4 groups

• Financial assets: Financial assets are easily tradable packages of capital and expected to give favorable future returns.
• Financial markets: Corporations require financial markets for setting up new business, expansion of existing business, diversification and working capital.
• Financial Intermediaries: Financial institutions serve as intermediaries in transferring the funds from investors having surplus savings to business.
• Regulators: At each stage in financial markets regulators have a crucial role to play in ensuring that the larger interests of the financial system always held upfront.

Here we will look at each group in detail:

Financial Markets:

Capital markets: Markets are classified into two broad categories

• Primary markets: Provide companies to issue new securities in order to raise capital. It is a market where securities are sold for the first time. In a primary issue, the company issues the securities directly to investors. Initial public offering (IPO) is one of the methods of issuing securities in primary market.
• Secondary markets: Secondary markets provide channel for trading of securities that is, buying and selling of existing securities so that investors can sell securities and exit the market and new investors can come into market by buying securities. Securities are first issued and bought by investors in primary market. Their subsequent buying and selling (trading) happens in secondary market. Ex: Buying and selling shares in BSE, NSE

Commodity Markets: Commodity markets are markets where raw or primary products are exchanged. Modern commodity markets have their roots in the trading of agricultural products.

Money Markets: The money market is where short-term obligations such as Commercial paper, Certificate of deposit, T-bills and Term money are bought and sold. The maturity period for these instruments will be less than one year. The most important feature of a money market instrument is that it is liquid and can be turned over quickly at low cost and provides an opportunity for balancing the short-term surplus funds of lenders and the requirements of borrowers.

Forex Markets: The foreign exchange market is where currency trading takes place. It is where banks and other official institutions facilitate the buying and selling of foreign currencies.

Financial Assets:

The below are different types of financial assets/Instruments:

Equity based: Equity/Stock/Share is an ownership in a company. Imagine that you own a business. If you were to divide that business up into small pieces and sell those pieces, you would essentially have issued stock. Quite simply, stock is ownership in a company.

Holding a company stock/share means that you are one of the many owners/share holders of that company. As a owner, you are entitled to your share of the company’s earnings as well as any voting rights attached to the stock.

There are two kinds of shares:

• Ordinary/equity shares: refers to as common stock gives the right to its owner to share in the profits of the company (dividends) and to vote at general meetings of the company.  The share holders are considered last if company goes bankrupt and has to sell off its assets.

• Preference shares:  Offer their owners preference over the ordinary shareholders. These shares give their owner an entitlement to a fixed dividend of the company, but which do not usually carry voting rights. If a company by any chance cannot pay its preference share dividend then it also means that it cannot pay any ordinary share dividend. This is because the preference shareholders have the right to receive their dividend before the ordinary shareholders under all circumstances – hence the term ‘preference’. In the event of winding up/ pay off/ bankruptcy these shareholders are given first preference over ordinary shareholders. Preference share are cumulative, this means that if a particular year’s dividend wasn’t paid, then it will be carried forward to subsequent year.  Here is an example below:

Debit Based: Debit securities represent a loan or money borrowed by government or corporate. These securities pay a fixed interest amount called coupon payments to the investors at pre-determined value. When you buy a bond, you lend the borrower (The issuer of the bond) your money for some period. The borrower could be a company or government. The problem large organizations run into is, that they typically need far more money than the average bank can provide. The solution is to raise more money by issuing bonds to public.

Derivatives: A derivative is an instrument whose value is derived from the value of one or more underlying asset, which can include commodities like precious metals, currency bonds, stocks and indices. The four most common examples of derivative instruments are forward contracts, future contracts, options and swaps.

Derivatives are contractual agreements between two parties, known as buyer and seller. The agreement mentions the rights and/or obligations of each party. Derivative contracts have a price, and buyers try to buy at lowest price while sellers try to sell at highest price.

There are two types of derivatives:

• Exchange Traded Derivatives: These are the derivative products that are traded via specialized derivatives exchanges. A derivative exchange acts as an intermediary to all related transactions.

There are two major classes of exchange-traded derivatives

• Futures Contract
• Options Contract
• Futures Contract: Futures contracts are a legally binding standardized agreement between parties to buy/sell a pre-determined underlying stock, commodity or index at a specified date in the future and at a future price, which is determined at the time, the contract was established. Futures contract is further divided based on Commodity, Stock and Stock Index.   Commodity/Stock: Is a commitment to deliver or receive a specific quantity of a commodity such as gold / Buy or sell a specific company stock such as Microsoft during a designated month at a price determined earlier. The buyer has an obligation to buy the commodity and the seller has obligation to sell the commodity.

Here is an example on how the Futures contract work:

• Stock Index: A future contract on a stock index is a future on the index that is, the underlying is index, as other derivatives the contract derives its value from the underlying index. Each contract is buying or selling a fixed value of index.

• Options Contract: Option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before certain date. The underlying asset can be a commodity, stock or stock index. The option buyer acquires a right, while the option seller takes on an obligation.

Still confused? The idea behind an option can be derived from everyday situations. Say, for example, that you discover a house that you’d love to purchase. Unfortunately, you won’t have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000. This price is called option premium or option price.

Now, consider two theoretical situations that might arise:

1. It’s discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million - $200,000 – $3,000).

2. While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option.

This example demonstrates two very important points. First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option.

Calls and Puts

The two types of options are calls and puts:

Call option: Call option deal with calling for or buying a stock from market. When you buy a call option on a stock, you have a right to buy the stock at a pre-specified price. When you sell a call option, you would have an obligation to deliver the stock.

Put option: Put option deals with putting into the market or selling stock in the market. When you buy a put option, you have the right to sell the stock at a specified price. When you sell a put option, you have an obligation to buy the stock.

• Over-The-Counter (OTC) derivatives: OTC derivatives are privately negotiated contracts between counterparties, which are customized in nature. Each contract is unique in nature and the terms and conditions of the derivative contracts can be tailored to the specific needs of the users. Most contracts are terminated through negotiations between the counterparties and are traded largely through computer or phone line and are not traded through any exchange. OTC derivative markets consist of the investment banks and include clients like hedge funds, commercial banks and government-sponsored enterprises.

Foreign Exchange: Foreign exchange market exits whenever one currency is traded for another. Trade is conducted electronically Over-The-Counter (OTC). This means that all transactions occur via computer network between traders/brokers around the world, rather than in one centralized exchange.

Financial Institutions: Financial institutions serve as intermediaries in the capital and debit markets. They facilitate transfer of funds from investors having surplus savings to business, which are need of those funds, thus channeling the funds for investment. Various types of financial institutions operate in market including: Banks, mutual funds, pension funds, hedge funds and insurance companies.

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