My accounts department dropped a bombshell one day. I was informed I would receive virtually no salary for the next two months if I didn't submit proof of having invested in tax-saving instruments.I rushed to call my insurance agent, demanding any policy with a 10,000-rupee premium. That was the sum I needed. My only condition was, the receipt should reach me in a couple of days.Cut to: 20 years later. I get a princely sum of Rs 60,000 from the insurance company. I am astounded. Was this supposed to help me retire? I calculate quickly. I paid Rs 2 lakh-plus (Rs 200,000), over the last two decades. What had happened to it?I realise I had opted for a money-back scheme, which gave me Rs 50,000 every five years. How and where, I wonder, did I use those funds that were earmarked for my retirement? I have landed myself in a soup. I could have opted for a higher cover with the same premium if only I had thought for a minute about the future rather than my next pay packet.
I can't change the past. I can only hope you learn from my mistake. This is what you should know.
1. Insurance is an absolute must. Don't delay that cover. Make sure it is adequate.2. Use insurance to save tax, but choose an amount and policy based on your future worth (sum of future earnings till you retire). Better still, choose one based on the amount your family needs to maintain its lifestyle after you.3. The riders in the insurance policies are worth considering. Make sure the critical illness rider figures in yours. It covers a few major illnesses such as cancer, heart disease and stroke, and takes care of the loss of income due to these illnesses.4. Don't neglect these riders just because the company you work for covers them already. Consider this: if you were skydiving, would you prefer to use a parachute you owned, or one you could rent out at a cheap price?What would happen if you quit your job and took a holiday before looking for a new assignment? Imagine handing over the rented parachute midair and hunting for a new one!5. Get financially savvy. Visit your financial doctor for a health checkup regularly and stay healthy. Regular checkups prevent unpleasant surprises.6. Life is not constant. Why should your cover be? Update, revisit and revise your insurance policies at every significant milestone in your life.Back to my situation. It is hopeless. But who can I blame? I was as guilty as my insurance agent. Luckily for me, my rich aunt passed away at the ripe old age of 78, leaving me a small fortune!Unless you have been really good to those grumpy relatives of yours, take my advice. Buy insurance. It is a more pleasant alternative!
Friday, January 30, 2009
Thursday, January 29, 2009
Now, you don't need proof to claim LTA, conveyance
Employers, while assessing the conveyance and leave & travel allowance (LTA) claims of their staff, are under no statutory
obligation to collect supporting evidence and furnish them to tax authorities, the Supreme Court said on Wednesday. A bench comprising Justice SH Kapadia and Justice Aftab Alam said that assessee employers are under no statutory obligation to collect bills and details to prove that the employees had utilised the amounts obtained against these claims on travel and related expenses. According to prevailing rules, if claims on LTA and conveyance are not supported by journey bills, they would be taxed. For instance, on an LTA allowance of Rs 1 lakh, if documentary proof such as air tickets, taxi vouchers and other public transport bills are submitted only for Rs 50,000, then tax is applicable on the rest of the amount. Regardless of the amount an executive is entitled to as LTA, tax laws allow air tickets only in the domestic sector for the claim. The apex court order came in a plea by companies including Larsen &Toubro and ITI. In its defence, the revenue department had argued that assessee companies were under statutory obligation under Income Tax Act, 1961, and relevant rules, to collect documentary proof to show that their employee(s) had actually utilised the amount paid towards the leave travel concession and conveyance allowance.
Source ET 29 Jan 2009, http://economictimes.indiatimes.com/Personal_Finance/No_proof_needed_for_LTA_conveyance/articleshow/4044623.cms
Monday, January 19, 2009
Relation Between Interest Rate & Income Fund
The rate of inflation should decline to zero sometime in the next six months, going by the chief economist of a leading private sector bank I was talking to the other day. Part of it would be due to the high base effect, of course, but an equally significant part would be on account of the sharp decline in prices of almost all commodities, especially of oil, which augurs well with regard to the inflation expectation of a commodity importing country such as ours.
With inflation no longer a threat, the government can pull out all stops to encourage growth and limit the collateral damage the recession-ravaged West can wreak on our economy. Indeed, the ball is already in play.
Last week, the Centre and the Reserve Bank of India (RBI) announced a coordinated stimulus package - monetary easing complemented with fiscal sops is expected to release a huge amount of liquidity that would hopefully ease the flow of funds through the financial pipelines of our economy.
Key amongst the various measures announced were a cut in the rate at which banks borrow from the RBI (repo rate) to the lowest ever of 5%. Simultaneously, the rate which RBI pays banks to park their idle funds (reverse repo rate) was also slashed to 4%, thereby sending a very strong signal to banks that the RBI is going to systematically disincentivise them from using it as a safe-keeper of their money.
With bond yields dipping to as low as 4.86%, banks spooked by counter party risk will at last be forced to use their assets for productive purposes such as lending, thereby kick-starting the credit cycle in the economy. At the same time, the cash reserve ratio, which is the share of deposits that banks need to park with the RBI, has been brought down in five successive cuts to 5%. The aggregate liquidity that has been released into the system due to monetary actions undertaken so far is expected to be in the region of Rs 3 lakh crore.
What does all this mean for us retail investors? Well, first and foremost, it is almost a given that such strong measures will without any doubt see a sharp drop in interest rates. In fact, K V Kamath of ICICI Bank has gone on record saying he expects interest rates to fall up to 5 percentage points over the next six months. Therefore, investors who intend to park their money in bank deposits should hurry, if they haven't invested already.
With bank deposit rates coming off, alternate investments such as company fixed deposits (FDs) would suddenly start seeming attractive. Though monetary policy is being eased, some corporates, especially in the real estate and construction sectors, would find raising money from traditional sources difficult. Offering the retail investor a higher rate on corporate FD would be the immediate recourse adopted and it is here that a retail investor should take care. An attempt to earn marginally higher return could well prove to be one in which the capital itself may get unstuck. Realise that company FDs are unsecured loans and not subject to a charge on the fixed assets of the company concerned. There is a reason why banks are chary of lending to corporates and investors must undertake the necessary due diligence.
If I were you, I would prefer to put my money in gilt and long-term bond funds. Over the next 12 months or so, this is the space that offers the highest potential for safe yet attractive returns.
This is because interest rates and prices of fixed income instruments share an inverse relationship. When the overall interest rates in the economy rise, the prices of fixed income earning instruments fall and vice versa. To illustrate how fluctuations in interest rates affect the returns, let us take the example of an income fund.
We assume that the current NAV of the fund is Rs 10 and its corpus is Rs 1,000 crore. This means that if the fund sells all the assets of the scheme and distributes the money on an equitable basis to all the unit holders, they will receive Rs 10 per unit.
Now, suppose the interest rate falls from 10% to 9%. Immediately thereafter, you wish to invest Rs 1 lakh in the scheme. Realise that the entire corpus of the fund stands invested at an average return of 10%. If the fund sells the units to you at its current NAV of Rs 10, you will be allotted 10,000 units. This will benefit you immensely. You will be a partner in sharing the benefit of the higher returns of 10%, though the fund will be forced to invest your Rs 1 lakh at the lower rate of 9%. This is injustice to the existing investors. Therefore, something has got to be done to protect their interest.
Here comes the 'mark to market' concept. The fund raises its NAV to Rs 11.11. You will be allotted only 9,000 units and not 10,000. The return on 9,000 units @10% would be identical to the return on 10,000 units @9%.In other words, the NAV rises when the interest rates fall.
Indeed, this has already started happening and the one-year return on most funds is already in the region of around 20% p.a. Going ahead, as the yield on government securities has already come off substantially, funds investing in corporate bonds as against gilts are expected to earn better return. The credit spread between gilts and corporate bonds still exists and a 15% annual return in a well-managed income fund of a good pedigree would be a very reasonable expectation.
Source: Live Mint
With inflation no longer a threat, the government can pull out all stops to encourage growth and limit the collateral damage the recession-ravaged West can wreak on our economy. Indeed, the ball is already in play.
Last week, the Centre and the Reserve Bank of India (RBI) announced a coordinated stimulus package - monetary easing complemented with fiscal sops is expected to release a huge amount of liquidity that would hopefully ease the flow of funds through the financial pipelines of our economy.
Key amongst the various measures announced were a cut in the rate at which banks borrow from the RBI (repo rate) to the lowest ever of 5%. Simultaneously, the rate which RBI pays banks to park their idle funds (reverse repo rate) was also slashed to 4%, thereby sending a very strong signal to banks that the RBI is going to systematically disincentivise them from using it as a safe-keeper of their money.
With bond yields dipping to as low as 4.86%, banks spooked by counter party risk will at last be forced to use their assets for productive purposes such as lending, thereby kick-starting the credit cycle in the economy. At the same time, the cash reserve ratio, which is the share of deposits that banks need to park with the RBI, has been brought down in five successive cuts to 5%. The aggregate liquidity that has been released into the system due to monetary actions undertaken so far is expected to be in the region of Rs 3 lakh crore.
What does all this mean for us retail investors? Well, first and foremost, it is almost a given that such strong measures will without any doubt see a sharp drop in interest rates. In fact, K V Kamath of ICICI Bank has gone on record saying he expects interest rates to fall up to 5 percentage points over the next six months. Therefore, investors who intend to park their money in bank deposits should hurry, if they haven't invested already.
With bank deposit rates coming off, alternate investments such as company fixed deposits (FDs) would suddenly start seeming attractive. Though monetary policy is being eased, some corporates, especially in the real estate and construction sectors, would find raising money from traditional sources difficult. Offering the retail investor a higher rate on corporate FD would be the immediate recourse adopted and it is here that a retail investor should take care. An attempt to earn marginally higher return could well prove to be one in which the capital itself may get unstuck. Realise that company FDs are unsecured loans and not subject to a charge on the fixed assets of the company concerned. There is a reason why banks are chary of lending to corporates and investors must undertake the necessary due diligence.
If I were you, I would prefer to put my money in gilt and long-term bond funds. Over the next 12 months or so, this is the space that offers the highest potential for safe yet attractive returns.
This is because interest rates and prices of fixed income instruments share an inverse relationship. When the overall interest rates in the economy rise, the prices of fixed income earning instruments fall and vice versa. To illustrate how fluctuations in interest rates affect the returns, let us take the example of an income fund.
We assume that the current NAV of the fund is Rs 10 and its corpus is Rs 1,000 crore. This means that if the fund sells all the assets of the scheme and distributes the money on an equitable basis to all the unit holders, they will receive Rs 10 per unit.
Now, suppose the interest rate falls from 10% to 9%. Immediately thereafter, you wish to invest Rs 1 lakh in the scheme. Realise that the entire corpus of the fund stands invested at an average return of 10%. If the fund sells the units to you at its current NAV of Rs 10, you will be allotted 10,000 units. This will benefit you immensely. You will be a partner in sharing the benefit of the higher returns of 10%, though the fund will be forced to invest your Rs 1 lakh at the lower rate of 9%. This is injustice to the existing investors. Therefore, something has got to be done to protect their interest.
Here comes the 'mark to market' concept. The fund raises its NAV to Rs 11.11. You will be allotted only 9,000 units and not 10,000. The return on 9,000 units @10% would be identical to the return on 10,000 units @9%.In other words, the NAV rises when the interest rates fall.
Indeed, this has already started happening and the one-year return on most funds is already in the region of around 20% p.a. Going ahead, as the yield on government securities has already come off substantially, funds investing in corporate bonds as against gilts are expected to earn better return. The credit spread between gilts and corporate bonds still exists and a 15% annual return in a well-managed income fund of a good pedigree would be a very reasonable expectation.
Source: Live Mint
Should you buy Jeevan Astha ??
It is in school that we are taught the basic difference between simple and compound interest. We are taught the fundamental principle that compound interest and not simple interest is the effective rate of return on any investment.
However, it increasingly seems to me that this is a lesson that is either not learnt well or is forgotten way too early. How else does one explain people falling over each other to invest in what essentially is a fixed deposit that, depending upon the age of the investor, offers at best 7.32% per annum (p.a.) and at worst a 4.32% p.a. return?
Yes, I am talking of LIC's Jeevan Aastha, a policy that seems to have taken the investor community by storm. The simple FD like structure gets complicated on account of the investment being combined with insurance and the usage of differing terminologies such as Basic Sum Assured, Maturity Sum Assured, Guaranteed Additions, Loyalty Additions, Death Benefit, Maturity Benefit and so on.
This week's article analyses Jeevan Aastha and tries to simplify it for the ready understanding of the common investor.
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Basically, Jeevan Aastha is a single premium assurance plan which offers guaranteed benefits on death or maturity. In simple terms, this policy is like a fixed deposit that offers a certain guaranteed return and a certain specific amount of insurance upon the death of the investor.
Anyone between the ages of 13 and 60 years may invest in this policy, which can be taken for a term of either 5 years or 10 years depending on one's choice. As in a fixed deposit, the premium (investment) has to be paid once, at the beginning. In insurance jargon, this is known as a single premium plan.
Now, to understand how Jeevan Aastha works, let's split up the investment and insurance cover. The two are mutually exclusive anyway. In other words, were the investor to survive the term of the plan, the insurance benefit offered by the policy doesn't kick in and vice versa.
Let's first take a case where the investor remains healthy, alive and kicking throughout the term of the plan (5 or 10 years as the case may be). The interest or return on investment as mentioned by LIC is Rs 100 per thousand of Maturity Sum Assured (MSA) per year for a policy of 10 years and Rs 90 per thousand MSA per year for a policy of 5 years term where the MSA is one-sixth of the Basic Sum Assured (BSA).Please note the significance of the words -- Rs 100 per thousand per year. The usage (Rs 100 per thousand) translates into Rs 10 per hundred or 10% per year.
Many unethical, unscrupulous agents are taking this rate of 10% per year and selling Jeevan Aastha as a product that offers 10% p.a tax-free return. And in the current mood of risk aversion, the public is lapping it up. However, note that the 10% is flat per year on a simple basis, meaning there is no interest on interest element (which by the way is the definition of compound interest). Instead the investor gets a flat 10% per year.
In terms of an example, a 30-year-old investor who invests Rs 24,810 will receive Rs 50,000 upon maturity at the end of 10 years, translating into a return of 7.26%. The accompanying table lists the age-wise maximum and minimum potential return on this plan.
Though there is a mention of loyalty addition, the same is variable and not guaranteed and hence not included in the computations. Generally, the same is around 5% over the term of the plan and hence will not materially alter the returns.
Coming to the insurance element, most investors are being led to believe that the insurance amount is six times the premium amount throughout the term. First of all, the insurance amount is six times the MSA plus guaranteed additions (9% or 10% as the case may be). However, this is only for the first year. From the second year onwards till maturity, the death benefit drastically falls to one-third of the above.
Tax tangleThough it is generally believed that insurance policy proceeds are free of tax, as per Sec. 10(10D), if the premium payable on any insurance plan exceeds 20% of the sum assured, the proceeds cease to be exempt and instead will be fully taxable. In the case of Jeevan Aastha, the single premium will always in all cases be more than 20% of the maturity proceeds. Would this not make the maturity amount from the plan fully taxable? A clarification from LIC would be helpful.
To sum Jeevan Aastha is a fixed-return investment plan that would offer a return in the range of 6.75% to 7.25% p.a in most cases. Any investment in this plan should be made with a clear understanding and recognition of this return.
In Nabard's Bhavishya Nirman Bonds, Rs 8,500 grows to Rs 20,000 in 10 years, yielding an after-tax return of 8.29% p.a.
Note that in terms of the example used in the article, an investment of Rs 24,810 would grow to Rs 53,562 if invested in the Public Provident Fund (PPF) scheme. One can invest only Rs 70,000 per year in PPF, of course, whereas there is no upper limit in the case of Jeevan Aastha. Besides, PPF makes for regular investing and one has to put in a minimum of Rs 500 per year to keep the account active.
While it is true that Jeevan Aastha offers insurance along with investment, regular readers of my column would know that I do not encourage combining insurance and investment. Always buy a term plan, which is the most economical insurance that you can buy and then try and optimise your investment returns.
Source : Sandeep Shanbhag DNA Times. Dt 14 Jan 09.
However, it increasingly seems to me that this is a lesson that is either not learnt well or is forgotten way too early. How else does one explain people falling over each other to invest in what essentially is a fixed deposit that, depending upon the age of the investor, offers at best 7.32% per annum (p.a.) and at worst a 4.32% p.a. return?
Yes, I am talking of LIC's Jeevan Aastha, a policy that seems to have taken the investor community by storm. The simple FD like structure gets complicated on account of the investment being combined with insurance and the usage of differing terminologies such as Basic Sum Assured, Maturity Sum Assured, Guaranteed Additions, Loyalty Additions, Death Benefit, Maturity Benefit and so on.
This week's article analyses Jeevan Aastha and tries to simplify it for the ready understanding of the common investor.
window.google_render_ad();
Basically, Jeevan Aastha is a single premium assurance plan which offers guaranteed benefits on death or maturity. In simple terms, this policy is like a fixed deposit that offers a certain guaranteed return and a certain specific amount of insurance upon the death of the investor.
Anyone between the ages of 13 and 60 years may invest in this policy, which can be taken for a term of either 5 years or 10 years depending on one's choice. As in a fixed deposit, the premium (investment) has to be paid once, at the beginning. In insurance jargon, this is known as a single premium plan.
Now, to understand how Jeevan Aastha works, let's split up the investment and insurance cover. The two are mutually exclusive anyway. In other words, were the investor to survive the term of the plan, the insurance benefit offered by the policy doesn't kick in and vice versa.
Let's first take a case where the investor remains healthy, alive and kicking throughout the term of the plan (5 or 10 years as the case may be). The interest or return on investment as mentioned by LIC is Rs 100 per thousand of Maturity Sum Assured (MSA) per year for a policy of 10 years and Rs 90 per thousand MSA per year for a policy of 5 years term where the MSA is one-sixth of the Basic Sum Assured (BSA).Please note the significance of the words -- Rs 100 per thousand per year. The usage (Rs 100 per thousand) translates into Rs 10 per hundred or 10% per year.
Many unethical, unscrupulous agents are taking this rate of 10% per year and selling Jeevan Aastha as a product that offers 10% p.a tax-free return. And in the current mood of risk aversion, the public is lapping it up. However, note that the 10% is flat per year on a simple basis, meaning there is no interest on interest element (which by the way is the definition of compound interest). Instead the investor gets a flat 10% per year.
In terms of an example, a 30-year-old investor who invests Rs 24,810 will receive Rs 50,000 upon maturity at the end of 10 years, translating into a return of 7.26%. The accompanying table lists the age-wise maximum and minimum potential return on this plan.
Though there is a mention of loyalty addition, the same is variable and not guaranteed and hence not included in the computations. Generally, the same is around 5% over the term of the plan and hence will not materially alter the returns.
Coming to the insurance element, most investors are being led to believe that the insurance amount is six times the premium amount throughout the term. First of all, the insurance amount is six times the MSA plus guaranteed additions (9% or 10% as the case may be). However, this is only for the first year. From the second year onwards till maturity, the death benefit drastically falls to one-third of the above.
Tax tangleThough it is generally believed that insurance policy proceeds are free of tax, as per Sec. 10(10D), if the premium payable on any insurance plan exceeds 20% of the sum assured, the proceeds cease to be exempt and instead will be fully taxable. In the case of Jeevan Aastha, the single premium will always in all cases be more than 20% of the maturity proceeds. Would this not make the maturity amount from the plan fully taxable? A clarification from LIC would be helpful.
To sum Jeevan Aastha is a fixed-return investment plan that would offer a return in the range of 6.75% to 7.25% p.a in most cases. Any investment in this plan should be made with a clear understanding and recognition of this return.
In Nabard's Bhavishya Nirman Bonds, Rs 8,500 grows to Rs 20,000 in 10 years, yielding an after-tax return of 8.29% p.a.
Note that in terms of the example used in the article, an investment of Rs 24,810 would grow to Rs 53,562 if invested in the Public Provident Fund (PPF) scheme. One can invest only Rs 70,000 per year in PPF, of course, whereas there is no upper limit in the case of Jeevan Aastha. Besides, PPF makes for regular investing and one has to put in a minimum of Rs 500 per year to keep the account active.
While it is true that Jeevan Aastha offers insurance along with investment, regular readers of my column would know that I do not encourage combining insurance and investment. Always buy a term plan, which is the most economical insurance that you can buy and then try and optimise your investment returns.
Source : Sandeep Shanbhag DNA Times. Dt 14 Jan 09.
Total Recall !! - Should you exit Equity markets ??
One of my friends joined as a lead software architect in a boutique firm last year. He was in charge of their largest client, until last month. Something went wrong with the account for which my friend claims he was not the reason. The point is not that. His annual performance review was due last month. And his supervisor could only recall the mistake my friend did just that week, not the additional billings that he generated in 11 months! So, my friend did not get a salary hike and promotion. Perhaps, you have experienced it as well. Why does this happen?
Psychologists claim that our memory is typically geared to remember only the final episodes of any event. Think of the film you like the most. You, perhaps, liked the movie because of the way it ended. The final episode
Researchers have conducted several experiments to prove the point. In one such experiment, students had to rate the quality of life of two women who had died recently. One had an exceptionally good lifestyle till age 60 and then slumped into merely satisfactory life for the next five years after which she died. The second woman had a good lifestyle till her death at age 55. The students gave the second woman a better lifestyle rating than the first, even though the former had more number of years of exceptionally good lifestyle. Why? The students preferred the final episode to the total movie called life.Learning the hard way
It is the same with investments. Suppose you had entered the market for the first time in 2003. You may have generated handsome profits until mid-January 2008 when the market crashed. The final episode would have stuck in your mind. So, did you immediately take a vow not to enter the market again?
While you cannot control how the market behaves, you certainly can ensure that everything goes well in the month leading to your annual performance review. My friend learnt the hard way on what it means to have it otherwise. You need not.
Source: Hindu Business Line
Wednesday, January 14, 2009
World of Options !! Part 1
Options, one of the most common derivative instruments, can be full of surprises. That’s the reason pricing of options is one of the most challenging jobs. However, we have different pricing models, which try to bring some order in an otherwise chaotic world of options. But these models use complicated equations which are beyond the reach of our friend Johnny. So let’s try to learn, in the language of a newbie, what goes into the pricing of options.
Jinny: Hi, Johnny! I see you are in a lighter mood. What’s up?
Johnny: I remain in a lighter mood whenever I am thinking about something serious.
Jinny: Really? Can I also join?
Johnny: Of course, you can. In fact, I was just wondering whether we can make a mathematical model for catching a fish. I am sure if we are ever able to make such a model, it would not be as complicated as some of our options pricing models. What do you say?
Jinny: Well, I can’t talk much about models for catching fish, but I can surely explain how options are priced without going into complicated details of models, if that is what you want to understand.
Johnny: That’s right, Jinny. But let’s get into the basics first.
Jinny: Options, as you know, are contracts in which the option buyer acquires the right but no obligation to buy from or sell to the option seller the underlying asset at a predetermined price called “strike price”. Options that give the right to buy are called “call options” and options that give the rights to sell are called “put options”. Further, options can be classified as “European options”, which can be exercised only on the expiry date, and “American options”, which can be exercised on or any day before the expiry date. As if these two were already not enough, we also have “Bermuda options” and “Asian options”, which we will ignore for now to avoid confusion.
In options of any kind, the option buyer is under no obligation to exercise his option. However, once he chooses to do so, the option seller is bound to honour his promise. To avail this kind of one-way ticket, the option buyer has to pay a price called “option premium” to the option seller.
we come to the crucial part. How do we decide the option price that is good enough to induce the option seller to undertake all the risk? Well, we can use any of the option pricing models such as the Black Scholes model or Binomial option pricing model or any one of the other variants for determining the option premium. These models no doubt use complex mathematical equations that look very intimidating to beginners. But once you understand their basics, you can use them like playthings.
Johnny: So far, so good. Tell me, Jinny, how is the price of an option determined?
Jinny: The pricing of an option revolves around two components—one is called the “intrinsic value” and the other is called the “time value”. “Intrinsic value” represents the true worth of your option at present. This value does not remain constant but keeps changing over the life of your option. In fact, its value may fluctuate between zero and infinite positive numbers.
What, you may wonder, if the intrinsic value gets into negative territory? Well, an option having intrinsic value in negatives is only as bad as an option having zero intrinsic value. Why? That I will explain in a while. Just keep in mind that at worst you can lose the bird in hand. You can’t lose more than what you actually had.
Johnny: How can we find out the intrinsic value of an option?
Jinny: For finding out the intrinsic value, there is no need to use complex mathematical equations. You simply need to find out whether the strike price of the underlying asset of your option is higher or lower than its current market price.
For a call option, a strike price lower than the current market price means you can buy the underlying asset at a lower price than the current market price by exercising your option. Such options have a positive intrinsic value which you can find out by subtracting the strike price from the current market price.
Suppose you hold a call option for buying a single share of company X at a strike price of Rs100 per share before the expiry date and the same share is presently trading at a higher price of Rs120. The intrinsic value of the present option is Rs120 minus Rs100, or Rs20. The benefit of such a situation is obvious. You can earn a profit of Rs20 by exercising an option having an intrinsic value of Rs20. In technical terms, we can also say that your option is “in the money” by Rs20.
Johnny: But what if the strike price of the call option is higher than the current market price?
Jinny: Well, that’s something you can think about till we meet next week.
What: The price of an option or option premium consists of “intrinsic value” and “time value”.
How: We can know the intrinsic value by comparing the current market price of the underlying asset with its “strike price”.
When: A call option is “in the money” when the strike price of the underlying asset is lower than its current market price.
Jinny: Hi, Johnny! I see you are in a lighter mood. What’s up?
Johnny: I remain in a lighter mood whenever I am thinking about something serious.
Jinny: Really? Can I also join?
Johnny: Of course, you can. In fact, I was just wondering whether we can make a mathematical model for catching a fish. I am sure if we are ever able to make such a model, it would not be as complicated as some of our options pricing models. What do you say?
Jinny: Well, I can’t talk much about models for catching fish, but I can surely explain how options are priced without going into complicated details of models, if that is what you want to understand.
Johnny: That’s right, Jinny. But let’s get into the basics first.
Jinny: Options, as you know, are contracts in which the option buyer acquires the right but no obligation to buy from or sell to the option seller the underlying asset at a predetermined price called “strike price”. Options that give the right to buy are called “call options” and options that give the rights to sell are called “put options”. Further, options can be classified as “European options”, which can be exercised only on the expiry date, and “American options”, which can be exercised on or any day before the expiry date. As if these two were already not enough, we also have “Bermuda options” and “Asian options”, which we will ignore for now to avoid confusion.
In options of any kind, the option buyer is under no obligation to exercise his option. However, once he chooses to do so, the option seller is bound to honour his promise. To avail this kind of one-way ticket, the option buyer has to pay a price called “option premium” to the option seller.
we come to the crucial part. How do we decide the option price that is good enough to induce the option seller to undertake all the risk? Well, we can use any of the option pricing models such as the Black Scholes model or Binomial option pricing model or any one of the other variants for determining the option premium. These models no doubt use complex mathematical equations that look very intimidating to beginners. But once you understand their basics, you can use them like playthings.
Johnny: So far, so good. Tell me, Jinny, how is the price of an option determined?
Jinny: The pricing of an option revolves around two components—one is called the “intrinsic value” and the other is called the “time value”. “Intrinsic value” represents the true worth of your option at present. This value does not remain constant but keeps changing over the life of your option. In fact, its value may fluctuate between zero and infinite positive numbers.
What, you may wonder, if the intrinsic value gets into negative territory? Well, an option having intrinsic value in negatives is only as bad as an option having zero intrinsic value. Why? That I will explain in a while. Just keep in mind that at worst you can lose the bird in hand. You can’t lose more than what you actually had.
Johnny: How can we find out the intrinsic value of an option?
Jinny: For finding out the intrinsic value, there is no need to use complex mathematical equations. You simply need to find out whether the strike price of the underlying asset of your option is higher or lower than its current market price.
For a call option, a strike price lower than the current market price means you can buy the underlying asset at a lower price than the current market price by exercising your option. Such options have a positive intrinsic value which you can find out by subtracting the strike price from the current market price.
Suppose you hold a call option for buying a single share of company X at a strike price of Rs100 per share before the expiry date and the same share is presently trading at a higher price of Rs120. The intrinsic value of the present option is Rs120 minus Rs100, or Rs20. The benefit of such a situation is obvious. You can earn a profit of Rs20 by exercising an option having an intrinsic value of Rs20. In technical terms, we can also say that your option is “in the money” by Rs20.
Johnny: But what if the strike price of the call option is higher than the current market price?
Jinny: Well, that’s something you can think about till we meet next week.
What: The price of an option or option premium consists of “intrinsic value” and “time value”.
How: We can know the intrinsic value by comparing the current market price of the underlying asset with its “strike price”.
When: A call option is “in the money” when the strike price of the underlying asset is lower than its current market price.
Source : Live Mint
All about Debt Funds
Equity markets disappointed investors last year and there is no clear sign of a quick revival in the near term. We have to search for such options which can sustain our wealth with acceptable returns in these bearish times. Debt schemes are one such opportunity where you can park your money in these tough times. With further rate cuts expected, debt investment instruments are likely to offer attractive platform to invest in low risk and high yield avenues. Apart from the traditional fixed deposits and provident fund schemes, mutual funds too actively manage debt products. Debt funds seek to invest in various debt instruments whose maturity could be short-term or long-term.Debt funds can be broadly classified as income funds, liquid funds and fixed maturity plans. The classification is based on the nature of instruments and their maturity.
Starting from Income Funds, these funds invest in Corporate Bonds and Government securities. These Funds provide investors with an opportunity to increase returns and generate capital gains, by taking duration bets in a benign interest rate environment.The credit quality of the instruments and the fund manager’s ability to tactically manage the portfolio maturity based on interest rate cycles would determine the performance of such funds.One should be careful while investing in these funds on the portfolio side because sometimes in urge of delivering high returns, the asset quality of the portfolio could be deteriorated. Here we take a look at the various debt funds:
At a time when investors have turned risk averse and credit concerns abound, gilt funds can fill a critical gap in asset allocation. These funds seek to generate steady and consistent returns from a basket of government securities across various maturities through proactive fund management aimed at controlling interest rate risk. These funds will invest in gilt including T-Bills with medium to long maturity. On the back of a possibility of deterioration in corporate credit quality, gilts funds are safer than income funds as Government debt comes with a sovereign guarantee and there is no risk to capital or interest payments
When some one wants to park their money for a very short term, liquid funds is one of the prudent options. These funds invest in short term debt market and money market instruments having very short maturity period, which ensures high liquidity. Liquid funds invest with minimal risk (like money market funds). Usually these funds do not have a lock-in period and offer redemption proceeds within 24 hours. As these funds have restrictions on the quantum of investment in mark-to-market instruments, the interest rate risk is lower. They do not, therefore, benefit from interest rate cycles, unlike income or gilt funds. Liquid-plus funds, on the other hand, can invest in slightly longer-term maturity instruments, thus enhancing the risk-return potential.
They offer flexibility in portfolio constitution according to the perception regarding interest rate movements. Investing in these kind fund are sensible decisions in volatile interest rate when you don’t have time for research and don’t want to shift your options on an active basis.
Fixed maturity plans are close-end funds whose maturity is linked to the expiry of the underlying instruments in which they invest. While FMPs typically help investors lock into the yields of the underlying instruments, such returns would be feasible only if an investor holds on to the fund, until its maturity. Further FMPs carry credit risk in case there is a default on some of the Corporate Papers which they might be holding. While FMPs are no doubt a superior option from a taxation perspective, they are not strictly comparable, as fixed deposits offer assured returns and are not directly linked to market sensitivities once the investment is made.
Floating Rate Funds is another option which is currently out of favor due to expectation of fall in interest rates. These funds have the potential to provide you returns in line with the prevailing interest rate. These should be preferred in times when the interest rates are likely to go up.
To conclude, we think that interest rates are likely to fall further from current levels which would help income funds and gilt funds to deliver good returns. Though, gilt funds have delivered handsome returns recently but still there is some steam left. A conservative investor who does not want to take any credit risk can park their money in gilt funds. The next rally in this category is most likely to be led by Income Funds as they have not seen a major movement yet. Further, the spread between G-sec yield and AAA papers is also very wide. Moderate and aggressive investors with a short and medium-term investment horizon can invest in income funds and can expect decent returns.
Starting from Income Funds, these funds invest in Corporate Bonds and Government securities. These Funds provide investors with an opportunity to increase returns and generate capital gains, by taking duration bets in a benign interest rate environment.The credit quality of the instruments and the fund manager’s ability to tactically manage the portfolio maturity based on interest rate cycles would determine the performance of such funds.One should be careful while investing in these funds on the portfolio side because sometimes in urge of delivering high returns, the asset quality of the portfolio could be deteriorated. Here we take a look at the various debt funds:
At a time when investors have turned risk averse and credit concerns abound, gilt funds can fill a critical gap in asset allocation. These funds seek to generate steady and consistent returns from a basket of government securities across various maturities through proactive fund management aimed at controlling interest rate risk. These funds will invest in gilt including T-Bills with medium to long maturity. On the back of a possibility of deterioration in corporate credit quality, gilts funds are safer than income funds as Government debt comes with a sovereign guarantee and there is no risk to capital or interest payments
When some one wants to park their money for a very short term, liquid funds is one of the prudent options. These funds invest in short term debt market and money market instruments having very short maturity period, which ensures high liquidity. Liquid funds invest with minimal risk (like money market funds). Usually these funds do not have a lock-in period and offer redemption proceeds within 24 hours. As these funds have restrictions on the quantum of investment in mark-to-market instruments, the interest rate risk is lower. They do not, therefore, benefit from interest rate cycles, unlike income or gilt funds. Liquid-plus funds, on the other hand, can invest in slightly longer-term maturity instruments, thus enhancing the risk-return potential.
They offer flexibility in portfolio constitution according to the perception regarding interest rate movements. Investing in these kind fund are sensible decisions in volatile interest rate when you don’t have time for research and don’t want to shift your options on an active basis.
Fixed maturity plans are close-end funds whose maturity is linked to the expiry of the underlying instruments in which they invest. While FMPs typically help investors lock into the yields of the underlying instruments, such returns would be feasible only if an investor holds on to the fund, until its maturity. Further FMPs carry credit risk in case there is a default on some of the Corporate Papers which they might be holding. While FMPs are no doubt a superior option from a taxation perspective, they are not strictly comparable, as fixed deposits offer assured returns and are not directly linked to market sensitivities once the investment is made.
Floating Rate Funds is another option which is currently out of favor due to expectation of fall in interest rates. These funds have the potential to provide you returns in line with the prevailing interest rate. These should be preferred in times when the interest rates are likely to go up.
To conclude, we think that interest rates are likely to fall further from current levels which would help income funds and gilt funds to deliver good returns. Though, gilt funds have delivered handsome returns recently but still there is some steam left. A conservative investor who does not want to take any credit risk can park their money in gilt funds. The next rally in this category is most likely to be led by Income Funds as they have not seen a major movement yet. Further, the spread between G-sec yield and AAA papers is also very wide. Moderate and aggressive investors with a short and medium-term investment horizon can invest in income funds and can expect decent returns.
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