PMS Short Notes

NISM SERIES XXI A –
PORTFOLIO MANAGEMENT SERVICES
Short Notes for Revision
Chapter 1 - Investments
People have, broadly, two options to utilise their savings. They can
either keep it with them until their consumption requirements exceed
their income, or, they can pass on their saving to those whose
requirements exceed their income with the condition of returning it
back with some increment.
NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|1

Saving versus Investment
Saving is just the difference between money earned and money spent.
Investment is the current commitment of savings with an expectation

of receiving a higher amount of committed savings. Investment
involves some specific time period. It is the process of making the
savings work to generate return.
Investment versus Speculation
Investment and speculation activities are so intermingled that it is very

difficult to distinguish and separate them. An attempt can be made to
distinguish between speculation and investment on the basis of
criteria like investment time horizon and the process of decision
making.
Investment Objectives
Investment objectives can be defined as investors’ goals expressed in

terms of risk, return and liquidity
preferences. Some investors may have the tendency to express their
goals solely on the basis of return. The return objective may be
simplified as follows:
Capital Preservation: It means minimizing or avoiding the chances of

erosion in the principal amount of investment. Highly risk averse
investors pursue this investment goal, as his investment objective
requires no or minimal risk taking. Also, when funds are required for
immediate short term, investors may state for capital preservation as
the investment objective.
Capital Appreciation: It is an appropriate investment objective for

those who want their portfolio value to grow over a period of time and
are prepared to take risks. This may be an appropriate investment
objective for long term investors.
Current Income: It is an investment objective pursued when investor

wants her portfolio to generate income at regular interval by way of
dividend, interest, rental income rather than appreciation in the value
of the portfolio. This investment objective is mostly pursued by people
who are retired and want their portfolios to generate income to meet
their living expenses.
Estimating the required rate of return
Investment is the commitment of rupee for a period of time to earn a)

pure time value of money for investors postpone their current
consumption b) compensation for expected inflation during the
period of investment for the change in the general price levels and c)
risk premium for the uncertainty of future payments. The price paid
for the exchange between current and future consumption is the pure
rate of interest.
It is the rate of return, the investor demands even if there is no

inflation and no uncertainty associated with future payments.

Required rate of return is the minimum rate of return investors expect
when making investment decisions. It is to be noted that required rate
of return is not guaranteed return or assured return. It is also different
from expected or forecasted return. It is also different from realized
return.
Real risk free rate is the basic rate of return or interest rate, assuming
no inflation and no uncertainty about future cashflows. It is the
compensation paid for postponing the consumption.
The nominal risk-free rate of return is the rate of return, an investor

is certain of receiving on the due date. Investor is certain of the
amount as well as the timing of the return.
Types of risks
Business Risk is the Uncertainty of income flows caused by the nature

of a firm’s business.
Financial risk relates to the means of financing assets – debt or equity.

It is uncertainty caused by the use of debt financing.
Liquidity is defined as ease of converting an asset into cash at close to

its economic worth. The more difficult the conversion, the more is
liquidity risk.
Exchange rate risk is the uncertainty of return introduced by acquiring
investments denominated in a currency different from that of the
investor.
Political risk is the uncertainty of returns caused by the possibility of

a major change in the political or economic environment in a country.
Geopolitics is influence of geography and politics on economics and

relationships between countries. Geopolitical risk is the risk
associated with wars, terrorist acts, and tensions between states that
affect the normal and peaceful course of international relations.
Regulatory risk is the risk associated with uncertainty about the

regulatory framework pertaining to investments.

Relationship between risk and return
Types of Investments
Equity
Equity Shares represent ownership in a company that entitles its
holders a share in profits and the right to vote on the company’s
affairs. Equity shareholders are residual owners of firm’s profit after
other contractual claims on the firm are satisfied and have the
ultimate control over how the firm is operated. Equity Shareholders
are residual claim holders. Investments in equity shares reward
investors in two ways: dividend and capital appreciation.

Fixed Income
Debt instruments, also called fixed income instruments, are contracts
containing a promise to pay a stream of cash flows during the term of
the contract to the investors. The debt contract can be transferable, a
feature specified in the contract that permits its sale to another
investor, or non-transferable, which prohibits sale to another party.
Government versus corporate debt securities
A Government Security (G-Sec) is a tradeable instrument issued by

the Central Government or the State Governments. It acknowledges
the Government’s debt obligation. Such securities are short term or
long term.
Corporate fixed income securities pay higher interest rates than the
government securities due to default risk. The difference between the
yield on a government security and the corporate security for the
same maturity is called “credit spread”.

High yield versus investment grade
Higher rating denotes lower default risk and vice versa. The
convention in the market is to classify bonds with rating BBB and
above as investment grade and bonds below the BBB as high yield or
junk bonds. Many institutional investors are prohibited from investing
in junk bonds as they involve high default risk.
Money Market versus capital market
Money market securities have maturities of one year or less than one
year. Treasury bills, commercial papers, certificate of deposits up to
one year maturity are referred as money market instruments.
Capital market is a place for long term fund mobilization. Securities

with maturities greater than one year are referred to as capital market
securities. Stocks and bonds are capital market securities.
Commodities
Commodities are subject to higher business cycle risk as their prices
are determined by the demand and supply of the end products in
which they are consumed. Soft commodities historically have shown
low correlation to stocks and bonds. Hence, they provide benefits of
risk diversification when held in a portfolio along with stock and
bonds.
Real Estate
Real estate is the largest asset class in the world. It has been a
significant driver of economic growth. It offers significant
diversification opportunities. It has been historically viewed as good
inflation hedge. Investors can invest into real estate with capital
appreciation as investment objective as well as to generate regular
income by way of rents. It is usually a long term investment. Real
estate is classified into two sub-classes: commercial real estate or
residential real estate.
Structured Products
Structured products are customized and sophisticated investments.
They provide investors risk-adjusted exposure to traditional
investments or to assets that are otherwise difficult to obtain.
Structured products greatly use derivatives to create desired risk
exposures. Many structured products are designed to provide risk-
adjusted returns that are linked to equity market indices, sector
indices, basket of stocks with some particular theme, currencies,
interest rates, commodity or a basket of commodities.

Distressed Securities
Distressed securities are the securities of the companies that are in
financial distress or near bankruptcy. Investors can make investments
in the equity and debt securities of publicly traded companies. These
may be available at huge discounts, however investments in them
require higher skills and greater experience in business valuation than
regular securities.
Channels for making investments

Investors can invest in any of the investment opportunities discussed
above directly or through intermediaries providing various managed
portfolio solutions.
Direct investments
Direct investments are when investors buy the securities issued by
companies and government bodies and commodities like gold and
silver. Investors can buy gold or silver directly from the sellers or
dealers. In case of financial securities, a few fee-based financial
intermediaries aid investors buy or sell investments viz. brokers,
depositories, advisors etc., for fees or commission.

Registered Investment Advisers
Investors can take the advice from SEBI Registered Investment Adviser
(RIAs). These advisers are paid fees by the investors who hire them for
investment advice. These advisers, like other fee-based professionals,
are only accountable to their investors. They are required to follow a
strict code of conduct and offer advice in the investors’ best interests.
Thus advisor can help investors create an optimum investment
portfolio and help them in making rational investment decisions.
Investments through managed portfolios
These investment vehicles are professionally managed. Through these

managed portfolios they can avail the professional expertise at much
lower costs.
The following are examples of managed portfolio solutions available

to investors in India:
• Mutual Funds
• Alternative Investment Funds
• Portfolio Managers
• Collective Investment Schemes

Mutual Fund
A mutual fund is a trust that pools the savings of a number of investors
who share a common financial goal. Money collected through mutual
fund is then invested in various investment opportunities such as
shares, debentures and other securities.
The following are the benefits of investing through mutual funds:

• Professional investment management
• Risk reduction through diversification
• Convenience
• Unit holders account administration and services
• Reduction in transaction costs
• Regulatory protection
• Product variety
Alternative Investment Fund

Alternative Investment Fund or AIF is a privately pooled investment
vehicle which collects funds from sophisticated investors, for investing
it in accordance with a defined investment policy for the benefit of its
investors. These private investors are institutions and high net worth
individuals who understand the nuances of higher risk taking and

complex investment arrangements. The minimum investment value in
AIF is one crore rupees. AIFs are categorized into three categories:
Category I AIF – is an AIF that invests in start-up or early stage ventures

or social ventures or SMEs or infrastructure or other sectors.
Category II AIF – is an AIF that does not fall in Category I and III and
which does not undertake leverage or borrowing other than to meet
day-to-day operational requirements or as permitted in the
regulations.
Category III AIF – is an AIF that which employs diverse or complex

trading strategies and may employ leverage including through
investment in listed or unlisted derivatives.
Portfolio Management Services

A portfolio manager is a body corporate who advises or directs or
undertakes on behalf of the investors the management or
administration of a portfolio of securities. There are two types of
portfolio management services available. The discretionary portfolio
manager individually and independently manages the funds of each
investor whereas the non-discretionary portfolio manager manages
the funds in accordance with the directions of the investors. The
portfolio manager is required to accept minimum Rs. 50 lakhs or
securities having a minimum worth of Rs. 50 lakhs from the client
while opening the account for the purpose of rendering portfolio
management service to the client.

Chapter 2 - Introduction to securities markets
The securities market provides an institutional structure that enables

a more efficient flow of capital in the economy. If a household has
some savings, such savings can be deployed to fund the capital
requirement of a business enterprise, through the securities markets.
A Security represents the terms of exchange of money between two

parties. They are purchased by investors who have the money to
invest. Security ownership allows investors to convert their savings
into financial assets which provide a return. Security issuance allows
borrowers to raise money at a reasonable cost.
Primary and Secondary market
Primary Market: The primary market, also called the new issue
market, is where issuers raise capital by issuing securities to investors.
Fresh securities are issued in this market. Various methods of issue in
the primary market are:
• Primary Issue
• Initial Public Offering (IPO)
• Further Public offer (FPO)
• Rights Issue
• Private Placement
• Preferential Issue
• Qualified Institutional Placements (QIP)
• Onshore and Offshore Offerings
• Offer For Sale (OFS)
• Employee Stock Ownership Plan (ESOP)
• Foreign Currency Convertible Bond (FCCB)
• Depository Reciepts (ADR/GDR)
• Anchor Investor
Secondary Market: The secondary market facilitates trades in already-

issued securities, thereby enabling investors to exit from an
investment or new investors to buy already existing securities.
An active secondary market promotes the growth of the primary

market and capital formation, since the investors in the primary
market are assured of a continuous market where they have an option
to liquidate or exit their investments. Let’s look at various
terminologies in the secondary market:

• Over-The-Counter Market (OTC)
• Exchange Traded Markets
• Trading
• Clearing and Settlement
Market Participants and their Activities
Market Infrastructure Institutions and other intermediaries
Stock Exchanges provide a trading platform where buyers and sellers

can transact in already issued securities. Trading happens on these
exchanges through electronic trading terminals which feature
anonymous order matching.
Depositories are institutions that hold securities (shares, debentures,

bonds, government securities, mutual fund units) of investors in
electronic form. Currently there are two Depositories in India that are
registered with SEBI—Central Depository Services Limited (CDSL), and
National Securities Depository Limited (NSDL).

A Depository Participant (DP) is an agent of the depository through
which it interfaces with the investors and provides depository
services. Depository participants enable investors to hold and transact
in securities in the dematerialized form.
Trading Members/Stock Brokers are registered members of a Stock

Exchange. They facilitate buy and sell transactions of investors on
stock exchanges.
Authorise Persons are agents of the brokers (previously referred to as

sub-brokers) and are registered with the respective stock exchanges.
APs help in reaching the services of brokers to a larger number of
investors.
A Custodian is an entity that is vested with the responsibility of

holding funds and securities of its large clients, typically institutions
such as banks, insurance companies, and foreign portfolio investors.
Clearing Corporations play an important role in safeguarding the

interest of investors in the Securities Market. Clearing agencies ensure
that members on the Stock Exchange meet their obligations to deliver
funds or securities.

Clearing Bank acts as an important intermediary between clearing
members and the clearing corporation. Every clearing member needs
to maintain an account with the clearing bank.
Merchant bankers are entities registered with SEBI and act as issue
managers, investment bankers or lead managers. They help an issuer
access the security market with an issuance of securities.
Underwriters are intermediaries in the primary market who

undertake to subscribe any portion of a public offer of securities which
may not be bought by investors.
Institutional Participants
Mutual Funds are professionally managed collective investment

scheme that pools money from many investors to purchase securities
on their behalf.
Pension Funds are established to facilitate and organize the

investment of the retirement funds contributed by the employees and
employers or even only the employees in some cases.

Insurance companies' core business is to insure assets. Depending on
the type of assets that are insured, there are various insurance
companies like life insurance and general insurance etc.
Alternative Investment Funds: The SEBI Regulations 2012 define

‘Alternative Investment Fund’ (AIF) as one which is primarily a
privately pooled investment vehicle. Under the SEBI AIF Regulations
2012, we can list the following types of funds as AIFs: Venture Capital
Fund, Angel Fund, Private Equity Fund, Debt Fund, Infrastructure
Fund, SME Fund, Hedge Fund and Social Venture Fund.
Foreign Portfolio Investors (FPIs) is an entity established or

incorporated outside India that proposes to make investments in
India. These international investors must register with the SEBI to
participate in the Indian securities markets.
Investment advisers work with investors to help them decide on asset

allocation and make a choice of investments based on an
assessment of their needs, time horizon return expectation
and ability to bear risk.

EPFO is a statutory body set up under the Employees’ Provident Funds
& Miscellaneous Provisions Act, 1952
National Pension System (NPS) is a pension cum investment scheme

launched by Government of India to provide old age security to
Citizens of India.
Family office can be defined as the ecosystem which the family builds
around itself to manage its wealth.
Corporate Treasuries: Traditionally, the role of corporate treasury has

been that of manager of financial risks and provider of liquidity. The
focus area of corporate treasuries has been debt management to
capital structure management with the key responsibility of raising
long term funds and minimizing the cost of capital.

Chapter 3 - Investing in stocks
Equity as an investment
Securities markets enable investors to invest and disinvest their

surplus funds in various instruments. These instruments are pre-
defined for their features, issued under regulatory supervision, and in
most cases have ready liquidity. When a company issues equity
securities, it is not contractually obligated to repay the amount it
receives from shareholders. It is also not contractually obligated to
make periodic payments to shareholders for the use of their funds.
Equity investors also known as shareholders have a claim on the
company’s net assets, i.e. assets after all liabilities have been paid.
Equity shareholders have residual claim in the business.
Diversification of risk through equity instruments
Diversification of equity investment achieves risk reduction.

Conceptually, it is achieved due to the relatively less correlated
behavior of various business sectors which underlie each equity
investment. A business cycle is shown as a dark line. Some businesses
may be at peak when others are at their trough, as shown by the
broken line. These products or businesses are called ‘counter-cyclical’
or defensive businesses. Businesses that do better in a recession are
called ‘recession-proof’ businesses. Some products, sectors or
countries come out of a recession faster than others; other products,
sectors or countries may go into recession later than others.
Risks of equity investments
Market risks arise due to the fluctuations in the prices of equity shares
due to various market related dynamics.
Sector specific risk is due to factors that affect the performance of

businesses in a particular sector.
Company specific risk is due to factors that affect the performance of

a single company.

Liquidity risk is the impact cost. The impact cost is the percentage
price movement caused by a particular order size.
Overview of Equity Market
Equity securities represent ownership claims on a company’s net

assets. A thorough understanding of equity market is required to
make optimal allocation to this asset class. The equity market provides
various choices to investors in terms of risk-return-liquidity profile.
In addition to equity shares, companies may also issue preference

shares. Preference Shares rank above equity shares with respect to
the payment of dividends and distribution of company’s net assets in
case of liquidation. However, preference share do not generally have
voting rights like equity shares, unless stated otherwise.
The chief characteristic of equity shares is shareholders’ participation

in the governance of the company
through voting rights.

Equity research and stock selection
The idea behind equity research is to come up with intrinsic value of

the stock to compare with market price and then decide whether to
buy or hold or sell the stock. There are many
frameworks/methodologies available for stock selection.
Fundamental Analysis
Fundamental analysis is the process of determining intrinsic value for

the stock. These values depend on underlying economic factors such
as future earnings or cash flows, interest rates, and risk variables. By
examining these factors, intrinsic value of the stock is determined.
Investor should buy the stock if its market price is below intrinsic value
and do not buy, or sell, if the market price is above the intrinsic value,
after taking into consideration the transaction cost.
Top-Down approach versus Bottom-up Approach: Analysts follow

two broad approaches to fundamental analysis—top down and
bottom up.
Buy side research versus Sell Side Research: Sell-side Analysts work
for firms that provide investment banking, broking, advisory services

for clients. They typically publish research reports on the securities of
companies or industries with specific recommendation to buy, hold,
or sell the subject security. Buy-side Analysts work for money
managers like mutual funds, hedge funds, pension funds, or portfolio
managers that purchase and sell securities for their own investment
accounts or on behalf of their clients.
Stock Analysis Process
The objective of stock analysis is to make the critical risk-return

decision at the market industry-company stock level. The stock
analysis process involves three steps. It requires analysis of the
economy and market. It includes
• Economic Analysis
• Industry/Sector Analysis Industry Life Cycle
• Introduction
• Growth
• Maturity
• Deceleration of Growth

Porter’s 5 Model
Michael Porter suggests that five competitive forces determine the

intensity of competition in the industry, that in turn affects the
profitability of the firms in the industry. The impact of
these factors can be different for different industries. The 5 factors are
rivalry among existing competitors, threat of new entrants, threat of
substitute products, bargaining power of buyers and bargaining power
of suppliers.
Company Analysis
Company analysis is the final step in the top-down approach to stock
analysis. Macroeconomic analysis prepares us to understand the
impact of forecasted macroeconomic environment on different asset
classes. It enables us to decide how much exposure to be made to
equity.
Fundamentals Driven model - Estimation of intrinsic

value
There are various approach to valuation. There are uncertainties

associated with the inputs that go into these valuation approaches. As
a result, the final output can at best be considered an educated
estimate, provided adequate due diligence associated with valuing the
asset has been complied with.
Discounted Cash Flow Model:

Conceptually, discounted cash flow (DCF) approach to valuation is the
most appropriate
approach for valuations when three things are known: Stream of
future cash flows, Timings of these cash flows, and Expected rate of
return of the investors (called discount rate).
Free Cash Flow Model:

There are two ways to look at the cash flows of a business. One is the
free cash flows to the firm (FCFF), where the cash flows before any
payments are made on the debt outstanding are taken into
consideration. This is the cash flow available to all capital
contributors—both equity and debt. The second way is to estimate
the cash flows that accrue to the equity investors alone. To calculate
the value of the firm, the FCFF is discounted by the weighted average
cost of capital (WACC) that considers both debt and equity. To
calculate the value of equity, FCFE is discounted using the cost of
equity.
As per Capital Asset Pricing Model (CAPM) ,the cost of equity is

computed as follows:
Ke = Rf + β * (Rm – Rf)
Asset Based Valuation

Under this method, the value of the business is found out by
subtracting the value of its liabilities from its assets.
Relative Valuation
Relative valuation is conducted by identifying comparable firms and
then obtaining market values of equity of these firms. These values
are then converted into standardized values which are in form of
multiples, with respect to any chosen metric of the company’s
financials, such as earnings, cash flow, book values or sales. Common
metrics used in relative valuation are:
• PE Ratio
• PB Ratio
• PS Ratio
• PEG Ratio
• EVA and MVA
• EBIT/EV and EV/EBITDA Ratio
• EV/S Ratio

Technical Analysis
Technical analysis is based on the assumption that any information
that can affect the performance of a stock, company fundamentals,
economic factors and market sentiments, is reflected already in its
stock prices. There are three elements in understanding price
behavior:
1. The history of past prices provides indications of the underlying

trend and its direction.
2. The volume of trading that accompanies price movements
provides important inputs on the underlying strength of the
trend.
3. The time span over which price and volume are observed factors
in the impact of long-term factors that influence prices over a
period of time.
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.

Assumptions of Technical Analysis
1. The market price is determined by the interaction of supply and

demand.
2. Supply and demand are governed by many rational and irrational
factors.
3. Price adjustments are not instantaneous and prices move in
trends
4. Trends persist for appreciable lengths of time.
5. Trends change in reaction to shifts in supply and demand
relationships.
6. These shifts can be detected in the action of the market itself.
There are numerous trading rules and indicators. There are indicators
of overall market momentum, used to make aggregate market
decisions. There are trading rules and indicators to be applied for
individual securities. Some of the popular ones are:
• Trend-line analysis
• Moving averages
• Bollinger-Band Analysis

Chapter 4 - Investing in fixed income securities
Since bonds create fixed financial obligations on the issuers, they are
referred as fixed income securities. The issuer of a bond agrees to
1) pay a fixed amount of interest (known as coupon) periodically
2) repay the fixed amount of principal (known as face value) at the
date of maturity.
The fixed obligations of the security are the most defining
characteristic of bond. Mostly bonds make semi- annual interest
payments, though some may make annual, quarterly or monthly
interest payment (except zero coupon bonds which make no interest
payment).
Bonds can also be issued with embedded options. Some common

types of bonds with embedded options are: bonds with call option,
bonds with put option and convertible bonds.
Determinants of bond safety
The most important document to understand the safety aspects of the

bond is its indenture. It is the legal agreement between the firm
issuing the bond and the bondholders, providing the specific terms of
the debt agreement. All the features of the bond i.e. its par value,
coupon rate, maturity period, periodicity of coupon payments,
collateral for the bond, seniority of the payments will be set forth in
the indenture. To understand the probability of default by the issuer,
most bond investors rely on Rating Agencies which have their own
methodology to gauge the creditworthiness. They use symbols to
express their opinion, Typically, ratings are expressed as grades from
‘AAA’ to ‘D’.
Analysis and Valuation of Bonds
Bond Pricing: The price of a bond is sum of present value of all future
cash flows of the bond. The interest rate used for discounting the cash
flows is the Yield to Maturity (YTM).
Bond Yield Measures:
The coupon yield is the coupon payment as a percentage of the face

value.

The current yield is the coupon payment as a percentage of the bond’s
current market price.
Yield to Maturity (YTM) is the discount rate which equates the

present value of the future cash flows from a bond to its current
market price.
Yield to call measures the estimated rate of return for bond held to
first call date in a bond with an embedded option.
Measuring Price Volatility of bonds:
Market price of a bond is a function of the Par value of the bond;

Coupon rate of the bond; Maturity period and Prevailing market
interest rate.
1. Bond prices and the interest rates have inverse relationship.
2. Bond price volatility is inversely related to coupon.
3. Bond price volatility is directly related to term to maturity
4. Bond price movements resulting from equal absolute increases
or decreases in yield are not symmetrical.

Interest Rate Risk is defined as the risk emanating from changes in the
interest rate in the market.
Determining duration: Duration (also known as Macaulay Duration)

of a bond is a measure of the time taken to recover the initial
investment in present value terms. Calculating Duration of a bond is
covered in detail in the NISM Workbook. Please go through it carefully
to understand the same.

Chapter 5 - Derivatives Market
Derivative is a contract or a product whose value is derived from value

of some other asset known as underlying. Derivatives are based on
wide range of underlying assets. These include metals, energy
resources, Agri commodities and financial assets.
Types of derivative products
Forward contract is an agreement made directly between two parties

to buy or sell an asset on a specific date in the future, at the terms
decided today.
A futures contract is an agreement made through an organized

exchange to buy or sell a fixed amount of a commodity or a financial
asset on a future date at an agreed price.
An Option is a contract that gives its buyers the right, but not an
obligation, to buy or sell the underlying asset on or before a stated
date/day, at a stated price, for a premium (price)

A swap is a contract in which two parties agree to a specified exchange
of cash flows on a future date(s).
Structure of derivative markets
OTC Markets: Some derivative contracts are settled between

counterparties on terms mutually agreed upon between them. These
are called over the counter (OTC) derivatives. They are non-standard
and they rely on the trust between parties to meet their commitment
as promised.
Exchange Traded Markets: Exchange-traded derivatives are standard

derivative contracts defined by an exchange, and are usually settled
through a clearing house. The buyers and sellers maintain margins
with the clearing-corporations, which enables players to enter into
contracts on the strength of the settlement process of the clearing
house.
Purpose of Derivatives
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.
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.
Arbitrage: Arbitrageurs are specialist traders who evaluate whether

the difference in price is higher than the cost of borrowing.
Commodity and Currency Futures and Options
Commodity derivatives: Commodity derivatives markets play an

increasingly important role in the commodity market value chain by
performing key economic functions such as risk management through
risk reduction and risk transfer, price discovery and transactional
efficiency. Commodity derivatives markets allow market participants
such as farmers, traders, processors, etc. to hedge their risk against
price volatility through futures and options.
Currency derivatives: Unlike any other traded asset class, the most
significant part of currency market is the concept of currency pairs. In
currency market, while initiating a trade you buy one currency and sell
another currency. A currency future, also known as FX future, is a
futures contract to exchange one currency for another at a specified
date in the future at a price (exchange rate) that is fixed on the
purchase date. Currency Options are contracts that grant the buyer of
the option the right, but not the obligation, to buy or sell underlying
currency at a specified exchange rate during a specified period of time.
Underlying concepts in derivatives
Zero Sum Game: In a futures contract, the counterparties who enter

into the contract have opposing view.
The sum of the two position’s gain and loss is zero assuming zero
transaction costs and zero taxes.
Settlement Mechanism: Earlier most derivative contracts were

settled in cash. However, SEBI has mandated physical settlement
(settlement by delivery of underlying stock) for all stock derivatives.
Arbitrage: The law of one price states that two goods (assets) that are
identical, cannot trade at different prices in two different markets. The
demand in the cheaper market will increase prices there and the
supply into the costlier market will reduce prices, bringing the prices
in both markets to the same level. Prices in two markets for the same
tradable asset will be different only to the extent of transaction costs.

Margining Process: Margin is defined as the funds or securities which
must be deposited by Clearing Members as collateral before executing
a trade. The provision of collateral is intended to ensure that all
financial commitments related to the open positions of a Clearing
Member can be offset within specified period of time.
Open Interest: Open interest is commonly associated with the futures

and options markets. Open interest is the total number of outstanding
derivative contracts that have not been settled. The open interest
number only changes when a new buyer and seller enter the market,
creating a new contract, or when a buyer and seller meet—thereby
closing both positions. Open interest is a measure of market activity.
However, it is to be noted that it is not trading volume.

Chapter 6 - Mutual fund
Mutual fund is a vehicle (in the form of a “trust”) to mobilize money

from investors, to invest in different markets and securities, in line
with stated investment objectives. Mutual funds offer different kinds
of schemes to cater to the need of diverse investors. Various investors
have different investment preferences and needs. In order to
accommodate these preferences, mutual funds mobilize different
pools of money.
Benefits of investing through mutual funds
• Affordable Portfolio Diversification

• Economies Of Scale
• Transparency
• Tax Benefits
• Convenient Options
• Regulatory Comfort

Working of mutual funds
Day to day operations of mutual fund is handled by the AMC. The

sponsor or, the trustees if
so authorized by the trust deed, shall appoint the AMC with the
approval of SEBI. Various functions include:
• Compliance Function
• Fund Management
• Operations and Customer Services Team
• Sales And Marketing Team
Types of Mutual fund products
Mutual Fund Schemes are classified on various parameters, some of

them being:
• Open Ended v/s Close Ended
• Active Funds v/s Passive Funds
• By the investment Universe: Equity Funds, Debt Funds,
Commodity Funds, Gold Funds, International Funds etc.

Processes of investing in mutual funds
Processes of units include Purchase, Redemption and Systematic
Transfers.
Net Asset Value, Total Expense Ratio, Pricing of Units
The NAV or Net Asset Value is the current value of a mutual fund unit.
This will depend upon the current mark to market (MTM) value of the
securities held in the portfolio of the fund and any income earned such
as dividend and interest.
Pricing of Units: In case of open-ended funds, transactions are priced

using the NAV to ensure parity among investors that buy new units,
investors that stay in the fund, and investors that move out of a fund.
Total Expense Ratio: All types of expenses incurred by the Asset

Management Company have to be clearly identified and appropriated
for all mutual fund schemes. The most important expense is the
Investment and Advisory Fees charged to the scheme by the AMC.

Chapter 7 - Role of portfolio managers
Risk and return are the two important aspects of financial investment.
Portfolio management involves selecting and managing a basket of
assets that minimizes risk, while maximizing return on investments. A
portfolio manager plays a pivotal role in designing customized
investment solutions for the clients.
Types of portfolio management services
On the basis of provider of the services PMS can be classified as:

1. PMS by asset management companies
2. PMS by brokerage houses
3. Boutique (independent) PMS houses
Discretionary Services: Discretionary portfolio manager individually

and independently manages the funds of each investor as per the
contract. This could be based on an existing investment approach or
strategy which the portfolio manager is offering or can be customized
based on client’s requirement.

Non-Discretionary Services: Non-discretionary portfolio manager
manages the funds in accordance with the directions of the client. The
portfolio manager does not exercise his/her discretion for the buy or
sell decisions. The portfolio manager has to consult the client for every
transaction.
Advisory Services: In advisory role, the portfolio manager suggests the

investment ideas or provides non- binding investment advice. The
investor takes the decisions. The investors also execute the
transactions.
(Kindly go through the compliance rules given in the workbook once)

Chapter 8 - Operational aspects of portfolio managers
Entities which can invest in PMS
The following entities can invest in PMS with a minimum investment

of Rs. 50 lacs:
• Individuals
• Non-resident Indians (as per the RBI guidelines)
• Hindu Undivided Family
• Proprietorship firms
• Association of person
• Partnership Firms
• Limited liability Partnership
• Trust
• Body Corporate

Disclosures to the prospective clients
Accurate and standardized disclosure by PMS providers is needed to

help existing & prospective investors take well informed investment
decisions. SEBI (Portfolio Managers) Regulation 2020 requires that the
disclosure document is to be given to the prospective client along with
the account opening form prior to signing of the agreement.
Best Practices for the disclosures – Global Investment

Performance Standards
The GIPS standards are ethical standards for calculating and

presenting investment performance based on the principles of fair
representation and full disclosure. These standards were originally
created for investment firms managing composite strategies, with a
focus on how firms present performance of composites to prospective
clients.
Process of On-boarding of clients
The two important elements of the customer life cycle are: client
onboarding and reporting. The following are the important aspects of
the client onboarding process in case of a PMS service:
1. Reading of Disclosure Document
2. Fulfilling KYC Requirements.
KYC Requirements differ as per the type of client.
Some of them are:
• KYC for Non-Residents
• NRI Demat Account
• NRI Trading Account
3. Submitting Duly Filled Application Form
Content of agreement between the portfolio manager and investor:

The portfolio manager before taking up an assignment of
management of funds and portfolio on behalf of a client, enters into
an agreement in writing with such client that clearly defines the inter
se relationship and sets out their mutual rights, liabilities, and
obligations relating to management of portfolio.
Direct On-boarding in PMS
As per the SEBI circular, Portfolio Managers shall provide an option to

clients to be onboarded directly, without intermediation of persons
engaged in distribution services. Portfolio Managers shall prominently
disclose in its disclosure documents, marketing material and on its
website, about the option for direct onboarding.
Costs, expenses and fees of investing in PMS
• Investment Management and Advisory Fees

• Custodian/Depository Fee
• Registrar And Transfer Agent Fee
• Brokerage and Transactions Costs
• Certification charges, Fund Accounting charges and Professional
fee
• Out of Pocket and Other Incidental Expenses
High Water Mark is the highest value that the portfolio/account has
reached. The portfolio manager charges performance-based fee only
on increase in portfolio value in excess of the previously achieved high
water mark.
Profit sharing/performance related fees are usually charged by

portfolio managers upon exceeding a hurdle rate or benchmark as
specified in the agreement.

Chapter 9 - Portfolio management process
Importance of Asset Allocation Decision
Asset allocation is the process of deciding how to distribute an

investor’s wealth into different asset classes for investment purposes.
An asset class is defined as a collection of securities that have similar
characteristics, attributes, and risk/return relationships.
Understanding correlation across asset classes and securities
Correlation measures the strength and direction of relationship

between two variables. Correlation coefficient vary in the range −1 to
+1. Understanding correlation across asset classes is very crucial in
making asset allocation decision. Correlation is the most relevant
factor in reaping the benefits of risk diversification
i.e. in reducing portfolio risk.

Investment Policy Statement (IPS)
Development of Investment Policy Statement (IPS) is the key step in
the process of portfolio management. IPS is the road map that guides
the investment process. Either investors or their advisors draft the IPS
specifying their investment objectives, goals, constraints, preferences
and risks they are willing to take. All investment decision are based on
IPS considering investors’ goal and objectives, risk appetite etc. Since
investors requirement’s change over a period time, IPS also needs to
be updated and revised periodically.
Investment Constraints
• Liquidity Constrains
• Regulatory Constrains
• Tax Constrains
Psychographic analysis of investor

Psychographic analysis of investor bridges the gap between standard
finance which treats investors as rational human beings and
behavioral finance which view them as normal human beings who
have biases and make cognitive errors. In other words, psychographic

analysis of investor recognizes investors as normal human beings who
are susceptible to biased or irrational behavior.
Lifecycle of investing
• Accumulation Phase
• Consolidation Phase
• Spending Phase
• Gifting Phase
The investment policy statement needs to provide a framework for

evaluating the performance of the portfolio. It will typically include a
benchmark portfolio which matches in composition of the investor’s
portfolio.

Asset allocation decision
The asset allocation decision which is made after taking into
consideration investor’s characteristics is strategic asset allocation
(SAA). It is the target policy portfolio.
Tactical asset allocation (TAA) is short-term asset allocation decision.

These decisions are taken more frequently than SAA. The idea behind
TAA is to take the advantage of the opportunities in the financial
markets.
Rebalancing of Portfolio
Portfolio needs to be continuously monitored and periodically
rebalanced. The need for rebalancing arises due to price changes in
portfolio holdings. Over time, asset classes produce different returns
that can change the portfolio's asset allocation. To keep the portfolio's
original risk-and-return characteristics, the portfolio may require
rebalancing.

Chapter 10 - Performance measurement and
evaluation of portfolio managers
The main issue in performance measurement and evaluation is the

human tendency to focus on the return, the investment has earned
over a period of time with little regard to the risk involved in achieving
that return.
Rate of return measures
• Holding Period Return

• Time weighted Rate of Return (TWRR) or Geometric Mean
• Money weighted Rate of return (MWRR)
• Arithmetic Mean Return
• Gross Return
• Net Return
• Compounded Annual Growth Rate
• Annualized Return
• Cash Drag adjusted Return
• Alpha and Beta Return

• Portfolio Return
Students should be aware about how each of the above returns are
calculated
Risk measures
Two possible measures of risk have received support in theory to

capture total risk: the variance and the standard deviation of the
estimated distribution of expected returns. Whereas downside risk
includes concepts such as semi-variance/standard deviation and
target semi variance/standard deviations.
Standard deviation is the square root of variance. It quantifies the

degree to which returns fluctuate around their average. A higher value
of standard deviation means higher risk
Semi variance measures the dispersion of the return below the mean
return. Target Semi variance measures the dispersion of the return
below the target return. In case of symmetrically distributed return,
semi variance will be proportional to variance and provides no
additional insight.

Portfolio risk versus individual risk
Standard deviation or variance of the returns is used as measure of

risk. While computing portfolio risk, it is to be borne in mind that
portfolio standard deviation is not the weighted average standard
deviation of individual investments in a portfolio (except when these
investments have perfect positive correlation with each other, which
is practically an impossibility). Portfolio risk depends on the weights of
the investments, their individual standard deviations and more
importantly the correlation across those investments
Systematic Risk and Unsystematic Risk
Systematic risk is defined as risk due to common risk factors, like

interest rates, exchange rates, commodities prices. It is linked to
supply and demand in various marketplaces. All investments get
affected by these common risk factors directly or indirectly.
Systematic risk is measured by Beta. Beta relates the return of a stock

or a portfolio to the return on market index. It reflects the sensitivity
of the fund’s return to fluctuations in the market index.

Beta = Cov (MrPr) / Var(Mr)
Tracking error is the standard deviation of the difference between the

portfolio and its target benchmark portfolio total return. Generally,
indices are used to benchmark portfolios.
Risk-adjusted return
Sharpe Ratio is the portfolio’s return in excess of the risk-free return

and divide the excess return by the portfolio’s standard deviation. This
risk adjusted return is called Sharpe ratio. This ratio named after
William Sharpe. It measures Reward to Variability.
The Treynor measure adjusts excess return for systematic risk. It is

computed by dividing a portfolio's excess return, by its beta.
The Sortino Ratio, portfolio’s return in excess of the risk-free return is

divided by the portfolio’s semi- standard deviation. Thus, Sortino Ratio
adjusts portfolio’s excess return to the downside risk.
The numerator in the information ratio represents the fund

manager’s ability to use his skill and information to generate a
portfolio return that differs from the benchmark. The denominator
measures the amount of residual (unsystematic) risk that the investor
incurred in pursuit of those excess returns.
The M2 Ratio is adjusted the risk of the portfolio to match the risk of
the market portfolio. For such a risk adjusted portfolio, they calculated
the return, and compared it with the market return to determine
portfolio’s over or underperformance.
Performance attribution analysis
Differential return can be achieved by choosing to over-invest in (or

overweight) a particular economic sector that outperformed the total
benchmark (sector allocation) for that period or to underinvest in or
avoid (or underweight) an asset category that underperformed the
total benchmark (asset allocation).
Differential return can also be achieved by selecting securities that

performed well relative to the benchmark or avoiding benchmark
securities that performed relatively poorly.
An Indian investor who buys and sells securities that are denominated
in currencies other than the Indian rupee need to calculate the return
after adjusting the fluctuation in Indian rupee against those foreign
currencies, as the return earned on investments denominated in
foreign currencies would not be the same when converted back to
rupee term.

Chapter 11 - Taxation
Taxation of investors
Income-tax liability of an assessee is calculated on basis of his ‘Total

Income’. What is to be included in the total income of assessee is
greatly influenced by his residential status in India and his citizenship
is of no consequence.
The residential status of an Individual as inferred from provisions of

Section 6 of the Act can be categorized into the following categories:
1. Ordinary Resident in India
2. Resident But Not Ordinarily Resident in India
3. Deemed resident
4. Non-Resident

Residential status of a company
• Indian Company
• Foreign Company
Capital Gains
Any profits or gains arising from the transfer of a capital asset is

taxable under the head ‘capital gains’ in the previous year in which
such transfer takes place. However, every transfer of a capital asset
does not give rise to taxable capital gains because some transactions
are either not treated as ‘transfer’ under Section 47 or they are
excluded from the meaning of a capital asset.
The Indexed Cost of acquisition shall be calculated in a two-step
process. The first step is to calculate the cost of acquisition of capital

asset. In the second step, such cost of acquisition is multiplied with
the Cost Inflation Index (CII) of the year in which capital asset is
transferred and divided by CII of the year in which asset is first held by
the assessee or CII of 2001- 02, whichever is later.
The income in the nature of dividend on securities is taxable in the

hands of the assessee under the head ‘income from other sources’.
The income in the nature of interest on securities is taxable in the

hands of the assessee under the head ‘income from other sources’.
This income is taxable as other sources if it is not in the nature of
business.

Chapter 12 - Regulatory, governance and ethical
aspects of portfolio managers
Prevention of Money Laundering Act, 2002
The Prevention of Money Laundering Act, 2002 (PMLA) forms the core
of the legal framework put in place in India to combat money
laundering. The provisions of PMLA came into force on July 1 2005.
The objective
of PMLA is, “to prevent money-laundering and to provide for

confiscation of property derived from, or involved in, money-
laundering and for matters connected therewith or incidental
thereto.”
SEBI (Prohibition of Insider Trading) Regulations 2015
Any dealing/trading done by an insider based on information which is

not available in public domain, gives an undue advantage to insiders
and affects market integrity. This is not in line with the principle of fair
and equitable markets. In order to protect integrity of the market, the

SEBI (Prohibition of Insider Trading) Regulations have been put in
place.
SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating

to Securities Market) Regulations, 2003
SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to

Securities Market) Regulations, 2003 prohibits fraudulent, unfair and
manipulative trade practices in securities. Regulation 2(1)(c) defines
fraud as inclusive of any act, expression, omission or concealment
committed to induce another person or his agent to deal in securities.
SEBI (Portfolio Managers) Regulations, 2020
This section gives a summary of the SEBI (Portfolio Managers)

Regulations, 2020.
Soft dollar practices
Investment management firms pay commission to brokerage firms for

executing trades. Soft dollar arrangements are the one where
investment managers pay a higher commission to the brokerage firm
in lieu of enjoying additional services like access to their research
reports, hardware, software or even non- research-related services,
etc. In portfolio management services, the investor is charged the
brokerage fee. Soft dollar arrangement must be avoided as it is
abusive in nature. There should be transparency with regard to the
services availed by the buy side firm such as portfolio manager and
the charges paid towards them.

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NISM SERIES XXI A –

PORTFOLIO MANAGEMENT SERVICES

Short Notes for Revision

NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|1

Investment is the current commitment of savings with an expectation

Investment versus Speculation

Investment and speculation activities are so intermingled that it is very

Investment objectives can be defined as investors’ goals expressed in

Capital Preservation: It means minimizing or avoiding the chances of

Capital Appreciation: It is an appropriate investment objective for

Current Income: It is an investment objective pursued when investor

Estimating the required rate of return

Investment is the commitment of rupee for a period of time to earn a)

It is the rate of return, the investor demands even if there is no

NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|3

The nominal risk-free rate of return is the rate of return, an investor

Business Risk is the Uncertainty of income flows caused by the nature

Financial risk relates to the means of financing assets – debt or equity.

Liquidity is defined as ease of converting an asset into cash at close to

Political risk is the uncertainty of returns caused by the possibility of

Geopolitics is influence of geography and politics on economics and

Regulatory risk is the risk associated with uncertainty about the

NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|5

NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|6

Government versus corporate debt securities

A Government Security (G-Sec) is a tradeable instrument issued by

NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|7

Money Market versus capital market

Capital market is a place for long term fund mobilization. Securities

NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|9

Channels for making investments

NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|10

Investments through managed portfolios

These investment vehicles are professionally managed. Through these

The following are examples of managed portfolio solutions available

NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|11

The following are the benefits of investing through mutual funds:

Alternative Investment Fund

NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|12

Category I AIF – is an AIF that invests in start-up or early stage ventures

Category III AIF – is an AIF that which employs diverse or complex

Portfolio Management Services

NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|14

The securities market provides an institutional structure that enables

A Security represents the terms of exchange of money between two

Primary and Secondary market

Secondary Market: The secondary market facilitates trades in already-

An active secondary market promotes the growth of the primary

NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|16

Market Participants and their Activities

Market Infrastructure Institutions and other intermediaries

Stock Exchanges provide a trading platform where buyers and sellers

Depositories are institutions that hold securities (shares, debentures,

NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|17

Trading Members/Stock Brokers are registered members of a Stock

Authorise Persons are agents of the brokers (previously referred to as

A Custodian is an entity that is vested with the responsibility of

Clearing Corporations play an important role in safeguarding the

NISM SERIES XXI A – PORTFOLIO MANAGEMENT SERVICES|18

Underwriters are intermediaries in the primary market who