Sunday, October 23, 2011

ABC of the Indian Financial and Investment Industry Chapter 1 (Part 1)

ABC of the Indian Financial and Investment Industry Chapter 1 (Part 1)

Basic Concept

1. A financial system is like spider's web of markets and institutions that smoothen the movement of funds between the various sectors of the economy. This movement of funds can take many forms, including money, financial assets and securities (debt, quasi-equity and equity). Let us understand this basic concept, which helps us traverse the financial system's web.


1.1       Money is anything that is accepted as storehouse of value, which can be exchanged for payment of debts and purchase of goods or services. Money is a medium of exchange and acts as a common denominator unit for valuing goods and services for the purpose of exchange. Many articles have acted as money; for example before the origin of metal and metallic coins, ordinary article as seashells acted as Articles got acceptance as unit of money on account of being durable, easily storable and portable. It is matter of confidence that a paper currency represents something of value. Confidence is vital as can be seen in foreign currency market where two paper currencies strive to find equilibrium like price i.e. Exchange rates in game of seesaw.

Legal tender (i.e. Notes and coins) is still commonly used form of money. They are getting replaced by plastic money (debit card, smart card and credit card) and electronic money by way of electronic funds transfer. These are all “liquid assets”, and are so called as they can be quickly converted to perform the function of cash. The concept of money also includes other forms of the “financial assets”.

Financial Assets

1.2 A financial asset is a document or certificate of title or a statement of depositary account, which represents the underlying physical asset. Example of financial assets (with their respective obligations) includes: Fixed Deposit Receipt (liability of bank to pay after the fixed period at contracted rate of interest), R BI relief bond (Liability of Indian Government towards the holder) and shares (Company shareholders' funds).

Currency (notes and coins) is the most liquid form of financial asset, while investment in a long-term loan to a company is comparatively illiquid. Liquidity refers to ease of conversion to cash with little or no cost (at fair valuation of the assets) and minimal delay.


1.3        Securities are documentary evidence of ownership of financial assets. In  India securities are defined by Securities contracts (Regulation) Act, 1956 (“the SCRA”) as per SCRA securities include:
1.  Shares, scrip's, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate;
2.  Derivative;
3.  Units or any other instrument issued by any collective investment scheme to the investors in such schemes;
4.  Government securities;
5.  Such other instruments as may be declared by the Central Government to be securities; and
6.  Rights or interest in securities.
Thus we see that distinguishing feature of securities is that they are tradable or exchangeable or salable in the market place. Major classification for securities is nature of reward for that investment. It can be fixed like debt or variable like equity.

Debt: It is the obligation by a borrower (person or company your legal person) to pay a specific amount of money to lender (another party). This obligation may include manner of repayment, term of loan, interest rate, and underlying security (or collateral guarantee). It may also provide for terms of takeover of security or invocation of collateral in event of default by borrower and prepayment options.

Equity: Equity stands for ownership. In context of financial markets, term 'equity' is used interchangeably with shares. When shares are purchased, you acquire part ownership in the issuer of the shares (such as company). This means you share in its profits (through the receipt of dividends) and the rise or fall in the value of its shares.

Debit securities
1.4 The debt market brings together households and institutions with surplus funds and those with shortages of funds. Certificate of paper called 'debt security ' are issued directly between the borrower and the lender.

Debt is an obligation by one party to pay a specific amount of money to another party. A simple case of debt involves the lender advancing a sum of money (the principal) to the borrower for a specified period of time: In return; the borrower pays the lender an agreed rate of interest (the charge for the borrowing) at specified intervals, and at the end of the agreed period, repays the original sum borrowed.

Both Governments and companies issue debt securities
     Government debt securities: Governments are major issuer of debt securities; they by issue of bonds to finance the gap between expenditure ad income. The Government of India borrows money by issuing both short term debt securities (Treasury notes) and long term debt securities (as those for period more than one year). These bonds on securities are held banks, financial institutions, household investors and also corporate.
     Corporate debt securities: Companies also borrow to meet their funding requirements. They issue short term debt securities in the form of bills of exchange, Commercial papers and Certificate of deposits, and are increasingly also issuing long term paper by way of debentures.

1.5 Investing in companies via shares gives investors’ opportunity to receive a capital gain or loss. If company prospers, it will grow large and the value of its shares will rise. The investor will be able to share at higher price than cost price and make profit by way of dividend to holders of share. In case of poor performance companies may skip dividend payment and investors may also face prospect of booking loss in case of share price of company falling below cost price.

Limited liability means the liability of shareholders is limited to the issue price of shares (generally the face value). If the company was wound up, shareholder who held partly paid shares would have to pay any unpaid portion of those shares. Limited liability has made investment in equities considerably attractive compared to partnership where liabilities are unlimited.

Self-Assessment exercise 1
Complete the table below by highlighting the key basic difference between the feature of debt and equity.

Capital/ Principal



Participation in profit of venture

1.6        “Risk” stands in financial market of possibility of something wrong with unknown certainty. Several of risks in financial markets are given below:
     Market risk
            The risk of adverse movement in the value of securities due to the              movements in the market price.
     Credit risk
            The risk that a counter party will default its obligations in whole or in part.
     Market liquidity risk
            The risk that a market may lack sufficient depth to facilitate efficient and    inexpensive entry into and exit from the market.
     Funding risk
            The risk that a participant may be unable to meet its payment obligation     when they are due.
     Operational risk
            The risk that inadequate internal controls or failures of risk management   systems through human or technological error may lead to unexpected            losses.
     Legal risk
            The risk that a counter party's performance obligations may not be legally enforceable or legal process to ensure enforcement takes too long time.
     Reputation risk
            The risk that a company's reputation may become tarnished through          imprudent or ill considered practices.

Primary and secondary Markets

1.7 Market is a place where buyers and sellers of goods, services, assets and instruments come together and interact. In emerging environment such places are more likely to be electronic rather than physical to ensure gathering of larger sets of buyers and sellers. The term 'primary market' is used to describe the first time issue of securities. An example is the new issue of shares y way of a prospectus.

The term 'secondary market' is used to describe all subsequent buying and selling of securities. An example is the trading of shares on the stock exchange.

The primary and secondary market usually has similar set of participants. Main difference in these two markets is issuance of the prospectus (providing legally mandated information) and increasing obligations by issuer of securities in case of primary market.

Saturday, October 23, 2010

Good Practices in Financial Planning –Part 1

Good Practices in Financial Planning –

Good practice related to Establishing and Defining the Relationship with the Client

Practice 1: Defining the scope of the engagement

The Scope of the engagement shall be mutually defined by the financial planning practitioner and the client prior to providing any financial planning service.

Prior to providing any financial planning service, a financial planning practitioner and the client should mutually define the scope of the engagement. The process of "mutually-defining" is essential in determining what activities may be necessary to proceed with the client engagement. This can be accomplished by

  • Identifying the service(s) to be provided;
  • Disclosing financial planning practitioner's compensation arrangement(s);
  • Determining the client's and the financial planning practitioner's responsibilities;
  • Establishing the duration of the engagement; and
  • Providing any additional information necessary to define or limit the scope.

The scope of the engagement may include one or more financial planning subject areas. It is acceptable to mutually define engagements in which the scope is limited to specific activities. This serves to establish realistic expectations both for the client and the practitioner.

While you may not put scope of the engagement in writing, however it will be advisable to do so to avoid confusion at a later stage.

Good Practice Related to Gathering Client Data

Good Practice 2: Determining a client's personal and financial goals, needs and priorities

The financial planning practitioner and the client prior to making and /or implementing any recommendations shall mutually define a client's personal and financial goals, needs and priorities that are relevant to the scope of the engagement and the service(s) being provided.

Prior to making recommendations to a client, a financial planning practitioner and the client shall mutually define the client's personal and financial goals, needs and priorities. In order to arrive at such a definition, the practitioner will need to explore the client's values, attitudes, expectations, and time horizons as they affect the client's goals, needs, and priorities. The process of "mutually-defining" is essential in determining what activities may be necessary to proceed with the client engagement. Personal values and attitudes shape a client's goals and objectives must be consistent with the client's values and attitudes in order for the client to make the commitment necessary to accomplish them.

Goals and objectives provide focus, purpose, vision, and direction for the financial planning process. It is essential those objectives relative to the scope of the engagement are determined and that they are clear, precise, consistent, and measurable. The role of the practitioner is to facilitate the goal-setting process in order to clarify, with the client, goals and objectives, and, when appropriate, the practitioner must try to assist clients in recognizing the implications of unrealistic goals and objectives.

These practice standard addresses only the tasks of determining a client's personal and financial goals, and priorities; assessing a client's values, attitudes and expectations; and determining a client's time horizons. These areas are subjective and the practitioner's interpretation is limited by what the client reveals. A practitioner performing the activity of "gathering client data" should consider together the various good practices applicable to such activity.

Monday, October 18, 2010

The financial planning process : The General Model

Step 1. Establishing Client- Planner Relationships

The CFP Board asserts that the first step in financial planning involves establishing the working relationship with the client. Planners should explain issues and concepts related to the overall financial planning process as appropriate to the client's situation and needs. They should also explain services provided, the process of planning, and the documentation required. Also invluded in the step is a clarification of the client and planner's responsibilies.

Step 2. Gathering Client Data and Determining Goals and Expectations

As with the generic model, the data gathering aspect of the step includes obtaining information about the client's financial resources and obligations via interview and questionnaire and collecting applicable client records and documents. The planner must also determine the client's time horizons and risk tolerance level. Planner must also determine the client's personal and financial goals, needs and priorities, and assess the client's values, attitudes, and expectations.

Step 3. Analyzing and Evaluating the Client's Financial Status

Several categories are involved in analyzing the client's financial status. The general category includes the client's current financial status ( such as, assets, liabilities, cash flow, debt management), capital needs, attitudes and expectations, risk tolerance, risk management, and risk exposure. In the special needs category are divorce/remarriage considerations; charitable planning; adult dependent, disabled child, and education needs; terminal illness planning; and closely held business planning. The risk management category includes needs and current coverage for life; disability, health, long-term care; home owners, auto and other liability (for example umbrella, professional, errors and omissions, directors, and officers); and commercial insurance. The investments category covers analysis and evaluation of current investments and current investment strategies and policies. Evaluation of the tax category involves investment strategies and policies. Evaluation of the tax category involves tax returns, current tax strategies, tax compliance status (such as estimated tax), and current tax liabilities.

In the retirement category, planners should evaluate and analyze current retirement plan tax exposures (for example, assets marked for retirement benefit such as Provident Fund, Gratuity, PPF, Special Insurance Policies) and current retirement strategies.

Planners should evaluate the client's employee benefits, including the benefits available and the client's current participation in those benefits. Finally, the planner should analyze the client's current estate plan, which includes and evaluation of estate planning documents and strategies as well as estate tax exposure.

Step 4. Developing and Presenting the Financial Plan

The planner should develop and prepare a client-specific financial plan tailored to meet the client's goals and objectives, commensurate with client's values, temperament, and risk tolerance. In addition to the client's current financial position, the plan should include the client's projected financial statements under the status quo as well as projected statements if the planners's recommendations are followed. Similarly, the planner should include the current status, projections under the status quo, and projections if recommendations are followed for the following categories: cash flow, estate tax, capital needs at retirement, capital needs at death, capital needs at disability, special capital needs, income taxes, and employee benefits. The planner should also provide a current asset allocation statement along with strategy recommendations and a statement that assumes that recommendations will be followed. Investments should be summarized and the planner should propose an investment policy statement and additional policy recommendations.

The plan should also include an assessment of risk exposures along with recommendations for insurance and other risk management techniques. Finally, the plan should include a list of prioritized actions items.

After developing and preparing the plan, the planners should present the plan to the client and review it with him or her. The planner should collaborate with the client to ensure that the plan meets the goals and objectives of the client and should revise it as appropriate.

Step 5. Implementing the Financial Plan

The planners should assist the client in implementing the recommendations. Often this requires coordinating with other professionals, such as accountants, lawyers, real estate agents, investment advisers, stock brokers, and insurance agents.

Step 6. Monitoring the Financial Plan

After the plan is implemented, the planner should periodically monitor and evaluate the soundness of recommendations, and review the progress of the plan with the client. The planner should discuss and evaluate changes in the client's personal circumstances such as family births or deaths, illness, divorce, job status, or retirement. Any relevant changes in tax laws and the economic environment should be reviewed and evaluated before the planner makes recommendations to accommodate new or changing circumstances.