PRAGATI PUBLIC SCHOOL

CLASS: XI
UNIT-5 : ETFs, Debt and Liquid Funds
Q1. What are ETFs?

Ans: 1.Exchange Traded Funds (ETFs) are mutual fund units which investors buy/ sell from the stock exchange, as against
a normal mutual fund unit, where the investor buys / sells through a distributor or directly from the AMC.

2. ETF structure is such that the AMC does not have to deal directly with investors or distributors. It instead issues units to
a few designated large participants, who are also called as Authorised Participants (APs), who in turn act as market
makers for the ETFs.

3. Buying and selling ETFs is similar to buying and selling shares on the stock exchange.

4. Globally there are ETFs on Silver, Gold, Indices (SPDRs, Cubes, etc), etc. In India, we have ETFs on Gold, Indices such as
Nifty 50, Bank Nifty etc.).

Q2. Explain Index ETF .

Ans: 1.An index ETF is one where the underlying is an index, say Nifty 50.

2.The APs deliver the shares comprising the Nifty, in the same proportion as they are in the Nifty, to the AMC and create
ETF units in bulk (These are known as Creation Units).

3.Once the APs get these units, they provide liquidity to these units by offering to buy and sell through the stock
exchange.

Q3. What are REITs?

Ans:1. REITs or Real Estate Investment Trusts invest in real estate assets and give returns to the investor based on the
return from the real estate.

2. Like a mutual fund, REITs collect money from many investors and invest the same in real estate properties like offices,
residential apartments, shopping malls, hotels, warehouses). These REITs are listed on stock exchanges. The investors can
directly buy and sell units from the stock exchanges.

3.REITs are actually trusts and hence their assets are in the hands of an independent trustee, held on behalf of the
investor. The trustee is bound to ensure compliance with applicable laws and protect the rights of the unit holders.

4.Income takes the form of rentals and capital gains from property which is distributed to investors as dividends.

Q4. Why Gold ETF?

Ans: Gold ETFs (G-ETFs) are a special type of ETF which invests in Gold and Gold related securities. This product gives the
investor an option to diversify his investments into a different asset class, other than equity and debt.

Holding physical Gold can have its‘ disadvantages:

1. Fear of theft

2. Payment Wealth Tax

3. No surety of quality

4. Changes in fashion and trends

5. Locker costs
6. Lesser realisation on remoulding of ornaments

Say for example 1 G-ETF = 1 gm of 99.5% pure Gold, then buying 1 G-ETF unit every month for 20 years would have given
the investor a holding of 240gm of Gold, by the time his child‘s marriage approaches (240 gm = 1 gm/ month * 12 months
* 20 Years).

Secondly, all these years, the investor need not worry about theft, locker charges, quality of Gold or changes in fashion as
he would be holding Gold in paper form. As and when the investor needs the Gold, he may sell the Units in the market
and realise an amount equivalent to his holdings at the then prevailing rate of Gold ETF.

Working

The G-ETF is designed as an open ended scheme. Investors can buy/ sell units any time at then prevailing market price.

The way Gold ETFs work is as under:

1.During New Fund Offer (NFO) 

AMC decides of launching G-ETF  The SID, SAI and KIM are prepared as per SEBI guidelines  Investors invest in the fund
and the AMC gives units to investors in return AMC buys Gold of specified quality at the prevailing rates

2. On an ongoing basis

1Authorised Participants (typically large institutional investors) give money/ Gold to AMC

2. AMC gives equivalent number of units bundled together to these authorized participants (AP)

3. APs split these bundled units into individual units and offer for sale in the secondary market

4.Investors can buy G-ETF units from the secondary markets either from the quantity being sold by the APs or by other
retail investors

5. Retail investors can also sell their units in the market

Q5. Explain Sovereign Gold Bonds

Ans. • The Government of India in October 2015 launched the Sovereign Gold Bonds Scheme

• SGB scheme offer investors returns that are linked to gold price and provides benefits similar to investment in physical
gold

• SGBs are issued by the Reserve Bank of India on behalf of the Government of India and distributed through Agents like
banks, designated post offices and Stock Holding Corp.

• Exchanges to be appointed as Agents from Tranche IV onwards

• SGBs are issued on payment of rupees and denominated in grams of gold and can be held in demat and paper form

• SGBs can be used as collateral for loans and can be traded on stock exchanges

• Can be bought initially through Stock brokers / Mutual Fund Distributors

• Commission would be 99bps.

Q6. Explain APS .

Ans:1. APs are like market makers and continuously offer two way quotes (buy and sell). They earn on the difference
between the two way quotes they offer. This difference is known as bid-ask spread. They provide liquidity to the ETFs by
continuously offering to buy and sell ETF units.

2. If the last traded price of a G-ETF is Rs 1000, then an AP will give a two way quote by offering to buy an ETF unit at Rs
999 and offering to sell an ETF unit Rs. 1001. Thus whenever the AP buys, he will buy @ 999 and when he sells, he will sell
at 1001, thereby earning Rs. 2 as the difference. It should also be understood that the impact of this transaction is that
the AP does not increase/ decrease his holding in the ETF. This is known as earning through DEALER SPREADS

Q7. Who is Custodian ?

2. The custodian makes respective entries in the Allocated Account thus transferring Gold into and out of the scheme at
the end of each business day.

3.The custodian has no right on the Gold in the Allocated Account.

4. The custodian may appoint a sub-custodian to perform some of the duties.

5. The custodian charges fee for the services rendered and has to buy adequate insurance for the Gold held.

6.The premium paid for the insurance is borne by the scheme as a transaction cost and is allowed as an expense under
SEBI guidelines. This expense contributes in a small way to the tracking error.

7.The difference between the returns given by Gold and those delivered by the scheme is known as Tracking Error. It is
defined as the variance between the daily returns of the underlying (Gold in this case) and the NAV of the scheme for any
given time period.

8. Gold has to be valued as per a specific formula mandated by regulations. This formula takes into account various inputs
like price of Gold in US $/ ounce as decided by the London Bullion Markets Association (LBMA) every morning, the
conversion factor for ounce to Kg, the prevailing USD/ INR exchange rate, customs duty, octroi, sales tax, etc.

Q8. Explain Creation units, Portfolio Deposit and Cash Component with an example.

Ans:Let us look at the following example to understand Creation Units, Portfolio Deposit and Cash

Component in detail.

Assumption: 1 ETF unit = 1 gm of 99.5% pure Gold

Amount Invested (Rs.): 5000

Price of 1 gm of Gold (Rs.): 1000

Since 1 ETF unit = 1 gm of Gold

Issue Price (Rs.) = 1000

Units Allotted (Number = Investment/ Issue Price): 5

Creation Units
1 Creation Unit = 100 ETF units

NAV (Rs.) = 1050

Price of 1 gm of Gold (Rs.): 1000

So, 100 Units will cost (Rs.) = 1050 * 100 = 1,05,000

100 ETF will be equal to 100 gm of Gold

Therefore, value of Portfolio Deposit (Rs.) = 1000 * 100 = 1,00,000

Hence Cash Component (Rs.) = 1,05,000 – 1,00,000 = 5,000

Thus it can be seen by depositing Gold worth Rs.1,00,000 as Portfolio Deposit and Rs. 5,000 as Cash Component, the
Authorised Participant has created 1 Creation Unit comprising of 100 ETF units.

Q9. What is Interest Rate Risk?

Ans: 1.The first risk which we discussed is known as the Interest Rate Risk. This can be reduced by adjusting the maturity
of the debt fund portfolio, i.e. the buyer of the debt paper would buy debt paper of lesser maturity so that when the
paper matures, he can buy newer paper with higher interest rates.
2.So, if the investor expects interest rates to rise, he would be better off giving short- term loans (when an investor buys a
debt paper, he essentially gives a loan to the issuer of the paper).

3. By giving a short-term loan, he would receive his money back in a short period of time. As interest rates would have
risen by then, he would be able to give another loan (again short term), this time at the new higher interest rates. Thus in
a rising interest rate scenario, the investor can reduce interest rate risk by investing in debt paper of extremely short-term
maturity.

4. For eg: In our example, we have discussed about a debt paper which has a maturity of 10 years and a coupon of 8%.
What will happen if interest rates rise after 2 years to 10%?
The investor would have earned Rs.8 for 2 years and will earn Rs.8 yet again in the 3rd year as well. But had he got the Rs.
100 with him (which he had invested 2 years ago), instead of investing at 8%, he would have preferred to invest @ 10%.
Thus by investing in a long term paper, he has locked himself out of higher interest income.

The best way to mitigate interest rate risk is to invest in papers with short- term maturities, so that as interest rate rises,
the investor will get back the money invested faster, which he can reinvest at higher interest rates in newer debt paper.
However, this should be done, only when the investor is of the opinion that interest rates will continue to rise in future
otherwise frequent trading in debt paper will be costly and cumbersome.

Q10. What is Credit Risk?

2. A bigger threat is that the borrower does not repay the principal. This can happen if the borrower turns bankrupt. This
risk can be taken care of by investing in paper issued by companies with very high Credit Rating.

3. The probability of a borrower with very high Credit Rating defaulting is far lesser than that of a borrower with low
credit rating. Government paper is highest in safety when it comes to credit risk (hence the description ‗risks free
security‘).

Different borrowers have different levels of credit risks associated and investors would like to know the precise risk level
of a borrower. This is done by a process known as Credit Rating. This process is carried by professional credit rating
agencies like CRISIL, ICRA etc. In India, credit rating agencies have to be registered with SEBI and are regulated by SEBI
(Credit Rating) Regulations, 1999.

AAA – These are the safest among corporate debentures. This rating implies investors can safely expect to earn interest
regularly as well as the probability of default of their principal is as good as nil.

BBB – These instruments are safe, however, in case environment changes, there is a probability that the coupon payment
and principal repayment ability may be hampered.

The above 2 ratings represent the topmost and lowest rating of investment grade securities.

Anything less than BBB is termed as SPECULATIVE GRADE. The rating grade ‗D‘ represents DEFAULT.

Q11. Explain YTM.

Ans: Yield To Maturity (YTM) is that rate which the investor will receive in case:

1. He holds a bond till maturity and

2. He reinvests the coupons at the same rate

It is a measure of the return of the bond. Yield to maturity is essentially a way to measure the total amount of money one
would make on a bond, but instead of expressing that figure as a Rupee amount, it is expressed as a percentage—an
annual rate of return.

For example, Company - ABC International Ltd.:

1. Bond purchased for Rs.950. Coupon rate 8%. Bond maturity 3 years

2. Its par value (the amount the issuer will refund you when the bond reaches maturity) is Rs.1000.

3. Current earning = Rs.50 (Rs.1000 – Rs.950).

The YTM is calculated as follows:

The above has been computed by using XIRR formula is MS Excel.

In the explanation for compounding, we have assumed that the interest earned after 1 year, gets reinvested in the FD for
the remaining 9 years @ 8%. Similarly the interest earned after 2 years (Interest on the initial investment plus the interest
earned on the interest reinvested after 1 year) is again reinvested in the FD at the same rate of 8% for the remaining 8
years, and so on. The second point mentioned above means exactly this.

This may be true for bank FDs, where we get the benefit of cumulative interest, however, for bonds; the coupon (interest
income) is a cash outflow every year and not a reinvestment as in case of FDs. So there is no reinvestment here. Even if
the investor receives the coupon as a cash outflow, and intends to reinvest the same, there is no

guarantee that for 10 years he will be able to reinvest the coupon, each year @ 8%.

Thus, YTM is based upon some assumptions (i.e. you will be reinvesting the interest earned at the coupon rate), which
may not always be true. In spite of its shortcomings,

YTM is an important indicator to know the total return from a bond.

Q12. Explain various types of Debt Fund schemes.

Ans:1. Fixed Maturity Plans are essentially close ended debt schemes. The money received by the scheme is used by the
fund managers to buy debt securities with maturities coinciding with the maturity of the scheme.

2.Capital protection funds are close ended funds which invest in debt as well as equity or derivatives.

3.Balanced funds invest in debt as well as equity instruments. These are also known as hybrid funds.

4. Monthly Income Plans (MIPs) are also hybrid funds; i.e. they invest in debt papers as well as equities. Investors who
want a regular income stream invest in these schemes.

5.Child Benefit Plans are debt oriented funds, with very little component invested into equities. The objective here is to
capital protection and steady appreciation as well.

6. Liquid funds carry an important position as an investment option for individuals and corporates to park their short
term liquidity.

Liquid mutual funds are schemes that make investments in debt and money market securities with maturity of up to 91
days only.

In case of liquid mutual funds cut off time for receipt of funds is an important consideration.

Q13. Explain VALUATION OF SECURITIES.

1) All money market and debt securities, including floating rate securities, with residual maturity of up to 60 days shall be
valued at the weighted average price at which they are traded on the particular valuation day. When such securities are
not traded on a particular valuation day they shall be valued on amortization basis.

2) All money market and debt securities, including floating rate securities, with residual maturity of over 60 days shall be
valued at weighted average price at which they are traded on the particular valuation day. When such securities are not
traded on a particular valuation day they shall be valued at benchmark yield/ matrix of spread over risk free benchmark
yield obtained from agency(ies) entrusted for the said purpose by AMFI.

3) The approach in valuation of non traded debt securities is based on the concept of using spreads over the benchmark
rate to arrive at the yields for pricing the non traded security.

a. A Risk Free Benchmark Yield is built using the government securities as the base.

b. A Matrix of spreads (based on the credit risk) are built for marking up the benchmark yields.

c. The yields as calculated above are Marked up/Marked-down for ill-liquidity risk
d. The Yields so arrived are used to price the portfolio

For example; Suppose a 90 Day Commercial Paper is issued by a corporate at Rs. 91. The paper will redeem at Rs. 100 on
maturity; i.e. after 90 days. This means that the investor will earn 100 – 91 = Rs. 9 as interest over the 90 day period. This
translates into a daily earning of 9/ 90 = Rs. 0.10 per day. (assuming zero coupon)

It is important to note here that although we said that the investor will earn 10 paise every day, there is no cash flow
coming to the investor. This means that the interest is only getting accrued.

Now if the investor wishes to sell this paper after 35 days in the secondary market, what should be the price at which he
should sell?

Here we add the total accrued interest to the cost of buying and calculate the current book value of the CP. Since we are

adding interest accrued to the cost, this method is known as COST PLUS INTEREST ACCRUED METHOD.

If 10 paise get accrued each day, then in 35 days, 35 * 0.10 = Rs. 3.5 have got accrued.

The cost of the investor was Rs. 91 and Rs. 3.5 have got accrued as interest, so the

current book value is 91 + 3.5 = Rs. 94.5

Q14. WHAT IS PORTFOLIO CHURNING IN LIQUID FUNDS?

Ans: A liquid fund will constantly change its portfolio. This is because the paper which it invests in is extremely short term
in nature. Regularly some papers would be maturing and the scheme will get the cash back. The fund manager will use
this cash to buy new securities and hence the portfolio will keep changing constantly. As can be understood from this,
Liquid Funds will have an extremely high portfolio turnover.

Liquid Funds see a lot of inflows and outflows on a daily basis. The very nature of such schemes is that money is parked
for extremely short term.

Also, investors opt for options like daily or weekly dividend. All this would mean, the back end activity for a liquid fund
must be quite hectic – due to the large sizes of the transactions and also due to the large volumes.

As in equities, we have different index for Large caps, Midcaps & Small caps, similarly in bonds we have indices depending
upon the maturity profile of the constituent bonds.

These indices are published by CRISIL e.g. CRISIL long term bond index,CRISIL liquid fund index etc.

Q15. Define Floating Rate Schemes

Ans These are the schemes where the debt paper has a Coupon which keeps changing as per the changes in the interest
rates