Managing Wealth is an art as well as science! Hope, you will agree with me. We need to know how to manage the income, expense, investments, tax and insurance effectively and accurately. In this article I will explain ‘Asset Allocation’ and the importance of having the right asset allocation in one’s financial portfolio.
Asset allocation is the systematic process of allocating the assets in the portfolio of a customer after understanding the income, expenses (current and future) and the financial liability. A portfolio contains a mix of Banking Accounts, Investment Products, Insurances and Loans. During the process of Asset Allocation, a financial consultant analyses the risk profile of the customer.
There can be a situation that the debt products like Bonds, Personal Loans are more in the Investment Portfolio compared to the Equity Products like Shares, Equity Mutual Funds. Based on the risk profile and future financial commitments, the financial consultant will suggest to add, or remove the Investments Products, Insurance Products, and Bank Accounts. And thus the Customer will be provided with the optimized Investment Portfolio.
Sample Asset Allocation (courtesy: Investopedia)
The risk profile of a customer may change over time, depending on the changes in her life cycle. Hence, what was right and worked for a customer at the younger age may not be the same when her at the age of 45 or 50.
Products To Invest
Customers should be having the knowledge on the various Investment Products as below
Equity :
Equities are issued by registered corporations to raise capital either to fund their new business or expand their existing operations. Equity is a share in the ownership of the company through Participation in voting — voting rights on corporate governance policies
Share in the profits in the form of dividends.
Stocks are riskier than bonds as they receive lesser priority in the case a firm runs into trouble. Stockholders have residual claimant right and right to vote.
Equities are generally classified as Common Stock and Preferred Shareholders
Common stock:
It is a common stock and not a preferred stock
Participates in the gains — dividend
Represents the ownership share in the corporation (entity)
Enjoys voting rights and residual claim in case of liquidation (after the payment of preferential creditors)
Preferential stock:
Preferential participation in dividends — fixed rate of dividend
Usually issued to cover the debt portion of the capital
Does not have voting rights but has a preferential claim in case of liquidation
It can be either convertible or non-convertible :
Blue chip Stocks
Penny Stocks
Income Stocks
Growth Stocks
Value Stocks
Different types of issue
Public issue — When the issue is made to the new investors to become shareholders of the issuing company. Generally classified into IPO (Initial Public offer) and FPO (Further Public offer)
Rights Issue — When an issuer makes an issue of equities to the existing shareholders for a consideration
Bonus Issue — When an issuer makes an issue of equities to the existing shareholders without a consideration either out of free reserves or share premium account on a specified ratio
Private placement — Privately placed equities to a select group. This can be either QIP (Qualified Institutions Buyers) or Preferential allotment
Bonds :
Bonds are long-term debt securities that mature between 10–30 years.
Issuer of bonds is obliged to pay fixed interest rate known as coupon rate periodically, usually ½ yearly or annually.
In addition to coupon interest payment, issuer of bonds also pay the par or face value of the bonds at maturity.
Bonds have the following characteristics:
Maturity
Call provision
Put provision
Convertibility
Secured & unsecured
Interest and yield
Discount and premium
Bonds yields
– Running yield (interest yield) — coupon payment only
– Redemption yield (yield to maturity) — coupon payment with capital gains/loss.
Derivatives :
A derivative is an instrument whose value depends on the values of its basic underlying variables
The derivative itself is merely a contract between two or more parties
Its value is determined by fluctuations in the underlying asset
The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes
Need for Derivatives
To hedge risks
To speculate (take a view on the future direction of the market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment without incurring the costs of selling one portfolio and buying another
Derivative Instruments
Forward Contracts
Futures Contracts
Forward Rate agreement
Options
Futures Contracts
A futures contract is an standardized agreement to buy or sell an asset at a certain time in the future for a certain price
Forward Agreements
Forward Agreements is an agreement between two specific parties to buy or sell an asset at a specified time and at a specified price.
Salient features of Forward Agreements are:
They are bilateral contracts and hence exposed to counter-party risk.
Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
The contract price is generally not available in public domain.
On the expiration date, the contract has to be settled by delivery of the asset.
If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being
Options
Options are instruments which gives the holder the right but not the obligation to buy (sell) a certain product at a certain time in the future at a pre-fixed price.
The premium charged for this benefit called the “Option Premium” is also known as the “Option Value”.
Foreign Exchange :
Forex trading is the simultaneous buying of one currency and the selling of another.
Currencies are traded through a broker or dealer
Currencies are traded in pairs (e.g.)
the Euro and the US dollar (EUR/USD).
the British pound and the Japanese Yen (GBP/JPY).
When one buys, say, US Dollars, one, in effect is buying a share in the American economy
Price of the currency is a direct reflection of what the market thinks about the current and future health of the economy of the country issuing the currency.
FX Forward
FX forward contract is an agreement to purchase or sell a set amount of a foreign currency at a specified price for settlement at a predetermined time in the future. “Closed” forward contracts must be settled at an exact date.
A currency forward is essentially a hedging tool that does not involve any upfront payment
It can be tailored to a particular amount and delivery period, unlike standardized currency future. Currency forward settlement can either be on a cash or a delivery basis, provided that the option is mutually acceptable and has been specified beforehand in the contract.
Currency forwards are over-the-counter (OTC) instruments, as they do not trade on a centralized exchange. Also known as an “outright forward.”