here's a new kid on the mutual fund block. And this one is different.

The J M Equity and Derivative Fund plans to invest in equity, fixed income instruments and derivatives.

Quite a mix, indeed.

Which brings us to should you opt for a part of this pie? Let's figure that out.

• Select the right mutual fund
• The benefits of a mutual fund

Derivatives? What on earth is it?

In a cash market, stocks are bought and sold for delivery immediately. Both premier stock exchanges in India, the Bombay Stock Exchange and the National Stock Exchange, have a cash market segment.

This is where you buy/ sell shares. These are also sometimes called spot markets.

• What's in a share? Money!
• Make money with shares

Likewise, in a derivatives market, derivatives will be bought and sold.

Very simply, a derivative is a financial instrument whose value is based on the performance of another underlying asset.

For example, the value of a stock derivative will be derived from certain shares.

How do these shares get their value? The value of a share is derived from the assets (factories, land, machinery) that the company owns, the money reserves it has, its profits and future earning prospects.

The value of an index derivative will be based on the index, say the Sensex. And the Sensex gets its value based on the 30 stocks that comprise the index.

• Sensex? What's that?

Two common types of derivatives are Futures and Options.

Future is a contract covering the sale of financial instruments for future delivery.

It is just an agreement to buy (or sell) some shares at a fixed price on a fixed date. If the price rises, you still buy at the earlier agreed price (you win). If the price falls, you still sell at the earlier agreed price (you win).

Option is a contract. It gives you the right to buy (or sell) shares at a specific price on or before a specific date. If you do not get the specific price, you have the option of not buying (or selling). No obligation to complete the transaction. 

Let's take a company, say TISCO [Get Quote]. So a Futures or an Options on the TISCO stock would involve, say, 100 shares of TISCO.

Likewise, there are 52 stocks whose derivatives can be bought and sold on the BSE and NSE.

You do not invest in Derivatives, which is essentially a contract to buy and sell. So you trade in them.

You invest in shares, which is an asset.

How does J M plan to benefit

The name of the game is arbitrage.

This refers to the difference in prices that exist between the cash and the derivatives market.

Let's say you were a trader and your entire occupation during the day was to buy and sell to make a profit.

Now you know that, say, TISCO can be bought at Rs 390 on the BSE, and there is a demand for the same stock for Rs 392 on the NSE.

What would you do? You would instantly buy the stock on BSE and sell it on the NSE, right?

What you are really doing is taking advantage of the mismatch in the price levels at the two exchanges to make a cool profit of Rs 2 per share. This is called price arbitrage.

Where do the derivatives come in?

Let's say the market sentiment is very good, prices are rising and everyone is sure they will go higher.

Ideally, in such a booming market, any stock derivative will quote at a premium (higher price) compared to its price in the cash (spot) market.

Conversely, when markets are going downhill, derivatives will quote at a discount (lower price) compared to their spot prices.

This happens because future expectations play a crucial role in determining future prices.

Now, JMEDF can buy any stock in the spot market and simultaneously enter into a sales contract in the derivatives market for the same stock.

For instance, on February 3, TISCO was quoting at Rs 392.55 in the cash market, but at Rs 395.20 in the Futures market. The arbitrage: a cool profit of Rs 2.65 per share.

March 1, 2005: JMEDF buys TISCO for Rs 390. Simultaneously sells a TISCO Futures for Rs 395.

It does so because it believes the price of TISCO will rise to this amount, and it can make a profit of Rs 5 per share.

On the day the Futures contract expires, TISCO is selling at Rs 400.

So the shares that JMEDF sells in the spot market that day will get it a cool profit of Rs 10 per share.

But in the Futures market, it only got Rs 395 per share (not Rs 400).

Let's say the reverse took place and the spot price was quoting at 385.

When they sold TISCO in the spot market, they would have incurred a loss of Rs 5 (after all, they bought at Rs 390). But they would have made a neat profit in the Futures market at Rs 10 per share.

They would have got Rs 395 per share (when the going rate was Rs 385).

Should you go for it?

The principal purpose of this fund is capital preservation, not profit generation.

So you may have to compromise on growth, but can be pretty much assured that your initial investment will not get wiped out.

Basically, they will try to optimise your profits and minimise losses when they do occur (and they will).

In a bear market, when prices are tumbling down, this fund can end up making losses, as regulatory restrictions prohibit mutual funds from selling in the cash market and buying in the Futures market.

Don't lose hope. In such a situation, the fund has the flexibility to invest in fixed income instruments, debts and bonds that will generate income for investors.

Go for it if you identify with any of the points mentioned below.

i. You have already invested in shares or equity mutual funds, and are willing to try something innovative. You can put in a small amount in this fund. The minimum is Rs 5,000.

ii. You are fairly market savvy, and Options and Futures have always caught your fancy. But you are wary of getting trapped. The team, with their expertise and research, are in a better position to do the scheming and planning and play the arbitration game.

• Greed = Loss at the stock market

iii. You want to invest your surplus funds and don't need this money in a tearing hurry. No entry [Images] load (fee). But if you want to get out, you will have to shell out an exit load of 2% (within 25 days); 1.5% (within 85 days); and 1% (within 175 days) of the amount being taken out. Being an interval fund, you can buy units anytime, but you can get out only for a limited period during a month.

iv. If you want just a small portion of your entire investment portfolio in equity, and you want your money to grow (no two ways about this), don't opt for this fund. Restrict your equity to shares of some good companies or units of some equity mutual funds.

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The fund's initial offering is open till February 21 (but could close earlier, February 11 being the earliest). Each unit is going for Rs 10. It will open later for subscription.