Personal Loan and Equity Investments

Personal loans are gaining popularity among loan seekers in a big way. Be it planning a vacation or getting you daughter married down payment of your new house or medical obligations a personal loan may be used for any purpose.

A personal loan may be a secured or an unsecured loan where the end use of the money is not supposed to be declared while taking the loan. The rate for unsecured personal loans ranges from about 15 % to 25 % per annum depending up on the credit history and the income of the loan seeker. This type of personal loan is more popular among the public.

The problem begins when people take these kinds of loans for investments into various instruments including equities. Markets have been pretty volatile for last few months and are expected to behave the same for quite some time.

So if you planning to take a personal loan and invest in to equities of mutual funds thinking that the markets are at low then think again. The inflation rate has been moving up. The last numbers posted was well above 12%. With the growth in the Gross Domestic Product (GDP) around 8% to 9% the economy may see a negative growth in the current fiscal.

The Reserve Bank of India has tried to tighten the liquidity situation by increasing the Cash Reserve Ratio (CRR) by 50 basis points. They may increase it by another 50 to 100 basis points if needed to keep a check on the inflation numbers.

The condition worsens if the loan you have taken is on a floating interest rate. You end up losing money in the equity markets and pay more towards the loan at the same time. This is like being the rope in a tug-of-war match where both sides are trying to pull you towards themselves to the fullest.

A better way to invest into equity market is by the way of arbitrage. It is buying in the cash market using the loan amount taken and selling it in derivative market by way of futures at a price which is more than the price bought added with the interest amount. On the day of maturity you reverse your position on both the markets and difference of the amount over and above the cash market price added with interest on the loan and the price sold in the futures market is your profit.

To explain arbitrage lets take the following example

One lot of Reliance Industries Limited (RIL) is of 75 shares. Suppose the price of one RIL share is Rs. 2200 on 1st July, 2008. The maturity is on 31st July, 2008. The total amount of loan of 75 shares is (220075) = Rs. 165000. If the interest rate is 18% per annum then for one month the amount of interest is (1650001.5%) = Rs. 2475 which is (2475/75) = Rs. 33 per share. Thus you need to short one lot of Reliance at any price which is more than (2200+33) = Rs. 2233. If you manage to short at a price say Rs. 2250, then you make a profit of (1775) = Rs. 1275 on one lot which is almost 9.3% per annum. Now no matter what the price is on the expiry, you will manage to earn the amount stated above as you have already squared off your position.
The main thing over here is to find the right price to buy in the cash market and sell in the futures market. If you manage to hit the right price over the screen, then bingo! You have made money where everyone is losing it.