What is Financial Market?
A market is defined as a place where goods and services are bought and sold. Along similar lines, a financial market is one where financial products and services are bought and sold regularly. Financial markets deal in the purchase and sale of different types of investments, loans, financial services, etc. The demand and supply of financial instruments determine their price, and the price is, therefore, quite dynamic.
Financial markets form a bridge between investors and borrowers. It brings together individuals and entities that have surplus funds and those who are in a deficit of funds so that funds can be transferred between them. This transfer of funds is done through different types of financial instruments that operate in the financial markets.
Structure of the Indian financial market
The Indian financial market is divided into two main types – the money market and capital market. The capital market is further sub-divided into different types of financial markets. Let's understand –
Let’s understand each type of financial market in details –
The money market is a marketplace for short-term borrowing and lending. Securities that have a maturity period of less than a year are traded on money markets. The assets traded in money markets are usually risk-free and are very liquid. Since the maturity period is low, the risk of volatility is low, and the returns are also low. Money market instruments are debt oriented instruments with fixed returns. Some common examples of money market instruments include Treasury Bills, Certificates of Deposits, Commercial Papers, etc.
Contrary to the money market is the capital market, which deals in long-term securities. Securities whose maturity period is more than a year are traded on the capital market. Capital market trades in both debt and equity-oriented securities. Individuals, companies, financial institutions, NRIs, foreign institutional investors, etc. are participants of the capital market. The capital market is divided into two sub-categories which are as follows –
- Primary market
Also called the New Issue Market, the primary market is that part of the capital market, which is engaged in the issuance of new securities. The newly issued securities are then purchased from the issuer of such securities directly. For instance, if a company offers an IPO (Initial Public Offering) and sells its shares to the public, it forms a part of the primary capital market. Investors directly buy the shares from the company, and no middlemen are involved. Similarly, if an already listed company issues more shares, called Follow-on Public Offerings (FPO), such shares can be bought by investors directly from the company.
- Secondary market
The secondary capital market is where the securities bought in the primary capital market are traded between buyers and sellers. Stock trading is a very common example of a secondary capital market wherein investors sell their owned stocks to interested buyers for a profit. A secondary market is characterised by an intermediary and the trading of securities takes place with the help of such intermediary. While securities in the primary market can be traded only once, securities in the secondary market can be traded any number of times. The stock exchange is a part of the secondary market wherein you can trade in stocks of different companies that have already been offered by the company at an earlier date.
Other types of financial markets
Besides the above-mentioned types of financial markets, there are other types of financial markets operating in India. These include the following –
- Commodity market
This market deals in the trading of a commodity like gold, silver, metals, grains, pulses, oil, etc.
- Derivatives market
Derivative markets are those where futures and options are traded.
- Foreign exchange market
Under a foreign exchange market, currencies of different countries are traded. This is the most liquid financial market since currencies can be easily sold and bought. The rate fluctuations of currencies make them favourable for traders who look to book profits by buying at a lower rate and selling at a higher one.
- Bond market
Bond market deals in trading of Government and corporate bonds, which are offered by Governments and companies to raise capital. Bonds are debt instruments that have a fixed rate of return. Moreover, bonds also have a specific tenure, and the bond market is, thus, not very liquid.
- Banking market
The banking market consists of banks and non-banking financial companies which provide banking services to individuals like the collection of deposits, the opening of bank accounts, offering loans, etc.
Financial market and services
The services offered by financial markets today are as follows –
- They provide a platform for buyers and sellers to trade on financial products
- The financial market determines the price of financial instruments traded on it. This price is based on the demand and supply mechanism of the instrument and can move up and down frequently
- The market provides liquidity to investors when they need to sell off their investments for funds
- The market provides funds to borrowers when they need financial assistance
- The Indian financial market is influential in the economic growth of India as a whole
- The financial market helps in mobilization of funds from investors to borrowers
Thus, the financial market and its services are varied, and that makes the financial market an important component of the Indian economy.
Regulators of financial markets
Financial markets and services offered by them should be regulated so that the participants of the market follow the laws of trading. As such, there are different regulators of the market that ensure that all participants trade fairly. These regulators are as follows –
- Reserve Bank of India
RBI is the regulator for banks and non-banking financial companies. It is the central bank of India entrusted with the formulation of monetary policies, credit policies, and foreign exchange policies, among others. Banks and financial institutions have to abide by RBI's rules and regulations to work in the financial market.
- Securities and Exchange Board of India
SEBI is the primary regulator of the capital market, which consists of both the primary as well as the secondary capital market. Trading done in the capital market is governed under SEBI's rules and laws.
- Insurance Regulatory and Development Authority
IRDA governs the rules and regulations which are to be followed by insurance companies and their intermediaries. Thus, IRDA is a regulator of the insurance market, both life, and general insurance market.
Financial markets today have evolved and have become quite competitive with the participation of multiple players. They directly play a part in the growth of India's economy and allows investors and borrowers to trade in financial products and services in an easy and smooth manner. To take advantage of the Financial markets and varied investing opportunities, consider the team at IndiaNivesh, which is well-versed with types of markets and regulatory bodies.
Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.
Cost Inflation Index - Meaning, Calculation & Benefits
Inflation is an economic term and referred to the continuous rise in the price of goods and services, thereby reducing the purchasing power of the money. The pinch of inflation is felt by all sections of the economy, be it, the consumers, investors, and the government. And, even though it increases the cost of living, inflation is a necessary evil and desirable for the growth and development of the economy. For the reason of inflation, it is only fair to pay more for your goods like comb and brush over the years due to an increase in the price. For the same reason, it is unfair to pay capital gains tax on your assets without taking into account the impact of inflation on the value of the asset. Cost Inflation Index(CII) is the index to calculate the increase in the price of assets year-on-year due to the impact of inflation. What is the Cost Inflation Index? Cost Inflation Index or CII is an essential tool for determining the increase in the price of an asset on account of inflation and is useful at the time of calculating the long-term capital gains on the sale of capital assets. It is fixed by the central government and released in its gazetted offices by the Ministry of Finance every year. Capital gains are the profits arising from the sale of assets like real estate, financial investment, jewellery, etc. The cost price of the asset is adjusted taking into account the Cost Inflation Index of the year of purchase and the year in which the asset is sold, and the entire process is known as Indexation. Cost Inflation Index Calculation The cost inflation index calculation is done by the government to match the inflation rate for the year and calculated using the Consumer Price Index (CPI). Cost Inflation Index India for the financial year 2019-20 has been set at 289. Change of the base year for the Cost Inflation Index The cost inflation index base year was changed in the Union Budget 2017 from 1881 to 2001. The base year was changed by the government to enable accurate and faster calculations of the properties purchased before April 1, 1981, as taxpayers started to face problems with valuations of older properties. The base year has an index value of 100, and the index of the following years is compared to the index value in the base year to determine the increase in inflation. With the change in the base year, the capital gains and tax burden has reduced significantly for the taxpayers as it now reflects the inflated price of the asset realistically. The current Cost Inflation Index Chart for each year is as under- How is the Cost Inflation Index (CII) used in calculating capital gains To calculate the capital gains on your assets the purchase price of the asset is indexed by the cost Inflation Index using the formula below- Indexed cost of the asset at the time of acquisition = (CII for the year of sale/ CII for the year of purchase or base year (whichever is later))*actual cost of acquisition If suppose you purchased a flat in December 2010 for Rs 42 lacs and sold in Jan 2019 for Rs 85 lacs. Your capital gain from the sale of the flat is Rs 43 lacs. The CII in the year in which the flat was purchased is 148, and the CII in the year the flat was sold in is 280. The purchase price of the flat after taking into account the Cost Inflation Index is = (280/148)*Rs42 lacs= Rs 79. 46 lacs This is the indexed cost of acquisition. Your long-term capital gain after taking indexation into account is Rs 85,00,000- Rs 79,45,946 = Rs.5,54,054. Long-term capital gains on the sale of property are taxed at 20% with indexation benefit. So, your tax liability, in this case, would be- 20% of Rs 5, 54, 054= Rs 1,10,810 Without indexation benefit, the capital gains are taxed at 10%. In this case, the capital gains would be- Sale price of the flat - purchase price of the flat = Rs 85,00,000 – Rs42,00,000 = Rs.43,00,000. The capital gains tax without indexation benefit will be 10% X Rs 43,00,000 = Rs.4,30,000. Thus, indexation helps reduce the long-term capital gains and reduce the overall tax burden for the taxpayer considerably. Indexation benefit can be used for investments in mutual funds, real estate, gold, FMPs, etc. but is not applied for fixed income instruments like FDs, recurring deposits, NSC, etc. Few important tips to remember about the Cost Inflation Index- If you receive an asset as a part of the will, then in such the CCI for the year in which it was transferred will be considered and not the CCI of the purchase of the asset Indexation benefit for the cost of improvement of the asset is the same as the cost of improvement of the asset. Cost of improvement incurred before 1981 to be ignored. CONCLUSION Cost Inflation Index is an important parameter to be considered at the time of selling long-term assets as it is beneficial for the investors. Reach out to our experts at IndiaNivesh for any queries about capital gains arising from the sale of assets for correct guidance. Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.
Internal Rate of Return (IRR) – Meaning, Calculation & Advantages
In the world of finance and investments, very often you hear the term IRR or internal rate of return. Many a time, company officials make announcements of going ahead with a project because it is financially viable. A company uses a variety of financial tools and metrics to evaluate the commercial attractiveness of a project to make its operating and investing decision. One of such vital parameters to determine the attractiveness of the project and whether or not a company should invest its resources in it is by calculating the internal rate of return, or IRR of the project. What is the Internal Rate of Return (IRR)? Internal rate of return (IRR) is a capital budgeting technique to gauge the performance of an investment and the help determine its profitability. IRR is expressed as a percentage, and it is the discount rate at which the net present value of an investment or project becomes zero. IRR takes into account the time value of money and capital inflows and outflows over the life of the investment. As the full form of IRR suggests, it is the internal rate of return and does not take into account external factors like inflation, state of the economy, etc. at the time of calculating returns. In simple terms, IRR is the breakeven rate of a project. If the IRR of a project is high and exceeds the required rate of return, then the company will go ahead and invest in the project, but if the IRR is low and below the required rate of return, then the company will not go ahead with it. It also helps analyze and compare between different projects and how to prioritize projects based on their IRR. How is IRR calculated? Calculating the IRR of a project is not a straightforward calculation. It requires trial and error as we try to arrive at a percentage wherein the net present value of the investment will become zero. IRR of a project can be easily calculated through financial calculators or using the IRR function in excel. The formula for IRR is 0= P0 P1(1 IRR) P2/(1 RR)2 P3/(1 IRR)3 P4/(1 IRR)4 ... Pn/(1 IRR)n Where P0, P1 ... Pn are the cash flows in the period 1, 2, .., n, respectively and IRR is the internal rate of return of the investment. Here is an example to show how to calculate IRR- A company is considering the purchase of machinery to increase its sales, whose cost is Rs 3,00,000. This new machinery has a life of three years, and it will help the company generate an additional profit of Rs 1,50,000 per annum in the three years, and the scrap value, in the end, is Rs 10000. The company’s rate of return from investing the cash in other investments will fetch a return of 15%. Now, if we want to find out if buying the machinery is a better option or not, we have to calculate IRR. 0 = -Rs 300,000 (Rs150, 000)/(1 .243) (Rs150,000)/(1 .2431)2 (Rs 150,000)/(1 .2431)3 Rs10,000/(1 .2431)4 The net present value of the investment becomes zero when the IRR assumed is 24.31% which is much higher than the required rate of return of 15%. Thus, the company must purchase the machinery. What are the advantages of using IRR in investments? There are many advantages of using IRR technique at the time of analyzing investments and include- Time Value of Money is considered One of the significant benefits of using the IRR technique is that it takes into account the time value of money at the time of calculating the returns from an investment. This makes IRR credible and accurate to determine the future earning potential of the money A simple technique for analysis Using the IRR technique to assess the profitability of the project is straightforward. If the project IRR is higher than the cost of capital or required rate of return, then it is advisable to go ahead otherwise not. Helps rank and compare projects from an investment perspective When you have to make a comparison between two or more projects, IRR is useful in comparing and ranking projects depending on the yield. The project with a higher IRR is preferred. Limitations of IRR technique Even though IRR is an important financial metric in capital budgeting, it has its limitations. The major drawbacks of using IRR technique are- Project duration, size, etc. not considered One of the most significant disadvantages of IRR is that it does not take into account important aspects such as the scale of the project, time taken for completion, etc. into account at the time of comparing projects, which can be misleading. The assumption about the reinvestment rate Another limitation of using the IRR technique is that it assumes the same reinvestment rate for all the future cash flows throughout the tenure of the project, which is not practical as not all the future cash flows may have the same reinvestment opportunity. One of the best ways to overcome the limitations of IRR is that one should not use IRR in isolation but use the NPV method and IRR together in capital budgeting to understand the profitability of the project. Another option is to use the MIRR, which is the modified internal rate of return, which helps overcome the assumption of reinvestment at the same rate. Conclusion IRR plays an important role in determining the return from your investments, and if you want to use IRR in practice, then open a Demat account with IndiaNivesh and get the correct guidance from our experts to get desirable returns on your investments. Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.
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