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Synopsis
The article published in the editorial section of The Hindu Newspaper talks about the changes in stock market due to the changes in recent budget and its impact on capital gains and speculation.
Background Information
What is a stock market?
The stock market is a significant marketplace where people buy and sell shares of ownership in companies. It serves as a means for companies to raise money for growth and improve their business, while investors use the market to buy shares, hoping the value will increase so they can sell them for a profit or earn money through dividends.
Stocks (shares) are small pieces of ownership in a company, with types such as common stocks that give voting rights and potentially dividends, and preferred stocks that give priority on dividends but no voting rights.
The stock price is the price of one share, which fluctuates based on how much people want to buy or sell it. Market capitalization is the total value of all a company’s shares, calculated by multiplying the stock price by the number of shares.
Indices, such as the S&P 500 or the Dow Jones Industrial Average, are a scorecard that shows how a group of stocks is performing. The stock market works in two main ways: the Primary Market, – When a company first sells its shares to the public, it’s called an Initial Public Offering (IPO).
This is like when a company opens a new store and sells products for the first time.and the Secondary Market, where After the IPO, stocks are bought and sold between investors on the stock exchange, like the New York Stock Exchange (NYSE) or NASDAQ
Key participants in the stock market include investors, brokers, market makers, and regulatory bodies like the Securities and Exchange Commission (SEC). Basic investment concepts include dividends, capital gains, risk and return, and diversification.
Dividends are paid by companies to shareholders, capital gains occur when a stock is sold for more than the original price, and risk and return are the potential risks associated with investing in the stock market. Diversification helps reduce the risk of losing money by buying different kinds of stocks.
Stock market strategies include buy and hold, day trading, value investing, and growth investing. Understanding basic concepts like stocks, stock prices, market capitalization, and indices helps navigate the stock market effectively. By understanding these concepts, investors can make informed decisions and navigate the stock market effectively.
What are Capital Gains?
Capital gains in the stock market are the profits made by investors when they sell a stock at a higher price than the purchase price.
There are two types of capital gains: short-term gains, which are gains from the sale of stocks held for less than a year, and long-term gains, which are gains from the sale of stocks held for more than a year and are taxed at a lower rate to encourage long-term investment.
Examples of capital gains include buying 100 shares of a company at ₹100 each, selling them at ₹150 each, and calculating the capital gain. High capital gains in the stock market can indicate a strong and growing economy, while low levels may suggest economic challenges.
Factors influencing capital gains include market conditions, company performance, and external factors such as political events, regulatory changes, and global economic conditions. Market conditions, company performance, and external factors can all impact stock prices.
In summary, capital gains in the stock market are a crucial part of investment strategy and are subject to taxation, which can vary depending on the holding period and tax laws.
What are Derivatives?
Derivatives are financial contracts that derive their value from an underlying asset, such as a stock, bond, commodity, or currency. They come in different forms, such as futures, options, swaps, and forwards. People use derivatives to hedge risks, speculate for profits, and gain market access.
Futures contracts are agreements to buy or sell something at a fixed price at a specific date in the future. Options contracts give the right but not the obligation to buy or sell something at a fixed price before or on a specific date.
Swaps are agreements between two parties to exchange financial flows or other financial instruments. Forwards contracts are customized agreements between two parties.
Derivatives serve various purposes, including protecting against price changes, speculation, and accessing markets or assets that are otherwise difficult to trade. Key benefits of derivatives include risk management, leverage, liquidity, and counterparty risk.
However, they also come with risks such as complexity, potential for significant losses, and the potential for significant losses.
Article Explanation
India’s recent budget changes include increased taxes on stock market profits and securities transactions. The government has raised taxes on short-term and long-term capital gains from the stock market, causing investors to pay more taxes on profits they make from buying and selling stocks.
Additionally, the government has increased taxes on derivatives transactions, such as futures and options.
The reasons behind these increases include comparing profits from stock market speculation to gambling, the Economic Survey’s view suggesting that developing countries should not waste their limited savings on stock market speculation, and Finance Secretary T.V. Somanathan’s statement suggesting that capital gains could be taxed at higher rates.
However, there is a perception that capital gains are seen as easy profits and contribute to growing economic inequality. The budget has also removed indexation benefits for real estate investors, which previously allowed them to adjust the purchase price of property for inflation when calculating capital gains.
The government’s changes aim to curb speculative investments and redirect savings towards more productive uses, but the perception of capital gains and their impact on society remains a contentious issue.
How capital gains occur
Capital gains occur due to the uncertainty and variability in forecasting future cash flows of businesses. Investors earn capital gains by efficiently allocating their capital to undervalued businesses whose true value gets recognized over time.
Efficient capital allocation is crucial for the economic health of a country, as it ensures that resources are directed towards sectors that meet societal needs effectively. Misallocation of capital can lead to inefficiencies and a poorer economy. A uniform capital gains tax may help prevent resource misallocation, but it can also affect private incentives and overall economic growth.
In the perfect forecast scenario, investors would all agree to pay ₹100 for a business that would yield ₹110 in a year and want a 10% return. In the real-world scenario, investors sometimes overvalue or undervalue businesses based on their cash flow forecasts.
Overvaluation occurs when investors overestimate a business’s future cash flow, paying more than its fair value, and undervaluation occurs when investors underestimate a business’s future cash flow.
Efficient capital allocation means that scarce resources are directed towards sectors that satisfy society’s needs effectively. An economy that efficiently allocates its capital will be wealthier than one that allocates capital inefficiently.
The issue of ‘gambling instincts’
The passage discusses the role of speculation and liquidity in the stock market, arguing that most buying and selling in the market do not directly benefit businesses. Critics argue that when a retail investor buys a share, the money often goes to the previous owner, not directly into the business.
They also overlook that early investors may not invest in a business without a liquid market like the stock exchange, as the ability to sell shares readily in the future is crucial for attracting initial investments.
Market liquidity is essential for encouraging long-term investing, as the government raises taxes on short-term capital gains. Short-term traders, often seen as having “gambling instincts,” provide liquidity by regularly buying and selling stocks, allowing long-term investors to sell their stocks easily when needed.
A highly liquid market ensures accurate pricing of shares, reflecting the true value and prospects of businesses. Accurate pricing helps promising companies raise funds more easily, leading to more efficient allocation of resources in the economy.
In summary, the passage argues that speculation and short-term trading play vital roles in the stock market by providing liquidity and ensuring accurate pricing of shares. While some critics argue that most stock transactions do not directly benefit businesses, the presence of a liquid market is crucial for attracting initial investments and allowing long-term investors to sell their shares when needed.
It is worse for derivatives
The passage discusses the social benefits of derivatives trading and identifies common misconceptions about speculation in financial markets. Derivatives are financial contracts that allow investors to buy or sell an underlying asset at a predetermined price in the future, enabling the transfer of risk from one group to another.
These benefits include risk transfer, which allows investors to offload the risk associated with price changes to another group willing to assume that risk. For example, farmers can use futures contracts to lock in a price for their produce, reducing the risk of future price fluctuations.
Speculation in derivatives trading can appear similar to gambling, as neither party intends to buy or sell the underlying asset but instead bets on price changes.
However, speculative trading in derivatives is not very different from much of the trading in the cash market, where traders may not have a long-term interest in the underlying business. Active trading, even if speculative, provides liquidity to long-term investors, enabling them to buy or sell based on fundamental analysis.
The benefits of speculative trading include liquidity, which helps long-term investors buy or sell assets more easily and at fair prices. Additionally, speculative traders in derivatives improve the availability of these instruments for fundamental investors who want to manage risk. By betting on price changes, speculators enhance the overall functioning of the market.
Better understanding of the benefits of stock market speculation can lead to more informed and effective public policy. Recognizing the role of speculation in providing liquidity and risk management can help policymakers design regulations that support a healthy financial market.
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