Financial Literacy PDF

FINANCIAL LITERACY A student guide to personal finance concepts and goals Dr. Saurabh Kumar Yadav BSC-SE-206  Module-1: Concept of Financial System Course Module-2: Financial Outline Product Module-3: Financial Services  Learning...

FINANCIAL LITERACY A student guide to personal finance concepts and goals Dr. Saurabh Kumar Yadav BSC-SE-206  Module-1: Concept of Financial System Course Module-2: Financial Outline Product Module-3: Financial Services  Learning Outcomes Financial literacy & Financial System Interpret the future and present value of Money Features of Financial Products Various investment plan in terms of risks and returns  Functions of Financial Instruments Enable issuers (companies, governments) to raise funds for growth and 1. Capital Mobilization: development. Provide returns to investors through interest, dividends, or capital 2. Income Generation: appreciation. Allow investors to convert their investments into cash easily. 3. Liquidity Simplify transactions in commodities, currencies, and other assets. 4. Facilitate Trade: Help in hedging against risks like price fluctuations, interest rate changes, 5. Risk Management: and currency volatility (e.g., derivatives).  Investment What is investment? Investment refers to the process of allocating resources, typically money, with the expectation of generating income or profit in the future. It involves committing funds to assets, projects, or financial instruments to achieve specific financial goals over time. Investments can take various forms, including purchasing financial assets (stocks, bonds, mutual funds), real estate, starting a business, or even acquiring education and skills. The goal is to grow wealth, generate income, or preserve purchasing power against inflation.  01 Wealth Creation Objectives of 02 Income Generation Investment 03 Capital Preservation 04 Inflation Hedging 05 Risk Diversification  Characteristics of Investment Investments have several defining characteristics that influence decision-making: 01 Return 1. The primary objective of investment is to generate returns. 2. Returns can be in the form of: 3. Capital Gains: Appreciation in the value of the asset. 4. Income: Interest, dividends, or rental income.  Characteristics of Investment Investments have several defining characteristics that influence decision-making: 02 Risk Investments carry varying degrees of risk, which refers to the uncertainty of returns. Types of risk include: 1. Market Risk: Changes in asset prices due to market fluctuations. 2. Credit Risk: Risk of default by the issuer. 3. Inflation Risk: Reduction in purchasing power due to rising prices. 4. Liquidity Risk: Difficulty in converting the investment into cash without loss of value.  Characteristics of Investment Investments have several defining characteristics that influence decision-making: 03 Liquidity 1. Liquidity refers to the ease with which an investment can be converted into cash without significantly affecting its value. 2. Highly liquid assets include stocks and money market instruments, while real estate and certain long-term investments are less liquid.  Characteristics of Investment Investments have several defining characteristics that influence decision-making: 04 Time Horizon Investments are classified based on the time frame for which funds are committed: Short-Term: Typically up to one year (e.g., treasury bills, savings accounts). Medium-Term: 1 to 5 years (e.g., bonds, fixed deposits). Long-Term: Over 5 years (e.g., equity, real estate).  Characteristics of Investment Investments have several defining characteristics that influence decision-making: 05 Diversification Spreading investments across various asset classes and sectors to reduce overall risk. A diversified portfolio balances high-risk and low-risk investments to achieve stable returns.  Characteristics of Investment Investments have several defining characteristics that influence decision-making: 06 Inflation Protection Investments should ideally grow at a rate higher than inflation to preserve the purchasing power of capital. Real assets like gold or real estate and certain equities often act as inflation hedges.  Characteristics of Investment Investments have several defining characteristics that influence decision-making: 07 Tax Efficiency Some investments provide tax benefits, which can enhance returns (e.g., tax-free bonds, retirement accounts like PPF). Tax implications vary based on the type of investment and the investor's tax bracket.  Characteristics of Investment 08 Safety Safety measures the assurance of the return of the original investment amount. Low-risk investments (e.g., government bonds, savings accounts) provide higher safety, while high-risk investments (e.g., equities, cryptocurrencies) may offer higher returns but with less safety.  Characteristics of Investment Investments have several defining characteristics that influence decision-making: 09 Growth Potential Investments vary in their potential to appreciate in value. Growth-oriented investments like stocks and mutual funds are suitable for long-term wealth creation, whereas fixed-income investments like bonds focus on stable returns.  Characteristics of Investment Investments have several defining characteristics that influence decision-making: 10 Marketability The ease with which an investment can be bought or sold in the market. Marketable securities like stocks and ETFs can be easily traded, while non-marketable investments like privately held businesses are harder to sell.  01 Financial Investments Types of Investments 02 Real Assets 03 Alternative Investments  Characteristics of Investment Investments have several defining characteristics that influence decision-making: 1 Financial Investments Equity: Shares of companies. Debt Instruments: Bonds, fixed deposits. Mutual Funds and ETFs: Pooled investments. Derivatives: Futures, options.  Characteristics of Investment 02 Real Assets: Real estate.. Commodities like gold, oil.  Characteristics of Investment Investments have several defining characteristics that influence decision-making: 03 Alternative Investments Cryptocurrencies Hedge funds Factors Influencing Investment Decisions Risk Tolerance: 01 The investor's ability to endure financial loss without affecting their goals. 02 Financial Goals: Short-term goals (vacation, emergency fund) vs. long-term goals (retirement, buying a house). 03 Economic Environment: Interest rates, inflation, and market conditions influence investment choices. Factors Influencing Investment Decisions Age and Life Stage: 4 Younger investors may opt for higher-risk, higher- return options, while older investors prefer safer investments. 5 Tax Considerations: o Tax efficiency can significantly impact net returns. 6 Liquidity Needs: Investors requiring easy access to funds prefer liquid investments.  Types of Risks Involved in Financial Investment Investing in financial markets and instruments involves various types of risks that can impact returns and even the invested capital. Understanding these risks is crucial for effective investment decision-making and risk management. Below is a detailed discussion on the types of risks involved in financial investment Market Risk Credit Risk Liquidity Risk Inflation Risk Reinvestment Risk Interest Rate Risk Systematic Risk Unsystematic Risk Political & Regulatory Risk  Types of Risks Involved in Financial Investment Investing in financial markets and instruments involves various types of risks that can impact returns and even the invested capital. Understanding these risks is crucial for effective investment decision-making and risk management. Below is a detailed discussion on the types of risks involved in financial investment Exchange Rate Risk Concentration Risk Counterparty Risk Geopolitical Risk Operationl Risk Behavioral Risk  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 01 Market Risk Market risk arises from fluctuations in the overall financial markets that can affect the value of investments. Types of Market Risk: Equity Risk: The risk of changes in stock prices affecting the value of equity investments. Interest Rate Risk: The risk that changes in interest rates will affect the value of fixed-income securities like bonds. Currency Risk: The risk that exchange rate fluctuations will impact investments in foreign currencies or assets. Commodity Risk: The risk of price volatility in commodities like gold, oil, or agricultural products. Example: A decline in the stock market can reduce the value of equity investments.  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 02 Credit Risk Credit risk refers to the risk that a borrower will default on their obligations, leading to a loss for the investor. Key Aspects: Default Risk: The risk that the issuer of a bond or debtor will fail to make scheduled payments. Downgrade Risk: The risk that a credit rating agency will downgrade the creditworthiness of the issuer, affecting the bond's price. Example: A corporate bond issuer goes bankrupt and is unable to pay interest or principal.  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 03 Liquidity Risk Liquidity risk occurs when an investor cannot easily sell or convert an investment into cash without significantly affecting its price. Key Aspects: Market Liquidity Risk: Arises when there are few buyers or sellers for an asset. Funding Liquidity Risk: The risk of not having sufficient cash or liquid assets to meet financial obligations. Example: Real estate investments are often less liquid compared to stocks, making them harder to sell quickly.  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 04 Inflation Risk Inflation risk refers to the possibility that the purchasing power of returns will decrease due to rising prices. Key Impact: Investments that provide fixed returns, such as bonds or fixed deposits, are particularly vulnerable to inflation risk. Example: If inflation rises to 5% but a bond yields only 3%, the real return is negative.  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 05 Reinvestment Risk REINVESTMENT RISK OCCURS WHEN THE RETURNS OR PRINCIPAL FROM AN INVESTMENT MUST BE REINVESTED AT A LOWER INTEREST RATE THAN THE ORIGINAL INVESTMENT. KEY IMPACT: COMMON WITH FIXED-INCOME SECURITIES LIKE BONDS WHEN INTEREST RATES DECLINE. EXAMPLE: A BOND MATURES, AND THE INVESTOR FINDS THAT NEW BONDS OFFER LOWER INTEREST RATES.  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 06 Interest Rate Risk INTEREST RATE RISK IS THE RISK OF CHANGES IN INTEREST RATES AFFECTING THE VALUE OF FIXED- INCOME INVESTMENTS. KEY ASPECTS: PRICE SENSITIVITY: BOND PRICES MOVE INVERSELY WITH INTEREST RATES. WHEN INTEREST RATES RISE, BOND PRICES FALL, AND VICE VERSA. DURATION: LONGER-DURATION BONDS ARE MORE SENSITIVE TO INTEREST RATE CHANGES. EXAMPLE: A RISE IN INTEREST RATES REDUCES THE MARKET VALUE OF A PREVIOUSLY ISSUED BOND WITH A LOWER COUPON RATE.  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 07 Systematic Risk SYSTEMATIC RISK IS THE INHERENT RISK THAT AFFECTS THE ENTIRE MARKET OR ECONOMY AND CANNOT BE DIVERSIFIED AWAY. SOURCES: ECONOMIC DOWNTURNS, POLITICAL INSTABILITY, NATURAL DISASTERS, OR GLOBAL FINANCIAL CRISES. EXAMPLE: A GLOBAL RECESSION LEADS TO WIDESPREAD DECLINES IN STOCK PRICES.  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 08 Unsystematic Risk Unsystematic risk is specific to a particular company, industry, or sector and can be mitigated through diversification. Sources: Company-specific risks such as poor management, product recalls, or financial instability. Industry risks like regulatory changes affecting a specific sector. Example: A pharmaceutical company faces lawsuits over a defective drug, causing its stock price to fall.  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 09 Political and Regulatory Risk Political and regulatory risks arise from changes in government policies, regulations, or political instability that can impact investments. Key Aspects: Changes in tax laws, trade policies, or environmental regulations. Risks of expropriation or nationalization in politically unstable countries. Example: A government imposes higher taxes on a specific industry, reducing its profitability.  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 10 Exchange Rate (Currency) Risk Currency risk arises when investments involve foreign currencies, and exchange rate fluctuations affect returns. Key Impact: A depreciation in the currency in which an investment is denominated reduces the value of returns when converted to the investor’s home currency. Example: A U.S. investor in European stocks suffers losses due to a weakening euro against the dollar.  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 11 Counterparty Risk Counterparty risk is the risk that the other party in a financial transaction may default on their obligations. Key Aspects: Common in derivative transactions, loans, and certain investment contracts. Example: Default loan  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 12 Operational Risk Counterparty risk is the risk that the other party in a financial transaction may default on their obligations. Key Aspects: Common in derivative transactions, loans, and certain investment contracts. Example: Default loan  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 13 Concentration Risk Concentration risk occurs when a portfolio is overly reliant on a single asset, sector, or region. Key Impact: Amplifies losses if the concentrated investment performs poorly. Example: A portfolio heavily invested in the tech sector suffers during a technology downturn.  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 14 Geopolitical Risk Geopolitical risk arises from international conflicts, trade wars, or other geopolitical events that affect markets. Example: A war in a major oil-producing region causes a spike in energy prices, affecting global markets  TYPES OF RISKS INVOLVED IN FINANCIAL INVESTMENT 15 Behavioral Risk Behavioural risk stems from investor biases and emotional decision-making, leading to suboptimal investment outcomes. Common Biases: Overconfidence, herd behavior, loss aversion. Example: Selling investments during a market panic due to fear of further losses. Capital Market Features of the Capital Market The capital market is a financial market 01 Long-Term Focus where long-term securities, such as stocks, bonds, and other instruments, are bought and sold. It serves as a critical 02 Wide Range of Instruments platform for raising capital, enabling businesses, governments, and 03 Liquidity individuals to fund their projects and investments. 04 Regulated Environment The capital market is essential for economic growth as it facilitates the efficient allocation of financial resources 05 Market Participants and encourages savings and investment. Functions of the Capital Market Mobilizing Savings: 01 Channels individual and institutional savings into productive investments. 02 Resource Allocation: Allocates financial resources efficiently to projects and sectors with the highest returns. Liquidity Provision: 03 Enables investors to buy and sell securities, ensuring liquidity in the financial system. Functions of the Capital Market Price Discovery: 04 Helps determine the fair market value of securities based on supply and demand. 05 Risk Management: Offers financial instruments like bonds, derivatives, and mutual funds to manage investment risks. Economic Growth: 06 Facilitates capital formation, leading to economic development and growth.  01 Primary Market Types of Capital 02 Secondary Market Markets 01 Primary Market Primary Market: Definition: The market where new securities are issued for the first time. Purpose: Allows companies and governments to raise capital directly from investors. Key Instruments: Initial Public Offerings (IPOs) Rights Issues Private Placements Participants: Issuers, underwriters, investors, regulatory bodies. Examples: A company issuing shares in an IPO to fund expansion. 02 Secondary Market Definition: The market where previously issued securities are bought and sold. Purpose: Provides liquidity and a platform for price discovery. Key Instruments: Stocks, bonds, ETFs, derivatives. Participants: Retail investors, institutional investors, brokers, market makers. Examples: Trading of shares on stock exchanges like BSE, NSE, NYSE,  Types of Instruments in the Capital Market Equity Instruments: 1. Stocks (Shares): Represent ownership in a company. Common shares offer voting rights and potential for capital appreciation. Preferred shares offer fixed dividends but limited or no voting rights. 2. Debt Instruments: Bonds: Long-term debt securities issued by governments or corporations. Provide periodic interest payments (coupon) and principal repayment at maturity. Debentures: Unsecured bonds backed by the issuer's creditworthiness. Convertible Bonds: Debt instruments that can be converted into equity under specific conditions.  Types of Instruments in the Capital Market Hybrid Instruments: 3. o Combine features of both equity and debt. o Examples: Preference shares, convertible bonds. 4. Derivatives: Contracts whose value is derived from underlying assets like stocks, bonds, or commodities. Examples: Options, futures, swaps. 5. Other Instruments: Mutual Funds: Pooled investments in diversified portfolios. Exchange-Traded Funds (ETFs): Similar to mutual funds but traded on stock exchanges.  Participants in the Capital Market Issuers: 1. Entities that issue securities to raise funds (e.g., corporations, governments). 2. Investors: Retail Investors: Individual investors buying stocks, bonds, or mutual funds. Institutional Investors: Large entities like mutual funds, pension funds, and insurance companies.  Participants in the Capital Market 3. Intermediaries: Brokers, dealers, investment banks, and underwriters facilitate transactions in the capital market. 4. Regulators: Ensure transparency, fairness, and protection of investor interests. Examples: Securities and Exchange Commission (SEC) in the U.S., Securities and Exchange Board of India (SEBI). 5. Stock Exchanges: Platforms where securities are traded. Examples: New York Stock Exchange (NYSE), London Stock Exchange (LSE), Bombay Stock Exchange (BSE). Advantages of the Capital Market Facilitates Economic Growth: 01 Encourages investment in productive projects, boosting economic development. 02 Efficient Allocation of Resources: Directs funds to sectors and projects with the highest returns. Liquidity: 03 Provides investors with the ability to buy and sell securities, making investments more attractive. Advantages of the Capital Market Transparency: 04 Regulated operations ensure fair practices and reduce information asymmetry. 05 Risk Diversification: Offers a wide range of financial instruments to help investors diversify their portfolios. Encourages Savings and Investments: 06 Offers attractive returns, motivating individuals and institutions to save and invest.  Challenges in the Capital Market Market Volatility: 01 Prices can fluctuate significantly, leading to uncertainty and potential losses for investors. 02 Regulatory Compliance: Companies and intermediaries must adhere to complex and evolving regulations. Insider Trading and Fraud: 03 Unethical practices can undermine investor confidence. Challenges in the Capital Market Liquidity Issues: 04 Some securities, particularly in smaller or emerging markets, may lack liquidity. 05 Economic Instability: Economic downturns or geopolitical events can negatively impact market performance. High Costs: 06 Costs associated with listing, trading, and regulatory compliance can be significant for issuers and investors.  Role of Regulators in the Capital Market Protecting Investors: 1. Ensures fair practices and transparency in the market. 2. Regulating Intermediaries: Oversees brokers, dealers, and other market participants.  Role of Regulators in the Capital Market 3. Facilitating Market Development: Promotes innovation and efficiency in the market. 4. Maintaining Market Stability: Prevents systemic risks and ensures smooth functioning of the market. 5. Disclosure Requirements: Enforces strict disclosure norms to reduce information asymmetry.  Comparison Between Primary and Secondary Markets Aspect Primary Market Secondary Market Definition New securities are issued. Existing securities are traded. Participants Issuers, underwriters, investors. Investors and traders. Purpose Raise new capital for issuers. Provide liquidity to investors. Focus on trading rules and investor Regulation Strict regulatory compliance for issuers. protection. Determined by market forces Pricing Determined by issuer and underwriters. (supply/demand). Funds Flow From investors to issuers. Between buyers and sellers of securities. INVESTMENT IN EQUITY IN THE PRIMARY MARKET The primary market is where companies raise capital by issuing shares for the first time, such as through an Initial Public Offering (IPO) or Follow-On Public Offering (FPO).  Understand the Offer: Step-by-Step Procedure Open a Demat and Trading Account Apply for the IPO Choose the Lot Size and Bid Price Submit the Application Wait for Allotment Allotment and Listing INVESTMENT IN EQUITY IN THE SECONDARY MARKET The secondary market is where investors buy and sell existing shares on stock exchanges like the NYSE, NASDAQ, or NSE.  Open a Demat and Trading Step-by-Step Procedure Account Choose a Brokerage Platform Analyze the Market Place a Buy Order Trade Execution Monitor and Manage Investments Selling Shares Documents and Requirements For Primary Market: 1. PAN Card. 2. Bank Account linked to Application Supported by Blocked Amount ASBA. 3. Demat Account details. For Secondary Market: 1. PAN Card. 2. Demat and Trading Account. 3. Bank Account for fund transfers.  Tips for Equity Investments Diversify: 1. Spread investments across sectors and companies to reduce risk. 2. Set Financial Goals: Define whether you're investing for growth, income, or capital preservation.  Tips for Equity Investments 3. Stay Informed: Follow market news, company updates, and global economic trends. 4. Understand Risks: Equities are volatile; be prepared for short-term price fluctuations. 5. Long-Term Focus: Invest with a long-term perspective to benefit from compounding and market growth.