Cards and Finance

I have moved

Dear Patrons,

Finally I have given in to my friends' persistent advice to move my blog to Wordpress. Blogger vs Wordpress debate had been going for too long and I admit that Wordpress surely has many advantages over Blogger. Fortunately I have been able to import all my posts and comments at the new address.

I have moved my Finance blog to following URL:
http://www.jasginder.com/bizblog

I have brought my technology, marketing and finance blogs under single blog - Business blog. Please update your Blogroll and bookmarks (if any!).

Understanding importance of Banks - I

3 comments Posted by Jas at 3:31 PM

Since starting of this blog, I have tried to cover the topics for the people like myself, those who understand only basics of finance and not the luscious terms like hedge funds, leveraged buy outs, mortgage funds etc.

So we will be writing a series on the importance of banks, how they effect our financial ecosystem. In this first post, let us quote Ilian Mihov, Professor of Economics at INSEAD, France. Here is how he explains it -

Banks fulfill a very important role in the economy by matching borrowers and lenders. When we deposit $100 in a bank, the bank keeps, at most, two to three dollars in its vaults (in fact the money is often in the central bank), the remaining $98 or so is lent to a borrower.

Most businesses require loans for their normal operations. When the banking sector does not work properly, businesses cannot get loans and they have to curtail their production and lay off workers. As they curtail production, they demand fewer products from their suppliers and therefore their suppliers have to reduce their output and fire workers. If manufacturers cannot sell their goods because the firm downstream does not need as many products as before, they cannot generate enough revenue to repay their earlier loans. Businesses go bankrupt and banks experience further problems as their balance sheet deteriorates due to non-performing loans. At this point, banks want to lend even less because of the uncertainty generated from bankruptcies. As they lend less, the vicious circle continues – with producers cutting production and firing workers.

On the top of this, depositors start worrying about their deposits because the non-performing loans have made some banks go belly up – your bank has lent out your money to borrowers who cannot return it. Depositors start withdrawing their cash and banks have even fewer possibilities for lending as they have to hoard cash in case there is a run on the bank. If the financial sector does not work, the real economy can go into a deadly spiral and shrink by 30 per cent as during the Great Depression.

Four Weeks of Financial Turmoil

0 comments Posted by Jas at 3:13 PM

Last four weeks have sent the financial world in a full carnage, as bear guzzled up the giants who had been on bull rampage for quite some time now.

We are sure you would have read about what happened, how it happened and what can happen further, so here are some links to just epitomize the blood bath.
(All of these are either interactive or images)

Journey of the four weeks of dominoes turmoil

Price-Earning ratios graph, indicating when its time for stock to bond market shift

How the Credit Crisis Unfolded

A timeline of bailouts and buyouts of financial companies in US and UK

Sources: NY Times website

Economics of a non-cash transaction

1 comments Posted by Jas at 3:31 PM

You would have seen these notices outside shops

All Major credit cards accepted, Conditions apply
Condition: Bill should be atleast Rs.200

No return, No Exchange
2% extra on credit cards

This makes us wonder about the business model of a credit card and how the economies of a credit card transaction are placed between various entities involved in a transaction.

Ideally in a transaction, you would see two parties - an entity who pays and an entity who accepts; but to complete a credit card transaction you will need five entities to come and work in unison. (It may happen that some of these entities are same and not different)

Lets go through the last transaction you did when you bought that book for yourself. Say the book was of Rs. 100 and you paid through your ICICI Visa card and signed on the slip, showing HDFC name, which was kept by the merchant. Now as per the illustration below, Merchant would get back only Rs. 98.10 from Acquirer out of 100 and is paid 1.9% less. This 1.9% will now feed the rest of the three entities. And you will pay back full Rs. 100 to your credit card issuer, ICICI bank, at end of your billing period. But ICICI will give Acquirer (HDFC here), the one who placed the card reader in the shop, Rs 98.60 keeping Rs 1.40 to itself. So by now HDFC has already made Rs 0.50 (98.6-98.1). Now HDFC will give Rs. 0.07 to VISA while ICICI will give Rs. 0.08 to VISA.

Now above numbers are for transaction of Rs. 100 so use these numbers in percentage points and you get an idea of money interchanged per transaction in percentage. The numbers here are just illustrative and would change according to network, merchant type etc. But they do give a fair idea.

But then there are many ways of doing a non cash transaction these days: Credit card, Debit Card, Prepaid Card, PayPal/Google Checkout or Mobile payments...

The snapshot below lists the approximate processing fees charged by each major player in various payment instruments (ranging from Cash/Check to Credt & Debit Cards and Mobile Payments).

Bear run investment tools

3 comments Posted by Jas at 6:05 PM

The markets have been giving shudders to the investors for a long while now, most have lost faith in Sensex, while most have become skeptical. The 'Relationship Managers' (RM) are after every person who seems to smell of cash. Mutual Funds, Insurance, ULIPs, loans are all being coaxed using telemarketing. The advisors and RMs would suggest that this is the time to actually invest in market as you will lose the opportunity once its up and appealing but the fear of losing always above then the lust for more, keeping the public away. So for risk averse people what are the investment options available right now.

For a risk averse investor the main aim is to save the assets from monetary erosion. So the investment options to be evaluated are the ones having low risk of erosion and almost gurantee of full cash back (atleast) in event of further weakening of economy. There are many instruments for investing where the return is more or less guranteed. The top choice these days is Fixed Deposits (as evident on the billboards). Bank deposits are the safest investment after Post office savings because all bank deposits are insured under the Deposit Insurance & Credit Guarantee Scheme of India. With effect from A.Y. 1998-99, investment on bank deposits, along with other specified incomes, is exempt from income tax up to a limit of Rs.12, 000/- under Section 80L. Also, from A.Y. 1993-94, bank deposits are totally exempt from wealth tax. The 1995 Finance Bill Proposals introduced tax deduction at source (TDS) on fixed deposits on interest incomes of Rs.5000/- and above per annum. But banks are not the only option for FD, you can go for post offices FD and FD given by the companies.

Another option that has got very popular recently is Fixed Maturity Plan (FMP). In FD, said above, your return is taxable in case interest is more than Rs. 5000 per annum (per FD). Thats where FMP starts shining in investors eyes. FMPs, as they are popularly known, are the equivalent of a fixed deposit in a bank, with a caveat. The maturity amount of a fixed deposit in a bank is 'guaranteed', but only 'indicated' in the FMP of a mutual fund.

FMPs are debt schemes, where the corpus is invested in fixed-income securities. The tenure can be of different maturities, from one month to three years. They are closed-ended in nature, which means that once the NFO (new fund offer) closes, the scheme cannot accept any further investment. The magic is in the tax treatment of a mutual fund FMP. FMPs are classified under the debt scheme category and enjoy certain tax benefits, such as:

Dividend in the hands of the investor is tax-free. But the mutual fund has to deduct a dividend distribution tax of 14.025 per cent in the case of individuals and Hindu Undivided Families (HUFs), and 22.44 per cent in the case of corporates.
Long-term capital gains (investment of more than a year) enjoy indexation benefit.
Short-term capital gains are added to the income of the investor and taxed as per his/her slab, whereas the interest on a bank deposit (except where special 80C approved) is added to the income of the investor and taxed as per his/her slab.

So going for a long term FMP (more than one year) the return on the FMP will be say 10% - .14025(10%); while that in FD will be 10%-.33(10%) essentially giving a return of 8.5975 - 6.6667 = 1.93%

Below is another pull up from Rediff to explain it further:

What is indexation benefit?

The finance minister has been generous enough to recognise that inflation erodes the real value of any investment. So every year, he comes out with an inflation index based on the prevailing rate of inflation. The cost of investment is indexed by multiplying the index of the year of maturity and divided by the inflation index prevailing on the year of investment. If you have arrived at an indexed cost, then the long-term capital gain is taxed at 22.44 per cent and if you do not opt for the indexed cost, then the tax is 11.22 per cent.

How does this pan out?

Take an example of a 30-month FMP which, if launched now, will mature in June 2009. It will pass through three financial years - launch in 2006-2007 and maturing in 2008-2009. Thus, it can have a benefit of triple-cost indexation for the purpose of calculating post-tax yield. Look at the workings: Note: Cost Inflation Index for FY06-07 is 519. The assumption is that the CII for FY07-08 is 567 and for FY08-09 is 592. Clearly, the post-tax return is superior for an FMP. Simran was convinced of its benefits and was gung-ho about investing in it.

	Bank Fixed Deposit	30 Month FMP
		With Indexation	Without Indexation
Amount of Investment (Rs.)	10000	10000	10000
Post Expenses Yield (p.a)*	8.30%	8.30%	8.30%
Tenor (in months)	30	30	30
Approx Maturity Amt	12,075	12,075	12,075

Gain	2075	2075	2075
Indexed Cost	NA	11,406	NIL
Indexed Gain	NA	669	NA

Tax Rate	33.66%	22.44%	11.22%
Tax	698	150	232

Post Tax Gain	1377	1925	1843

Approx Post Tax Annualised Return	5.5%	7.7%	7.3%

Source: Rediff article

Happy Investing!

PS: I would like to thank Tabassum Shaikh, RM (HSBC) for introducing me to benefits of the FMP and indexation.

Enabling Finance over the Internet

5 comments Posted by The DoC at 10:11 PM

In a blog about Finance , I think it is good to talk about an enabler of Finance - Cryptography. Today millions of dollars are being transferred all over the world on its basis alone. It secures all data traveling through the net. But how does it work ?

Let us take Jack who wants to make a deposit with his Bank. He decides to do it over the internet . But unknown to him is the fact that his soon to be ex-wife Jane, a supreme computer hacker is monitoring all data flowing from jack's computer so she can't be cheated out of any money in her settlement.

Now Jack does not know all this. He logs on to the bank's website and clicks the necessary buttons and the money goes to the bank, but this data also goes to Jane. Now can Jane find out the information from this data. In today's day and age - No. Why ?

Well Jack has used public key cryptography to ensure the safety of his data. How does this work ? Let us for simplicity imagine that if Jane knows a special number she will be able to break Jack's code. So how does Jack ensure the code remains secret ? He knows about a certain mathmetical function of the form R = p^q ( mod (N))

Now the Bank has a public key ( or say 2 number which everyone knows ) called q,N . The bank forms N by multiplying 2 prime numbers a,b ( say 3, 5 ) and chooses q which is relatively prime to the (a-1) x ( b-1 ) , say 7. In this case q=7, N = 15 ( Usually they are very large prime numbers ). It then makes it available to the public . Now say Jack wants to send the number 2 ( p) ( which tells his bank to make a deposit to his account ) to the Bank. He hence uses the formula and calculates R ( in this case R= 2^7 ( Mod (15) )= 8 )

Now Jane knows R = 8, q = 7, N =15, So she should be able to find out p easily ! Right ? Wrong ! The mathmetical function is a one-way function , which means calculating R is easy once one knows p, but it is impossible to figure out p given the value of R . But if one knows the components of N ( i.e the 2 prime numbers chosen by the bank ) one can easily calculate p by a special method given a value of R.

Thus it is possible to transmit data for Jack without Jane getting to find out about it as she can't find out p, but the bank is able to find out p, and based on it make a deposit in Jack's Account leaving Jane hanging in the air.

[Note: This is a very simplified version of explaining public key cryptography. If any one wants to know more read the book by Simon Singh called the 'Code Book']

Income distribution since 1970

2 comments Posted by Jas at 11:56 AM

The distribution of income is central to one of the most enduring issues in political economics. On one extreme you will find the communists who argue that all incomes should be the same, or as nearly so as possible, and that a principal function of government should be to redistribute income from the haves to the have-nots. On the other extreme are those who argue that any income redistribution by government is bad. They argue that income redistribution makes people lazy and gives them incentive not to work, it favors the free riders and punishes the hard workers.

I was just checking the income distribution change in India with respect to the other nations. The rise of Indian middle class is so so evident here, and at the same time one can see how China's middle class gave in to a better distribution of money. Number of higher income people are much higher in China and Brazil than India, their BRIC partner. You can check these graphs from the website http://www.gapminder.org

Income Mobility
Another factor to consider when studying the degree of inequality in a society is the amount of income mobility. Income mobility refers to the ease with which workers can move up and down in the hierarchy of earning power. If the rich always stay rich and the poor always stay poor, then an unequal income distribution is a permanent and serious problem. But if they can move then it is much better for national economy.

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