The BSE Sensex and Nifty rose more than 1 percent on Monday to two-year highs after a slower-than-expected rise in inflation cemented hopes the RBI will cut interest rates later this month, boosting banks and property shares such as DLF.
Sentiment was also supported after India delayed the implementation of controversial rules on tax avoidance to 2016, helping remove uncertainty about whether foreign investors would continue their strong buying of domestic equities.
Infosys rallied for a second session to a nine-month high after some brokerages including Barclays upgraded their ratings on the stock following its better-than-expected earnings and revenue guidance.
"The enthusiasm with regards to reforms continuing, lower inflation and tepid industrial growth are making way for rate cut, which have led to a rally in the market," said Kaushik Dani, fund manager at Peerless Mutual Fund.
The BSE Sensex rose 1.23 percent, or 242.77 points, to end at 19,906.41, its highest close since January 6, 2011, and its biggest single-day percentage gain since November 29, 2012.
The broader Nifty rose 1.22 percent, or 72.75 points, to end at 6,024.05, closing above the psychologically important 6,000 level and matching the same milestones as those for the Sensex.
Nomura said it expects the Sensex to touch 21,700 by the end of 2013, on the back of positive factors including potential rate cuts, easier domestic liquidity and reform momentum.
However, Nomura warned risks could include a "broken" capex cycle, weak government finances, and a poor external account.
Gains on Monday were sparked by data showing the headline inflation slowed to its lowest level in three years. Analysts now expect at least a 25 basis point rate cut by the Reserve Bank of India at its policy review on January 29.
Rate-sensitive stocks led gainers, with real estate developer DLF jumping 7.3 percent, marking its biggest single-day percentage gain since October 28, 2011, helped as well by J.P.Morgan's upgrade to "overweight" from "neutral".
The investment bank said DLF stands to benefit from debt reduction and the launch of luxury projects in Gurgaon, a suburb of New Delhi.
Among banks, ICICI Bank gained 1.9 percent, while State Bank of India rose 0.4 percent.
Infosys rose 3.5 percent, after already gaining nearly 17 percent on Friday. CLSA, J.P.Morgan and Barclays Capital were among the banks that upgraded the stock following its earnings results.
Rival Tata Consultancy Services gained 2.15 percent ahead of its October-December earnings results due later in the day.
ITC gained 1.7 percent after Goldman Sachs said a recent correction in shares of the cigarette maker is overdone, and that the cigarette maker has "robust" pricing power and will benefit from the launch of new cigarettes.
However, among stocks that fell, Jaiprakash Power Ventures Ltd shares dropped 4.6 percent on fears of equity dilution after its board approved raising up to 35 billion rupees.