Financial Assets & Market Efficiency: Types, Valuation & Efficiency Tests

TAKEAWAYS:

• Financial assets (stocks, bonds, derivatives) are tradable claims on future cash flows, valued using models like NAV, P/E, and dividend discount.
• Market efficiency tests (weak, semi-strong, strong form) determine how quickly prices reflect new information—Nepal’s NEPSE is semi-strong efficient.
• Mutual funds pool investments and calculate Net Asset Value (NAV) daily, which students must compute for exams (e.g., Rs 15/share with 5% load fee = Rs 15.75).
• Derivatives (futures, options) hedge risks (e.g., farmers using NMB’s crop insurance) but require understanding of payoff diagrams and Black-Scholes model.
• Exam hotspots: NAV calculations, P/E ratios, and explaining why NEPSE’s delayed reactions to news prove semi-strong efficiency.
• Real-world tie: Khalti’s IPO (2023) used a book-building method (price discovery via demand-supply), while NMB Bank’s bonds are zero-coupon instruments (valued at discount).

1. What Are Financial Assets?

Financial assets are traded claims on future cash flows, categorized into:

classDiagram
    class FinancialAsset {
        +Type: Stocks, Bonds, Derivatives
        +Valuation: NAV, P/E, Discounted Cash Flow
        +Risk: Market, Credit, Liquidity
    }
    class Stock {
        +Dividends + Capital Gains
        +Valuation: P/E, Dividend Discount Model
    }
    class Bond {
        +Fixed Interest + Principal Repayment
        +Valuation: YTM, Current Yield
    }
    class Derivative {
        +Futures, Options, Swaps
        +Valuation: Black-Scholes, Binomial Model
    }
    FinancialAsset <|-- Stock
    FinancialAsset <|-- Bond
    FinancialAsset <|-- Derivative

Key Definitions

2. Valuing Financial Assets

A. Stock Valuation

Stock prices reflect expected future cash flows (dividends + capital gains). Two key models:

1. Dividend Discount Model (DDM) $$P_0=\frac{D_1}{r-g}$$

   • $P_0$ = Current stock price
   • $D_1$ = Next year’s dividend
   • $r$ = Required return (discount rate)
   • $g$ = Growth rate of dividends

   Example: NMB Bank pays a Rs 10 dividend, growing at 5%. If investors require 12% return: $$P_0=\frac{10}{0.12-0.05}=\text{Rs 142.86}$$

2. Price-to-Earnings (P/E) Ratio $$\text{P/E}=\frac{\text{Market Price per Share}}{\text{Earnings per Share (EPS)}}$$

   • Low P/E: Undervalued (e.g., NTC’s P/E ~ 8 in 2023).
   • High P/E: Overvalued (e.g., Khalti’s P/E ~ 40 pre-IPO).

   Worked Example: If Nepal Bank’s EPS = Rs 15 and P/E = 12, its stock price is: $$\text{Price}=\text{EPS}\times \text{P/E}=15\times 12=\text{Rs 180}$$

B. Bond Valuation

Bonds are valued using Yield to Maturity (YTM), the discount rate that makes present value of coupons = bond price. $$\text{Bond Price}=\sum _{t=1}^n\frac{C}{(1+YTM{)}^t}+\frac{F}{(1+YTM{)}^n}$$

• $C$ = Coupon payment
• $F$ = Face value
• $n$ = Years to maturity

Example: A GoN bond pays 8% annual coupon, matures in 5 years, face value Rs 1,000, trading at Rs 950. What’s YTM? (Use financial calculator or trial-and-error: YTM ≈ 9.1%)

C. Mutual Fund NAV Calculation

Mutual funds calculate Net Asset Value (NAV) daily: $$\text{NAV}=\frac{\text{Total Assets}-\text{Total Liabilities}}{\text{Shares Outstanding}}$$

Worked Example: NMB Mutual Fund holds:

• 2,000 shares of NMB Bank (Rs 60/share)
• 1,000 shares of NTC (Rs 50/share)
• Liabilities: Rs 50,000
• Shares outstanding: 10,000

$$\text{NAV}=\frac{(2000\times 60)+(1000\times 50)-50,000}{10,000}=\frac{120,000+50,000-50,000}{10,000}=\text{Rs 12}$$

Exam Tip: Always subtract liabilities before dividing by shares!

3. Market Efficiency: How Fast Do Prices Adjust?

Market efficiency tests whether asset prices fully reflect available information. Three forms:

Evidence for Nepal’s NEPSE

• Semi-strong efficiency: Stock prices adjust within 1–2 days of major news (e.g., budget announcements, NMB’s quarterly results).
• Weaknesses:
  • Low liquidity: Small-cap stocks take weeks to adjust.
  • Insider trading: 2019 case where NEPSE insiders traded before policy announcements.

Real-World Tie: Khalti’s IPO (2023)

• Used book-building (investors bid prices based on demand).
• Final price (Rs 110) reflected all public financials (semi-strong efficiency).
• If markets were weak-form efficient, the price would’ve been set by past trends alone.

4. Derivatives: Hedging and Speculation

Derivatives (futures, options, swaps) transfer risk. Key terms:

Black-Scholes Model (For Options)

$$C=S_{0}N(d_1)-X{e}^{-rT}N(d_2)$$

• $C$ = Call option price
• $S_0$ = Current stock price
• $X$ = Strike price
• $r$ = Risk-free rate
• $T$ = Time to expiration
• $N(d)$ = Cumulative normal distribution

Worked Example: NMB Bank stock at Rs 180, strike Rs 170, 6 months to expiry, risk-free rate 8%, volatility 20%. (Use Black-Scholes calculator: $C\approx \text{Rs 12.50}$)

5. Financial Assets in Nepal’s Economy

A. Role in Financial Inclusion

• Microfinance: Small loans (e.g., Siddhartha Microfinance) use collateralized bonds to fund rural credit.
• NEPSE’s Growth: From 1994–2023, market cap grew from Rs 20B to Rs 2.5T, driven by demutualization of banks (e.g., NMB, NBL).

B. Risk Management

• Banks: Use interest rate swaps to hedge against GoN bond rate changes.
• Farmers: Buy put options on NMB’s crop insurance to lock in prices.

C. Investment Opportunities

In the Real World

1. Khalti’s IPO (2023)

   • Used book-building (semi-strong efficiency) to price shares at Rs 110, reflecting all public financials.
   • Investors paid 5% load fee (like exam question: Rs 15 NAV + 5% = Rs 15.75).

2. NMB Bank’s Bonds

   • Issues zero-coupon bonds (sold at discount, e.g., Rs 950 for Rs 1,000 face value).
   • Farmers buy put options on NMB’s crop insurance to hedge against price drops.

3. NEPSE’s Delayed Reactions

   • When NMB announces a dividend, stock prices rise 1–2 days later (semi-strong efficiency).
   • Insider trading cases (e.g., 2019) prove markets aren’t strong-form efficient.

Exam Tip

1. NAV Questions: Always subtract liabilities before dividing by shares. Example:

   A fund holds Rs 500,000 assets, Rs 50,000 liabilities, 10,000 shares. NAV = (500,000 – 50,000)/10,000 = Rs 45.

2. Market Efficiency: Nepal’s NEPSE is semi-strong efficient. Expect questions on:

   • Why Khalti’s IPO price reflected all public info.
   • How NEPSE’s delayed reactions to news prove semi-strong efficiency.

3. Derivatives: Draw payoff diagrams for options. Example:

   • For a call option on NMB stock (strike Rs 170, premium Rs 5), label:
     • Break-even: Rs 175
     • Max profit: Unlimited
     • Max loss: Rs 5

4. Bond Valuation: Use YTM formula or trial-and-error. Example:

   A Rs 1,000 bond pays 8% coupon, matures in 3 years, sells at Rs 980. YTM ≈ 8.5%.

5. Mutual Fund Load Fees: If NAV = Rs 15 and load fee = 5%, investor pays Rs 15.75.

flowchart TD
    A["Financial Assets"] --> B["Stocks"]
    A --> C["Bonds"]
    A --> D["Derivatives"]
    A --> E["Mutual Funds"]
    B --> F["Valued via P/E or DDM"]
    C --> G["Valued via YTM"]
    D --> H["Hedging/Speculation"]
    E --> I["NAV Calculation"]
    I --> J["Exam Focus: Subtract Liabilities!"]
    H --> K["Black-Scholes for Options"]
    K --> L["Draw Payoff Diagrams"]