Types of Financial Assets & Markets: Classification & Functions

TAKEAWAYS

• Financial assets are claims to future cash flows (e.g., bonds, stocks, derivatives) and are classified by risk, maturity, and ownership rights.
• Debt instruments (bonds, loans) promise fixed payments; equity (shares) offers residual claims; derivatives (futures, options) derive value from underlying assets.
• Primary markets issue new securities (e.g., IPOs on NEPSE), while secondary markets trade existing assets (e.g., NEPSE’s daily trading).
• Organized exchanges (NEPSE, NYSE) ensure transparency, but OTC markets (e.g., bond trading) offer flexibility.
• Liquidity, risk, and regulatory frameworks (e.g., SEBON in Nepal) differ across asset types and markets.
• Portfolio diversification (e.g., mixing bonds and stocks) reduces risk, a principle used by investors in Nepal’s NEPSE and globally (e.g., Google’s treasury operations).

1. Definition and Classification of Financial Assets

Financial assets are liquid claims on real or financial assets, representing future cash flows. They include:

• Debt instruments (fixed payments, e.g., bonds, loans).
• Equity instruments (residual claims, e.g., stocks).
• Derivatives (value tied to underlying assets, e.g., futures, options).
• Hybrid instruments (combine debt + equity, e.g., preferred stock).

Why classify?

• Risk assessment: Bonds are lower-risk than stocks.
• Investment strategy: Diversification mixes asset types.
• Regulation: SEBON (Nepal) and SEC (USA) classify assets for compliance.

2. Types of Financial Assets

A. Debt Instruments

Definition: Promises to repay principal + interest by a fixed date. Examples:

• Bonds: Issued by governments/corporations (e.g., Nepal Government Securities).
• Loans: Direct borrower-lender agreements (e.g., bank loans to businesses).
• Debentures: Unsecured corporate bonds (e.g., IFC’s debentures).

Key Features:

Worked Example: A 10-year bond with Rs 1,000 par value, 8% coupon rate, and Rs 800 market price has a yield to maturity (YTM) of ~9.5% (calculated via Excel’s YIELD function or manual iteration). Real-world tie: Nepal’s Nepal Government Securities (NGS) are debt instruments traded on NEPSE, used by banks to park liquidity.

B. Equity Instruments

Definition: Ownership claims in a company, entitling dividends and capital gains. Examples:

• Common stock: Voting rights + residual claims (e.g., Ncell’s shares).
• Preferred stock: Fixed dividends, no voting (e.g., utility companies).

Key Features:

Worked Example: If Nepal Corporation’s stock trades at Rs 100/share with Rs 20 EPS and a 50% payout ratio, its dividend yield = 10% (Rs 10 dividend / Rs 100 price). Real-world tie: Ncell’s IPO (2017) raised funds via equity, listing shares on NEPSE for public trading.

C. Derivatives

Definition: Contracts whose value depends on an underlying asset (e.g., stocks, commodities). Examples:

• Futures: Agreements to buy/sell at a future date (e.g., wheat futures).
• Options: Right (not obligation) to buy/sell (e.g., call/put options on NEPSE-listed stocks).
• Swaps: Exchange of cash flows (e.g., interest rate swaps by banks).

Why use derivatives?

• Hedging: Banks use interest rate swaps to lock in rates.
• Speculation: Traders bet on price movements (e.g., gold futures).
• Leverage: Options allow control over large positions with small capital.

Mermaid Diagram: Option Types

Real-world tie: Daraz uses forward contracts with suppliers to lock in commodity prices (e.g., electronics), reducing supply chain risk.

D. Hybrid Instruments

Definition: Combine debt + equity features. Examples:

• Convertible bonds: Can be converted to equity (e.g., IFC’s hybrid bonds).
• Preferred stock: Fixed dividends + equity-like features.

Advantages:

• Lower cost of capital for issuers (e.g., startups).
• Tax benefits (interest deductions for debt-like features).

3. Financial Markets: Classification and Functions

A. Primary vs. Secondary Markets

Worked Example: When Ncell went public in 2017, its shares were issued in the primary market (NEPSE IPO). Later, traders bought/sold these shares in the secondary market.

B. Organized vs. Over-the-Counter (OTC) Markets

Real-world tie:

• NEPSE (organized) lists stocks like Ncell, IFC, Siddhartha with daily price transparency.
• OTC bonds (e.g., Nepal Bank’s corporate bonds) are traded privately, offering flexibility but less liquidity.

C. Money vs. Capital Markets

Worked Example:

• Money market: Nepal Government issues 91-day Treasury bills (traded on NMB).
• Capital market: Ncell’s IPO (2017) raised Rs 1.5 billion via long-term equity.

4. Role of Financial Markets in Nepal

A. Stock Market (NEPSE)

• Primary function: Raise capital for businesses (e.g., Daraz’s potential IPO).
• Secondary function: Provide liquidity to investors (e.g., Ncell shareholders).
• Current status (2024):
  • Market cap: ~Rs 1.2 trillion (down from 2021 peak due to economic slowdown).
  • Key sectors: Finance (40%), manufacturing (20%), real estate (15%).
  • Challenges: Low retail participation, regulatory gaps.

Mermaid Diagram: NEPSE Sectors

pie
    "Finance (40%)" : 40
    "Manufacturing (20%)" : 20
    "Real Estate (15%)" : 15
    "Utilities (10%)" : 10
    "Others (15%)" : 15

B. Bond Market (Nepal Rastra Bank)

• Government securities: Used by banks to park liquidity (e.g., NGS auctions).
• Corporate bonds: Issued by firms like Nepal Bank for expansion.

Real-world tie:

• NTC’s bond issuance (2023) raised Rs 5 billion for infrastructure, traded on NMB’s bond platform.

In the Real World

1. eSewa & Khalti (Digital Wallets)

   • Idea: Money market funds (short-term, low-risk investments).
   • How: eSewa partners with banks to invest idle user funds in T-bills (Nepal Rastra Bank), earning ~5–7% interest.
   • Example: If you park Rs 10,000 in eSewa’s savings account, it’s likely invested in 91-day Treasury bills, a money market instrument.

2. Pathao (Ride-Hailing App)

   • Idea: Derivatives for price hedging.
   • How: Pathao uses futures contracts on fuel prices to lock in costs for its fleet, protecting profits from oil price volatility.
   • Example: If crude oil spikes, Pathao’s fuel costs stay stable due to pre-negotiated futures.

3. NEPSE (Nepal Stock Exchange)

   • Idea: Secondary market liquidity.
   • How: When you sell Ncell shares on NEPSE, the buyer could be a pension fund or retail investor—no new funds go to Ncell, but liquidity ensures your investment can be converted to cash quickly.
   • Worked Example:
     • You buy 100 shares of Ncell at Rs 500/share (Rs 50,000).
     • Next year, you sell them at Rs 550/share (Rs 55,000).
     • Profit = Rs 5,000 (secondary market transaction).

Exam Tip

1. Memorize classifications:

   • Assets: Debt (fixed), Equity (residual), Derivatives (derived), Hybrid (mix).
   • Markets: Primary (new), Secondary (existing); Organized (NEPSE), OTC (bonds).

2. Calculate YTM/Dividend Yield:

   • Bonds: Use the formula: $$YTM=\frac{C+\frac{F-P}{n}}{\frac{F+P}{2}}$$ where $C$ = coupon, $F$ = face value, $P$ = price, $n$ = years.
   • Stocks: Dividend yield = (Dividend/Price) × 100.

3. Compare markets:

   • Primary vs. Secondary: Who benefits? (Issuer vs. trader).
   • Organized vs. OTC: Transparency vs. flexibility.

4. Nepal-specific focus:

   • Mention NEPSE, NMB, SEBON in answers.
   • Discuss current challenges (e.g., low retail participation in NEPSE).

5. Real-world links:

   • Tie examples to Ncell, Daraz, NTC, or eSewa (as above).
   • Use Nepal Government Securities (NGS) for debt examples.

Final Note: This unit is 50% theory (classification) + 50% calculation (YTM, dividend yield). Practice past papers (e.g., NEPSE IPO valuation, bond YTM) and relate concepts to Nepal’s financial ecosystem.