Financial Markets & Instruments: Types, Functions & Securities

TAKEAWAYS:

• Financial markets are the marketplaces where savers (investors) and borrowers (businesses/governments) meet to exchange funds for securities.
• Primary markets issue new securities (e.g., NEPSE IPOs), while secondary markets trade existing ones (e.g., NEPSE’s stock exchange).
• Instruments like bonds (fixed income), stocks (equity), and derivatives (futures/options) serve distinct purposes—bonds fund debt, stocks fund equity, derivatives hedge risks.
• Nepal’s money market (short-term, <1 year) includes Treasury bills and commercial paper, while the capital market (long-term) includes stocks and bonds.
• Regulators like SEBON (securities) and NIBL (banks) ensure market integrity, while platforms like eSewa (for payments) or Khalti (for digital transactions) rely on these instruments.
• Exam focus: Differentiate markets/instruments, calculate bond/stock valuations, and explain real-world applications (e.g., NTC’s bond issuance, Daraz’s equity funding).

1. What Are Financial Markets?

Financial markets are organized platforms where participants trade financial assets (securities) to raise capital or manage risk. They connect:

• Suppliers of funds (investors, banks, insurance companies).
• Demanders of funds (businesses, governments, individuals).

Types of Financial Markets

graph TD
    A["Financial Markets"] --> B["By Time Horizon"]
    A --> C["By Instrument"]
    B --> B1["Money Market\n(<1 year)"]
    B --> B2["Capital Market\n(>1 year)"]
    C --> C1["Debt Market\n(Bonds, Loans)"]
    C --> C2["Equity Market\n(Stocks)"]
    C --> C3["Derivatives Market\n(Futures, Options)"]
    C --> C4["Foreign Exchange\n(FX)"]

Key Functions

1. Capital Formation: Channels savings into productive investments (e.g., NEPSE funds companies like Nabil Bank).
2. Liquidity: Allows easy buying/selling of securities (e.g., trading NEPSE shares via Merchant Securities).
3. Price Discovery: Market prices reflect true value (e.g., Khalti’s stock price on NEPSE).
4. Risk Management: Derivatives (e.g., Nepal Rastra Bank’s FX futures) hedge against volatility.

2. Primary vs. Secondary Markets

Real-World Example: NEPSE IPOs (Primary Market)

• Company: NMB Bank issued 10 million shares at Rs 100/share in 2023.
• Proceeds: Rs 1 billion raised for expansion.
• Secondary Market: After IPO, shares trade at Rs 120–150 based on demand.

3. Money Market vs. Capital Market

IMAGE: Nepal Rastra Bank Treasury Bills | Nepal’s short-term borrowing instrument to manage liquidity

4. Financial Instruments

Financial instruments are contracts that represent financial assets/liabilities. They are classified into:

A. Debt Instruments (Fixed Income)

1. Bonds:

   • Issued by governments/corporations to borrow money.
   • Pay fixed interest (coupon) + return principal at maturity.
   • Example: NTC’s 10-year bond (8% coupon, Rs 1000 face value).

   flowchart LR
     A["Investor"] -->|"Buys"| B["NTC Bond\n(Rs 1000, 8%)"]
     B -->|"Pays"| C["NTC\n(Uses funds for infrastructure)"]
     C -->|"Annual"| B["Rs 80 interest"]
     C -->|"2033"| B["Rs 1000 principal"]

2. Commercial Paper:

   • Short-term (3–270 days) unsecured debt issued by corporations.
   • Example: Nabil Bank’s 90-day CP (7% yield).

B. Equity Instruments (Ownership)

1. Common Stock:

   • Represents ownership; pays dividends (variable).
   • Example: Khalti’s stock (trades on NEPSE; dividends depend on profits).

   Year	Dividend (Rs)	Growth Rate
   2022	5.00	—
   2023	6.50	30%
   2024 (e)	8.15	25%

2. Preferred Stock:

   • Hybrid (fixed dividend + no voting rights).
   • Example: NMB Bank’s preferred shares (6% dividend).

C. Derivatives (Risk Management)

1. Futures:
   • Contract to buy/sell an asset at a future date (e.g., Nepal Rastra Bank’s FX futures).
2. Options:
   • Right (not obligation) to buy/sell (e.g., NEPSE index options).
3. Swaps:
   • Exchange cash flows (e.g., interest rate swaps between banks).

5. Financial Markets in Nepal: Real-World Applications

Example 1: NTC’s Bond Issuance (Capital Market)

• Instrument: 10-year bond, Rs 1000 face value, 8% coupon.
• Primary Market: NTC sells bonds to investors (banks, insurance companies) to fund telecom expansion.
• Secondary Market: Bonds trade on NEPSE; price may rise to Rs 1050 if interest rates fall.

Example 2: eSewa’s Equity Funding (Primary Market)

• Scenario: eSewa raises Rs 500 million via IPO (2022).
  • Proceeds: Used to expand digital payments (e.g., Khalti merger).
  • Secondary Market: Shares now trade at Rs 250 (up from IPO price of Rs 100).

Example 3: Daraz’s Working Capital (Money Market)

• Instrument: 90-day commercial paper (7% yield).
• Use: Daraz borrows Rs 200 million to manage inventory before festive season.

6. Regulators and Market Infrastructure

IMAGE: NEPSE Trading Floor | Where stocks like Khalti and NTC are traded

7. Worked Example: Bond Valuation (NTC Bond)

Problem: NTC issues a 5-year bond with:

• Face value = Rs 1000
• Coupon rate = 9% (paid annually)
• Market interest rate (YTM) = 10% Calculate the bond’s current price.

Solution: Use the Present Value (PV) formula: $$\text{Bond Price}=\sum _{t=1}^5\frac{C}{(1+r{)}^t}+\frac{F}{(1+r{)}^5}$$ Where:

• $C=\text{Coupon}=9\%\times 1000=\text{Rs 90}$
• $r=\text{YTM}=10\%=0.10$
• $F=\text{Face value}=\text{Rs 1000}$

Answer: The bond trades at Rs 988.28 (below face value because YTM > coupon rate).

8. Exam Tip: How to Score Full Marks

1. Definitions:

   • Always define terms precisely. Example:

     "A primary market is a platform where new securities are issued and sold to investors for the first time, raising capital for the issuer."

2. Differentiate Clearly:

   • Use tables (like Primary vs. Secondary Markets) to compare concepts.

3. Numerical Problems:

   • Show all steps (like the bond valuation table above).
   • Label assumptions (e.g., "Assuming semi-annual coupons").

4. Real-World Links:

   • Tie answers to Nepal’s context (e.g., "Like NTC’s bond issuance").

5. Diagrams:

   • Draw flowcharts for processes (e.g., how a bond works).
   • Use T-accounts for ledger entries (though not in this unit, useful for finance).

6. Common Pitfalls:

   • ❌ "Primary and secondary markets are the same." → Wrong! They serve different purposes.
   • ✅ "Primary markets issue new securities (e.g., NEPSE IPOs), while secondary markets trade existing ones (e.g., NEPSE’s daily trading)."

In the Real World

1. Khalti (Digital Payments):

   • Instrument Used: Equity (Common Stock).
   • How: Khalti raised capital via NEPSE IPO (2022) to expand its fintech platform. Investors buy shares, and the company uses funds for tech upgrades (e.g., UPI integration).

2. NTC’s Infrastructure Projects:

   • Instrument Used: Bonds (Debt).
   • How: NTC issues 10-year bonds at 8% to fund 5G expansion. Investors earn fixed interest, while NTC gets long-term capital without equity dilution.

3. Daraz’s Inventory Financing:

   • Instrument Used: Commercial Paper (Money Market).
   • How: During Diwali, Daraz issues 90-day commercial paper at 7% to manage cash flow spikes. This is cheaper than a bank loan.

4. Nepal Rastra Bank’s Monetary Policy:

   • Instrument Used: Treasury Bills (Money Market).
   • How: NRB issues 91-day T-bills to control liquidity. Banks buy them to park excess cash, affecting interest rates.

5. NEPSE’s Retail Investor Growth:

   • Instrument Used: Stocks (Equity).
   • How: Platforms like Merchant Securities enable retail investors to trade stocks (e.g., Global IME, NMB) via mobile apps, democratizing access to capital markets.

Final Summary Table