Financial Markets & Instruments: Types, Functions & Instruments

What Are Financial Markets?

Financial markets are organized platforms where buyers and sellers trade financial assets (e.g., stocks, bonds, derivatives) to raise capital, manage risk, or invest. They connect savers (investors) with users (businesses/governments) and are classified by:

1. Classification of Financial Markets

classDiagram
    class Market {
        <<abstract>>
        +type: String
        +function: String
    }
    class PrimaryMarket {
        +function: "Issuance of new securities"
        +examples: IPOs, bond offerings
    }
    class SecondaryMarket {
        +function: "Trading existing securities"
        +examples: NEPSE, NYSE
    }
    class MoneyMarket {
        +function: "Short-term funds (<1 year)"
        +examples: T-bills, commercial paper
    }
    class CapitalMarket {
        +function: "Long-term funds (>1 year)"
        +examples: Stocks, corporate bonds
    }
    Market <|-- PrimaryMarket
    Market <|-- SecondaryMarket
    Market <|-- MoneyMarket
    Market <|-- CapitalMarket

Key Differences

2. Financial Instruments: The Building Blocks

Instruments are contracts that represent financial claims. They are categorized by maturity, risk, and function.

A. Debt Instruments (Bonds)

Definition: Borrowed funds with fixed interest (coupon) and maturity date. Issued by governments (e.g., Nepal Rastra Bank bonds) or corporations (e.g., NMB Bank bonds).

How Bonds Work

1. Face Value (Par Value): Rs 100 (standard in Nepal).
2. Coupon Rate: Annual interest (e.g., 8% of Rs 100 = Rs 8).
3. Yield to Maturity (YTM): Total return if held to maturity (affected by market interest rates).

Example: Nepal Government 10-year bond at 7% coupon, trading at Rs 95 (discount).

• Current Yield = Annual Interest / Market Price = (7/95) × 100 ≈ 7.37%.
• Why trade at discount? Market rates rose to 8%.

Interest Rates ↑ → Bond Price ↓
Interest Rates ↓ → Bond Price ↑

Types of Bonds in Nepal

B. Equity Instruments (Stocks/Shares)

Definition: Ownership claims in a company. Returns come from dividends and capital gains.

How Stocks Work

1. Par Value: Nominal value (e.g., Rs 100 for NEPSE stocks).
2. Market Price: Fluctuates based on supply/demand, company performance, and market sentiment.
3. Dividends: Profit-sharing (e.g., Nepal Bank pays 15% dividend in FY 2023).

Example: Nepal Electricity Authority (NEA) stock

• Par Value: Rs 100
• Market Price: Rs 120 (premium due to monopoly status)
• Dividend: Rs 8/share (8% of par)

Market Price = f(Company Earnings, Industry Growth, Macroeconomic Factors, Investor Sentiment)

Types of Stocks

C. Derivative Instruments

Definition: Financial contracts derived from underlying assets (stocks, bonds, commodities). Used for hedging or speculation.

Common Derivatives

Example: A Kathmandu importer uses a forward contract to lock in USD/NPR at Rs 130 (vs. spot Rs 132) to hedge against exchange rate risk.

3. Financial Markets in Nepal: NEPSE and Beyond

A. Nepal Stock Exchange (NEPSE)

• Type: Secondary market (auction-based).
• Index: NEPSE Index (tracks 25 blue-chip stocks).
• Key Stocks: Nepal Bank, NMB, Global IME, Ncell.

1. Investor places order (via broker like **Citizen Investment**)
2. Order matched in NEPSE’s electronic trading system
3. Settlement in **T+2** (trade date + 2 days)
4. Dividends paid via bank (e.g., **Nabil Bank**)

NEPSE vs. Global Exchanges

B. Money Market in Nepal

Definition: Short-term borrowing/lending (<1 year) for liquidity management.

Key Instruments

Example: A Kathmandu hotel borrows Rs 50 million via a 91-day T-Bill at 6.5% to cover peak season cash needs.

4. Role of Financial Markets in Business

A. Capital Formation

• Primary Markets: Companies raise funds via IPOs (e.g., Ncell’s 2005 IPO at Rs 100/share).
• Secondary Markets: Investors trade shares, keeping markets liquid.

B. Risk Management

• Hedging: Farmers use forward contracts to sell wheat at fixed prices.
• Diversification: Investors buy Nepal Bank (banking) + F1Soft (tech) to reduce risk.

C. Price Discovery

• Market prices reflect true value of assets (e.g., NEA stock trades at premium due to monopoly).

In the Real World

1. eSewa & Khalti

   • Instrument Used: Electronic Payment Systems (Derivatives of Cash)
   • How? Both platforms use real-time settlement systems (like a secondary market for digital money) to match buyers/sellers instantly. When you pay via Khalti, the system acts like a clearinghouse, ensuring funds transfer in seconds—similar to how NEPSE matches stock trades.

2. Daraz (Alibaba Group)

   • Instrument Used: Supply Chain Financing (Receivables Discounting)
   • How? Daraz partners with banks to offer short-term loans to sellers based on their future sales (like a money market instrument). For example, a Kathmandu seller gets Rs 500,000 upfront for an order, and Daraz collects payment later—effectively using trade credit as a financial instrument.

3. Ncell (Nepal Telecom)

   • Instrument Used: Corporate Bonds + Stocks
   • How? Ncell raised Rs 12 billion via bonds in 2020 to expand 4G networks. Simultaneously, its stock (traded on NEPSE) allows retail investors to own a stake. The bondholders earn fixed interest (6%), while shareholders benefit from dividends (10% in FY 2023) and stock price appreciation.

Worked Example: Kathmandu Retail Shop’s Financing

Scenario: Mr. Sharma runs a retail shop in Thamel. He needs Rs 2 million for inventory. He has two options:

1. Bank Loan: 10% interest, 2-year term.
2. Corporate Bond Issuance: 8% coupon, 3-year term.

Step 1: Calculate Loan Cost

• Annual Interest: Rs 2,000,000 × 10% = Rs 200,000.
• Total Repayment: Rs 2,000,000 + (Rs 200,000 × 2) = Rs 2,400,000.

Step 2: Calculate Bond Cost

• Annual Coupon: Rs 2,000,000 × 8% = Rs 160,000.
• Total Repayment: Rs 2,000,000 (face value) + (Rs 160,000 × 3) = Rs 2,480,000.

Step 3: Decision

• Bank Loan is cheaper (Rs 2,400,000 vs. Rs 2,480,000).
• But: Bonds may offer tax advantages (interest is tax-deductible in Nepal).

Visual Comparison:

Bank Loan: Rs 2.4M total
Bond Issuance: Rs 2.48M total
→ Choose Bank Loan (lower cost)

Exam Tip: How to Score Full Marks

1. Define Clearly

   • Always start with standard definitions (e.g., "A bond is a debt instrument representing a loan...").
   • Example: For "primary market", write:

     "The primary market is a platform where new securities (stocks/bonds) are issued and sold for the first time to raise capital."

2. Use Nepali Examples

   • Examiners love real-world ties. Relate theories to:
     • NEPSE (stocks, IPOs)
     • NRB bonds (government securities)
     • Bank loans (debt instruments)
   • Avoid: Generic examples like "XYZ Corp"—use Ncell, Nepal Bank, or NMB.

3. Show Calculations

   • For bond yields, break-even analysis, or CAPM, always:
     1. Write the formula.
     2. Plug in numbers.
     3. Show step-by-step working.
   • Example: For "Calculate YTM":

     YTM = [Coupon + (Face Value – Price)/Years] / [(Face Value + Price)/2]
     For a Rs 100 bond at Rs 95, 8% coupon, 3 years:
     YTM = [8 + (100–95)/3] / [(100+95)/2] ≈ 9.2%
     

4. Compare Instruments

   • Use tables to contrast stocks vs. bonds or money vs. capital markets.
   • Example:

     Feature	Stocks	Bonds
     Ownership	Ownership in company	Debt (loan to company)
     Returns	Dividends + capital gains	Fixed interest
     Risk	High (market-dependent)	Lower (fixed income)
     Nepali Example	Nepal Bank stock	NMB 5-year bond

5. Link to Past Exam Questions

   • CAPM Questions: Always use the formula: $$\text{Required Return}=R_f+\beta \times (\text{Market Risk Premium})$$ Example: For β = 1.5, Rf = 4%, MRP = 6%: $$\text{Return}=4\%+1.5\times 6\%=13\%$$
   • Break-Even: Use the formula: $$\text{Break-Even (units)}=\frac{\text{Fixed Costs}}{\text{Selling Price}-\text{Variable Cost}}$$ Example: For BMC (Rs 200,000 fixed, Rs 20 variable, Rs 60 selling price): $$\text{Break-Even}=\frac{200,000}{60-40}=10,000\text{ units}$$

6. Diagrams > Text

   • Always draw:
     • T-accounts for ledger entries (if accounting is involved).
     • Flowcharts for processes (e.g., "How NEPSE trades work").
     • Graphs for relationships (e.g., "Bond price vs. interest rates").
   • Example: For "Primary vs. Secondary Market", use a Venn diagram showing:
     • Primary: Issuance (IPOs, bonds)
     • Secondary: Trading (NEPSE, stock exchanges)
     • Overlap: Securities (stocks, bonds)

Common Pitfalls to Avoid

• Mixing Primary/Secondary Markets: Remember—primary = new issuance, secondary = trading.
• Ignoring Risk: Always mention default risk (bonds) or market risk (stocks).
• Incorrect Formulas: Double-check CAPM, YTM, and break-even calculations.
• Overlooking Nepali Context: Examiners deduct marks for global examples without local ties. Always relate to NEPSE, NRB, or Nepali banks.