Security Markets & Intermediaries: Types, Roles & Mechanics

TAKEAWAYS

• Security markets connect borrowers (companies/government) with investors via primary (new issues) and secondary (trading) channels.
• Intermediaries (brokers, dealers, underwriters) facilitate transactions but differ in risk-taking and pricing roles.
• Rights issues let existing shareholders subscribe to new shares at a discount, preserving ownership control.
• Closed-end funds trade like stocks but have fixed shares, creating NAV vs. market price discrepancies.
• Nepal’s NEPSE operates as a secondary market for equities, while NMB Bank uses underwriters for IPOs.
• Exam focus: Calculate rights issue prices, NAV, and compare primary/secondary market functions.

1. Security Markets: Primary vs. Secondary

Security markets are platforms where financial assets (stocks, bonds, derivatives) are issued or traded. They enable companies to raise capital and investors to earn returns.

1.1 Primary Market

• Definition: Market for newly issued securities (IPOs, bonds, rights issues).
• Key Players:
  • Issuer (company/government)
  • Underwriter (e.g., NMB Capital, Global IME, Standard Chartered Nepal) – guarantees sale and bears risk.
  • Investors (institutional or retail).
• Process:
  1. Issuer files a prospectus with SECC (Securities Exchange Commission of Nepal).
  2. Underwriter sets price via book-building (demand-based pricing).
  3. Shares/bonds sold directly to investors (no secondary trading yet).

flowchart TD
    A["Issuer Files Prospectus\n(SECC Approval)"] --> B["Underwriter\n(Book-Building)"]
    B --> C["Price Determination\n(Demand-Based)"]
    C --> D["Allotment to Investors\n(No Secondary Trading)"]
    D --> E["Listing on NEPSE\n(Secondary Market Entry)"]

REAL WORLD

• NMB Bank’s IPO (2077): Underwritten by NMB Capital and Global IME, priced at Rs. 100/share (later traded at Rs. 250+ on NEPSE).
• Himal Cement’s Rights Issue (2078): Raised Rs. 50M via rights offering at Rs. 100/share (vs. market price Rs. 220).

1.2 Secondary Market

• Definition: Market for existing securities (trading after issuance).
• Key Players:
  • Stock Exchanges (NEPSE in Nepal, NYSE/NASDAQ globally).
  • Broker-Dealers (e.g., Siddhartha Stock, Nepal Investment Bank).
  • Investors (buy/sell for capital gains or dividends).
• Functions:
  • Provides liquidity (easy buying/selling).
  • Determines market prices (reflects issuer’s risk/performance).
  • Enables portfolio diversification.

2. Rights Issues: Mechanics & Example

Rights issues allow companies to raise capital without diluting control by offering existing shareholders first dibs on new shares.

2.1 How Rights Issues Work

1. Announcement: Company declares a rights issue (e.g., "1 new share for every 2 held").
2. Subscription Price: Set below market price (e.g., Rs. 100 vs. market Rs. 220).
3. Rights Period: Shareholders can buy new shares at the discount.
4. Ex-Rights Date: Share price drops by the theoretical ex-rights value (TEV).
5. Allotment: New shares issued; old shares adjust for dilution.

Formula for Theoretical Ex-Rights Price (TEV): $$\text{TEV}=\frac{(\text{Market Price}\times \text{Old Shares})+(\text{Subscription Price}\times \text{New Shares})}{\text{Total Shares After Issue}}$$

2.2 Worked Example: Himal Cement

• Current: 1M shares at Rs. 220/share.
• Rights Offer: 500K new shares at Rs. 100/share (2:1 ratio).
• TEV Calculation: $$\text{TEV}=\frac{(220\times 1,000,000)+(100\times 500,000)}{1,500,000}=\frac{220M+50M}{1.5M}=\text{Rs. 180}$$
• Post-Issue: Share price drops to ~Rs. 180 (ex-rights).

REAL WORLD

• Green Food Limited (2079): Raised Rs. 2M via rights issue at Rs. 80/share (market price: Rs. 120). Shareholders could buy 1 new share for every 3 held.
• Pathao’s Potential IPO: If Pathao lists on NEPSE, it may use a rights issue to fund expansion while keeping control with founders.

3. Security Intermediaries: Brokers vs. Dealers

Intermediaries enable trading but differ in risk and revenue models.

3.1 Security Brokers

• Role: Agent who matches buyers/sellers (no inventory risk).
• Revenue: Commission (e.g., 0.5% per trade).
• Example: Siddhartha Stock (Nepal’s largest brokerage).

3.2 Security Dealers

• Role: Principal who buys/sells for own account (takes inventory risk).
• Revenue: Bid-ask spread (profit from price difference).
• Example: Nepal Investment Bank’s trading desk.

Comparison Table:

flowchart LR
    A["Investor\n(Wants to Buy/Sell)"] --> B["Broker\n(Matches Orders)"]
    B --> C["Exchange\n(NEPSE Clearing)"] --> D["Dealer\n(Provides Liquidity)"]
    D -->|"Holds Inventory"| E["Market Makers\n(e.g., NMB Capital)"]

4. Closed-End Funds: NAV vs. Market Price

Closed-end funds (CEFs) issue a fixed number of shares but trade like stocks. Their price can diverge from Net Asset Value (NAV).

4.1 Key Concepts

• NAV: Fund’s asset value per share = (Total Assets – Liabilities) / Shares Outstanding.
• Market Price: Determined by supply-demand (can trade at premium/discount to NAV).
• Example: The Mega Fund (Nepal’s first closed-end fund).

4.2 Worked Example: The Mega Fund

• Assets: Rs. 220M
• Liabilities: Rs. 10M
• Shares Outstanding: 20M
• NAV Calculation: $$\text{NAV}=\frac{220M-10M}{20M}=\text{Rs. 10.5 per share}$$
• Market Price: Trades at 2% premium → Rs. 10.71.
• Discount/Premium: $$\text{Discount}=\frac{\text{NAV}-\text{Market Price}}{\text{NAV}}\times 100$$

REAL WORLD

• NMB Mutual Fund (Closed-End): Often trades at a 5–10% discount to NAV due to low liquidity.
• Global Funds in Nepal: Many foreign CEFs (e.g., Templeton Global) are held by Nepali investors via NMB/Standard Chartered.

5. Exam Tip: How to Score Full Marks

1. Primary vs. Secondary Market:

   • Primary: New issues (IPO, rights, bonds) → underwriter’s role.
   • Secondary: Trading (NEPSE) → broker/dealer’s role.
   • Exam trick: If a question asks about "raising capital," it’s primary. If it’s about "trading," it’s secondary.

2. Rights Issues:

   • Always calculate TEV using the formula.
   • Show before/after equity in T-accounts.
   • Example: For Himal Cement, if asked about dilution, say:

     "Old shareholders get priority, but total shares increase from 1M to 1.5M, reducing ownership %."

3. Closed-End Funds:

   • NAV = (Assets – Liabilities) / Shares.
   • Market Price ≠ NAV → Explain premium/discount causes (e.g., low liquidity, investor sentiment).
   • Shortcut: If NAV is Rs. 10 and market price is Rs. 9, it’s a 10% discount.

4. Intermediaries:

   • Broker: "I connect you to the market" (no risk).
   • Dealer: "I buy/sell for myself" (takes risk).
   • Exam tip: Draw a flowchart showing broker → exchange → dealer if asked about order execution.

5. Numerical Questions:

   • Always show steps (e.g., TEV calculation).
   • Units matter: If shares are in thousands, convert to millions for clarity.
   • Example: For NEPSE questions, assume Rs. in millions and shares in thousands for simplicity.

6. Practice Questions (From Past Exams)

1. Rights Issue Calculation:

   Himalaya Power Co. has 2M shares at Rs. 150. It offers 1 new share for every 5 held at Rs. 100. Calculate TEV. Answer: $$\text{TEV}=\frac{(150\times 2M)+(100\times 0.4M)}{2.4M}=\text{Rs. 141.67}$$

2. NAV Calculation:

   A fund has assets of Rs. 500M, liabilities of Rs. 50M, and 10M shares. What’s NAV? If it trades at Rs. 45, what’s the discount? Answer: $$\text{NAV}=\frac{500M-50M}{10M}=\text{Rs. 45}$$ $$\text{Discount}=\frac{45-45}{45}\times 100=0\%\text{ (trades at par)}$$ (Note: If market price were Rs. 40, discount = 11.11%)

3. Primary Market Example:

   Define primary market in Nepal with an example. Answer: "The primary market in Nepal is where new securities are issued for the first time, e.g., NMB Bank’s IPO in 2077, underwritten by NMB Capital and listed on NEPSE. It raises capital directly from investors via prospectus filing with SECC."

7. Key Formulas to Memorize

8. Common Mistakes to Avoid

• Ignoring the ex-rights date: Always adjust the share price post-issue.
• Mixing brokers/dealers: Brokers don’t hold inventory; dealers do.
• NAV vs. Market Price: CEFs can trade at a premium or discount—don’t assume they’re equal.
• Units: Forgetting to convert shares to millions or amounts to Rs. can lead to calculation errors.

9. Real-World Application: NEPSE and Nepali Investors

Scenario: You’re advising a small retailer in Kathmandu who wants to invest in stocks.

1. Primary Market: They could buy NMB Bank’s IPO (if available) to get in early.
2. Secondary Market: They’d use a broker like Siddhartha Stock to trade NMB shares on NEPSE.
3. Rights Issue: If Himal Cement announces a rights offer, they’d get 1 new share for every 2 held at Rs. 100 (vs. market Rs. 220).
4. Closed-End Funds: They might buy The Mega Fund at a 10% discount to NAV for steady returns.

sequenceDiagram
    participant Investor as Kathmandu Retailer
    participant Broker as Siddhartha Stock
    participant Exchange as NEPSE
    participant Company as Himal Cement

    Investor->>Broker: "Buy NMB shares (Secondary Market)"
    Broker->>Exchange: "Execute order"
    Exchange-->>Broker: "Allot shares"
    Broker-->>Investor: "Confirm trade"

    Company->>Investor: "Announce Rights Issue"
    Investor->>Broker: "Subscribe to new shares"
    Broker->>Company: "Pay Rs. 100/share"
    Company-->>Investor: "Allot new shares"