Financial Markets & Instruments: Roles, Instruments & Risks

TAKEAWAYS:

• Financial markets connect borrowers and lenders, enabling efficient allocation of capital.
• Primary markets issue new securities (e.g., IPOs), while secondary markets trade existing ones (e.g., NEPSE).
• Financial instruments include bonds (debt), stocks (equity), and derivatives (options/futures) to hedge or speculate.
• Market participants (brokers, dealers, investors) play distinct roles, but inefficiencies (e.g., low liquidity in Nepal) persist.
• Risk management tools like diversification and hedging mitigate market, credit, and liquidity risks.
• Regulation (e.g., SEBON in Nepal) ensures transparency but can stifle innovation.

1. Introduction to Financial Markets

Financial markets are platforms where buyers and sellers trade financial assets. They classify into primary (new issues) and secondary (existing trades) markets, with money markets (short-term) and capital markets (long-term) as subcategories.

Primary vs. Secondary Markets

flowchart TD
    A["Financial Markets"] --> B["Primary Market"]
    A --> C["Secondary Market"]
    B --> D["New securities issued (IPOs, bonds)"]
    C --> E["Existing securities traded (NEPSE, stock exchanges)"]
    D --> F["Issuer (company) <--> Investor"]
    E --> G["Buyer <--> Seller (no issuer involved)"]

Example in Nepal:

• Primary: NEPSE lists new companies (e.g., Daraz Nepal’s IPO in 2021 raised ₹1.5 billion).
• Secondary: Investors trade Daraz shares on NEPSE after listing.

2. Key Participants in Financial Markets

Traders at NEPSE’s Kathmandu office execute orders for listed firms like Siddhartha Hospital. (Image: Thomas J. O'Halloran, Public domain, via Wikimedia Commons)

3. Financial Instruments

Financial instruments are contracts representing financial value. They fall into three categories:

(A) Debt Instruments

• Bonds: Fixed-income securities (e.g., government bonds, corporate bonds).

  • Example: Nepal’s 10-year sovereign bond yields ~8% (2023).
  • Key Terms:
    • Par Value: ₹1,000 (face value).
    • Coupon Rate: Annual interest (e.g., 7% of ₹1,000 = ₹70).
    • Maturity: 5–30 years.
    • Call Option: Issuer can redeem early (e.g., Ncell called its bonds in 2022).

  Worked Example: A bond pays ₹75 yearly coupon, matures in 5 years, and trades at ₹950. Calculate yield to maturity (YTM). $$\text{YTM}=\frac{C+\frac{F-P}{n}}{\frac{P+F}{2}}$$ Where:

  • $C=₹75$ (coupon),
  • $F=₹1,000$ (face value),
  • $P=₹950$ (price),
  • $n=5$ (years). $$\text{YTM}=\frac{75+\frac{1,000-950}{5}}{\frac{950+1,000}{2}}=\frac{75+10}{975}=8.36\%$$

(B) Equity Instruments

• Stocks: Ownership claims (e.g., NEPSE-listed Nepal Bank).
  • Types:
    • Common Stock: Voting rights, residual claims.
    • Preferred Stock: Fixed dividends, no voting.

(C) Derivative Instruments

• Options/Futures: Derive value from underlying assets (e.g., NEPSE S&P 500 index futures).
  • Purpose: Hedging (e.g., farmers using futures to lock wheat prices) or speculation.

4. Money vs. Capital Markets

5. Risks in Financial Markets

Financial institutions face market risk, credit risk, liquidity risk, and operational risk.

(A) Market Risk

• Price fluctuations (e.g., NEPSE index dropping 10% in 2022 due to global recession).
• Mitigation: Diversification, hedging with futures.

(B) Credit Risk

• Borrower defaults (e.g., Ncell’s debt restructuring in 2021).
• Tools:
  • Credit Ratings (e.g., Moody’s, S&P; Nepal uses SEBON).
  • Collateral (e.g., mortgages for home loans).

(C) Liquidity Risk

• Inability to sell assets quickly (e.g., illiquid NEPSE stocks like Sagarmatha Bank).
• Solution: Hold liquid assets (cash, T-bills).

6. Role of Financial Instruments in Real World

(A) eSewa’s Digital Payments

• Instrument Used: Electronic Funds Transfer (EFT) (a money market instrument).
• How: eSewa processes ₹50 billion+ monthly via real-time clearing systems (like RTGS in Nepal).

(B) Daraz’s Supply Chain Financing

• Instrument Used: Commercial Paper (short-term debt).
• How: Daraz issues ₹100 million CP to suppliers to delay payments, improving cash flow.

(C) NEPSE’s Index Futures

• Instrument Used: Index Futures (derivative).
• How: Investors hedge against NEPSE volatility by trading NEPSE S&P 500 futures.

7. Regulation and Market Efficiency

• Nepal: SEBON (Securities Exchange Board of Nepal) regulates NEPSE.
• Issues:
  • Low liquidity (only 10% of NEPSE-listed firms trade daily).
  • Lack of derivatives trading (unlike global markets).
• Global Comparison:

  Market	Liquidity	Derivatives	Regulator
  NEPSE	Low	Limited	SEBON
  NYSE	High	Extensive	SEC
  London Stock Ex.	High	Extensive	FCA

8. Exam Tip: How to Score Full Marks

1. Define Terms Clearly:

   • For bonds: Always mention par value, coupon, and maturity.
   • For markets: Distinguish primary (new issues) vs. secondary (trading).

2. Use Real Examples:

   • Link NEPSE to capital markets, eSewa to money markets.
   • Cite Ncell’s bond call for debt instruments.

3. Compare Tables:

   • For risks, list credit vs. market risk with Nepal-specific examples.

4. Worked Examples:

   • Solve YTM or present value problems step-by-step (show formulas).

5. Critique Nepal’s Market:

   • Mention low liquidity, lack of derivatives, or SEBON’s role in 2–3 lines.