Investment Banking & Securities Markets: Roles, Instruments & Markets

TAKEAWAYS:

• Investment banks underwrite IPOs, advise mergers, and trade securities but do not take deposits (unlike commercial banks).
• Primary markets issue new securities (e.g., NMB’s IPO in 2023), while secondary markets trade existing ones (e.g., NEPSE’s daily trading).
• Stocks represent equity ownership (e.g., KBL shares), bonds are debt instruments (e.g., government securities), and derivatives hedge risks (e.g., futures on NEPSE indices).
• Brokers execute trades, dealers provide liquidity, and market makers ensure tight bid-ask spreads (e.g., NMB Capital as a dealer).
• Nepal’s NEPSE and global exchanges (NYSE, LSE) use auction and continuous trading systems with different clearing mechanisms.
• Regulators like SEBON (Nepal) and SEC (USA) enforce transparency, fraud prevention, and fair disclosure.

1. Investment Banking: Functions and Players

Investment banks connect issuers (companies, governments) with investors by underwriting securities, advising on M&A, and trading. Unlike commercial banks, they do not accept deposits but earn fees for capital-raising services.

Key Functions

flowchart TD
    A["Capital Raising"] -->|"IPOs, bonds"| B["Underwriting"]
    A -->|"M&A"| C["Advisory"]
    A -->|"Trading"| D["Market Making"]
    A -->|"Risk Management"| E["Derivatives"]

• Underwriting: Guaranteeing issuance of securities (e.g., NMB’s Rs 500M IPO in 2023).
• Advisory: Mergers (e.g., Siddhartha Bank + Global IME Bank), acquisitions, or restructuring.
• Trading: Buying/selling securities for clients (e.g., NMB Capital trading KBL shares).
• Derivatives: Structured products (e.g., interest rate swaps for banks).

Investment Banks vs. Commercial Banks

2. Securities Markets: Primary vs. Secondary

Securities markets classify by when the security is issued:

• Primary Market: New securities sold to investors (e.g., IPOs, bond issuances).
• Secondary Market: Existing securities traded (e.g., NEPSE, NYSE).

Primary Market Process (Nepal Example: NMB IPO)

sequenceDiagram
    participant Issuer as NMB Bank
    participant IB as NMB Capital (Investment Bank)
    participant Investors as Retail/Institutional
    Issuer->>IB: Files IPO prospectus (SEBON approval)
    IB->>Investors: Roadshow & marketing
    Investors->>IB: Bid submissions (Rs 500M target)
    IB->>Issuer: Allocates shares (e.g., 50% retail, 30% institutions)
    Issuer->>Investors: Shares listed on NEPSE

Worked Example: NMB’s IPO in 2023

• Offer Price: Rs 1,200 per share.
• Allotment: 500,000 shares to retail investors (Rs 600M), 300,000 to institutions (Rs 360M).
• Underwriting Spread: NMB Capital charged 2% of Rs 500M = Rs 10M fee.

3. Types of Securities

(A) Equity Securities (Stocks)

• Represent ownership in a company (e.g., KBL, NMB shares).
• Dividends: Profit shares (e.g., NMB paid Rs 15/share in 2023).
• Voting Rights: Shareholders elect boards (e.g., NEPSE’s governance rules).

(B) Debt Securities (Bonds)

• Government Bonds: Low risk (e.g., Nepal Government Securities, NGN).
• Corporate Bonds: Higher yield (e.g., Siddhartha Bank’s Rs 100M bond in 2022).
• Treasury Bills: Short-term (e.g., 90-day T-bills at 7% yield).

Bond Valuation Formula: The price of a bond is the present value of its cash flows: $$P=\sum _{t=1}^n\frac{C}{(1+r{)}^t}+\frac{F}{(1+r{)}^n}$$ Where:

• $C$ = Coupon payment (e.g., Rs 10/year),
• $F$ = Face value (e.g., Rs 1,000),
• $r$ = Discount rate (e.g., 8%),
• $n$ = Years to maturity.

Worked Example: 90-day T-bill at 8% yield

• Face Value (F): Rs 1,000,000.
• Bank Discount Yield: 8% → Discount = Rs 80,000.
• Price Paid: $1,000,000-80,000=\text{Rs 920,000}$.

(C) Derivatives

• Futures: Agreements to buy/sell at a future date (e.g., NEPSE 50 index futures).
• Options: Right to buy/sell (e.g., call options on KBL shares).
• Swaps: Exchange cash flows (e.g., interest rate swaps for banks).

Derivatives Market Example:

• Pathao uses futures to hedge fuel price risks for its delivery fleet.

4. Market Participants

Broker vs. Dealer:

• Broker: Acts as agent (e.g., you tell them to buy KBL shares).
• Dealer: Acts as principal (e.g., NMB Capital buys KBL shares for its own account).

5. Trading Mechanisms

flowchart TD
    A["NEPSE Auction Market"] --> B["Order Book: Buyers & Sellers"]
    B --> C["Price Discovery: Highest Bid vs. Lowest Ask"]
    C --> D["Trade Execution: Match at Midpoint"]
    D --> E["Continuous Trading: 2:30 PM - 5:00 PM"]
    E --> F["Clearing & Settlement: T+2 (Next Day)"]
    F --> G["NEPSE Clearing Corporation"]

(A) Auction Market (NEPSE)

• Order Matching: Buyers/sellers compete at opening/closing (e.g., NEPSE’s 9:30 AM auction).
• Continuous Trading: After auction, trades execute at best bid/ask.

NEPSE Trading Example:

• Bid Price: Rs 1,840 (highest buyer offer).
• Ask Price: Rs 1,850 (lowest seller price).
• Trade Executed: At Rs 1,845 (midpoint).

(B) Dealer Market (OTC)

• Over-the-Counter: No central exchange (e.g., corporate bonds traded privately).
• Bid-Ask Spread: Wider than NEPSE (e.g., Rs 20 for a Rs 1,000 bond).

6. Nepal’s Securities Market: NEPSE

• Founded: 1994 (first listed company: Nepal Bank Ltd.).
• Listed Companies: 300+ (e.g., KBL, NMB, Siddhartha Bank).
• Index: NEPSE-50 tracks top 50 stocks.

NEPSE Trading Hours:

9:30 AM - 12:30 PM (Auction + Continuous)
2:30 PM - 5:00 PM (Continuous)

7. Challenges in Nepal’s Securities Market

1. Low Liquidity: Few traders → wide bid-ask spreads.
2. Fraud Risks: Ponzi schemes (e.g., 2017 "Nepal Stock Exchange" scam).
3. Regulatory Gaps: SEBON lacks enforcement power.
4. Digital Divide: Rural investors struggle with online trading.

Solution: NEPSE’s mobile app (eSewa integration) improves access.

8. Global Comparison: NEPSE vs. NYSE

In the Real World

1. eSewa & Khalti (Digital Payments)

   • Idea Used: Securities Settlement
   • How: eSewa partners with NEPSE to enable instant stock purchases via mobile (e.g., buying KBL shares with UPI-like transfers). The settlement (transfer of shares) happens in T+2 (trade + 2 days), but digital wallets reduce friction.

2. Daraz (E-commerce)

   • Idea Used: Debt Securities (Supplier Financing)
   • How: Daraz issues short-term commercial paper (a type of bond) to fund inventory. Suppliers (e.g., Nepal’s textile factories) get early payments, and Daraz borrows at lower rates than bank loans. This is like how NMB uses corporate bonds to finance its loan portfolio.

3. NTC (Telecom)

   • Idea Used: Equity Financing via IPO
   • How: In 2022, NTC considered listing on NEPSE to raise Rs 5B for 5G expansion. An investment bank (e.g., NMB Capital) would underwrite the IPO, setting the offer price (e.g., Rs 500/share) based on valuation models like Discounted Cash Flow (DCF).

Worked Example: Bond Valuation for a Nepalese Business

Scenario: Siddhartha Bank issues a 5-year bond with:

• Face value: Rs 1,000,
• Coupon rate: 7% (paid annually),
• Market discount rate: 9%.

Calculate the bond’s market price.

Solution: Using the bond valuation formula: $$P=\sum _{t=1}^5\frac{70}{(1.09{)}^t}+\frac{1,000}{(1.09{)}^5}$$ Calculate each term:

• Year 1: $\frac{70}{1.09}=64.22$
• Year 2: $\frac{70}{1.09^2}=58.80$
• Year 3: $\frac{70}{1.09^3}=53.90$
• Year 4: $\frac{70}{1.09^4}=49.50$
• Year 5: $\frac{70+1,000}{1.09^5}=769.42$ (coupon + face value)

Total Price: $$64.22+58.80+53.90+49.50+769.42=\text{Rs 995.84}$$ Interpretation: The bond trades at a discount (Rs 995.84 < Rs 1,000) because the market requires a higher yield (9%) than the coupon (7%).

Exam Tip

1. Memorize Key Formulas:

   • Bond price: $P=\sum \frac{C}{(1+r{)}^t}+\frac{F}{(1+r{)}^n}$.
   • Present value of an annuity (for pensions/loans): $PV=PMT\times \frac{1-(1+r{)}^{-n}}{r}$.

2. Nepal-Specific Focus:

   • Always cite NEPSE, SEBON, or NMB Capital in answers.
   • Example: "Nepal’s primary market is dominated by IPOs underwritten by investment banks like NMB Capital, which charge a 2% spread as seen in the NMB 2023 IPO."

3. Compare Global vs. Local:

   • Highlight differences (e.g., "Unlike NYSE’s high liquidity, NEPSE faces low trading volumes due to limited retail participation").

4. Worked Examples:

   • Practice bond pricing and annuity calculations (common in past exams).
   • Example question: "A 3-year bond with Rs 100 coupon pays annually. If the market yield is 8%, what is its price?"

5. Regulatory Questions:

   • SEBON’s role in fraud prevention or NEPSE’s trading rules are frequent topics.

Final Note: Investment banking and securities markets are the engine of capital allocation. In Nepal, NEPSE’s growth depends on digital adoption (like eSewa’s role) and regulatory reforms. Globally, firms like Goldman Sachs underwrite IPOs (e.g., Stripe’s 2022 listing), while Wharton’s endowment fund uses derivatives to hedge risks. Always tie theory to real examples—examiners reward this!