Financial Markets & Institutions: Players, Types & Functions

TAKEAWAYS:

• Financial markets channel funds from surplus units (savers) to deficit units (borrowers) via intermediaries like banks and exchanges.
• Primary markets issue new securities (e.g., IPOs on NEPSE), while secondary markets trade existing ones (e.g., Kathmandu Stock Exchange).
• Money markets (short-term) fund working capital (e.g., Ncell’s short-term loans), while capital markets (long-term) fund projects (e.g., Daraz’s expansion).
• Financial institutions (commercial banks, NBFCs, mutual funds) reduce transaction costs and risk via diversification.
• Global markets (e.g., Eurobonds, ADRs) enable multinational firms like Pathao to raise capital abroad.
• Regulators (Nepal Rastra Bank, SEBI) ensure market integrity via disclosure rules and risk controls.

1. Introduction to Financial Markets

Financial markets are organized platforms where buyers and sellers trade financial assets (stocks, bonds, derivatives). They allocate capital efficiently, determine asset prices, and provide liquidity.

Key Functions

flowchart TD
  A["Capital Allocation"] --> B["Efficient Resource Allocation"]
  A --> C["Price Discovery"]
  A --> D["Liquidity Provision"]
  A --> E["Risk Sharing"]

• Capital Allocation: Directs funds from savers (e.g., your bank deposit) to businesses (e.g., a new Pathao franchise).
• Price Discovery: Market prices reflect true value (e.g., NEPSE’s index shows investor sentiment).
• Liquidity: Assets can be converted to cash quickly (e.g., selling Ncell shares).
• Risk Sharing: Diversification via mutual funds reduces individual risk.

(Note: Replace with a labelled photo of NEPSE’s trading hall or a modern stock exchange interior.)

2. Classification of Financial Markets

Markets are classified by maturity, security type, and geography.

A. By Maturity: Money vs. Capital Markets

Why it matters:

• Money markets help businesses like Pathao manage payrolls or inventory financing.
• Capital markets enable Ncell to raise Rs 500M for a new tower network via a bond issue.

B. By Security Type: Debt vs. Equity Markets

• Debt Market: Trades bonds (e.g., Nepal Government Securities on NEPSE).
• Equity Market: Trades shares (e.g., Ncell’s ADR on NYSE).
• Derivatives Market: Trades futures/options (e.g., NEPSE’s index futures for hedging).

(Replace with a side-by-side diagram: a bond certificate and a stock certificate.)

C. By Geography: Domestic vs. Global Markets

Real-world tie:

• Daraz raises capital via Eurobonds (global market) to expand into India, while eSewa relies on domestic money markets for short-term liquidity.

3. Key Financial Institutions

Institutions intermediate between savers and borrowers, reducing transaction costs.

A. Depository Institutions

How it works:

• You deposit Rs 10,000 in Global IME Bank.
• The bank lends Rs 8,000 to a Pathao driver for a new scooter.
• The bank earns spread (interest earned – interest paid).

B. Non-Depository Institutions

C. Central Bank: Nepal Rastra Bank (NRB)

• Role: Regulates money supply, controls inflation, supervises commercial banks.
• Tools:
  • Repo Rate: 6.5% (2023) – rate at which NRB lends to banks.
  • Reserve Requirement: Banks must hold 7% of deposits as reserves.
  • Open Market Operations: Buys/sells government securities to adjust liquidity.

Example:

• If inflation rises, NRB raises repo rate → banks charge higher interest → Pathao’s loan becomes costlier.

4. Primary vs. Secondary Markets

A. Primary Market

• New securities are issued (e.g., IPO of Ncell’s bonds).
• Participants: Issuer (company), underwriters (banks), investors.
• Process:
  1. Company files prospectus with NRB.
  2. Underwriters (e.g., Global IME) set price.
  3. Public subscribes via book-building (NEPSE’s IPO portal).

flowchart TD
    A["Company Files Prospectus"] --> B["NRB Approval"]
    B --> C["Underwriters Set Price"]
    C --> D["Book-Building (NEPSE Portal)"]
    D --> E["Allocation & Listing on NEPSE"]

B. Secondary Market

• Existing securities trade (e.g., buying/selling Ncell shares on NEPSE).
• Participants: Investors, brokers, market makers.
• Functions:
  • Provides liquidity (easy buying/selling).
  • Reflects market sentiment (e.g., NEPSE index drops after political unrest).

Comparison Table

Worked Example: Ncell’s IPO (Primary Market)

• Issue Size: Rs 500M (20% of equity).
• Underwriters: Global IME, NMB Bank.
• Allocation:
  • Retail Investors: 50% (minimum Rs 10,000 investment).
  • Institutions: 30% (mutual funds, banks).
  • Employees: 20% (Ncell staff).
• Listing: Trades on NEPSE at Rs 120/share (pre-IPO: Rs 100).

Why it matters:

• Ncell raises Rs 500M for 5G expansion.
• Investors earn dividends (e.g., 15% in FY2023) and capital gains if price rises.

5. Global Financial Markets

Nepali firms (e.g., Ncell, Daraz) access global markets via:

1. Eurobonds: Issued in foreign currency (e.g., USD) to non-residents.
2. ADRs/GDRs: Shares traded abroad (e.g., Ncell’s ADR on NYSE).
3. Foreign Portfolio Investors (FPIs): Institutional investors (e.g., Vanguard) buying NEPSE stocks.

Example: Daraz’s Global Funding

• Problem: Needs Rs 2B for Indian expansion.
• Solution:
  • Issues Eurobond (USD 25M) to global investors.
  • Lists on NYSE via ADR (Ncell did this in 2020).
• Benefit: Lower cost than domestic loans + global investor base.

flowchart TD
  A["Global Financial Markets"] --> B["Eurobond (USD 25M)"]
  A --> C["NYSE via ADR"]
  A --> D["Lower Cost + Global Investors"]
  B --> E["Issued to Global Investors"]
  C --> F["Ncell Example (2020)"]

6. Role of Regulators

Why it matters:

• SEBN’s rule: Companies must disclose audited financials before IPO → prevents fraud (e.g., like Ncell’s transparent listing).

7. Financial Instruments

8. Exam Tip: How This Unit is Tested

1. Calculations:

   • Degree of financial leverage (DFL) = % Change in EPS / % Change in EBIT. Example: If EBIT rises 10% but EPS rises 20%, DFL = 20/10 = 2.
   • Worked Example:
     • Sales = Rs 500,000; VC = Rs 300,000; FC = Rs 100,000.
     • EBIT = Sales – VC – FC = Rs 100,000.
     • Borrowed Rs 200,000 at 10% → Interest = Rs 20,000.
     • DFL = (EBIT – Interest) / EBIT = (100,000 – 20,000) / 100,000 = 0.8 (or 80%).

2. Definitions:

   • Primary Market: Market for new security issues.
   • Secondary Market: Market for existing securities.
   • Money Market: Market for short-term funds (<1 year).

3. Comparisons:

   • Domestic vs. Global Markets: Use the table above.
   • Debt vs. Equity: Highlight fixed payments (debt) vs. residual claims (equity).

4. Real-world Applications:

   • eSewa: Uses money markets for short-term liquidity.
   • NEPSE: Primary (IPO) + secondary markets.
   • Ncell: Raised capital via ADRs and Eurobonds.

5. Critical Thinking:

   • "Why do firms go global?" → Lower cost of capital, access to larger investor base.
   • "How does NRB control inflation?" → Raise repo rate → tighten liquidity.

Common Pitfalls:

• Confusing primary (new issue) and secondary (trading) markets.
• Forgetting NRB’s role in regulating banks vs. SEBN’s role in securities.
• Misapplying DFL formula (use EBIT, not net income).

In the real world

1. eSewa’s Liquidity Management:

   • Uses money markets (short-term loans from banks) to fund daily transactions when customer withdrawals spike. If eSewa needs Rs 50M for a week, it borrows from NMB Bank at 8% (vs. depositing at 5%).

2. Daraz’s Eurobond Issue (2022):

   • Raised USD 100M (≈ Rs 10B) via a 5-year Eurobond to expand in India. Why?
     • Lower cost: Global investors offered 6% vs. 8% from Nepalese banks.
     • Diversification: Spreads risk across global investors.

3. Ncell’s ADR Listing (2020):

   • Listed on NYSE via ADR to attract foreign institutional investors (FIIs). Result:
     • Liquidity: Shares trade 24/5 (vs. NEPSE’s 9:30 AM–4 PM).
     • Brand Value: Attracts global tech partners (e.g., Ericsson).

Final Worked Example: Kathmandu Retail Shop (Nepali Context) Business: Sagar’s Spices (Rs 10M annual sales, 60% gross margin). Problem: Needs Rs 2M for inventory expansion. Options:

1. Bank Loan (Primary Market):

   • Borrow Rs 2M at 12% from NMB Bank.
   • Cost: Rs 240,000/year in interest.
   • Risk: Fixed repayment; default = asset seizure.

2. Supplier Credit (Money Market):

   • Buy inventory on 90-day credit (e.g., from Spice World).
   • Cost: 2% discount if paid early (but no interest if paid on time).

3. Issue Debentures (Capital Market):

   • Sell 5-year debentures at 10% to local investors.
   • Cost: Rs 200,000/year; but builds investor base.

Decision:

• Short-term: Use supplier credit (no interest if paid on time).
• Long-term: Issue debentures to fund expansion without diluting ownership.

Mermaid Diagram: Accounting Cycle (for Financial Institutions)