Unit 1: Introduction

• Overview of Financial Markets : A financial

market is a market in which financial assets
such as stocks and bonds can be purchased or
sold .
• Funds are transferred in financial markets
when one party purchases financial assets
previously held by another party.
• Investing by households, firms and
government agencies
 Functions of Financial Markets
• Investors exchange financial instruments in a
financial market.
• Four major functions : mobilization of
savings ,price discovery ,provide liquidity and
reduces the transaction cost .
 Mobilization of savings
• Mobilization of savings and their
channelization into more productive uses.
• Gives motion to the savings of the people.
• Many financial instruments are made available
for transferring finance from one sector to
other.
 Price Discovery

• Price discovery means that the interactions of

buyers and sellers in a financial market
determine the price of the traded asset.
• Financial markets signal how the funds
available from those who want to lead or
invest funds are allocated among those
needed funds.
 Provide Liquidity
• For investors to sell a financial instrument and
offer investors liquidity.
• Liquidity is the presence of buyers and sellers
ready to trade.
• Conditions arise that allow for the disposal of
the financial instrument
• The issuer is contractually obligated to pay it
off.
 Reduces the Transaction cost
• Reduces the cost of transacting when parties want to
trade a financial instrument.
• Search costs and information costs
• Search costs : explicit costs and implicit costs
• explicit costs refers to expenses to advertise one’s
intention to sell or purchase a financial instrument.
• Implicit costs include the value of time spent in locating a
counterparty .
• A buyer for seller or a seller for a buyer to the transaction.
• Organized financial market reduces search costs.
 Cond.......
• Information costs are costs associated with
assessing a financial instrument investment
attributes.
• Price efficient market ,prices reflect the
aggregate information collected by all market
participants .
,
 Structure of Financial Markets
• Security markets are classified on the basis of
nature of claim, maturity of the
claim ,seasonality of claim,delivery,
organizational structure,trading
time ,negotiation and institutional
arrangement.
 On the basis of nature of claim
• Debt market: It is the market where debt instruments
are traded.
• A debt instrument is a contractual agreement by the
borrower to pay the holder of the instrument fixed
rupee amounts at regular intervals (interest and
principal payment )until a specified date ,when the
final payment is made.
• Short term debt market (less 1 year)
• Intermediate term (1-10)
• Long term debt market (more than 10 years)eg
• New York Bonds Exchange
 Equity market
• The market where equity securities are
traded.
• Equity instruments are claims to share in the
net income and assets of a business.
 On the basis of maturity of claim
• Money Market : Money markets are markets that trade debt securities or
instruments with maturities of one year or less .
• In money markets ,economic agents with short term excess supplies of funds can
lend funds to economic agents who have short term needs or shortage of funds.
• A varity of money market securities are issued by corporations and government
units to obtain short term funds.
• Treasury bills ,federal funds ,repurchase agreement ,commercial paper,negotiable
certificate of deposit and banker’s acceptances .
• Treasury bills: short term obligations issued by the government.
• Federal funds : short term funds transferred between FIs usually for no more than
one day .
• Repurchase agreement : agreements involving the sale of securities by one party to
another with a promise by the seller to repurchase the same securities from the
buyer at a specified date and price.
• Commercial paper : short term unsecured promissory notes issued by a company
to raise short term cash.
 Contd........
• Negotiable certificate of deposit : bank issued
time deposit that specifies an interest rate
and maturity date and is negotiable.
• Banker ‘s acceptance :time draft payable to a
seller of goods ,with payment guaranteed by a
bank.
 Capital Markets
• Capital markets are markets that trade equity
and debt instruments with maturities of more
than one year.
• Suppliers of capital market securities are
corporations and governments.
• Such instruments experience wider price
fluctuations in the secondary markets in which
they trade than do money market
instruments.
 Capital Market Instruments
• Corporate stock : the fundamental ownership claim in a public
corporation.
• Mortgages : loans to individuals or businesses to purchase a
home ,land ,or other real property.
• Corporate bonds : long term bonds issued by corporations
• Treasury bonds : long term bonds issued by the government.
• State and local government bonds: long term bonds issued by
state and local governments.
• U.S. Government agencies : long term bonds collateralized by a
pool of assets and issued by agencies of the U.S. Government.
• Bank and consumer loans : loans to commercial banks and
individuals.
 Money and capital market
Money market Capital market
• Transacted for a period of less than one • Greater than one year .
year. • Capital market securities traded in lower
• Traded in high denominations . denominations .
• Firms buy and sell securities in their own • A broker receives commission to act as
accounts ,at their own risk (dealer an agent while investor takes the risk of
market) holding the stock.(auction market )
• Securities traded in high face values. • Securities traded have face value of
• Money market instruments are highly denomination.
marketable instruments. • Capital market instruments are less
• Money market instruments have less liquid instruments.
default risk. • They have high default risk.
• Provide low return • Long term securities provide high return.
• The money market has close and direct • The capital market has indirect
relationship with the central bank . relationship between central bank.
 Open and Negotiated markets
• Open market : open market is the market where
institutional mechanisms created by society to
make loans and trade securities in which any
individual and institution can participate.
• Negotiated market : Negotiated market is the
market where institutional mechanisms set by
society to make loans and trade securities in
which the terms of trade are set by direct
bargaining between a lender and a borrower.
Organized Stock Exchange and OTC Market

• OSE ; Organized stock exchanges are the physical

locations where the securities are traded under
some government rules and regulations .
• This type of stock market is the registered in the
government agency.
• In Nepal ,Nepal Stock Exchange is the organized
stock exchange .
• Transaction of only listed companies are also
made.
 Over the Counter market (OTC)
• The market where the securities of the companies not listed in the
stock exchange are traded is called over the counter (OTC) market.
• This market is also known as impersonal or curb market.
• The transaction of such securities is made by intermediaries and
authorized dealers.
• The customers may order the intermediary and authorized dealer to
buy and sell the securities by means of telephone or fax. They set up
the price of securities.
• The broker dealers who engage in OTC common stock trades are linked
by a network of telephones and computer terminals through which
they deal directly with one another and with customers.
• There are no membership requirements for trading ,nor are there
listing requirements for securities
 Difference between OSE and OTC market

OSE MARKET OTC MARKET

• FORMAL MARKET • Informal market .
• Price is determined by • Price is determined on the basis of
negotiation .so, it is negotiated
demand and supply.so, it is market.
auction market. • Only non listed securities are traded.
• Only listed securities are • Physical location and time is not
traded. fixed ,anywhere can be traded.
• Physical location and time for • This market is registered in the
authorized dealer(National
trading is fixed.
Association of Securities Dealer
• This market is registered in the Automation Quotations ) in America.
government agency. • Commission is determined by
• Commission is fixed. negotiation.
 On the basis of institutional
arrangement ,third and fourth markets
• Third market : The third market refers to the
trading of any securities that are listed on
organized stock exchange and over the
counter market .
• Trading hours is not fixed
• Third market broker are market makers who
are in direct competition with the specialist
that make markets on the organized
exchanges.
 Fourth Market
• The fourth market refers to those institutional investors
and wealthy investors who buy and sell securities directly
from each other.
• Fourth market participants completely bypass normal
dealer services.
• A communication network among institutional investors
that trade large blocks without the aid of a brokerage
house.
• The fourth market organizer may collect a small
commission or a flat annual fee for helping to arrange
these large transactions.
 Spot market
• spot market is one in which securities or financial
services are traded for immediate delivery .

• Derivatives Market : the markets in which

derivative securities trade .
• Derivative security : An agreement between two
parties to exchange a standard quantity of an
asset at a predetermined price on a specified date
in the future.
 Primary Markets
• Primary markets are markets in which users of
funds raise funds through new issues of
financial instruments such as stocks and
bonds.
• The fund users have new projects or expanded
production needs but do not have sufficient
internally generated funds to support these
needs.
 Secondary Market
• Rebought and resold
• Buyers of secondary market securities are
economic agents (consumers, businesses,and
governments) with excess funds.
• Secondary markets provide a centralized
marketplace where economic agents know
they can transact quickly and efficiently.
Difference between primary and secondary
market
Primary market Secondary market
• The new securities are traded in • The second hand securities are
the primary market. traded in the secondary market.
• The transaction are less in • The transactions are more in
primary market. secondary market.
• the investment bankers perform • The brokers perform the role
the role of an expert in issuing for the trading securities in the
new securities. secondary market.
• Funds transfer from savers to • Funds transfer from seller to
demanders(issuers). buyer of the securities.
• To make the financial capital
• To provide liquidity to the
available to make new
purchasers of securities.
investments.
 Derivative Security Markets
• The markets in which derivative securities trade
• A derivative security is a financial security ( such as futures
contract , option contract , swap contract etc) whose payoff
is linked to another ,previously issued security such as a
security traded in the capital or foreign exchange markets.
• Derivative securities generally involve an agreement
between two parties to exchange a standard quantity of an
asset or cash flow at a predetermined price and at a
specified date in the future.
• As the value of the underlying security to be exchanged
changes , the value of the derivative security changes.
 Contd…..
• A Futures of forward contract is an agreement whereby 2
parties agree to transact with respect to some financial asset
at a predetermined price on specified future date.
• An option contract gives the owner of the contract the right
but not the obligation to buy or sell a financial asset at a
specified price from or to another party.
• Not limited to financial assets also commodities and precious
metals.
• No financial assets based derivative markets in Nepal but , a
few commodity exchanges deal on selected commodities-
based derivatives. However, they are not regulated by SEBON.
 Foreign Exchange Markets
• Markets where foreign currencies are traded.
• Liberalization of the economy and advance in information and
communication technology , many companies of the developed countries
operate globally.
• Financial managers understand how events and movements in financial
markets in other countries affect the profitability and performance of
their own companies.
• Cash flows from the sale of securities ( other assets) denominated in a
foreign currency expose U.S . Corporations and investors to risk regarding
the value at which foreign currency cash flows can be converted into U.S.
dollars.
• The sensitivity of the value of cash flows on foreign investments to
changes in the foreign currency’s price in terms of Dollars is referred to as
“ Foreign exchange risk”.
 Overview of Financial Institutions
• Financial institutions ( commercial and savings
banks , credit unions ,insurance companies ,
mutual funds) perform the essential function
of channeling funds from those with surplus
funds ( suppliers of funds) to those with
shortages of funds ( users of funds)
 Types of Financial Intermediaries
• Depository Institutions:
a) Commercial banks
b) Savings Institutions
c) Credit Unions
 Depository Institutions
• Depository institutions accept deposits from surplus units and
provide credit to deficit units through loans and purchases of
securities .They are popular financial institutions for the following
reasons :
• They offer deposit accounts that can accommodate the amount
and liquidity characteristics desired by most surplus units.
• They repackage funds received from deposits to provide loans of
the size and maturity desired by deficit units.
• They accept the risk on loans provided.
• They have more expertise than individual surplus units in
evaluating the creditworthiness of deficit units.
• They diversify their loans among numerous deficit units.
 Commercial Banks
• In aggregate,commercial banks are the most dominant
depository institution.
• They serve surplus units by offering a wide variety of deposit
accounts,and they transfer deposited funds to deficit units
by providing direct loans or purchasing debt securities.
• Commercial bank operations are exposed to risk because
their loans and many of their investments in debt securities
are subject to the risk of default by the borrowers.
• Commercial banks serve both the private and public
sectors ;their deposit and lending services are utilized by
households,businesses, and government agencies.
 Thrift
• Depository institutions in the form of savings
associations ,savings banks and credit unions.
• Generally ,thrifts perform services similar to
commercial banks ,but they tend to
concentrate their loans in one segment such
as real estate loans or consumer loans.
 Savings institutions
• Savings institutions ,which are sometimes
referred to as thrift institutions,are another
type of depository institution.
• Savings institutions include savings and loan
associations and savings banks .
 In Nepal , depository institutions are
classified into 4 classes :
• Commercial banks – class A
• Development bank –B
• Finance Company – C
• Micro finance Development Bank –D
 Non – Depository Institutions
• Non- depository institutions are financial
institutions that do not accept the deposits
from general public.
• Insurance companies
• Mutual funds
• Pension funds
• Securities firms and investment banks
• Hedge funds
 Insurance companies
• Financial institutions that protect individuals
and corporations ( policyholders) from
adverse events. Life insurance companies
provide protection in the event of untimely
death , illness and retirement. Property
casualty insurance protects against personal
injury and liability due to accidents , theft , fire
and so on.
 Non –depository institutions
• Pension funds : FIs that offer savings plans through
which fund participants accumulate savings during their
working years before withdrawing them during their
retirement years. Funds originally invested in and
accumulated in a pension fund are exempt from current
taxation.
• Hedge funds : financial institutions that pool funds from
a limited number of wealthy individuals and other
investors and invest these funds on their behalf ,usually
keeping a large proportion of any upside return and
charging a fee on the amount invested.
 Non- depository Institutions
• Mutual funds : Financial institutions that pool
financial resources of individuals and companies
and invest those resources in diversified portfolios
of assets .
• Finance companies : Financial intermediaries that
make loans to both individuals and businesses.
Unlike depository institutions , finance companies
do not accept deposits but instead rely on short-
and long- term debt for funding.
 Non – depository institutions
• Securities firms and investment banks : Financial
institutions that help firms issue securities and engage in
related activities such as securities brokerage and
securities trading.
Unique Economics Functions Performed by Financial
Institutions
• Direct Transfer : A corporation sells its stock or debt
directly to investors without going through a financial
institution.
• Indirect Transfer : A transfer of funds between suppliers
and users of funds through a financial intermediary .
 Services Benefiting Suppliers of Funds
• Monitoring costs : Aggregation of funds in an FI
provides greater incentive to collect a firm’s information
and monitor actions. The relatively large size of the FI
allows this collection of information to be accomplished
at a lower average cost ( economies of scale)
• Liquidity and price risk : FIs provide financial claims to
household savers with superior liquidity attributes and
with lower price risk .
• Transaction cost services : Similar to economies of scale
in information production costs , an FI’s size can result in
economies of scale in transaction costs.
 Contd…
• Maturity intermediation : It is the intermediaries for
matching the maturity of financial assets and
liabilities. It play important roles by providing the
loans to deficit units for desired period and
accepting the funds as per investor’s desired
investment horizon.
• Denomination intermediation : FIs such as mutual
funds allow small investors to overcome constraints
to buying assets imposed by large minimum
denomination size.
Services Benefiting the overall Economy
• Money supply transmission : Depository institutions are the
conduit through which monetary policy actions impact the rest
of the financial system and the economy in general.
• Payment Services : The efficiency with which depository
institutions provide payment services directly benefits the
economy
• Credit Allocation : Fis are often viewed as the major and
sometimes only source of financing for a particular sector of
the economy such as farming and residential real estate .
• Intergenerational wealth transfer : FIS especially life insurance
companies and pension funds , provide savers with the ability
to transfer wealth from one generation to the next.
 Regulation of Financial System
• The financial system is the most regulated sectors of the
any economy.
• 2 main reasons : To increase the information available
to investors and to ensure the soundness of the
financial system.
• Principles regulatory agencies of the Nepalese Financial
System :
• A) NRB : Regulatory agency
• Regulation : all depository institutions and some
cooperatives .
• Nature of regulations : Establishment and operations.
• B) Securities Board of Nepal : Organized exchanges , financial
market and derivative markets
• Nature of Regulations : Establishment and operations
• C) Insurance Board of Nepal : life and non- life insurance
companies .
• Nature of Regulations : Establishment and operation
• D) Deposit and credit Guarantee Fund ( DCGF) : Commercial
banks , development banks , finance company and micro
financial institutions.
• E) Company Registrar Office ( CRO) : All company registered
at CRO
• F) Credit Information Bureau ( CIB) of Nepal.: CBs,
development banks , finance company and micro financial
institutions.
• G) Cooperative Board of Nepal : All types of Cooperatives
• To regulate the Nepalese financial system, we have
4 regulators including NRB ,SEBON , Insurance
Board and Company Registrar Office.
• By using related Act , regulations , bylaws and
guidelines , regulators regulate the entire financial
system.
• Financial system : Financial Markets , Financial
instruments and Financial institutions .