Financial System

Financial system consists of the financial institutions and financial markets. They can be
deposit-taking institutions (banks, finance companies), insurance companies, mutual
funds, pension funds, cooperatives, market brokers, stock exchanges, investment bankers,
listing companies, etc. In any economy, for its smooth functioning, financial system plays
a vital role. Financial system basically creates a platform to channelise the resources from
surplus to deficits. It helps creating the capital to the investment opportunities, manages
the risks, and facilitates the transfer of investment ownerships or the claims. In a way,
financial system of the economy helps to mobilize the savings to a productive use. It
helps in capital formation and risk management.

Financial market and Instruments:

The word market instantly creates an image of commodity market in our minds; where
consumer daily commodity and durables are traded. Similarly, financial market is that
market where money itself is traded-loaned or borrowed- in terms of different financial
assets or instruments like stocks and bonds are traded. In this market, buyers and sellers
of financial instruments come together. Business, individuals and government units often
need to raise funds; on the other hand, some individuals and firms have income greater
than their current expenditure, so they have funds available to invest. Interest of such
both parties can be met through the mechanism known as financial market.

Financial asset or instrument or simply a security is only a piece of paper that represents
the investor’s right to certain prospects or property and the conditions under which he/she
may exercise those rights. It is transferable to another investor, and with it goes all its
rights and conditions. Thus, it is just a legal representation of the right to receive
prospective future benefits under stated conditions. Simply, these are marketable
financial claims issued by government and companies. Common stocks and bonds are the
common examples of financial assets or instruments.

Financial markets are generally categorized in these ways:

• Money market and capital market
• Primary market and secondary market

Money market is that financial market where funds are borrowed or loaned for short
periods- usually less than a year. In contrast, capital market deals with the longer-term
instruments. The financial market, in which corporation raise funds by issuing new
securities , is the primary market whereas secondary market is the market in which
securities are traded among the investors after they have been issued by corporations and
public agencies. Once the securities are issued in the primary market, they can be bought
and sold an endless number of times. The values of securities in these subsequent
transactions, in secondary market, will vary, depending on the fortunes of the firm and
the economy. The trading of securities in secondary markets is not a source of new
capital for a corporation.

There is a close relationship between the primary and secondary markets. Without an
effective secondary market, the primary market would fail, because investors subscribe to
new issues only if they are hopeful of being able to resell at a profit in future without too
much difficulties, and many people get the money to invest in new issues by selling
stocks already held.

The major purpose of financial market is to transfer funds from lender to borrowers. They
are the intermediary link in facilitating the flow of funds from savers to investors. By
providing an institutional mechanism for mobilizing domestic saving and efficiently
channeling them into productive investments, they lower the cost of capital to investors
and accelerate economic growth of the country. Financial markets are conduits through
which those who do not spend all their income can make their excess funds available to
those who want to spend more than their income.

Participants in the financial market commonly distinguish between the “capital market”
and the “money market”, former referring to borrowing and lending for long-term
investment purpose and the later term generally refereeing to borrowing and lending for
period of a year or less.

A. Money Market Instruments:

Money market deals with the short-term financial needs. It facilitates the transfer of
short-term funds from individuals, corporations or governments with excess funds to
those with deficient funds. Here the investors find the instruments with the maturity of
short period, usually less than a year which is referred to as money market
securities/instruments.

Instruments that are traded in the money market have the

characteristics like:
• They are all debt obligations; they have maturities ranging from one day to a full
year
• They exhibit typically high degree of safety of principal (they are subject to
negligible interest rate risk, and issued by generally high credit standing
borrowers like: central bank), and
• They have high degree of liquidity.

Some popular instruments of money market are:

1. Treasury bill
2. Commercial papers
3. Certificates of deposit
4. Banker’s acceptance
5. Repurchase agreements
6. Short-term municipal securities
7. Other instruments

1. Treasury Bills or T-bills:

This is one of the government securities, and is a very popular money market instrument.
T-bills have very short maturities, with a maximum of one year. These securities are
bought at a discount from its promised payment in maturity. T-bills have no coupon or
stated interest. The interest on the investment is represented by the difference between the
promised payment and purchase price. The size of the discount is determined in an
auction, which will depend on the terms of the bill and the prevailing market conditions.

Because of the low risk and short maturity of these instruments, T-bills are attractive
investments for many financial market participants. Individuals, corporations, state and
local governments and money market mutual funds have large holdings. To individual
and commercial investors, T-bill has the added attraction of being exempt from state and
local taxes. In our country, NRB makes the auction of T-bills.

2. Commercial Paper:
Commercial paper is a short-term unsecured promissory note issued by corporations and
foreign governments. It is low-cost alternatives to bank loan for many large credit-worthy
issuers. Issuers are able to efficiently raise large amounts of funds quickly and without
expansive Security Exchange registrations. They sell paper, either directly or through
independent dealers. Investors in commercial paper earn competitive, market-determined
yields in notes whose maturity and amounts can be tailored to their specific needs. The
notes often additionally backed by unused bank lines of credit and/ or a guarantee of a
present corporation. These notes are issued for terms ranging from on day to one year.

Commercial paper is typically issued at a discount form the face value, matures on a
specific day, and is negotiable. Credit risk is perceived to be relatively low, and liquidity
is also low. Accordingly, investors tend to hold to maturity. Consequently, yields on
commercial papers exceed those on Treasury obligations of similar maturities. Because of
the advantages of commercial paper for both investors and issuers, commercial paper has
become one of the America’s most important debt markets. It is the second largest money
market instruments, in terms of outstanding debt, behind T-bills. Insurance, banks, thrifts,
nonofficial corporations, and state and local government bodies are also important
investors in this instrument.

3. Certificate of Deposit (CD):

A certificate of deposit is a document evidencing a time deposit placed with a depository
institution. The certificate states
• The amount of the deposit
• The date on which it matures
• The interest rate and
• The method under which the interest is calculated

A CD can be legally negotiable or nonnegotiable, depending on certain legal

specifications of the CD. Negotiable CDs can be sold by depositors to other parties who
can in turn resell them. Nonnegotiable CDs generally must be held by the depositor until
maturity. Most CDs feature a fixed interest rate to maturity; however some CDs have
variable interest rates. CDs are issued both in bearer and registered form. If American
scenario is seen, four types of CDs are mostly popular with differing rates, risk and
liquidity. They are- Domestic CDs, Eurodollar CDs, Yankee CDs and Thrift CDs.
4. Banker’s Acceptance (BA):
A Bankers Acceptance was invented to suit the needs of a party requiring temporary
finance to facilitate the trading of specific goods. The party requiring finance would
approach investors for this temporary finance. The investors or lenders would then lend a
certain amount to the borrowers in exchange for a documents stating that the debt would
be paid back on a certain date in the short-term future. The redemption of the loan would
have to be guaranteed by a bank, called the acceptance by the bank, making the
arrangement. Thus the name is “bankers’ acceptance”

It is, thus, simply a time draft drawn on and accepted by a bank. Before acceptance, the
draft is not an obligation of the bank; it is merely an order by the drawer to the bank to
pay a specified sum of money on a specified date to a named person or to the bearer of
the draft. Upon acceptance, which occurs when an authorized bank employee stamps the
draft “accepted” and signs it, the draft becomes a primary and unconditional liability of
the bank. If the bank is well known and enjoys a good reputation, the accepted draft may
be readily sold in an active market. Investors in BAs include commercial banks, foreign
central banks, money market funds, and Non-finance Corporation. They are sold at a
discount from the face value, are issued in bearer form and are issued with maturities
ranging from one to six months.

BAs have very active secondary market, in the money market like of America. The yields
of BAs are slightly lower than those on commercial paper because BAs are less risky due
to the borrower’s pledge to pay, the collateral of goods and the guarantee for the
accepting bank. BAs are very popular in export-import business.

5. Repurchase agreements:
The repurchase agreement (REPO) and reverse repurchase agreement refer to a type of
transaction in which a money market participant acquires immediately available funds by
selling securities and simultaneously agreeing to purchase the same or similar securities
after a specified time at a give price, which typically include interest at an agreed-upon
rates. Such a transaction is called REPO when viewed from the perspective of the
supplier of the securities (the party acquiring funds) and a reverse REPO or matched sale-
purchase agreement when described from the point of view of the supplier of funds.

The securities used may be a Treasury obligation, agency issues, mortgage-backed

security, corporate debt issue, or money market instrument such as negotiable CDs or
BAs, and the timing of the two transactions can be one day or several months apart. At
the end of the period, the initial seller gets back the security and the purchaser gets back
the yield, implied by the difference in the prices of purchase and repurchase- the REPO
rate. The REPO rate charged to the initial seller depends on the nature of the underlying
security (risk, liquidity and maturity) and the creditworthiness of the initial seller. The
major players in the REPO market are banks, saving institutions, and non-bank securities
dealers.
6. Short-term Municipal Securities:
Local governments often have temporary need for cash to finance their own expenditures,
to provide funds to some tax-exempt entities such as colleges and non-profit hospitals,
and, to a limited degree, to provide funds to private firms and individuals. To meet such
needs, they often issue short-term municipal securities. These securities are issued in two
forms: interest bearing notes and discounts notes. Individuals, mutual funds, banks and
other corporations are the major types of investors in municipal securities.

B. Capital market instruments:

Capital market provides a channel for the borrowing and lending of long-term funds. This
is designed to finance long-term investments by business, governments, and households.
Financial instruments in the capital market have original maturities of more than one
year. The principal suppliers and demanders of funds in the capital market are more
varied than in money market e.g. families and individuals, governments, business of
varied sizes, pension funds, mutual funds etc. Trading of funds in the capital market
makes possible for construction of huge establishments like: factories, schools and
highways.

Popular instruments traded in capital market are:

1. Equity or Stock (ownership instruments)
2. Bond (Debt instruments)
3. Mortgage Loans
4. Options and Futures- derivative financial instruments

1. Equity/Stock:
Equities are often termed as – stocks or shares. Stocks represent part-ownership of a
corporation. Holding a stock certificate means that the holder owns the part of the
corporation. Thus there are only corporate stocks, no government or state and local
government stocks, since individuals cannot ‘own’ governments (at least not legally).
Equities or stocks are basically the contracts that establish an on-going relationship
between “borrower” and “lender” and almost always bundling some combination of
“control rights” and right to be a “residual claimant”. In the establishment of corporations
of small and medium sizes, stock sales to the incorporators are usually the principle
source of cash and other assets. The income that the stockholder receives is the dividend.
Investment on equities is also known as – investment by way of proprietary interest. Such
investment gives the investor a status of proprietor. He may be a sole proprietor, a
partner, or a member of a joint stock company.

People invest in equities because they want to make more income than they do in a
saving account. For the possibility of making more income, they assume more risk. There
are several advantages and disadvantages of investing in stock. The likelihood of
dividends and price appreciation motivates most investors to consider common stocks.
Many companies might declare relatively small cash dividends, perhaps with a return of 2
or 3 percent. But these companies may also offer a good chance for price appreciation
over time. Greater than average returns are possible if one buys and sell the correct
stocks. On the other hand, in equity investments risks of various types are also present.
There is financial risk that the company will go bankrupt. There is liquidity risk that the
price of a stock might be quite low when one wants to sell it. Along with them, inflation
risk also presents. In the period of high inflation, market prices of equity are depressed.
Uncertainty of yield is another disadvantage of common stocks. Even a company with an
excellent record of paying cash dividends might skip some dividends during market
downturn. Since, many stocks vary in price with certain news events, world happenings
and economic and political variables, investors need to be alert to current happenings in
order to know when to sell quickly in order to reap profits or reduce losses.

There are two main types of equity ownership or stocks or

shares prevalent in the market:
• Common Stock, and
• Preferred Stock

A. Common Stock:
Common stock is the first security of a corporation to be issued and, in the event of
bankruptcy, the last to be retired. It represents an ownerships share in the firm; it has the
lowest-priority claims on earnings and assets of all securities issued. This is the residual
claimant to the earnings. An investor in common stock receives certificates of ownership,
stating the number of shares and par value of share. Common stock holders have the
voting rights, they can vote for a board of directors and to vote on major issues that may
be presented before them. Dividend is not a must for common stocks; some pay it but not
all. Companies in early growth stages typically pay low or no dividends; rather, they
retain as much earning as possible to finance rapid growth. As companies become more
established, they may pay a high percentage of profits as dividends. Payment of the
common dividend is purely discretionary on the part of management, but may be
constrained by certain covenants that are designed to protect other claimants’ interests. If
earnings are retained rather than distributed, stockholder do benefit in the sense that if the
retained earning are invested profitably, the firm will grow in size, and the stockholder
will eventually capture the growth.

Authors like Weirich, Garman, Eckert, and Forgue have classified common stocks
among- blue chip stocks, income stocks, growth stocks, speculative stocks, cyclical
stocks, and defensive stocks. Authors remark that such classification will aid when
matching an investor’s preferences with stock investment options.

• A blue-chip stock indicates a company with a well-regarded reputation and

a long history both of good earnings and consistent cash dividends.
• An income stock has a cash dividend that is higher than average because
the company has high earnings and chooses to regularly declare cash dividends.
• Stock of companies that are leader in their fields and have several consecutive
years of above-average earnings are considered growth stock
• A speculative stock has a spotty earnings record but has an apparent
potential for substantial earnings at some time in the future even though such
earnings may never be realized.
 • A cyclical stock has a price that typically follows the general state of the
economy and the various phases of the business cycle.
• Despite a general decline in economic activity, some companies maintain
substantial earnings because their products are needed. These companies offer
defensive stocks.

B. Preferred Stock:
Preferred stock is also a form of equity ownership. It is a hybrid of sorts between a fixed
and a variable income security. Its claim isn’t really fixed and definite in the sense that it
can force the firm into bankruptcy if it is not paid in full. On the other hand, its claim is
limited in size to a specified amount. In general, no dividends can be paid on the common
stock until the specified dividends have been paid to preferred stocks. Preferred stocks
are usually perpetual however some can be callable also. Preferred shareholders do not
share in the profitability of a firm beyond the stated dividend rate, unless are stated as the
participative preferred stock. Preferred stocks are superior in two
areas:

• Although they have no rights to dividends, if corporation allocates earnings to

declare dividends, preferred shareholders must receive before common
stockholder.
• In the event of forced liquidation, preferred shareholders have a claim on
remaining assets up to the par value, as a priority over common shareholders.

It seems that preferred stock is a hybrid security with characteristics of both common
stock and bonds.

There are two basic types of preferred stocks

Cumulative and Non-Cumulative:
In the case of cumulative preferred stocks, if the firm does not pay dividend in any year,
no dividend can be paid to common stocks until that dividend and any other arrear
dividends on the preferred stocks have been paid in full. The arrear dividend goes on
cumulating. Nevertheless, in case of non-cumulative preferred stocks, if the firm skips
the dividends on the preferred in any given year, it can pay dividends on the common as
long as it pays the dividends on the preferred in the dame year.

A term-preferred share is a relatively recent Canadian phenomenon. The phrase

is used to describe a particular type of share that has many of the characteristics of debt.
A term-preferred share pays dividends and is preferred over the common shares as to
assets but often has additional features. For example, the divided is frequently set at
floating rate and is guaranteed by the company. Term preferred shares are usually
privately placed.

Probably 90 percent of all stocks outstanding today are common stock since it has a
broader appeal to investors than preferred stock. Since the yield is fixed, the price of
preferred stock generally will not increase as the company becomes more profitable and
successful. Thus, the typical preferred stock holder does not benefit from price
appreciation as would a common stock holder. Instead, the price of preferred stock is
based on prevailing interest rates.

Thus stockholder can expect to receive their income in the form of capital gains as well
as dividends. The board controls the distribution of income between dividends and capital
gains through its control over the fraction of earnings distributed as dividends.

2. Bond:
Bond represents the debt instruments which represents borrowing. These are also known
as contractual obligations since the creation of a debt is implemented by some form of
contract fixing the rate of interest and defining the terms and conditions of repayment.
Bonds exist in a wide variety of forms- the corporate bonds (debentures), government
bonds, municipal bonds, etc. The firm which wants to raise a few millions amounts prints
up fancy piece of papers called bonds and try to sell them. Many individuals and financial
institutions are interested in buying these papers. This paper states that the issuer (the
borrower) promises to pay whoever owns the bond (the lender) certain interest payments
at specified dates in the future. The paper also states when the bond will mature- the date
when the loan will be paid off to whoever owns the bond at that time. Some bonds have
an original maturity of only a few years, while others have twenty or thirty years. At
times, perpetual bonds called consoles have also been issued. The differentiation
made in bonds as notes and bonds are also seen, according to the maturity period.
Notes have maturities at issue of ten or fewer years, whereas bond maturities exceed ten
years at issue. The term to maturity is also known as tenor. Corporate bonds are often
known as debentures.

Bonds have usually the stated interest rate, which is known as coupon rate. For that
reason, bonds are often termed as coupon securities. However, some bonds have been
issued without coupons, which are refereed as zero-coupon bonds. They are sold
at a discounted price. The interest could be floating also; such debt instruments will be
known as floating rate instruments. These are debt securities whose coupon
rates vary over time according to a predetermined formula. The coupon rate is pegged to
a reference rate such as the prime rate or T-bill rate. The coupon rate equals the reference
rate plus a mark-up to reflect the credit risk of the issuer. The coupon rate is reset at
regular intervals.

Most corporate bonds contain call provisions that allow the issuer to retire the bonds
beyond some specific call date but prior to maturity. Usually, there is a modest premium
paid above par value by corporation to the bondholders when exercising this call. Some
bonds are convertible into common stock at a pre-specified price. This is attractive to
investors because investors can benefit form appreciating stock prices by converting into
common shares, while being protected form depreciating stock prices by retaining the
bond status. Because of this attractive feature, convertible have lower promised coupon
payments than ordinary bonds. The option of conversion is a sweetener attached to
straight debt. Since holders of a convertible have a choice to convert debt into equity, the
agency problem is reduced. Often convertibles are viewed as delayed equity.
Convertibles will also result in lower dilution.
Types of Bonds:
Corporate bonds come in five main varieties
A. Those backed by the full faith and credit of the corporation, but no specific
collateral, are referred to as debentures.
B. Debentures that have a secondary claim to the general assets and revenues of a
firm are called subordinated debentures. In the event of a default,
holders of such subordinated securities must wait until the claims of the senior
debt obligations have been satisfied before they are eligible to receive the
proceeds of asset liquidations.
C. Bonds backed by mortgage collateral assets are referred to as mortgage
bonds.
D. Bonds backed by marketable securities are known as collateral trust
bonds.
E. Bonds backed by rolling stock are termed equipment obligations.

Mortgage bonds, collateral trust bonds, and equipment trust certificates are examples of
secured bonds or senior debts.

The nature of any bond is indicated by its bond indenture. It is the legal document
that spells out the rights and obligations of the issuer and the investor. In it, the collateral
is specified; protective covenants such as limits on executive salary, additional debt, and
future dividends are listed; and payment dates are set forth. In addition, provisions are
stipulated for default, call and sinking funds.

As per the convertibility, the debentures can be categorized in three groups as-
non-convertible, partly-convertible, and fully-convertible. A non-convertible debenture is
a straight debt instrument. A fully-convertible debenture gets converted into shares of the
company at a specified price after a specified period of time. In case of partly-convertible
debentures only a portion of the principal gets converted into shares with the remaining
portion being redeemed at maturity.

Companies with high leverage ratios and smaller capitalization should give higher post-
conversion ownership (and put provision) and companies with valuable growth
opportunities could issue convertibles with shorter maturities and less call-protection and
issue those with longer maturities when credit is easy to get. Firms with predictable
taxable income could issue ‘debt like’ instruments to take advantage of tax-deductibility
of interest expense and issue ‘equity like’ instruments when the outlook for the economy
is good. At the times of issue, the coupon on convertible is set higher than dividends on
the share (otherwise the investor will immediately convert). As long as the coupon is
higher than dividends, the investor enjoys higher income, simultaneously retaining the
option. The issuer can induce investors to convert by raising dividends. When dividends
are sufficiently high bondholders voluntarily decide to convert. Since the objective of the
management is to maximize the value of stock, the bond could be called as soon as the
conversion value reaches the call price.
Bond Rating:
Corporate bonds offered to investors in public market are rated according to their
perceived risk. Standard and Poor’s Corporation and Moody’s investors service
Incorporations are the two principal rating agencies. The greater the risk, lower will be
the ratings. Expected yields increases as the rated risk increases. The bonds are rated as
the rating like AAA (highest grade, as per Standard & Poor’s), BBB (medium grade),
CCC (very speculative bonds) and likewise.

Major investors in corporate bonds are life insurance companies, state and local
employee retirement funds, private pension funds, and foreigner. There is relatively little
trading in these securities, and the secondary markets are therefore proportionately small.

The market of bonds is also affected by the different external factors. The effect of 9/11
was one very crucial example of American Securities Market. The bonds of dozen of
firms were trading at or close to levels that suggested their imminent bankruptcy.
Because bonds investors do not usually earn more from their investment than their
coupon, they heavily worry more about getting their principal back than investors in
shares, whose potential upside is limited only to a company’s ability to earn profits in
future.

3. Mortgage Loans:
Loans granted for the purchase and construction of real property, that is, land and
buildings, are called ‘mortgage loans’ because, in almost all instance, the borrower is
required to pledge the property to the lender as security for the loan. For the average
consumer, a mortgage loan is multi-year loan obtained form a retail lender that uses the
value of the real property as collateral. The document by which the pledge is made is the
mortgage. The borrower signs a mortgage note in which he specifically promises to repay
the loan- probably in periodic installments- with interest at a designated rate. He also
binds himself to other ‘covenants’ such as to keep the property in a good state of repair,
to pay taxes levied on it, and to provide adequate insurance coverage. If he defaults on his
interest or principal obligations or the additional covenants, the lender is privileged to
take legal actions to get clear title to the pledged property and to sell it to recover the
unpaid principal of its loan and accumulated unpaid interest. If, on the other hand, the
borrower meets all his obligations, the lender gives him a written document called a
‘satisfaction of mortgage’. Like bonds, mortgages are debt instrument. In this
case loan is generally amortized, which means that the principal is gradually repaid along
with the interest, during the life of mortgage.

Mortgages are classified in different ways like: one-to-four-family home mortgages,

multifamily residential mortgages (apartment houses), and commercial (including farm)
mortgages. Mortgages are also classified by whether or not they are insured by
government agency. Traditionally, mortgages were normal fixed-rate securities, with the
interest rate fixed over the life of the loan. But in the early eighties, they led the
movement to variable-rate (or floating rate) debt, with the interest rate adjusted
periodically to reflect the changes in financial environment.
Commercial bank, saving institutions, insurance companies, mortgage pools and the
individual investors are the major investors of mortgage.

4. Rights:
Growing corporations frequently need to raise additional capital. They do this by issuing
bonds or / by selling new shares of stock. If additional stock is sold, stockholder of most
corporations will experience dilution of their ownership position. The issuing corporation
often prefers selling shares to current stockholder because it is less expensive. A right is a
legal instrument offered to a stock holder to purchase a proportionate number of shares of
new company stock at a specific price during a limited time period. Rights have intrinsic
financial value because they are normally offered at a price somewhat lower than the
current market value of the stock. Consequently, a market exists for the baying and
selling of rights, and once again we enter the world of the speculator. An especially,
attractive speculative investment is using margin to buy rights with the hope that the
value will rise.

5. Derivatives:
Derivatives are given their names as derivatives because their value is derived from the
underlying asset with which they are associated. These instruments provide investors
with confidence that a degree of liquidity is maintained.

Option and Futures:

Option and futures are often lumped together, because they both represent contractual
agreements between two parties concerning some third asset. Thus, both options and
futures are often called derivative financial instruments, because they derive their value
from an underlying asset. Options and futures are also similar in that they are both traded
on organized securities exchange. Option and futures are not used by corporations or
individuals to raise funds. But, the differences between these two instruments far
outweight their similarities.

a. Options:
Options contracts also deal in rights and obligations with respect to an underlying asset.
An option gives its holder the right to buy or sell a particular asset at a particular price on
(or possibly before) a particular expiration date. However, these rights and obligations are
separated, there are two types of options- call and put options.

Call option gives its holder the right to buy an asset at a particular price (called the
strike price). A put option gives its holder the right to sell at a particular price. Put
and call options are examples of secondary securities. They are not issued by the firms,
and the net supply of these securities is zero. Options are written and sold by individual
investors. If one sells a call option, he gives someone the right to buy a share of stock
form you at a stated price. He receives cash upon its sale, and he can carry the obligation
as a liability. If one buys a call option, he purchases the right to buy the stock. He pays
cash upon purchase, and carries the option as asset. The seller of these options, called
option writers, have the obligation to sell or buy the underlying assets as the case may be,
and in return receive payment, called the option premium. Organized call option trading
began in the US with the creation of the Chicago Board Option Exchange in
April 1973, followed by the introduction of put option trading in June 1977. In Canada,
call option trading began in mid-September 1975 and put option trading was added in
1978.

Cap, Floor and Collars

A cap is a call option on interest rates, often with multiple exercise dates. A floor is a put
option on interest rates, often with multiple exercise dates. Collar is a position taken
simultaneously in a cap and a floor.

b. Future:
Investors can profit from increase or decrease in the prices of various commodities by
purchasing and selling future contracts. A future contract deals in both rights and
obligations regarding the underlying commodity. The buyer of futures, also called the
long, has the right and obligation to receive the underlying commodity, at some future
date. The seller of the futures, also called the short, has the right and obligation to
deliver the asset on a specific date in the future. Forward contracts are also very similar
with futures contracts. These contracts obligate you to buy or sell commodity at a
particular price on a particular day. The price at which the asset is transferred is
negotiated when the contract is sold by the short to the long on the floor of a future
exchange. Thus, both parties know exactly how much the asset will cost them in future
time. If prices go up in the meantime, the long makes money and the short lose money.
Forward, can do something none of the contract can. Their values can become negative!
If you have obligated yourself to buy a commodity at a price of Rs 100 and the
commodity is currently selling at a price of Rs 70, the values of your forward contract to
buy is negative. Forward contracts serve two main functions-price protection and transfer
of asset ownership. One reason why people buy and sell future contracts, therefore, is that
they disagree on the future course of prices for an underlying asset and hope to profit as
prices move in their anticipated direction. Another reason is that selling or buying the
asset at a known price at a specific date in the future eliminates the risk of price
fluctuation for someone who must buy or sell the asset in future.

When originated, the contracted price you must later buy or sell for is set such that the
buyer and seller will exchange the contract with no associated cash payment. That is, the
forward or futures prices set to make the current market value to the contract equal to
zero. The market value of a forward contract is allowed to subsequently become positive
or negative as the commodity price goes up or down. In the case of a futures contract,
however, one aspect of the contract is changed each day to keep the market value of the
contract at zero. The aspect of the contract that is revised is the future’s price, in a
process called marking to market. The process of marking to market is an
important feature which differentiated a future from a forward contract.

Futures are written on commodities such as gold, silver and agricultural products as well
as various financial contracts such as treasury bills, treasury bonds, pass-through and
even stocks. The market for financial futures is currently exploding in terms of types of
contract traded, volume of trading, and investor interest.

c. Warrants:
A warrant, on the other hand, is a primary security. It is issued by a firm, and it is a claim
on the assets of the firm. A warrant is in all other respects, identical to a call option,
although warrants usually have longer lives than call options. A warrant gives it holder
the right to purchase shares of stock in the firm at a particular price before a particular
date. If the warrant is exercised, the firm must issue new shares of common stock to the
holder of the warrant. Thus, the effect of exercise is to dilute the per share value of the
stock. Warrants are often given to executives as part of their compensation. They are also
frequently attached to other securities, such as bonds and preferred stock offerings. When
originally issued to make the issue more attractive to investors.

A distinction between a right and a warrant is that right are issued as a pre-emptive right
to current stockholder whereas warrants are issued attached to other securities. Some of
these warrants are detachable and some are not; a trading market exists for detachable
warrants. Warrants are sometimes called purchase warrants and each has a speculative
value until the expiration date, at which time it may be worthless.

d. Swaps:
Swaps are more recent addition to the financial markets than the contingent claims
discussed so far. The swaps market has been in existence since the early 1980s, and the
introduction of standardized contracts and dealing mechanism through the
Intellectual Swap Dealers Association has lowered the transaction costs
and made operations more accessible to users. Currency and interest rate swaps are the
most common types in the market. A currency swap transfers obligation for payment in
one currency to another party who, in turn, undertakes an obligation for payment in
another currency. The difference between the two types of swaps is that an interest rate
swap only involves the exchange of interest payments, while the principle remains the
obligation of the initial borrower. Therefore the riskiness of the loan is still associated
with the writer of the debt, and not transferred. Swaps are conducted through an
intermediary, usually a market-maker, or a bank, which accepts the default risk, and earns
a fee from both participants dependent on the level of that risk. Swap prices are negotiate
by auction, usually conducted on the telephone, are very much under the control of the
market-maker.

Securities Innovation:
One of the chief characteristics of financial market is their ability to develop innovative
financial instruments. The last two decades have witnessed unprecedented innovation in
the range of and manner in which firm issues securities. Just as engineers apply scientific
principles to design new products and services, financial engineers apply principles of
financial economics for the purpose of structuring, pricing and managing the risk of
financial contracts. Financial engineering involves the design, development and
implementation of innovative financial instruments and processes, and the formulation of
creative solution to problems in corporate finance. Innovative instruments make financial
markets more complete and efficient.

The major factors that are responsible for financial innovation

are:
• Transaction costs.
• Taxation
• Agency cost
• Risk-opportunities to reduce some forms of risk or to reallocate risk from one
market participant to another whose either less risk averse or else willing to bear
the risk at a lower cost,
• Opportunities to increase an asset’s liquidity
• Regulatory and legislative changes
• Level and volatility of prices and interest rates
• New financial theories and similar other technological factors

Recent innovations include the creation of asset-backed securities, which are securities
that are collateralized by cash flows from assets, like mortgages and account receivables.

Overview of Financial markets and Instruments of

Nepal
Nepalese financial market has not the very old history. The issuances of government
securities as well as corporate securities have not made a long history in Nepal. In the
corporate sector the shares floated by the Biratnagar Jute Mills, the first corporate entity
in Nepal, in 1936 AD, were the first common stock issued for public. It issued 8,000
ordinary shares of Rs 100 each. Not only for common stocks, Biratnagar Jute mills is the
pioneer for the issuance of debentures also. It issued 1600 debentures of Rs 500 each. In
Nepal, the treasury-bill, for the first time, was issued by the government, four decades
ago, in 1962. Likewise, Development Bonds were issued for the first time in 1964.

Very few companies followed the Biratnagar Jute Mills. Due to very high dividend (i.e.
110%) declared by the Mill, some companies’ issuance even resulted in over-subscription
by three to four times. Before the establishment of Security Exchange Center (SEC),
there were no institutional arrangements to undertake and to manage the new issues of
securities. Initial Public offerings (IPO’s) have to be made as per the provision of the then
Company Acts. But, the provisions made in Company Acts were not adequate and
relevant. The Company Act 1936 had not even included preference share as corporate
securities. It was recognized as corporate security only by Company Act 1964.

Later on, then government felt that, one separate body should be established to give a
systematic figure to the financial market of Nepal. As a result, SEC came into existence
in 1976. At that time, to handle or manage the purchase and sale of government securities
became its major activity due to very few public issues made by corporate bodies.
Till 1983, the concept of well structured secondary market has not evolved in Nepal. No
separate acts were there to regulate trading of securities. It was 1983, when the first
Security Exchange Act 1983 got enacted. The act prohibited the exchange of unlisted
securities. It entrusted the SEC as the operator as well as regulator of stock exchange.
Since November 1984, SEC operated the stock exchanges by listing the corporate
securities. Actually that Security Exchange Act 1983 has created dual responsibilities-
operator and regulator- for SEC that was difficult and contradictory also. That
necessitated the reform in that act, which later on resulted on amendment in Security
Exchange Act in 1992 which came into force since 1993. This amendment converted
SEC into Nepal Stock Exchange Limited (NEPSE) and created a separate body-
Securities Board (SEBO). NPSE is acting till now as an organized exchange market in
Nepal. In 1993, Government of Nepal also released Securities Exchange Regulations
1993 for the effective implementation of Security Exchange Act. This regulation made
detailed provisions regarding licensing, operating, registration, listings, as well as
functions, powers and duties of SEBO. Further on, SEBO was empowered as an apex
regulator of the capital market, by the second amendment in Security Exchange Act in
1997.

In this way, finally capital market has got a structured shape and institutional
arrangement. It is still growing and developing. SEBO is developing several guidelines
and directives to regulate the stock exchanges, IPO’s, issuing bodies, and brokers.
NEPSE is also empowered to make bylaws to regulate listing and trading of securities.

Although, the history of financial instruments in Nepal begins with the issues made by
Biratnagar Jute mills, it got further developments only after the restoration of democracy
and liberalization policy. Between 1984 and 1990, 42 companies were listed, out of
which more than 25 companies had some form of government ownership. The growth of
the stock market has mainly been due to the liberalization and the resulting growth of the
financial sector (commercial banks and finance companies) rather than that of the
industrial sector.

The companies like Bank, finance, insurance, hotel, manufacturing, trade, aviation,
hydropower etc have entered security market for their capital but the companies form the
sectors like construction, information technology etc have not entered in security market,
so far. The commercial banking industry has historically performed very well in the
capital markets.

Current Picture:
• At the end of the fiscal year 2004/05 there were 125 companies listed in the
security market of Nepal, which has increased by more than 9% form the last
fiscal year
• Total market capitalization of the listed companies at the end of the fiscal year
2004/05 is recorded to be Rs 61365.89 million, which is 48% higher than that of
the previous fiscal year.
• In the fiscal year 2004/05, the contribution of market capitalization to the GDP
has been estimated to be 12.17%
 • The price index of the listed securities (NEPSE index) has closed at 286.67 points
in the fiscal year 2004/05. It is 64.63 points higher than that of the previous fiscal
year.
• In the fiscal year 2004/05, 13 companies consisting of four commercial bank, two
development banks, six finance companies and one hydropower company issued
their securities to the public. The amount of issue was Rs 1476.82 million
• Out of 125 listed companies, NEPSE classified 48 companies consisting of nine
commercial banks, one development bank, 27 finance companies, 10 insurance
companies and one manufacturing and processing company under group “A” and
the rest under group “B”, as per the provision of the “Securities Listing Bye-
Laws, 1996”.
• The total paid-up value of the listed securities at the end of the fiscal year 2004/05
reached Rs 16771.85 million

Investors in Nepal are of varied types. Some are small investors who hold just 10 or 20
shares of a company. However, some inventors are so cunning and shrewd that they play
with different securities to earn more. Very few investors have technical knowledge of
investments like: portfolio formation and risk diversification. Besides, institutional
investors are also the major segment. Although they are not actively participating in the
secondary market, in the primary market they are also considered as the notable segment
of investors, or the purchasers of the securities.

Secondary market:
As discussed in prior segments, secondary markets are those in which outstanding
securities are traded among the investors. Though the company has no direct role in
secondary trade, financial manager’s aim is always to maximize the firm’s stock price, to
maximize the value of stock holders’ wealth. Thus, fort the financial manger, the most
important is the secondary securities market where the prices of firm’s stocks are
established.

Secondary market simply means the market where the different types of securities are
traded. For example Nepal Stock Exchange. Such exchange is known as the physical
location exchange. This type of exchange is the formal organization having
tangible physical location that conducts the auction or the trading of the listed securities.
Other major stock exchanges are New York Stock Exchange, American Stock Exchange
and so on. Such exchange operates through the security brokers.

Over the counter market:

This is not the physically located exchanges, neither the formal organization. A large
number of brokers and dealers, connected electronically by telephone and computers,
trade the unlisted securities, in such market. Such markets are also known as Dealer
market. This includes all facilities that are needed to conduct security transactions not
conducted on the organized exchanges. These facilities include: the inventories of the
securities (only few dealer-the broker firms-hold such inventories), brokers who act as
the agent in bringing the dealers together with investors, the computers, terminals, and
electronic networks that provide a communication link between dealers and brokers.
NASD- National Association of Securities Dealers- is a self regulatory
body of the brokers and dealers who participate in the over the counter market. NASD
licenses the brokers and oversees the trading practices. The computerized network used
by the NASD is known as the NASD Automated Quotation system –NASDAQ- which
has grown to become an organized securities market with its own listing requirements.