Financial derivatives are financial contracts whose value is derived from an underlying asset, index, rate, or event. The underlying may be a share, bond, currency, interest rate, commodity (gold, oil), or even weather. The contract itself has little or no intrinsic value at inception; its price moves with the underlying. The main types are:

• Forwards — a customised agreement to buy/sell an asset at a fixed price on a future date (traded over-the-counter, OTC).
• Futures — standardised, exchange-traded forwards with daily mark-to-market and clearing-house guarantee.
• Options — the right (not obligation) to buy (call) or sell (put) at a strike price before/on expiry; the buyer pays a premium.
• Swaps — exchange of cash-flow streams, e.g. fixed-for-floating interest rate swaps, currency swaps.
• Other — caps, floors, collars, credit default swaps (CDS), swaptions.

In Nepal, derivatives are still at an early stage: NEPSE has no active futures/options market, but banks use forwards and swaps for foreign exchange and interest-rate risk, and Nepal Rastra Bank permits limited hedging products.

---

Risks of Derivatives

1. Market risk — adverse movement in the underlying price (rate, exchange rate, index) causes loss on the position.
2. Credit (counterparty) risk — the other party defaults before settlement; high in OTC forwards and swaps where there is no clearing house.
3. Liquidity risk — the contract cannot be closed or sold quickly at a fair price; common in customised OTC deals and in thin markets like Nepal.
4. Operational risk — faulty models, wrong valuation, settlement errors, weak IT and back-office systems.
5. Legal and regulatory risk — unenforceable contracts, unclear netting law, changing NRB/SEBON rules.
6. Basis risk — the hedging instrument does not move exactly with the hedged exposure (e.g. hedging NPR/USD with a USD/INR-linked contract).
7. Leverage risk — small margin controls a large notional, so losses can exceed the initial outlay; speculative misuse caused the 2008 global crisis and the 1995 Barings collapse.
8. Systemic risk — failure of one large player spreads through interconnected positions.

Benefits of Derivatives

1. Risk transfer and hedging — exporters, importers and banks lock in exchange rates and interest costs, stabilising cash flows.
2. Price discovery — futures prices reveal the market's expected future price, helping planning.
3. Liquidity and market depth — standardised contracts attract many buyers and sellers.
4. Lower transaction cost — hedging with derivatives is cheaper than restructuring the underlying asset.
5. Capital efficiency — only margin/premium is blocked, not the full asset value.
6. Arbitrage and efficiency — keeps cash and derivative prices aligned, improving market efficiency.
7. Portfolio management — used to alter exposure (beta, duration) quickly without selling the underlying.
8. Access to new markets — investors gain exposure to assets, currencies, or commodities otherwise hard to reach.

---

How to Manage These Risks and Benefits — Suggestions

For the institution (bank/corporate):

1. Clear policy and mandate — a board-approved derivatives policy stating purpose (hedging, not speculation), permitted products, limits, and authorised dealers.
2. Limit system — counterparty limits, notional limits, stop-loss limits, and value-at-risk (VaR) ceilings per desk and per dealer.
3. Credit risk control — credit assessment of counterparties, ISDA-style master agreements, collateral/margin, and netting arrangements.
4. Mark-to-market and revaluation — daily valuation of all positions, independent of the front office.
5. Segregation of duties — separate front office (dealing), middle office (risk control), and back office (settlement and accounting).
6. Hedging discipline — hedge only genuine underlying exposure; match tenor and currency to avoid basis risk; avoid naked positions.
7. Model and system control — validated pricing models, tested IT systems, contingency plans.
8. Training and ethics — certified dealers, continuous training, whistle-blower policy, and a strong risk culture.
9. Capital and provisioning — hold capital against market and credit risk as per NRB directives; provide for expected losses.
10. Disclosure and audit — internal audit, external audit, and disclosure of derivative exposures to the board and regulators.

For the regulator (NRB/SEBON):

1. Issue clear product-approval and reporting guidelines; permit only simple, well-understood hedges first.
2. Strengthen netting and collateral law so close-out is legally certain.
3. Require capital adequacy, exposure limits, and stress testing.
4. Develop exchange-traded, centrally cleared products to cut counterparty risk.
5. Build supervisory capacity — trained examiners, off-site surveillance, and data collection.

For the market as a whole:

1. Develop market infrastructure — clearing house, central counterparty, reliable benchmark rates and yield curve.
2. Improve liquidity through market makers and wider participation.
3. Promote financial literacy so users understand leverage and payoff profiles.

Conclusion: Derivatives are useful risk-management tools, but they concentrate market, credit, and operational risks. Used with a clear hedging mandate, strong limits, independent risk control, proper collateral, and sound regulation, they protect earnings and add depth to Nepal's financial market; used for speculation without controls, they can cause severe losses. The right path for Nepal is gradual, well-regulated introduction of simple, transparent, centrally cleared products.

1. Objectives of Financial Sector Reform

Financial sector reform (FSR) refers to deliberate policy measures aimed at making the financial system sound, efficient, competitive and inclusive. Its principal objectives are:

1. Financial stability — building a banking and financial system capable of absorbing shocks and avoiding systemic crises.
2. Efficiency and competition — reducing monopoly, encouraging new entrants (domestic and foreign), and improving the quality and cost of financial services.
3. Resource mobilisation and financial deepening — increasing savings, credit and the ratio of financial assets to GDP.
4. Allocative efficiency — directing credit towards productive, high-return sectors rather than on political or directed-lending considerations.
5. Strengthening regulation and supervision — adopting international standards (Basel norms, CAMELS, risk-based supervision) and improving supervisory capacity.
6. Institutional strengthening — restructuring weak banks, improving corporate governance, and developing money and capital markets.
7. Financial inclusion — extending banking access to rural, remote, poor and unbanked populations.
8. Integration with the global financial system — liberalising the external sector, current/capital account convertibility, and attracting foreign investment.
9. Consumer protection and market discipline — transparency, disclosure, deposit insurance and grievance-handling mechanisms.

2. Major Obstacles in Implementing Effective Financial Reform in Nepal

A. Institutional and governance obstacles

1. Weak corporate governance in many banks and financial institutions (BFIs); board interference and related-party lending.
2. Political instability and frequent changes in government, which break policy continuity.
3. Politicisation of appointments in regulatory bodies and state-owned banks.

B. Regulatory and supervisory obstacles

1. Limited supervisory capacity — shortage of trained supervisors, weak off-site and risk-based supervision.
2. Dual/multiple regulatory overlap and coordination gaps among NRB, SEBON, Beema Samiti and the Ministry of Finance.
3. Weak enforcement — penalties are small and cases drag on for years.

C. Structural and market obstacles

1. Dominance of banks over capital markets, insurance and cooperatives; shallow bond and equity markets.
2. Large informal financial sector (dhukuti, unregistered lenders) outside regulation.
3. Proliferation of BFIs in the past, leading to fragmentation and unhealthy competition.

D. Operational obstacles

1. High non-performing loans (NPLs) and weak loan recovery, including through debtors' protection provisions.
2. Low financial literacy, especially in rural areas.
3. Inadequate credit information, weak accounting and audit standards, and poor disclosure practices.

E. External and macroeconomic obstacles

1. Balance of payments pressure and foreign exchange constraints limiting liberalisation.
2. Remittance dependence making the financial system vulnerable to external shocks.
3. Pressure from interest groups (bankers' associations, unions) resisting reforms.

3. Potential Strategies to Overcome the Obstacles

Conclusion: Financial sector reform in Nepal has achieved notable progress — consolidation of BFIs, adoption of Basel III, improved access to finance — but its effectiveness is constrained by political instability, weak governance and limited supervisory capacity. Sustained reform therefore requires not only technical measures but also political commitment, institutional autonomy and continuous capacity building.

Significance of Capital Budgeting

Capital budgeting is the process of evaluating and selecting long-term investment projects whose returns are expected over more than one year (plant, machinery, expansion, replacement, new product lines). Its significance:

1. Huge and irreversible commitment of funds — long-term assets lock up large sums for years; a wrong decision is costly to reverse.
2. Determines the firm's growth and profitability — the asset mix chosen today decides future earning capacity and competitive position.
3. Wealth maximisation of shareholders — only projects with returns above the cost of capital add value (positive NPV).
4. Risk exposure over the long run — long payback periods expose the firm to demand, cost, technology and political risks.
5. Capital rationing — funds are scarce, so projects must be ranked and the best combination selected.
6. Financing and dividend policy implications — large projects affect the firm's debt capacity, capital structure and dividend-paying ability.
7. Long-term commitment of managerial talent — scarce managerial and technical skills get tied up for years.

Capital Budgeting Evaluation Techniques

A. Traditional (non-discounting) techniques

(i) Payback Period (PBP) Time required to recover the initial investment from cash inflows. $PBP = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow (if uniform)}}$ Merits: simple, easy to understand; measures liquidity; less risky (short payback); useful where funds are tight. Demerits: ignores time value of money; ignores cash flows after the payback period; no objective accept/reject criterion; not a measure of profitability.

(ii) Accounting Rate of Return (ARR) $ARR = \frac{\text{Average Annual Profit After Tax}}{\text{Average Investment}} \times 100$ Merits: based on accounting profit, easily available; considers the whole project life; simple. Demerits: ignores time value of money; uses accounting profit, not cash flow; no unique accept/reject rule.

B. Discounted (modern) techniques

(iii) Net Present Value (NPV) $NPV = \sum_{t=1}^{n} \frac{CF_t}{(1+k)^t} - I_0$ Decision rule: accept if NPV > 0; reject if NPV < 0; for mutually exclusive projects, choose the highest NPV. Merits: considers time value of money and all cash flows over the whole life; consistent with the goal of wealth maximisation; additive, so projects can be combined and ranked; uses the opportunity cost of capital. Demerits: requires an accurate discount rate; difficult when projects have unequal lives; absolute figure (not comparable across projects of different size); ignores the option value of postponement.

(iv) Internal Rate of Return (IRR) The discount rate at which NPV = 0: $\sum_{t=1}^{n} \frac{CF_t}{(1+IRR)^t} = I_0$ Decision rule: accept if IRR > required rate (k). Merits: considers time value of money and all cash flows; gives a percentage, easy to compare with the cost of capital; no need to pre-specify k. Demerits: tedious trial-and-error calculation; may give multiple IRRs when cash flows change sign; can conflict with NPV in ranking (scale and timing differences); assumes reinvestment at IRR, which is unrealistic.

(v) Profitability Index (PI) / Benefit–Cost Ratio $PI = \frac{\text{PV of Cash Inflows}}{I_0} = 1 + \frac{NPV}{I_0}$ Decision rule: accept if PI > 1. Merits: considers time value of money; relative measure, so useful under capital rationing and for comparing projects of different sizes. Demerits: can conflict with NPV in ranking; the discount rate must still be known; not suitable when projects are mutually exclusive and of different scale.

(vi) Discounted Payback Period — payback computed on discounted cash flows. Merits: combines liquidity with time value of money. Demerits: still ignores cash flows beyond the payback period.

Which Technique Is the Best?

NPV is the best technique, for the following reasons:

1. Directly measures wealth maximisation — a positive NPV is exactly the addition to shareholder wealth, which is the firm's primary objective. IRR and PI only indicate relative attractiveness.
2. Uses the opportunity cost of capital — cash flows are discounted at the rate actually available in the market, so the reinvestment assumption is realistic. IRR wrongly assumes reinvestment at the IRR itself.
3. No multiple-rate or no-rate problem — IRR can give multiple or no solutions with non-conventional cash flows; NPV always gives one unambiguous figure.
4. Additive and consistent — NPVs of projects can be summed, so the value of a combination of projects is known; this is essential under capital rationing.
5. Unambiguous ranking — for mutually exclusive projects, the highest NPV always identifies the project that adds most value, whereas IRR and PI can give conflicting rankings when project size or timing of cash flows differs.
6. Flexible — the discount rate can be changed for projects of differing risk, and NPV can be extended to risk-adjusted and real-options analysis.

PI is superior only in the special case of capital rationing, where funds must be allocated among divisible projects; and IRR is preferred by many managers because it is expressed as a rate and needs no discount rate. But on theoretical grounds — consistency with the objective of maximising shareholders' wealth — NPV is the superior and generally recommended technique.

Portfolio Management Process: Asset Class Analysis, Risk Assessment and Rebalancing

Portfolio management is the continuous process of constructing and maintaining a collection of assets so that the investor's risk-return objectives are met over time. For a bank such as Nepal Bank Ltd., which manages both its own investment portfolio and those of its clients, this process is not a one-time exercise but a cycle of planning, execution, monitoring and revision. The three elements named in the question — asset class analysis and selection, risk assessment in portfolio construction, and portfolio rebalancing — are the core stages of this cycle. Each is analysed below.

1. Asset Class Analysis and Selection

Asset class analysis is the starting point of portfolio construction. It involves identifying the broad classes of assets available to the investor and studying their risk, return, liquidity, tax and correlation characteristics before selecting the mix.

Major asset classes available in Nepal:

Importance of asset class analysis:

• Return determination: Academic evidence and Nepali practice both show that the choice of asset classes, not individual security selection, explains the bulk of a portfolio's return variability. A portfolio heavy in fixed deposits will behave very differently from one heavy in NEPSE equity.
• Diversification: Asset classes have imperfectly correlated returns. When NEPSE falls, NRB bonds and fixed deposits generally hold value, cushioning the portfolio. This is the practical basis of the "don't put all eggs in one basket" principle.
• Suitability and mandate: A pension fund, a bank's treasury portfolio and a retail investor have different liquidity needs, regulatory limits (NRB directives cap sectoral and single-borrower exposures) and time horizons. Asset class analysis aligns the portfolio with these constraints.
• Selection: Once classes are chosen, specific securities are selected within each class — e.g., choosing between a 5-year NRB development bond and a commercial bank debenture, or between a blue-chip bank script and a hydropower script — based on valuation, credit quality and expected return.

2. Risk Assessment in Portfolio Construction

Risk assessment converts the investor's objectives into measurable constraints and ensures the portfolio's expected return is commensurate with the risk taken. Key dimensions:

• Risk identification: Market risk (systematic, non-diversifiable), credit/default risk (relevant for debentures and loans), interest rate risk (duration of bonds), liquidity risk (ability to exit without price concession), inflation risk, and for banks, regulatory and concentration risk.
• Risk measurement: Standard deviation of returns, beta (sensitivity to NEPSE movements), Value at Risk (VaR), duration and credit ratings. For a bank portfolio, NRB's capital adequacy and investment limits act as hard risk ceilings.
• Risk-return trade-off: The efficient frontier concept shows that for a given level of risk, only one portfolio mix maximises return. The investor's risk aversion determines the chosen point on this frontier — a conservative investor holds more fixed income, an aggressive one more equity.
• Correlation and covariance: Portfolio risk depends not only on individual asset risks but on how they move together. Low or negative correlation between asset classes reduces total portfolio variance without sacrificing return — the mathematical basis of diversification.
• Stress testing and scenario analysis: Assessing how the portfolio would behave under adverse events (e.g., a NEPSE correction, a spike in interest rates, or a liquidity crunch) so that contingency plans exist.

3. Portfolio Rebalancing

Rebalancing is the periodic realignment of the portfolio back to its target asset allocation. It is essential because market movements cause the actual weights to drift from the desired weights, silently changing the portfolio's risk profile.

Why rebalancing matters:

• Restores risk-return objectives: If equity rallies strongly, its weight rises above target, making the portfolio riskier than intended. Rebalancing trims equity and adds fixed income, restoring the desired risk level.
• Enforces a disciplined buy-low, sell-high approach: It systematically sells what has become relatively expensive and buys what has become relatively cheap, avoiding emotional, momentum-driven decisions.
• Prevents concentration: Without rebalancing, one asset or sector can dominate the portfolio, defeating diversification and increasing vulnerability to a single shock.
• Adapts to changing circumstances: Rebalancing also accommodates changes in the investor's life stage, liquidity needs, or regulatory limits.

Methods of rebalancing:

For a bank, rebalancing must also respect transaction costs, tax implications and NRB exposure limits, so a threshold approach with periodic review is generally preferred.

4. The Integrated Portfolio Management Process

The three elements operate as a continuous cycle:

1. Planning: Define objectives, constraints and the Investment Policy Statement.
2. Asset class analysis and selection: Study available classes and decide the strategic asset allocation.
3. Portfolio construction: Select securities within each class, applying risk assessment (diversification, beta, VaR, regulatory limits) to build an efficient portfolio.
4. Monitoring: Track performance, risk metrics and market conditions.
5. Rebalancing: Realign weights to target when drift or changed circumstances warrant.
6. Review and revision: Revisit the policy and allocation as objectives or markets change, then repeat the cycle.

Conclusion

Asset class analysis and selection provide the strategic foundation by determining the return potential and diversification of the portfolio. Risk assessment ensures that the portfolio's expected return is matched to the investor's tolerance and to regulatory constraints. Rebalancing keeps the portfolio on course as markets move, preserving the intended risk-return profile. Together, these three elements form a disciplined, ongoing portfolio management process that is as relevant to Nepal Bank's treasury operations as it is to its client advisory services.

Capital budgeting is the process of evaluating, selecting and financing long-term investment projects whose benefits extend beyond one accounting year — plant and machinery, branch expansion, technology systems, or a new product line. For a bank such as Nepal Bank Limited, it also covers large, lumpy commitments like core banking software, ATM and digital channel networks, and treasury or subsidiary investments. Its significance in strategic financial planning rests on the following:

1. Link between strategy and resource allocation. Strategic plans are only realisable if capital is directed to the projects that actually deliver the chosen strategy. Capital budgeting converts strategy into a ranked, funded list of projects.
2. Large, irreversible commitments. Long-term assets lock up funds for years and are difficult to reverse without heavy loss. A wrong decision therefore damages the bank's earnings and capital base for many years.
3. Magnitude of funds involved. Such projects typically absorb a large share of the bank's investible funds, so each decision materially affects the balance sheet, capital adequacy and liquidity.
4. Long-term consequences and risk. Returns accrue over a long horizon, exposing the bank to interest-rate, technology, regulatory and market risk. Systematic appraisal is the only defence.
5. Wealth maximisation and shareholder value. The basic financial objective — maximising shareholder wealth — is achieved only when projects earn more than their cost of capital.
6. Coordination of functional plans. It forces marketing, operations, IT, treasury and risk functions to agree on a common, quantified plan.
7. Capital rationing. Since funds and managerial capacity are scarce, capital budgeting provides the discipline for choosing the best combination of projects.
8. Growth and survival. Replacement, modernisation, expansion and diversification decisions determine whether the bank grows, stagnates or declines.

Techniques and their use

1. Net Present Value (NPV). All expected cash inflows and outflows of the project are discounted to the present at the bank's cost of capital (or weighted average cost of capital) and the initial outlay is deducted:

$\text{NPV} = \sum_{t=1}^{n}\frac{CF_t}{(1+k)^t} - I_0$

Decision rule: accept if NPV > 0, reject if NPV < 0; where projects are mutually exclusive, choose the highest NPV. NPV measures the absolute addition to the bank's value in today's rupees, so it directly tests viability and is the theoretically best criterion because it uses all cash flows, the time value of money and the cost of capital.

2. Internal Rate of Return (IRR). The discount rate at which NPV equals zero:

$0 = \sum_{t=1}^{n}\frac{CF_t}{(1+IRR)^t} - I_0$

Decision rule: accept if IRR > required rate of return (cost of capital); among mutually exclusive projects, choose the highest IRR. IRR expresses viability as a percentage, which managers find easy to compare with the bank's cost of funds or with the yield on alternative uses of money. Its limitations — multiple IRRs with non-conventional cash flows and the reinvestment assumption — mean it should be read together with NPV.

3. Profitability Index (PI). Also called the benefit–cost ratio:

$\text{PI} = \frac{\text{Present value of future cash inflows}}{I_0} = 1 + \frac{\text{NPV}}{I_0}$

Decision rule: accept if PI > 1. PI measures value created per rupee invested, so it is especially useful when capital is rationed: projects are ranked by PI and funds are committed from the top until the budget is exhausted. This is how scarce resources are allocated efficiently, and it is superior to IRR ranking when project sizes differ.

How these techniques serve the stated objectives

• Viability of investment projects. Each technique discounts future cash flows at the cost of capital, so only projects that recover their outlay and earn a surplus are accepted. NPV gives the surplus in rupees, IRR gives it as a rate of return, and PI gives it per rupee invested — together they give a complete viability picture. Non-financial factors (regulatory approval, brand, customer service) are then weighed alongside.
• Efficient allocation of scarce resources. Under capital rationing the bank cannot fund every positive-NPV project. Ranking by PI (or by NPV where the budget is fixed and projects are indivisible) selects the combination with the highest total NPV for the given outlay. This avoids spreading funds thinly over marginal projects and directs them to the highest-yield ones.
• Minimising financial risk. The discount rate is the bank's risk-adjusted cost of capital, so riskier projects are automatically penalised with a higher hurdle rate. Sensitivity analysis, scenario analysis and simulation on the cash-flow estimates show how far NPV can fall before the project turns unviable. Diversification across sectors and geographies, and the use of NPV rather than payback alone, reduce the chance of over-committing to a single risky venture. Capital budgeting also protects capital adequacy by ensuring projects are funded only when they can service their cost.
• Ensuring sustainable growth. By funding replacement and modernisation projects the bank maintains its existing earning capacity; by funding expansion and digital projects it builds new capacity. Since only value-adding projects are accepted, each addition raises the bank's earning base without eroding capital — the essence of sustainable, self-financing growth. Profitable reinvestment compounds shareholder value over time.

Conclusion. Capital budgeting is not merely a project-appraisal exercise; it is the operational core of strategic financial planning. NPV, IRR and PI together establish whether a project is viable, PI and NPV guide the allocation of scarce capital, the risk-adjusted discount rate and sensitivity analysis contain financial risk, and the acceptance of only value-creating projects ensures growth that is both profitable and sustainable.

Major differences between traditional and discounted cash flow techniques of capital budgeting

Techniques appropriate for an investment plan in a hydroelectricity project

A hydropower project is typically characterised by:

• Very large initial capital outlay (dam, tunnel, penstock, powerhouse, turbines, transmission line);
• Long gestation period (5–10 years or more) before generation starts;
• Long economic life (30–50 years or more) with steady revenue from power sales;
• Cash flows spread over decades, so the time value of money is critical;
• High risk — hydrology (water availability), construction delay, cost overrun, currency and PPA (power purchase agreement) risks, regulatory and political risk;
• Often financed by debt plus equity, so the cost of capital and financing structure matter.

Because of these features, discounted cash flow techniques are the most appropriate, supported by traditional techniques as screening tools:

1. Net Present Value (NPV) — primary technique. It discounts all future cash inflows (energy sales revenue, capacity payments) and outflows (construction, O&M, financing) at the project's weighted average cost of capital. A positive NPV means the project adds value to the firm/shareholders. Since hydropower has long-lived, back-loaded cash flows, NPV correctly captures the time value of money. It is also additive, so it can handle phased construction and multiple units.

2. Internal Rate of Return (IRR) — supporting technique. Useful to compare the project's return with the hurdle rate or with alternative investments (solar, thermal). However, IRR can be misleading if there are non-conventional cash flows (e.g. major refurbishment later) or when comparing projects of different scale. Hence IRR should be read along with NPV, not in place of it.

3. Profitability Index (PI) — useful when capital is rationed. In hydropower, capital is often limited and projects are large; PI (PV of inflows ÷ initial outlay) helps rank projects per rupee invested when the firm cannot fund all positive-NPV projects.

4. Discounted Payback Period — supplementary. It shows how long it takes to recover the investment in present-value terms. Given the long gestation period, this is useful for liquidity and debt-servicing planning, but it should not be the sole criterion because it ignores cash flows beyond the payback period.

5. Traditional techniques — screening only.

   • Payback period is useful as a quick check of how long funds remain locked up, which matters for a project with a long construction phase. But it ignores time value and post-payback flows.
   • ARR may be used for a rough accounting-based comparison, but it is based on profit, not cash flow, and ignores the timing of returns.

Reasoning / conclusion

For a hydroelectricity project, the decision should rest mainly on NPV, because:

• The investment is huge and irreversible, so wealth maximisation must be measured in present-value terms;
• Cash flows extend over decades, making discounting essential;
• Risk can be built into the discount rate (risk-adjusted WACC), reflecting hydrology, construction and offtake risk;
• NPV handles the long gestation period and phased capital expenditure better than payback or ARR.

IRR and PI should be used as cross-checks, especially when comparing hydropower with other generation options or when capital is rationed. Payback and ARR may be used only as supplementary screening tools. Thus, the appropriate approach is a DCF-based evaluation led by NPV, supported by IRR and PI, with traditional techniques used only for preliminary screening.

Financial Sector Reform Initiatives in Nepal

1. Background and Need for Reform

Nepal's financial sector until the late 1980s was characterised by a repressed, state-dominated system: directed credit, subsidised interest rates, a small number of banks, weak supervision and widespread non-performing loans. Financial liberalisation began with the Structural Adjustment Programme (1985–87) and accelerated after the restoration of democracy in 1990. Since then, reform has been carried out in phases, supported by the IMF, World Bank and Asian Development Bank.

2. Phases of Reform

First Phase (1985–1990): Financial Liberalisation

• Interest rate deregulation and removal of directed credit programmes.
• Entry of joint-venture banks (Nepal Arab Bank, 1984; Nepal Indosuez Bank, 1986; Nepal Grindlays, 1986).
• Introduction of open licensing policy for banks and financial institutions (BFIs).

Second Phase (1990–2000): Institution Building

• Enactment of the Commercial Banks Act 2031 BS (1974 AD), Nepal Rastra Bank Act 2058 BS (2002 AD), Bank and Financial Institution Act (BAFIA) 2063 BS (2006 AD).
• Establishment of the Debt Recovery Tribunal under the Debt Recovery Act 2058 BS to speed up recovery of bad loans.
• Restructuring of two large state-owned banks — Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL) — under the Financial Sector Reform Programme (FSRP) with World Bank/IMF assistance.
• Introduction of CAMEL-based off-site supervision and a credit information bureau (Credit Information Bureau, set up in 1989).

Third Phase (2000–2015): Consolidation and Strengthening

• BAFIA 2063 unified licensing, regulation and supervision of all BFIs under NRB.
• Monetary Policy shifted to a more market-based framework; interest rate corridor introduced.
• Deposit and Credit Guarantee Corporation (DCGC) strengthened to protect small depositors.
• Medium-term roadmaps such as the Financial Sector Development Strategy (2017-2022) guided reform.
• Donor-supported programmes (ADB, World Bank) focused on legal reform, supervision and capital market development.

Fourth Phase (2015–present): Stability, Inclusion and Digitalisation

• Banking and Financial Institutions Act 2073 (2016) and NRB Act (Third Amendment) strengthened resolution powers.
• Consolidation drive (2017–2020): merger/acquisition policy reduced the number of BFIs sharply, from over 200 to fewer than 100 licensed banks and financial institutions in classes A, B and C, raising capital and reducing fragmentation.
• Minimum paid-up capital raised sharply (commercial banks to Rs 8 billion).
• Digital financial services: mobile banking, QR payments, connectIPS, RTGS, retail payment strategy, and the National Payment Switch.
• Financial inclusion: expansion of branches to all 753 local units, priority-sector lending (agriculture, SME, energy), and Deposit and Credit Guarantee cover.
• Basel III implementation, risk-based supervision, and stress testing institutionalised.

3. Major Achievements of Reform Programs

1. Restoration of financial stability: NPLs of RBB and NBL reduced from above 50% to single digits; both banks returned to profitability and were handed back to government management.
2. Stronger regulatory framework: BAFIA 2063/2073 and NRB Act gave NRB clear powers over licensing, capital, liquidity and resolution.
3. Sound banking system: Capital adequacy well above Basel III minimum; NPLs kept low for most of the period, though they have risen since COVID-19; profitability and reserves improved.
4. Consolidation: Fewer but stronger BFIs; larger capital base and better economies of scale.
5. Expanded access: Branch network reached all 753 local units; deposit accounts and loan accounts grew substantially; financial inclusion rose sharply.
6. Digital transformation: Mobile banking users in the tens of millions; QR payments, internet banking and card services widely used; payment systems modernised.
7. Capital market development: SEBON strengthened, NEPSE automated, CDSC and central depository system operational, dematerialisation of shares.
8. Improved supervision: Off-site and on-site supervision, risk-based approach, stress testing and consolidated supervision of groups.
9. International integration: Compliance with FATF/APG anti-money laundering standards; Basel III adoption; NRB participation in international fora.
10. Institutional strengthening: Establishment of DCGC, Credit Information Bureau, Insurance Board (now Nepal Insurance Authority), and Employees Provident Fund reforms.

4. Remaining Challenges

• Dominance of banks over capital markets; shallow bond and equity markets.
• High cost of credit and wide interest spreads.
• Weak credit culture and rising NPLs in some sectors (especially after COVID-19).
• Limited access to finance for SMEs, women and remote areas.
• Governance issues in some cooperatives and BFIs.
• Coordination gaps between NRB, SEBON, Insurance Authority and Ministry of Finance.

5. Conclusion

Nepal's financial sector reform has moved from liberalisation to consolidation, stability and digital inclusion. The achievements — a sound banking system, stronger supervision, wider access and modern payment infrastructure — have laid the foundation for sustainable growth. The next phase must focus on capital market deepening, financial literacy, governance and integrated supervision so that the financial sector effectively supports national development.

Financial System Framework of Nepal

Meaning: The financial system of Nepal is the organised network of institutions, markets, instruments and regulatory bodies that mobilises savings from surplus units and channels them to deficit units, thereby supporting production, trade and economic growth.

Structure / Framework of the Nepali Financial System

1. Regulatory and Supervisory Bodies

• Nepal Rastra Bank (NRB) — the central bank, established in 1956 under the NRB Act, 1955 (now NRB Act, 2058). It is the apex monetary, regulatory and supervisory authority.
• Securities Board of Nepal (SEBON) — regulates the capital market under the SEBON Act, 2063.
• Insurance Board / Nepal Insurance Authority — regulates insurance and reinsurance business.
• Ministry of Finance — formulates fiscal policy and coordinates the overall financial sector.

2. Financial Institutions (Organised Sector)

• Class "A" — Commercial Banks: largest in number and assets; operate nationwide through branch networks.
• Class "B" — Development Banks: provide medium- and long-term credit, mainly to industry, agriculture and infrastructure.
• Class "C" — Finance Companies: hire-purchase, leasing, housing and consumer finance.
• Class "D" — Microfinance Financial Institutions: micro-credit and financial inclusion in rural areas.
• Infrastructure Development Bank and Nepal Reconstruction and Development Bank as specialised institutions.
• Insurance companies, Employees Provident Fund, Citizen Investment Trust, Nepal Stock Exchange (NEPSE), CDSC and mutual funds as other constituents.

3. Unorganised / Informal Sector

• Dhungi (money lenders), dhukuti (rotating savings), chit funds, parma (labour exchange) and goldsmith lending — still significant in rural Nepal.

4. Financial Markets

• Money market: inter-bank lending, treasury bills, NRB bonds — instruments for short-term liquidity.
• Capital market: shares, debentures, government bonds traded through NEPSE and managed by SEBON.
• Foreign exchange market: licensed dealers and exchange houses under NRB control.

5. Financial Instruments

• Deposits, loans, shares, debentures, government securities, insurance policies, remittance instruments and digital payment products.

Problems of the Financial System in Nepal

1. Financial exclusion: a large share of the population, especially in remote districts, remains outside the formal banking net.
2. Dominance of commercial banks: banks hold the bulk of assets; development banks, finance companies and microfinance institutions are comparatively weak.
3. Weak capital market: NEPSE is thin, speculative and dominated by a few scrips; bond and debenture markets are underdeveloped.
4. High non-performing loans and weak credit culture: poor appraisal, wilful default and weak recovery mechanisms.
5. Weak corporate governance: family-dominated boards, related-party lending and inadequate disclosure.
6. Inadequate supervision: shortage of skilled supervisors, weak enforcement and limited risk-based supervision.
7. Financial crimes: money laundering, hundi, gold smuggling and terror financing.
8. Low financial literacy: misuse of loans, over-borrowing and poor repayment discipline.
9. Dual and fragmented regulation: overlapping jurisdiction among NRB, SEBON and the insurance regulator.
10. Excessive dependence on remittance: consumption-driven credit rather than productive investment.

Reform Measures for a Safe and Sound Financial System

1. Strengthen the legal framework: timely amendment of the NRB Act, Bank and Financial Institutions Act (BAFIA), SEBON Act and insurance law to align with Basel III.
2. Adopt risk-based supervision: move from compliance-based to risk-based supervision with on-site and off-site monitoring.
3. Consolidation of institutions: merger and acquisition policy to create strong, well-capitalised institutions and reduce fragmentation.
4. Capital adequacy and liquidity discipline: enforce Basel III capital buffers, leverage ratio and liquidity coverage ratio.
5. Strengthen corporate governance: independent directors, fit-and-proper criteria, strict limits on related-party transactions.
6. Financial inclusion: expand branch and branchless banking, mobile and digital financial services in rural areas.
7. Develop the capital market: deepen bond and debenture markets, encourage institutional investors, strengthen SEBON's surveillance.
8. Anti-money laundering: effective enforcement of the AML/CFT framework and the Financial Information Unit.
9. Human resource development: training and certification of supervisors and bankers.
10. Deposit insurance and crisis management: operationalise the Deposit and Credit Guarantee Fund and a clear resolution framework.
11. Coordination among regulators: a unified supervisory council to avoid regulatory gaps and overlaps.
12. Financial literacy campaigns: through schools, local governments and media.

Conclusion

Nepal's financial system has expanded rapidly in reach and diversity, but it still suffers from exclusion, weak markets, poor governance and supervisory gaps. A safe and sound system requires strong laws, risk-based supervision, well-capitalised institutions, financial inclusion and effective coordination among regulators — all aimed at maintaining public confidence and financial stability.

Nepal Bank — Assistant Manager (Level 6)

Finance — Model Answers

---

2.1 Financial Management, Financial System and Market, Capital and Money Market, Securities Market, Financial Derivatives and Instruments

(a) Financial Management

Meaning: Financial management is the process of planning, organising, directing and controlling the financial activities of an enterprise — procurement of funds and their effective utilisation — with the objective of maximising the wealth of shareholders.

Scope / Functions:

1. Investment decision — selection of assets (fixed and current) in which funds are to be invested; evaluated through capital budgeting.
2. Financing decision — determination of the best mix of debt and equity (capital structure) and the choice of source.
3. Dividend decision — distribution of profit between shareholders' dividend and retained earnings.
4. Liquidity / working capital management — maintenance of an optimum balance between profitability and liquidity.

Objectives:

• Profit maximisation (traditional) — criticised for ignoring risk, time value and wealth.
• Wealth maximisation (modern) — maximisation of the market price per share, which considers risk, timing and return. This is the accepted goal.

Agency problem: Separation of ownership (shareholders) from control (managers) creates conflict; managers may pursue perquisites and empire-building rather than shareholder wealth. It is mitigated by incentives, monitoring and the market for corporate control.

---

(b) Financial System

Meaning: A financial system is the set of institutions, markets, instruments and services through which savings are mobilised and channelled into investment. It is the "nervous system" of the economy.

Components:

Functions:

1. Pooling of small savings into large investible funds.
2. Allocation of funds to the most productive uses (efficiency of capital).
3. Payment and settlement mechanism.
4. Liquidity provision — conversion of assets into cash.
5. Risk transfer and diversification.
6. Price discovery for financial assets (interest rates, share prices).
7. Transmission of monetary policy.

---

(c) Capital Market vs Money Market

Money market instruments in Nepal: Treasury bills (91, 182, 364 days), NRB bonds, inter-bank lending, repo/reverse repo, commercial paper, certificates of deposit.

Capital market instruments in Nepal: Ordinary shares, preference shares, right shares, bonus shares, debentures, government development bonds, foreign employment bonds.

---

Securities Market

Meaning: The market for long-term securities — shares and debentures — divided into the primary market (new issue market) and the secondary market (stock exchange).

Primary market methods of issue:

• Public issue — issue to the general public through a prospectus.
• Rights issue — issue to existing shareholders in proportion to holding.
• Private placement — issue to a select group of institutional investors.
• Offer for sale — existing shareholders sell to the public through an issuing house.

Secondary market: NEPSE (Nepal Stock Exchange Ltd., established 1994, sole secondary market) with licensed broker members; CDSC (CDS and Clearing Ltd.) provides dematerialised settlement; SEBON regulates.

Functions of the securities market:

1. Mobilisation of savings for industrial investment.
2. Liquidity to investors — easy entry and exit.
3. Valuation of securities through continuous trading.
4. Diversification of risk.
5. Channel for foreign portfolio investment.
6. Support to monetary policy and privatisation.

Problems in Nepal: Thin trading and low turnover; dominance of a few scrips; weak disclosure and enforcement; limited institutional investors; low financial literacy; underdeveloped bond market.

---

Financial Derivatives and Instruments

Meaning: A derivative is a financial contract whose value is derived from the value of an underlying asset — shares, indices, interest rates, currency or commodities. No principal is exchanged at inception; settlement is on the basis of price movement.

Types:

1. Forward — a customised agreement to buy/sell an asset at a fixed price on a future date; traded over the counter; carries counterparty risk.
2. Futures — standardised, exchange-traded forward contracts with daily mark-to-market and clearing-house guarantee.
3. Options — the buyer gets a right (not obligation) to buy (call) or sell (put) at a strike price before/on expiry, against a premium. Payoff is asymmetric; loss limited to premium.
4. Swaps — exchange of cash-flow streams, e.g. interest-rate swap (fixed for floating) and currency swap.

Uses: Hedging price/interest/currency risk; speculation; arbitrage; price discovery; improving market liquidity.

Instruments in the Nepali context: Shares, debentures, government bonds, treasury bills, NRB bonds, mutual-fund units, insurance policies, remittance-linked instruments. Formal exchange-traded derivatives are not yet permitted in Nepal; forward contracts on foreign exchange are used by banks for hedging, and NRB has issued a Derivatives Transaction Directive permitting banks to deal in interest-rate and currency derivatives subject to approval. The main constraint is the absence of a deep, liquid underlying market.

---

2.2 Financial Planning, Present Value and Opportunity Cost of Capital, Financial Investment Analysis

Financial Planning

Meaning: Financial planning is the process of deciding in advance the financial objectives of a firm and the means of achieving them — how much funds are needed, when, and from where.

Steps:

1. Determination of financial objectives (profit, sales growth, wealth).
2. Estimation of capital requirements (fixed and working capital).
3. Forecasting of internal accruals and the funding gap.
4. Selection of sources — debt, equity, retained earnings, hybrid.
5. Preparation of pro-forma financial statements and cash budget.
6. Monitoring, review and revision.

Importance: Ensures adequate and timely funds; avoids over/under-capitalisation; balances risk and return; coordinates with production and marketing plans; provides a basis for control.

---

Present Value and Opportunity Cost of Capital

Present value is the current worth of a future cash flow discounted at the required rate of return.

$PV = \frac{CF_t}{(1+k)^t}$

For an annuity: $PV = CF \times \frac{1-(1+k)^{-n}}{k}$

Opportunity cost of capital is the return available on the next best investment of equivalent risk — the rate at which a project's cash flows must be discounted. It is the minimum acceptable rate of return (hurdle rate) and equals the investor's required return for that risk class.

Illustration: Rs 1,00,000 receivable after 3 years at 10%:

$PV = \frac{1,00,000}{(1.10)^3} = \frac{1,00,000}{1.331} = \text{Rs }75,131.48$

---

Financial Investment Analysis

Meaning: The process of evaluating investment avenues to select those giving the best risk-adjusted return consistent with the investor's objectives, constraints and time horizon.

Steps:

1. Define objectives (income, growth, safety, liquidity, tax saving).
2. Identify constraints (liquidity, time horizon, tax, regulation).
3. Analyse the economy, industry and company (E-I-C analysis).
4. Estimate return and risk of each security.
5. Construct and evaluate portfolios.
6. Select, execute and monitor; revise as required.

Approaches: Fundamental analysis (intrinsic value from earnings, dividends, growth) and technical analysis (price patterns, trends, volume).

---

2.3 Financial Sector Reforms in Nepal

Background: Before 1985 the financial system was repressed — administered interest rates, directed credit, entry barriers, weak supervision and negative real interest rates. Reform began with the Structural Adjustment Programme (1985) and accelerated under the Financial Sector Reform Programme (FSRP, 1989) with World Bank/IMF support.

Major reform measures:

1. Interest rate liberalisation (1990) — removal of ceilings/floors; rates determined by market forces.
2. Entry liberalisation — licensing of private commercial banks (from 1984), development banks and finance companies; joint-venture banks.
3. Prudential regulation — capital adequacy (Basel I/II/III), loan classification and provisioning, single-borrower limits, insider lending restrictions, CAMELS-based supervision.
4. Nepal Rastra Bank Act 2058 (2002) — autonomy to NRB, price stability and balance-of-payments objectives.
5. Bank and Financial Institutions Act (BAFIA) 2063 (2006), replaced by the new BAFIA 2073 (2017) — single regulatory framework, licensing, merger and acquisition provisions.
6. Debt recovery: Debt Recovery Act 2058 (2002) and Debt Recovery Tribunal for recovery of non-performing loans.
7. Restructuring of state-owned banks — Rastriya Banijya Bank and Nepal Bank Ltd. restructured (2002–2006) with management contracts; Nepal Bank returned to profit and was partly privatised.
8. Capital market reform — SEBON Act 2063 (2007), Securities Act 2063 (2007), establishment of NEPSE (1994) and CDSC (2007), dematerialisation, automation and online trading.
9. Consolidation — mergers and acquisitions encouraged; number of BFIs reduced substantially.
10. Financial inclusion — branch expansion directives, no-frills accounts, microfinance, mobile and branchless banking, priority-sector lending (agriculture, energy, tourism, SMEs).
11. Payment systems — Payment and Settlement Act 2075 (2019), Payment Systems Department of NRB, retail payment strategy, QR and digital wallets.
12. Anti-money laundering — AML/CFT framework, Financial Information Unit, Asset (Money) Laundering Prevention Act 2064.

Achievements: Sounder banks, higher capital, lower NPLs in the 2010s, wider access, modern payment systems, improved supervision.

Remaining challenges: Financial access still low in remote districts; dominance of banks over capital markets; weak credit culture and rising NPLs in recent years; liquidity volatility; low financial literacy; governance issues in cooperatives; limited long-term financing; exposure concentration in real estate and imports.

---

2.4 Project Appraisal and its Applications

Meaning: Project appraisal is the systematic and comprehensive evaluation of a proposed project before committing resources, to judge its technical, economic, financial, commercial, managerial and social viability.

Aspects of appraisal:

Steps in project appraisal:

1. Identification of project ideas.
2. Pre-feasibility study.
3. Feasibility study (detailed appraisal).
4. Appraisal by the financing institution.
5. Approval and negotiation of terms.
6. Implementation and monitoring.
7. Post-completion evaluation.

Applications: Selection of new projects; expansion and diversification decisions; replacement and modernisation; lending decisions by banks and BFIs; foreign-aid and donor-funded project approval; government capital expenditure screening; privatisation and public–private partnership evaluation.

---

2.5 Capital Budgeting: Techniques, Significance, Application of the Concept, Cohesion among Alternative Proposals, Pay Back Method, Capital Rationing

Meaning and Significance

Capital budgeting is the planning and evaluation of long-term investment proposals whose benefits extend beyond one year. It is significant because:

1. Large funds are committed for long periods — mistakes are costly and often irreversible.
2. It determines the firm's growth, profitability and competitive position.
3. It affects the firm's risk profile and cost of capital.
4. It is the basis of dividend and financing policy.
5. It involves the time value of money and risk assessment.

Techniques

Traditional (non-discounting):

1. Payback Period (PBP) — time required to recover the initial investment.
2. Accounting Rate of Return (ARR) — average annual profit ÷ average investment.

Discounted cash flow (DCF):

3. Net Present Value (NPV) — PV of inflows minus PV of outflows.
4. Internal Rate of Return (IRR) — discount rate at which NPV = 0.
5. Profitability Index (PI) — PV of inflows ÷ initial investment.
6. Discounted Payback Period — payback using discounted cash flows.

Pay Back Method

$PBP = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow (if uniform)}}$

For uneven flows, cumulative inflows are compared with the initial outlay; the fraction of the year is found by interpolation.

Illustration: Investment Rs 5,00,000; inflows Rs 1,50,000 per year for 5 years.

$PBP = \frac{5,00,000}{1,50,000} = 3.33 \text{ years} = 3 \text{ years } 4 \text{ months}$

Merits: Simple, easy to understand, emphasises liquidity and quick recovery, useful where funds are scarce or technology changes fast, a rough measure of risk.

Demerits: Ignores the time value of money; ignores cash flows after the payback period; not a measure of profitability; the choice of the cut-off period is arbitrary.

Cohesion among Alternative Proposals

Projects may be independent (acceptance of one does not affect the other) or mutually exclusive (only one can be accepted). In mutually exclusive cases the ranking by NPV and IRR may conflict when:

• Scale difference — project size differs.
• Time pattern difference — one project has early returns, the other late returns.
• Life difference — unequal project lives.

Conflict resolution: Use NPV as the decision rule, since it measures the absolute addition to shareholder wealth and assumes reinvestment at the cost of capital (a more realistic assumption than IRR's reinvestment at IRR). For unequal lives, use the equivalent annual annuity (EAA) or replacement chain method. PI is used for ranking under capital rationing.

Capital Rationing

Meaning: Capital rationing exists when the firm cannot finance all positive-NPV projects because of a limit on funds — either internal (soft) rationing imposed by management, or external (hard) rationing imposed by lenders or the market.

Decision rule: Rank projects by Profitability Index (NPV per rupee invested) and accept projects in descending order until the budget is exhausted. Where projects are indivisible, use integer (zero-one) linear programming to maximise total NPV subject to the budget constraint.

Illustration: Budget Rs 10,00,000.

Accept B (Rs 4,00,000) and A (Rs 5,00,000) = Rs 9,00,000 invested, total NPV Rs 2,20,000. Project C cannot be taken as only Rs 1,00,000 remains. (If A and C were mutually exclusive, compare combinations: B+A = NPV 2,20,000; B+C = 2,10,000; hence B+A is better.)

---

2.6 Portfolio Management: Analysis and Selection, Associated Risk Analysis

Meaning

A portfolio is a combination of two or more securities held to reduce risk through diversification. Portfolio management is the process of constructing, revising and evaluating a portfolio to achieve the investor's objectives.

Steps in Portfolio Management

1. Determination of objectives — return target, risk tolerance, time horizon, liquidity, tax.
2. Security analysis — fundamental and technical analysis to estimate expected return and risk of individual securities.
3. Portfolio construction — selection of securities and determination of weights, based on expected return, variance, covariance and correlation.
4. Portfolio revision — rebalancing when prices, objectives or market conditions change.
5. Portfolio evaluation — performance measurement using Sharpe, Treynor and Jensen measures.

Return and Risk of a Portfolio

Expected return:

$E(R_p) = \sum_{i=1}^{n} w_i E(R_i)$

Variance (two assets):

$\sigma_p^2 = w_1^2\sigma_1^2 + w_2^2\sigma_2^2 + 2w_1w_2\rho_{12}\sigma_1\sigma_2$

Covariance: $\text{Cov}_{12} = \rho_{12}\sigma_1\sigma_2$

Diversification: As long as $\rho < +1$, portfolio risk is less than the weighted average of individual risks. With $\rho = -1$, risk can be eliminated entirely (for two assets). Systematic (market) risk cannot be diversified; unsystematic (firm-specific) risk can.

Risk Analysis

Types of risk:

• Systematic (non-diversifiable): market risk, interest-rate risk, purchasing-power (inflation) risk, exchange-rate risk, political risk. Measured by beta.
• Unsystematic (diversifiable): business risk, financial risk, default/credit risk, liquidity risk, management risk.

Beta: $\beta_i = \frac{\text{Cov}(R_i, R_m)}{\sigma_m^2}$ — sensitivity of a security's return to market return. $\beta = 1$: average risk; $\beta > 1$: aggressive; $\beta < 1$: defensive.

CAPM: $E(R_i) = R_f + \beta_i (R_m - R_f)$

SML: plots required return against beta; securities above the line are undervalued.

Performance measures:

• Sharpe ratio: $\frac{R_p - R_f}{\sigma_p}$ (total risk)
• Treynor ratio: $\frac{R_p - R_f}{\beta_p}$ (systematic risk)
• Jensen's alpha: $\alpha_p = R_p - [R_f + \beta_p(R_m - R_f)]$

Illustration: $R_f = 6\%$, $R_m = 14\%$, $\beta = 1.2$.

$E(R) = 6 + 1.2(14-6) = 6 + 9.6 = 15.6\%$

If the security actually yields 17%, it is undervalued (alpha = +1.4%).

---

2.7 Profit Management, Break Even Analysis

Profit Management

Meaning: Profit management is the planning and control of revenue, cost and profit to achieve the target return on investment. It covers:

1. Profit planning — setting profit objectives, cost-volume-profit analysis, budgeting.
2. Cost control — standard costing, variance analysis, value engineering, cost reduction.
3. Revenue management — pricing policy, product mix, sales promotion, market segmentation.
4. Profit measurement — gross profit, operating profit, net profit, EBIT, EBITDA, EPS, ROI.
5. Profit appropriation — dividend policy, retention, reserves, taxation.

Factors affecting profit: Volume of sales, selling price, variable cost per unit, fixed cost, product mix, competition, government policy, efficiency and capacity utilisation.

Break Even Analysis

Meaning: Break-even analysis (cost-volume-profit analysis) determines the sales volume at which total revenue equals total cost — i.e. no profit, no loss.

Assumptions: Selling price constant; variable cost per unit constant; fixed cost constant; single product or constant mix; production equals sales; costs split into fixed and variable.

Formulae:

$BEP \text{ (units)} = \frac{\text{Fixed Cost}}{\text{Contribution per unit}} = \frac{F}{S - V}$

$BEP \text{ (Rs)} = \frac{F}{\text{P/V ratio}}, \quad \text{P/V ratio} = \frac{S - V}{S} \times 100$

$MOS \text{ (Rs)} = \text{Actual Sales} - \text{BEP Sales}; \quad MOS\% = \frac{MOS}{\text{Actual Sales}} \times 100$

$\text{Profit} = \text{MOS (Rs)} \times \text{P/V ratio}$

$\text{Required sales for target profit} = \frac{F + \text{Target Profit}}{\text{P/V ratio}}$

Illustration: Fixed cost Rs 2,00,000; selling price Rs 100; variable cost Rs 60.

Contribution per unit = Rs 40; P/V ratio = 40%.

$BEP \text{ (units)} = \frac{2,00,000}{40} = 5,000 \text{ units}$

$BEP \text{ (Rs)} = 5,000 \times 100 = \text{Rs }5,00,000$

If actual sales are Rs 7,00,000 (7,000 units): MOS = Rs 2,00,000; Profit = 2,00,000 × 40% = Rs 80,000.

Uses: Determination of minimum sales volume; profit planning; pricing decisions; make-or-buy and product-mix decisions; capacity expansion decisions; assessment of risk (margin of safety).

Limitations: Assumes linear cost and revenue functions; fixed cost may change in steps; multi-product mix may vary; ignores stock changes and time value.

---

2.8 International Financial Organizations — World Bank, IMF, ADB, WTO

World Bank (IBRD)

• Established: 1944, Bretton Woods Conference; began operations 1946. Headquarters: Washington, D.C.
• Members: 189 countries. Nepal joined in 1961.
• Group: IBRD, IDA (1960), IFC (1956), MIGA (1988), ICSID (1966).
• Objectives: Reconstruction and development; poverty reduction; promotion of foreign private investment; balanced growth of international trade; provision of long-term loans for productive purposes.
• Functions: Long-term loans (15–20 years) at near-market rates; concessional credits through IDA for poorest countries; technical assistance; policy advice; guarantees.
• Nepal: Major donor for roads, hydropower, education, health, rural water supply and budget support. IDA is a key source of concessional financing.

IMF

• Established: 1944 (operations 1947); Headquarters: Washington, D.C.; members 190. Nepal joined 1961.
• Objectives: Promote international monetary cooperation; facilitate balanced growth of trade; promote exchange stability; eliminate exchange restrictions; provide short-term balance-of-payments support.
• Functions: Surveillance and Article IV consultations; quota-based resources; lending facilities (Stand-By Arrangement, EFF, RCF, SCF, ECF); SDR allocation; technical assistance and training.
• Nepal: Uses IMF support for BOP needs, macroeconomic stabilisation and capacity building; Nepal's quota determines its SDR subscription and voting power.

ADB

• Established: 1966; Headquarters: Manila, Philippines; 69 members (49 regional). Nepal is a founding member.
• Objectives: Foster economic growth and cooperation in Asia–Pacific; reduce poverty; promote inclusive and sustainable growth.
• Functions: Loans (OCR and Asian Development Fund concessional window), grants, technical assistance, co-financing, guarantees.
• Nepal: Leading multilateral financier of hydropower, roads, urban infrastructure, education, agriculture and energy sector reform.

WTO

• Established: 1 January 1995, succeeding GATT (1947); Headquarters: Geneva; 166 members. Nepal became a member in April 2004 (first LDC to join through accession).
• Objectives: Liberalise international trade; remove tariff and non-tariff barriers; provide a forum for trade negotiations; settle trade disputes; ensure transparency and non-discrimination.
• Principles: Most-Favoured-Nation (MFN), National Treatment, reciprocity, binding commitments, transparency.
• Nepal: Enjoys MFN access and LDC concessions (duty-free quota-free market access, longer transition periods, TRIPS flexibilities); must comply with commitments on tariffs, services and intellectual property.

---

2.9 Regional Organizations — SAARC, ASEAN, EU, BIMSTEC, BRICS

SAARC (South Asian Association for Regional Cooperation)

• Established: 8 December 1985, Dhaka; Secretariat: Kathmandu. Founding members: Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan, Sri Lanka; Afghanistan joined 2007.
• Objectives: Promote welfare and economic growth; accelerate economic, social and cultural development; collective self-reliance; cooperation with other regional bodies.
• Instruments: SAPTA (1993) and SAFTA (2006) for trade liberalisation; SAARC Development Fund; agreements on terrorism, environment and education.
• Limitations: Low intra-regional trade (about 5% of total trade); political tensions; weak implementation; non-implementation of SAFTA tariff concessions in full.

ASEAN (Association of Southeast Asian Nations)

• Established: 8 August 1967, Bangkok; Secretariat: Jakarta. Members: 10 (Indonesia, Malaysia, Philippines, Singapore, Thailand, Brunei, Vietnam, Laos, Myanmar, Cambodia).
• Objectives: Accelerate economic growth, social progress and cultural development; regional peace and stability; free trade area (AFTA).
• Significance: One of the most successful regional groupings; intra-regional trade above 20%; ASEAN+3 and RCEP linkages.
• Nepal: Not a member; interacts as a dialogue/sectoral partner and through SAARC–ASEAN cooperation.

EU (European Union)

• Established: Maastricht Treaty 1993 (preceded by EEC (European Economic Community, 1957 Treaty of Rome); Secretariat: Brussels.
• Members: 27 after the UK left in 2020 (Brexit); 20 members use the euro.
• Objectives: Single market (free movement of goods, services, capital and people), common trade policy, monetary union, peace and common values.
• Institutions: European Commission, European Parliament, Council of the EU, European Council, European Court of Justice and European Central Bank.
• Nepal: Nepal enjoys the EU's Everything But Arms (EBA) preferential access as an LDC, and the EU is a major export market (carpets, garments, handicrafts) and development partner.

BIMSTEC (Bay of Bengal Initiative for Multi-Sectoral Technical and Economic Cooperation)

• Established: 6 June 1997 (Bangkok Declaration) as BIST-EC; renamed BIMSTEC in 1999 after Myanmar and Nepal joined (Nepal in 2004). Secretariat: Dhaka (since 2014).
• Members: 7: Bangladesh, Bhutan, India, Myanmar, Nepal, Sri Lanka, Thailand.
• Objectives: Technical and economic cooperation in sectors such as trade, energy, transport, tourism, agriculture, fisheries and counter-terrorism; a bridge between South and Southeast Asia.
• Progress: Charter adopted at the 5th Summit (Colombo, 2022); a Free Trade Area agreement is under negotiation.
• Nepal: Gives landlocked Nepal access to Bay of Bengal ports and markets; Nepal is the lead country for the sectors it was assigned. Nepal hosted the 4th Summit in Kathmandu in 2018.

BRICS

• Meaning: Grouping of emerging economies: Brazil, Russia, India, China and South Africa (added in 2010). It began as BRIC, a term coined by Jim O'Neill in 2001. First summit in 2009 (Yekaterinburg).
• Expansion: Egypt, Ethiopia, Iran and the UAE joined in 2024, and Indonesia in 2025. Saudi Arabia was invited, and some further countries are partners.
• Objectives: Economic cooperation, reform of global financial institutions (more voting power in the IMF and World Bank), and a multipolar world order.
• Institutions: New Development Bank (NDB, Shanghai, 2014/15) and the Contingent Reserve Arrangement (CRA).
• Nepal: Not a member; has expressed interest and benefits indirectly through the investment and trade of India and China, its two neighbours.