Financial Markets and Services

The four kinds of financial assets are:

1. Debt instruments: bonds, debentures, treasury bills and loans, which give a fixed claim to interest and principal.
2. Equity instruments: common and preferred stock, which give an ownership claim on income and assets.
3. Derivatives: futures, forwards, options and swaps, whose value depends on an underlying asset.
4. Hybrid or pooled assets: convertible bonds, mutual fund units and similar securities that combine features of the above.

Four common characteristics of financial services:

1. Intangibility: they cannot be touched or seen; the customer buys a promise, advice or a service.
2. Inseparability: production and consumption occur together, so the provider and customer interact directly.
3. Perishability: they cannot be stored; a service not used today is lost.
4. Heterogeneity (variability): quality varies with the person, time and place of delivery, and depends on trust and customer-specific needs.

Holding period return:

$\frac{100{,}125-100{,}000}{100{,}000}=0.00125=0.125\%$

Annualised yield (365-day year):

$0.125\%\times\frac{365}{5}=0.125\%\times 73=9.125\%$

The yield on the repo to the bank is about 9.13% per annum.

Tax-equivalent rate:

$r_{TE}=\frac{r_{muni}}{1-T}=\frac{6.25\%}{1-0.21}=\frac{6.25\%}{0.79}=7.91\%$

A taxable bond must pay about 7.91% to give the same after-tax return as the 6.25% municipal bond.

Key features of microfinance in Nepal:

• It provides small loans, savings and insurance to poor, low-income and rural people, especially women, who lack access to formal banks.
• Loans are mostly collateral-free and based on group guarantee and social collateral (group lending, centre meetings).
• It is delivered by licensed microfinance financial institutions, cooperatives, NGOs and "A, B, C, D" class banks' deprived-sector lending, regulated by Nepal Rastra Bank.
• Its aims are poverty reduction, income generation and self-employment through small enterprises.
• Loans are short-term with frequent repayment instalments, high interest costs and strong emphasis on repayment discipline.

Your ownership is

$\frac{20{,}000}{2{,}000{,}000}=1\%$

Under preemptive rights you may buy 1% of any new shares issued. For example, if the company issues 500,000 new shares, you can buy $0.01\times500{,}000=5{,}000$ shares, which keeps your 1% ownership unchanged.

Total cash received at the end of the year:

• Sale proceeds net of fee: $106-1.5=104.5$
• Dividend: $2$
• Capital gain distribution: $3$

$\text{Total}=104.5+2+3=109.5$

$\text{Return}=\frac{109.5-100}{100}=9.5\%$

The one-year rate of return is 9.5%.

Credit rating agencies are specialised firms that assess the creditworthiness of borrowers and debt securities, i.e. the ability and willingness of an issuer to pay interest and principal on time. They publish their opinion as letter grades (for example AAA, AA, BBB, down to D), which help investors judge default risk and price the debt. Examples are Standard & Poor's, Moody's and Fitch; in Nepal, ICRA Nepal and CARE Ratings Nepal.

AT I stands for Additional Tier I capital. Under Basel III, Tier I capital consists of Common Equity Tier I (CET1) plus Additional Tier I. AT I includes perpetual, loss-absorbing instruments such as perpetual non-cumulative preference shares and perpetual debt that can be written off or converted to equity when the bank's capital falls below a trigger level.

The financial system of Nepal consists of the following key components:

1. Regulators and policy makers: Ministry of Finance, Nepal Rastra Bank (central bank, supervising banks and financial institutions), Securities Board of Nepal (SEBON, regulating the capital market) and the Nepal Insurance Authority.
2. Financial institutions:
   • Commercial banks (class "A"), development banks (class "B"), finance companies (class "C").
   • Microfinance institutions (class "D"), cooperatives and savings and credit organisations.
   • Insurance companies (life and non-life) and reinsurers.
   • Contractual and investment institutions such as the Employees Provident Fund, Citizen Investment Trust, Social Security Fund and mutual funds.
3. Financial markets:
   • Money market: treasury bills, inter-bank lending, repo and standing liquidity facility.
   • Capital market: primary and secondary markets for shares and bonds through the Nepal Stock Exchange (NEPSE), CDS and Clearing Limited, stock brokers and merchant bankers.
4. Financial instruments: deposits, loans, treasury bills, development bonds, debentures, shares, mutual fund units and insurance policies.
5. Supporting infrastructure: Credit Information Bureau, credit rating agencies, payment systems (Nepal Clearing House, digital wallets, ConnectIPS), and the legal framework.

Together they channel savings from surplus units to deficit units and support economic growth.

Financial markets are regulated for the following reasons:

1. Protecting investors: small investors lack information and expertise, so rules on disclosure, prospectuses and accounting protect them from fraud, insider trading and manipulation.
2. Ensuring market integrity and fairness: regulation prevents price manipulation and unfair practices and builds public confidence.
3. Correcting information asymmetry: adverse selection and moral hazard are reduced through disclosure and licensing requirements.
4. Maintaining financial stability: capital adequacy, reserve and liquidity requirements reduce the risk of bank failures, contagion and systemic crises.
5. Protecting depositors: deposit insurance and supervision protect savings held in banks.
6. Controlling monopoly and promoting competition: entry rules, licensing and merger controls prevent abuse of market power.
7. Supporting monetary policy and economic goals: regulation lets the central bank control credit and money supply and directs credit to priority sectors.
8. Preventing illegal activity: anti-money-laundering and terrorist-financing rules.

Insurance is a contract in which an insurer, in return for a premium, agrees to compensate the insured for a specified loss or to pay a sum on a specified event. Its essential features are:

1. Risk transfer: the risk of a loss is shifted from the insured to the insurer.
2. Pooling of risk (law of large numbers): many people pay premiums into a common pool from which the few who suffer losses are paid.
3. Insurable interest: the insured must stand to suffer a financial loss if the event occurs.
4. Utmost good faith: both parties must disclose all material facts honestly.
5. Premium: the price of cover, set from the probability and size of expected loss plus expenses and profit.
6. Indemnity: in general insurance the insured is restored to the same financial position as before the loss, not made better off (life insurance is a fixed-sum contract).
7. Contingent event: the loss must be uncertain and fortuitous, not intentional or certain.
8. Proximate cause and subrogation/contribution: the loss must be caused by an insured peril, and the insurer may take over the insured's rights against third parties.
9. Legal contract: a written policy, with defined sum assured, term and conditions.

Mutual fund. A mutual fund is an investment company that pools money from many investors and invests it in a diversified portfolio of securities such as stocks, bonds and money market instruments under professional management. Investors hold units, and returns (dividends and capital gains) are shared in proportion to their units. Net asset value per unit is calculated as total assets minus liabilities divided by units outstanding. Funds can be open-ended or closed-ended.

Importance to investors in Nepal:

1. Small investment: a small saver can start with a low amount and still own a diversified portfolio.
2. Diversification: spreading money over many securities reduces risk, which is valuable in the thin and volatile NEPSE market.
3. Professional management: fund managers have the expertise, research and time that most individuals lack.
4. Liquidity: units can be traded on the stock exchange (closed-end funds) or redeemed with the fund (open-end funds).
5. Low transaction cost: economies of scale in buying and selling securities.
6. Mobilising savings: it brings idle household savings into the capital market and supports capital formation and economic growth.
7. Transparency and regulation: SEBON regulates funds and requires NAV disclosure.
8. Tax and other benefits: examples include dividend income benefits and attractive returns over bank deposits at times.

Hence mutual funds are a convenient, lower-risk way for Nepali investors to participate in the capital market.

Data: $P=99.51$, $F=100$, $t=28$ days.

(a) Bank discount rate

$BD=\frac{F-P}{F}\times\frac{360}{t}=\frac{0.49}{100}\times\frac{360}{28}=0.0049\times12.857=6.30\%$

(b) Coupon equivalent yield

$CEY=\frac{F-P}{P}\times\frac{365}{t}=\frac{0.49}{99.51}\times\frac{365}{28}=0.004924\times13.036=6.42\%$

(c) Effective annual rate

$EAR=\left(1+\frac{F-P}{P}\right)^{365/28}-1=(1.004924)^{13.036}-1\approx6.61\%$

Employee contribution: $12\%\times60{,}000=\text{Rs }7{,}200$

Employer match: 50% of the first 5% of earnings: $0.50\times(5\%\times60{,}000)=0.50\times3{,}000=\text{Rs }1{,}500$

Annual investment in the plan:

$7{,}200+1{,}500=\text{Rs }8{,}700$

Because contributions are made before tax, the employee's own after-tax cost is $7{,}200\times(1-0.31)=\text{Rs }4{,}968$.

One-year return: at 10%,

$8{,}700\times1.10=\text{Rs }9{,}570,\quad\text{earnings}=\text{Rs }870\ (10\%)$

Compared with the employee's own after-tax outlay of Rs 4,968, the gain is $9{,}570-4{,}968=\text{Rs }4{,}602$, i.e. a return of about $4{,}602/4{,}968=92.6\%$ (before tax on withdrawal), which shows the benefit of the tax shield and the employer match.

The capital market channels long-term funds from savers to users such as firms and governments. Companies mainly raise long-term funds with bonds, preferred stock and common stock, each with distinct features.

1. Bonds (debt)

• A bond is a long-term borrowing in which the issuer promises fixed interest (coupon) and repayment of face value at maturity.
• Bondholders are creditors, not owners, have no voting rights, and have a priority claim on income and assets in liquidation.
• Interest is tax-deductible for the issuer and the risk to the investor is lower.
• Example: a 10-year, 9% debenture of Rs 1,000 face value issued by a Nepali bank pays Rs 90 each year and Rs 1,000 at maturity.

2. Preferred stock (hybrid)

• Pays a fixed dividend, ranking ahead of common stock but after bonds for dividends and liquidation.
• Usually no voting rights; dividends are not tax-deductible and can be cumulative, convertible or redeemable.
• Skipping a dividend does not cause default.
• Example: 8% cumulative preference share of Rs 100 pays Rs 8 a year, and any missed dividends accumulate before common dividends are paid.

3. Common stock (equity)

• Represents ownership, with voting rights and a residual claim on profits and assets.
• Dividends are variable and discretionary; return comes from dividends and capital gains, with the highest risk and return and limited liability.
• Holders often have preemptive rights to buy new shares.
• Example: an investor holding 100 ordinary shares of a company listed on NEPSE votes at the annual general meeting and receives dividends declared by the board.

Comparison

Companies choose among them according to cost, control and risk.

Price of house = Rs 12,500,000 (Rs 125,00,000). The interest rate is not given, so assume a 9% annual mortgage rate with monthly payments for 30 years.

(a) Required down payment

A typical bank requires a down payment of about 20% of the price:

$0.20\times12{,}500{,}000=\text{Rs }2{,}500{,}000$

so the mortgage amount is $12{,}500{,}000-2{,}500{,}000=\text{Rs }10{,}000{,}000$.

(b) Monthly payment

$r=0.09/12=0.0075$, $n=30\times12=360$.

$PMT=\frac{P\,r}{1-(1+r)^{-n}}=\frac{10{,}000{,}000\times0.0075}{1-(1.0075)^{-360}}=\frac{75{,}000}{1-0.06788}\approx\text{Rs }80{,}462$

(c) Interest and principal in the 25th payment

Balance after 24 payments:

$B_{24}=P(1+r)^{24}-PMT\,\frac{(1+r)^{24}-1}{r}=10{,}000{,}000(1.196414)-80{,}462(26.1885)\approx\text{Rs }9{,}856{,}960$

$\text{Interest}=0.0075\times9{,}856{,}960\approx\text{Rs }73{,}927$

$\text{Principal}=80{,}462-73{,}927\approx\text{Rs }6{,}535$

In the 25th instalment about Rs 73,927 is interest and about Rs 6,535 is principal repayment.

Figures in Rs million. Under the Nepal Rastra Bank capital framework, the following are classified as below.

(a) Common equity tier I (CET1)

(b) Total capital

Tier II (supplementary) capital:

$450+750+70+75+71=1{,}416$

There is no additional tier I, so tier I = 5,322.

$\text{Total capital}=5{,}322+1{,}416=\text{Rs }6{,}738\text{ million}$

(c) Adequacy

$CET1\ \text{ratio}=\frac{5{,}322}{70{,}250}=7.58\%,\qquad CAR=\frac{6{,}738}{70{,}250}=9.59\%$

NRB requires a total capital adequacy ratio of at least 11% (and tier I of at least 8.5% including the buffer). The bank's 9.59% is below 11%, so it does not hold adequate capital. At 11%, it needs $0.11\times70{,}250=7{,}727.5$ million, a shortfall of about Rs 990 million.

Premiums = Rs 7.25 million. Express all items as a percentage of premiums.

$\text{Loss ratio}=\frac{2.11}{7.25}=29.10\%$

(a) Combined ratio = loss ratio + loss adjustment expense ratio + dividend ratio

$=29.10\%+5.6\%+2.5\%=37.20\%$

(b) Operating ratio = combined ratio − investment income ratio

$\text{Investment income ratio}=\frac{0.20}{7.25}=2.76\%$

$\text{Operating ratio}=37.20\%-2.76\%=34.44\%$

(c) Net profitability = 100% − operating ratio

$=100\%-34.44\%=65.56\%$

Shares sold: 5,200,000 at Rs 54.

(a) Money received by Himal

$\text{Gross proceeds}=5{,}200{,}000\times54=\text{Rs }280{,}800{,}000$

$\text{Fee}=5{,}200{,}000\times1.25=\text{Rs }6{,}500{,}000$

$\text{Himal receives}=280{,}800{,}000-6{,}500{,}000=\text{Rs }274{,}300{,}000$

(b) Investment bank's profit

Under best-efforts the bank earns only the fee on shares sold: Rs 6,500,000 (before its own costs).

(c) Who bears the risk?

The issuer (Himal Company) bears the risk. The investment bank only acts as an agent and tries its best to sell; it does not buy the shares or guarantee the sale. The 800,000 unsold shares remain with the issuer, who raises less than planned. Under firm commitment, by contrast, the underwriter would bear the risk.

(a) Major issues discussed

• The role of Nepal Rastra Bank in fine-tuning the money supply.
• Monetary policy tools: open market operations, discount window loans and required reserve ratio (RRR).
• The meaning of the required reserve ratio and its effect on lending capacity.
• The inverse relationship between RRR and deposit/money supply, and the effect of a fall in RRR from 8% to 7% on a bank with Rs 500 billion of transaction deposits.

(b) Initial balance sheets (Rs billion)

Required reserves $=8\%\times500=40$. Assume the other assets of the commercial bank are loans and securities of 460, and that the central bank holds 40 of government securities against bank reserves.

(c) Change in deposits

New required reserves $=7\%\times500=35$, so excess reserves $=40-35=5$ billion.

Round 1: loans $=0.80\times5=4$; borrowers return $0.70\times4=2.8$ as deposits.

Each round, the new deposit adds to required reserves at 7%, so excess reserves left after a round with loans $l$:

$-l+0.7l-0.07(0.7l)=-0.349\,l$

With $l=0.8e$, the excess falls to $e(1-0.2792)=0.7208\,e$ each round. Total loans:

$L=\frac{0.8\times5}{1-0.7208}=\frac{4}{0.2792}\approx14.33$

$\Delta D=0.70\times14.33\approx10.03\text{ billion}$

New deposits $=500+10.03=\text{Rs }510.03$ billion. (After round 1 alone, deposits are 502.8.)

(d) Final balance sheets (Rs billion)

Of the loans of 14.33, 30% (4.30) is held as currency, so bank reserves are $40-14.33+10.03=35.70$, which equals the required $7\%\times510.03=35.70$.

(e) Why the negative relationship?

Banks must hold a fraction of deposits as reserves and may lend the rest. A lower RRR frees reserves into excess reserves, which the bank lends; much of the lent money returns as new deposits, which can be lent again, so deposits expand. A higher RRR cuts lendable funds and forces contraction. The potential multiplier is $1/RRR$ (less with currency leakage and unlent excess), so the lower the RRR, the bigger the deposit expansion, and vice versa.

Given: premiums = Rs 7.25 million, losses = Rs 2.11 million, loss adjustment expenses = 5.6%, policyholder dividends = 2.5%, investment income = Rs 200,000.

Loss ratio: $\frac{2.11}{7.25}\times100=29.10\%$

(a) Combined ratio

$\text{Combined ratio}=\text{Loss ratio}+\text{LAE ratio}+\text{Dividend ratio}=29.10+5.6+2.5=37.20\%$

(b) Operating ratio

Investment income ratio: $\frac{0.20}{7.25}\times100=2.76\%$

$\text{Operating ratio}=\text{Combined ratio}-\text{Investment income ratio}=37.20-2.76=34.44\%$

(c) Net profitability

$\text{Net profitability}=100\%-\text{Operating ratio}=100-34.44=65.56\%$

The company earns about 65.56% of premium income as profit, since its operating ratio is well below 100%.

Given: shares issued = 6,000,000; shares sold = 5,200,000; price = Rs 54; fee = Rs 1.25 per share sold (best-efforts basis).

(a) Money received by Himal

Total sales proceeds: $5{,}200{,}000\times54=\text{Rs }280{,}800{,}000$

Investment bank's fee: $5{,}200{,}000\times1.25=\text{Rs }6{,}500{,}000$

Money received by Himal: $280{,}800{,}000-6{,}500{,}000=\text{Rs }274{,}300{,}000$ (equivalently $5{,}200{,}000\times52.75$).

(b) Investment bank's profit

On a best-efforts basis the bank only acts as an agent and keeps its commission, so its revenue is Rs 6,500,000. This is its profit before its own selling costs, as no other costs are given. Unsold shares (800,000) earn nothing and are not bought by the bank.

(c) Who bears the risk

The issuer (Himal Company) bears the risk. In a best-efforts underwriting the investment bank does not guarantee the sale or buy unsold shares; it only tries its best to sell and earns a commission on the shares actually sold. If demand is weak, the issuer is left with unsold shares (here 800,000) and raises less capital than planned, whereas the bank loses nothing except the effort. In a firm commitment underwriting the bank would bear the risk.

(a) Major issues discussed

• The central bank's (Nepal Rastra Bank's) role in fine-tuning the money supply.
• The monetary policy tools: open market operations, discount window loans and the required reserve ratio.
• The meaning of the required reserve ratio and its effect: a higher ratio reduces the funds available for lending and so the total money in the banking system, and a lower ratio does the opposite.
• The effect of a change in the required reserve ratio (8% to 7%) on deposits, reserves and loans of a commercial bank with Rs 500 billion of transaction deposits.

(b) Initial balance sheets (Rs billion, simplified)

Required reserves = $8\%\times500=40$. The bank is assumed to hold exactly the required reserves.

Commercial bank:

Central bank:

(c) Change in deposits

New required reserves = $7\%\times500=35$.

Excess reserves = $40-35=5$ billion.

Loans made = $80\%\times5=4$ billion.

Funds returned as deposits = $70\%\times4=2.8$ billion.

$\text{Change in transaction deposits}=+\text{Rs }2.8\text{ billion}$ $\text{New deposits}=500+2.8=\text{Rs }502.8\text{ billion}$

(d) Balance sheets after the change (Rs billion)

Reserves = $40-4+2.8=38.8$ (the Rs 1.2 billion not returned leaves as currency held by the public).

Commercial bank:

Required reserves are now $7\%\times502.8=35.2$, so excess reserves are about 3.6.

Central bank:

(e) Why the relationship is negative

The required reserve ratio fixes the share of deposits the bank must keep idle, so the money multiplier is approximately $1/rr$. When the ratio falls, more of each deposit can be lent, and the loans return to the banking system as new deposits, so deposits expand through repeated rounds of lending. When the ratio rises, banks must hold more reserves, lend less, and deposits contract. Therefore the required reserve ratio and deposit expansion move in opposite directions. Here, a fall from 8% to 7% released Rs 5 billion of reserves and produced additional deposits.

Financial assets are intangible assets whose value comes from a contractual claim on future cash flows or on an underlying asset, such as shares, bonds, bank deposits, debentures and mutual fund units. They are held for investment and can be bought and sold in financial markets.

Two functions of merchant bankers:

• Issue management: Managing public issues of shares and debentures, including preparing the prospectus, getting regulatory approval, marketing and allotment.
• Underwriting: Guaranteeing to buy any part of an issue that the public does not subscribe.

Other functions include portfolio management, corporate advisory services, and merger and acquisition advice.

Two purposes of capital markets:

• Mobilising long-term funds: They channel savings of individuals and institutions into long-term investment by companies and governments through shares and bonds.
• Providing liquidity and price discovery: Investors can easily buy and sell securities, and trading sets fair prices that reflect information about firms.

They also support economic growth and capital formation.

Financial services are the economic services provided by financial institutions that help in raising funds and in the efficient use of money. They include banking, insurance, leasing, hire purchase, factoring, merchant banking, mutual funds, venture capital, credit rating and stock broking. They link savers and investors and help firms and individuals manage their funds and risks.

1. Accepting deposits: Commercial banks mobilise savings from the public through current, savings and fixed deposit accounts and keep them safe.
2. Granting loans and advances: They lend these funds to businesses, households and government through overdrafts, term loans and discounting of bills, earning interest income.

Other functions include remittance, agency services and credit creation.

Life insurance products used in Nepal include:

• Endowment policy: pays the sum assured at maturity or on earlier death.
• Whole life policy: covers the insured for the entire life, with the sum paid on death.
• Term life policy: pure risk cover for a fixed period with no maturity benefit.
• Anticipated endowment (money-back) policy: pays part of the sum assured at fixed intervals.
• Children's and pension (annuity) plans, foreign employment term policies and micro-insurance for low-income groups.

$\text{NAV}=\frac{\text{Market value of assets}-\text{Liabilities}}{\text{Shares outstanding}}$

Assets = $100\times140 + 200\times150 = 14{,}000+30{,}000 = \text{Rs }44{,}000$

$\text{NAV}=\frac{44{,}000-5{,}000}{1{,}000}=\text{Rs }39\text{ per share}$

Expected claim at the end of the year $= 0.01\times 500{,}000 = \text{Rs }5{,}000$.

Fair (net) premium is its present value, paid at the start of the year:

$\text{Premium}=\frac{5{,}000}{1.12}=\text{Rs }4{,}464.29$

Career average benefit (annual) = benefit rate $\times$ years of service $\times$ average salary.

Average annual salary $=30{,}000\times 12 = \text{Rs }360{,}000$

$0.06\times 30\times 360{,}000 = \text{Rs }648{,}000\text{ per year}$

This equals $0.06\times30=180\%$ of the average monthly salary, i.e. Rs 54,000 per month (Rs 648,000 per year).

Financial services are the products and services offered by financial institutions that help people and firms raise, save, invest, transfer and protect money. Their importance in the financial system is as follows.

1. Mobilisation of savings: Banks, cooperatives and insurers collect small scattered savings and channel them into productive investment.
2. Capital formation and economic growth: Loans, leasing, venture capital and share issue finance industry, trade and infrastructure, raising output and employment.
3. Liquidity and payment services: Cheques, cards, mobile wallets and remittance make exchange easy and cheap.
4. Risk management: Insurance, derivatives and diversification through mutual funds transfer or reduce risk.
5. Efficient resource allocation: Credit rating, merchant banking and brokerage give information so funds go to the best uses.
6. Support for the government and policy: Government borrows through T-bills and bonds, and central bank policy works through banks.
7. Price discovery and wealth creation: Securities markets set fair prices and let households build wealth.

The money market is the market for short-term funds (up to one year). Its main participants are:

1. Central bank (Nepal Rastra Bank): Regulates liquidity through open market operations, standing liquidity facility, repo and reverse repo, and issues T-bills for the government.
2. Commercial banks: The largest participants; they borrow and lend in the interbank (call) market and hold T-bills to manage liquidity and reserve requirements.
3. Other financial institutions: Development banks, finance companies, insurers, Employees Provident Fund and Citizen Investment Trust invest surplus funds in short-term instruments.
4. Government: Raises short-term funds by selling treasury bills.
5. Corporations: Raise working capital through commercial paper and invest idle cash in money market instruments.
6. Brokers and dealers: Act as intermediaries who match buyers and sellers and make the market.
7. Individuals and mutual funds: Participate directly in small amounts or indirectly through money market funds.

Concept: A credit rating agency (CRA) is an independent institution that assesses the creditworthiness of a borrower or of a debt instrument, such as a bond or debenture, and expresses it as a letter grade, e.g. AAA, AA, BBB. The grade shows the probability that interest and principal will be paid on time. In Nepal, ICRA Nepal and CARE Ratings Nepal are licensed by SEBON.

Functions:

1. Information provision: Gives investors an independent, reliable and standard assessment of risk, reducing information asymmetry.
2. Investment decision aid: Helps investors choose securities that suit their risk appetite.
3. Pricing of debt: Higher-rated issuers pay a lower interest rate, so rating helps price securities.
4. Market access for issuers: A good rating makes it easier to raise funds from the public and widens the investor base.
5. Regulatory compliance: Rating is compulsory for public issue of debentures, and bank capital rules use ratings for risk weights.
6. Monitoring and discipline: Ratings are reviewed and revised regularly, pushing issuers toward better financial management.

(a) NAV at current prices

Fund A: $10{,}000\times200 + 5{,}000\times150 = 2{,}000{,}000+750{,}000 = \text{Rs }2{,}750{,}000$

$\text{NAV}_A=\frac{2{,}750{,}000}{100{,}000}=\text{Rs }27.50$

Fund B: $8{,}000\times200 + 4{,}000\times150 = 1{,}600{,}000+600{,}000 = \text{Rs }2{,}200{,}000$

$\text{NAV}_B=\frac{2{,}200{,}000}{100{,}000}=\text{Rs }22.00$

(b) NAV after one month (Himal Rs 220, Tarai Rs 140)

Fund A: $10{,}000\times220 + 5{,}000\times140 = 2{,}200{,}000+700{,}000 = 2{,}900{,}000$, so NAV $=\text{Rs }29.00$

Fund B: $8{,}000\times220 + 4{,}000\times140 = 1{,}760{,}000+560{,}000 = 2{,}320{,}000$, so NAV $=\text{Rs }23.20$

The rise in Himal outweighs the fall in Tarai in both funds, so NAV rises by Rs 1.50 in A and Rs 1.20 in B.

Holding period return (no dividends, no fees):

$HPR_A=\frac{29.00-27.50}{27.50}=5.45\%\qquad HPR_B=\frac{23.20-22.00}{22.00}=5.45\%$

Both funds earn the same return because they hold Himal and Tarai in the same 2:1 proportion.

(a) Hi and Lo are the highest (Rs 260) and lowest (Rs 160) prices at which the stock traded during the last 52 weeks.

(b) Volume is quoted in hundreds: $340\times100 = 34{,}000$ shares were traded on the quotation day.

(c) Dividend yield is the annual dividend as a percentage of the current market price:

$\text{Dividend yield}=\frac{\text{Annual dividend per share}}{\text{Closing price}}\times100=\frac{10}{250}\times100=4\%$

This matches the 4% shown in the table.

(d) Net change is the difference between today's closing price and the previous day's closing price. A net change of $-3$ means the stock closed Rs 3 lower than the day before, so the previous closing price was $250+3=\text{Rs }253$.

(a) Flat benefit formula

$800\times30=\text{Rs }24{,}000\text{ per year}$

(b) Career average formula

$0.04\times20{,}500\times30=\text{Rs }24{,}600\text{ per year}$

(c) Final pay formula

Average of last four years $=\dfrac{28{,}000+28{,}500+29{,}000+30{,}000}{4}=\dfrac{115{,}500}{4}=\text{Rs }28{,}875$

$0.03\times28{,}875\times30=\text{Rs }25{,}987.50\text{ per year}$

(a) Expected claim

$20\times100{,}000=\text{Rs }2{,}000{,}000$

(b) Present value of expected claim (paid at the end of the year)

$PV=\frac{2{,}000{,}000}{1.10}=\text{Rs }1{,}818{,}181.82$

(c) Net premium per policy

$\frac{1{,}818{,}181.82}{10{,}000}=\text{Rs }181.82$

A financial system is a network of financial markets, financial institutions, financial assets (instruments) and regulators that moves funds from savers to borrowers. The financial system of Nepal consists of the four components below.

Components of the Nepalese financial system

1. Financial markets:
   • Money market: short-term funds, e.g. T-bills, interbank lending, repo.
   • Capital market: long-term funds, i.e. primary and secondary markets for shares, bonds and debentures, with NEPSE as the only stock exchange.
2. Financial institutions:
   • Banking (depository) institutions: Nepal Rastra Bank (central bank), commercial banks (class A), development banks (class B), finance companies (class C) and microfinance institutions (class D).
   • Non-bank (contractual and investment) institutions: insurance companies, Employees Provident Fund, Citizen Investment Trust, Social Security Fund, and cooperatives.
   • Capital market intermediaries: stock brokers, merchant bankers (capital companies), depositories, and credit rating agencies.
3. Financial instruments (assets): deposits, loans, T-bills, development bonds, shares, debentures, insurance policies, mutual fund units.
4. Regulators: Nepal Rastra Bank regulates banks and financial institutions and conducts monetary policy; Nepal Insurance Authority (formerly Beema Samiti) regulates insurance; Securities Board of Nepal (SEBON) regulates the capital market; the Department of Cooperatives regulates cooperatives; and the Ministry of Finance sets overall policy.

Banks dominate the system and hold most financial assets, while the capital market and insurance are comparatively small but growing.

The financial system of Nepal has thus developed from the establishment of Nepal Bank Limited (1937) and Nepal Rastra Bank (1956) into a multi-institution system, with reforms since the 1980s liberalising interest rates and entry. Today it also faces challenges of financial inclusion, high concentration in banks, and a shallow capital market.

Position before the change

Required reserves at 10% $=0.10\times350=\text{Rs }35$ million. Assume Bhumi Bank was fully loaned up, with reserves of Rs 35 million and loans of Rs 315 million (amounts in Rs million).

New requirement

Required reserves at 11% $=0.11\times350=\text{Rs }38.5$ million.

Excess reserves $=35-38.5=-\text{Rs }3.5$ million, which is a reserve deficiency, not an excess. There are no excess reserves to convert into loans, so the bank cannot lend anything in either case, and the amounts returned as deposits (50% in (a), 60% in (b)) are zero.

(a) and (b): same result

Loans made $=100\%\times0=0$ in (a), and $75\%\times0=0$ in (b), so deposits remain Rs 350 million. The bank must cover the Rs 3.5 million shortage, for example by borrowing from the central bank (discount window) or selling securities to it.

Bhumi Bank (Rs million)

Central Bank (change, Rs million)

If the bank instead recalls Rs 3.5 million of loans (Rs 311.5 million remaining), it moves toward compliance, but only if the repaid money comes from outside the bank so that deposits fall and required reserves drop; a higher reserve ratio therefore contracts credit and the money supply.

Face value Rs 100,000, price Rs 98,500, 90 days. Dollar discount $=100{,}000-98{,}500=\text{Rs }1{,}500$.

(a) Bank discount yield

$d=\frac{1{,}500}{100{,}000}\times\frac{360}{90}=0.015\times4=6.00\%$

(b) Bond equivalent yield

$BEY=\frac{1{,}500}{98{,}500}\times\frac{365}{90}=0.015228\times4.0556=6.18\%$

(c) Holding period return

$HPR=\frac{100{,}000-98{,}500}{98{,}500}=1.52\%$

(d) Effective annual yield

$EAY=(1+HPR)^{365/90}-1=(1.015228)^{4.0556}-1=1.0632-1=6.32\%$

Bond (coupon $=0.12\times1{,}000=\text{Rs }120$, $n=15$, $k=14\%$)

$V=120\times\frac{1-(1.14)^{-15}}{0.14}+\frac{1{,}000}{(1.14)^{15}}=120(6.1422)+1{,}000(0.1401)=737.06+140.10=\text{Rs }877.16$

Market price Rs 1,100 > value Rs 877.16, so the bond is overvalued by about Rs 222.84.

Common stock ($D_0=20$, $g=6\%$, $k=20\%$)

$D_1=20(1.06)=\text{Rs }21.20$

$V=\frac{D_1}{k-g}=\frac{21.20}{0.20-0.06}=\text{Rs }151.43$

Market price Rs 90 < value Rs 151.43, so the stock is undervalued by about Rs 61.43.

Decision: Invest in the common stock. A security should be bought when its intrinsic value exceeds its market price. The stock offers a margin of 68% over its price, whereas the bond costs Rs 222.84 more than it is worth and would yield less than the required 14%. The Rs 1,000,000 buys about $1{,}000{,}000/90\approx11{,}111$ shares. The stock also carries greater risk, so the investor should be comfortable that the 6% growth forecast is realistic.

(a) Capital (Rs million)

Core capital (Tier 1):

Supplementary capital (Tier 2):

The general loan loss provision is within the limit of 1.25% of risk weighted assets. Borrowings are not subordinated debt, so they are excluded.

$\text{Total capital}=1{,}350+180=\text{Rs }1{,}530\text{ million}$

(b) Risk weighted assets

On-balance-sheet:

Off-balance-sheet: advance payment guarantees $2{,}100\times100\%=2{,}100$; performance bonds $1{,}600\times50\%=800$, total 2,900.

$\text{Total RWA}=8{,}960+2{,}900=\text{Rs }11{,}860\text{ million}$

(c) Capital adequacy

$\text{CET1 (core) ratio}=\frac{1{,}350}{11{,}860}=11.38\%\ (\text{min }5\%)$

$\text{Tier I ratio}=\frac{1{,}350}{11{,}860}=11.38\%\ (\text{min }7.5\%)$

$\text{Total capital ratio}=\frac{1{,}530}{11{,}860}=12.90\%\ (\text{min }10\%)$

The bank meets all three requirements, since each ratio is above the minimum. The bank has Rs 344 million of capital above the required 10% ($0.10\times11{,}860=1{,}186$), so it can expand risk assets further.

(d) Significance of the Capital Adequacy Framework 2015

1. Based on Basel III, it raises the quantity and quality of capital by emphasising common equity (CET1), so banks can absorb unexpected losses.
2. It sets higher minimum ratios and adds a capital conservation buffer and a countercyclical buffer, so banks build capital in good times.
3. It requires capital for credit, market and operational risks, and Pillar II supervisory review adjustments, so risk is captured more fully.
4. It requires disclosure under Pillar III, so market discipline improves and depositors and investors are better informed.
5. It protects depositors and the financial system, promoting stability and public confidence.
6. It limits excessive lending and risk-taking, and improves international comparability of Nepalese banks.

Non-depository institutions are financial institutions that do not accept deposits from the public. They raise funds by selling policies, units, shares or contributions, and invest them in long-term assets. Examples: insurance companies, mutual funds, Employees Provident Fund, Citizen Investment Trust, Social Security Fund, and securities brokers.

Four functions of Citizen Investment Trust (CIT):

1. Mobilises long-term savings through retirement schemes and unit schemes.
2. Manages the retirement funds of employees and individuals (approved retirement funds).
3. Operates mutual fund (unit) schemes and issues units to small investors.
4. Provides merchant banking services such as issue management, underwriting, portfolio management and share registrar, and invests in shares and debentures.

Two major objectives of monetary policy:

1. Price stability: keeping inflation at a low, stable level (Nepal targets around 5-6%).
2. Exchange rate and external stability with adequate foreign reserves, together with supporting economic growth and employment by managing money supply and credit.

Financial services are the services offered by financial institutions that help individuals and businesses to raise, save, invest, transfer and protect funds. Examples: banking, insurance, leasing, hire purchase, factoring, merchant banking, credit rating and mutual fund management.

Four money market instruments practised in Nepal:

1. Treasury bills (T-bills): government securities of 28, 91, 182 and 364 days sold by auction.
2. Interbank (call) money: very short-term loans between banks and financial institutions to manage liquidity.
3. Repo and reverse repo: central bank buys or sells securities with an agreement to reverse the transaction, as an open market operation.
4. Certificates of deposit and commercial paper, or Standing Liquidity Facility/deposit collection auction: short-term instruments used by banks and companies to raise or absorb liquidity.

Two major functions of credit rating:

1. Provides information to investors: an independent opinion on the issuer's ability to pay interest and principal, which reduces information asymmetry and helps investment decisions.
2. Helps issuers raise funds: a good rating improves access to the market and lowers the cost of borrowing, as higher-rated issuers pay less interest.

Four features of an insurance contract:

1. Utmost good faith: both parties must disclose all material facts honestly.
2. Insurable interest: the insured must stand to suffer a financial loss from the event.
3. Indemnity: (for non-life) the insured is compensated for the actual loss only, not more.
4. Contract of adhesion and conditional payment: the policy terms are set by the insurer, and the claim is payable only on the occurrence of the insured event after premium payment.

With a front-end load, the investor pays the offering price:

$\text{Offering price}=\frac{\text{NAV}}{1-\text{load}}=\frac{15}{1-0.05}=\text{Rs }15.79\text{ per share}$

The load fee is about Rs 0.79 per share.

The required purchase price is the present value of the ordinary annuity:

$PV=200{,}000\times\frac{1-(1.10)^{-20}}{0.10}=200{,}000\times8.5136=\text{Rs }1{,}702{,}712$

Deposits at the start of each year form an annuity due:

$FV=15{,}000\times\frac{(1.10)^{10}-1}{0.10}\times1.10=15{,}000\times15.9374\times1.10$

$FV\approx\text{Rs }262{,}967$

Financial services play the following roles in the economy.

1. Mobilising savings and channelling them to investment: They turn scattered household savings into funds for business and government projects, increasing capital formation.
2. Economic growth and employment: Credit, leasing, venture capital and share markets finance industries, trade and infrastructure, creating jobs and output.
3. Facilitating payments and trade: Banking, remittance and electronic payment systems make exchange of goods and services fast and cheap.
4. Risk protection: Insurance and diversification protect people and firms from loss of life, property and business.
5. Liquidity and price discovery: Securities markets let investors convert assets into cash and show fair prices.
6. Efficient allocation of resources: Credit rating, merchant banking and advisory services guide funds to the most productive uses.
7. Support to government and monetary policy: Governments borrow through bonds and T-bills, and the central bank transmits policy through banks and markets.
8. Financial inclusion and living standards: Microfinance, cooperatives and mobile banking bring services to the poor and remote areas.

Stock broker: A member of the stock exchange who buys and sells securities on behalf of clients and earns commission. In Nepal brokers are licensed by SEBON and members of NEPSE. Functions:

1. Execute buy and sell orders of clients on the exchange.
2. Advise clients on investment choices and market conditions.
3. Maintain client accounts, collect payments and arrange settlement and delivery of shares.
4. Provide market information and research, and act as an agent only, without taking ownership of the shares.

Stock dealer: A person or firm that trades securities on its own account, buying and selling as a principal to make profit from price differences. Functions:

1. Create liquidity by always being ready to buy or sell, quoting bid and ask prices (market making).
2. Take positions in securities and bear the price risk.
3. Narrow the spread and stabilise prices.
4. Earn profit from the bid-ask spread and trading gains rather than commission.

The broker acts as an agent for a commission, whereas the dealer acts as a principal.

Concept: The capital market is the market for long-term funds, with securities of maturity longer than one year, such as shares, debentures, bonds and mutual fund units. It has the primary market, where new securities are issued, and the secondary market (stock exchange, NEPSE), where existing securities are traded. Participants include companies, government, investors, brokers, merchant bankers and the regulator SEBON.

Functions:

1. Mobilises long-term savings and converts them into long-term investment.
2. Finances business and government: Companies raise equity and debt, and government raises funds through development bonds.
3. Provides liquidity through the secondary market, so investors can sell securities easily.
4. Price discovery: Supply and demand set the fair value of securities.
5. Promotes capital formation and economic growth by directing funds to productive uses.
6. Efficient allocation of resources to profitable firms and sectors.
7. Investment opportunities and wealth creation for small investors, with diversification.
8. Corporate governance: Listing and disclosure rules force transparency and discipline.

An investment banker (merchant banker) is a financial intermediary that helps companies and government raise long-term capital and gives related advice. In Nepal, merchant banking is carried out by licensed capital companies (e.g. NIBL Capital, Nabil Investment Banking, Global IME Capital), licensed by SEBON.

Roles:

1. Issue management: Prepares the prospectus, manages the public issue of shares and debentures and allots securities.
2. Underwriting: Guarantees to buy unsold securities, which assures the issuer of the funds.
3. Share registrar and depository services: Maintains shareholder records and manages share transfers.
4. Portfolio and fund management: Manages investments for individuals and institutions, and mutual fund schemes.
5. Corporate advisory: Advises on capital structure, mergers, acquisitions, valuation and restructuring.
6. Project and loan syndication: Prepares project reports and arranges finance.
7. Market making and promotion of the capital market, helping to deepen it and protecting investors.

(a) Current NAV

Assets $=2{,}000\times60+1{,}000\times50=120{,}000+50{,}000=\text{Rs }170{,}000$

$\text{NAV}=\frac{170{,}000}{10{,}000}=\text{Rs }17.00$

(b) Expected NAV at year end

Assets $=2{,}000\times70+1{,}000\times45=140{,}000+45{,}000=\text{Rs }185{,}000$

$\text{NAV}=\frac{185{,}000}{10{,}000}=\text{Rs }18.50$

(c) Holding period return

$HPR=\frac{18.50-17.00}{17.00}=8.82\%$

Assume the mortality rate is constant at 1.5% per year for the 25 years.

Expected annual benefit $=0.015\times600{,}000=\text{Rs }9{,}000$

Present value of this 25-year annuity at 12%:

$PV=9{,}000\times\frac{1-(1.12)^{-25}}{0.12}=9{,}000\times7.8431=\text{Rs }70{,}588$

The present value of expected benefits is about Rs 70,588.

Annual benefit $=0.05\times\text{career average salary}\times\text{years of service}$

Concept of the financial system

A financial system is a network of markets, institutions, instruments and regulators that transfers funds from surplus units (savers) to deficit units (borrowers). Its main functions are mobilising savings, allocating resources efficiently, providing payment and settlement services, managing risk, and creating liquidity. A sound financial system supports capital formation and economic growth.

Components of the Nepalese financial system

1. Financial markets:
   • Money market: short-term funds, e.g. T-bills, interbank lending, repo.
   • Capital market: long-term funds, i.e. primary and secondary markets for shares, bonds and debentures, with NEPSE as the only stock exchange.
2. Financial institutions:
   • Banking (depository) institutions: Nepal Rastra Bank (central bank), commercial banks (class A), development banks (class B), finance companies (class C) and microfinance institutions (class D).
   • Non-bank (contractual and investment) institutions: insurance companies, Employees Provident Fund, Citizen Investment Trust, Social Security Fund, and cooperatives.
   • Capital market intermediaries: stock brokers, merchant bankers (capital companies), depositories, and credit rating agencies.
3. Financial instruments (assets): deposits, loans, T-bills, development bonds, shares, debentures, insurance policies, mutual fund units.
4. Regulators: Nepal Rastra Bank regulates banks and financial institutions and conducts monetary policy; Nepal Insurance Authority (formerly Beema Samiti) regulates insurance; Securities Board of Nepal (SEBON) regulates the capital market; the Department of Cooperatives regulates cooperatives; and the Ministry of Finance sets overall policy.

Banks dominate the system and hold most financial assets, while the capital market and insurance are comparatively small but growing.

Types of insurance companies

1. Life insurance companies: Provide cover against death and survival risks, with products such as endowment, whole life, term, anticipated endowment, children's and pension plans, and also offer savings and investment value.
2. Non-life (general) insurance companies: Cover property and liability risks, such as fire, motor, marine, engineering, aviation, agriculture and livestock, travel and health (medical) insurance. These contracts are mostly annual and based on indemnity.
3. Reinsurance companies: Insure the insurers by taking over part of the large risks they have underwritten (e.g. Nepal Reinsurance Company, Himalayan Reinsurance).
4. Micro-insurance companies: Offer small-premium life and non-life cover to low-income and rural people.

Present condition of the insurance industry in Nepal

1. Regulation: The industry is regulated by the Nepal Insurance Authority (formerly Beema Samiti, established 1968), under the Insurance Act 2079 (2022).
2. Structure: Roughly 40 insurers operate, comprising about 14 life, 13 non-life, 2 reinsurance and a few micro-insurers, along with agents, surveyors and brokers. The first insurer was Nepal Insurance Company; Rastriya Beema Sansthan was government-owned.
3. Growth: Premium income and the number of policies have grown steadily, led by the life segment, which collects the majority of premium. Penetration is low, at around 3-4% of GDP, compared with higher figures in India and developed countries.
4. Capital and consolidation: Higher minimum capital requirements have caused mergers and acquisitions to strengthen the sector. Many companies have listed their shares on NEPSE.
5. Distribution: Mainly through agents; digital channels and bancassurance are expanding.
6. Challenges: Low awareness and trust, delayed claim settlement, limited rural reach, weak investment options, lack of skilled actuaries and competition, with high expense ratios.
7. Prospects: Compulsory insurance (e.g. third-party motor, workers), agriculture and health insurance programmes, and increasing income and awareness provide scope for further growth.

(a) Price at 10% (coupon = Rs 120)

$P=120\times\frac{1-(1.10)^{-7}}{0.10}+\frac{1{,}000}{(1.10)^7}=120(4.8684)+1{,}000(0.5132)=584.21+513.16=\text{Rs }1{,}097.37$

(b) Price at 11%

$P=120\times\frac{1-(1.11)^{-7}}{0.11}+\frac{1{,}000}{(1.11)^7}=120(4.7122)+1{,}000(0.4817)=565.46+481.66=\text{Rs }1{,}047.12$

(c) Percentage change in price

$\frac{1{,}047.12-1{,}097.37}{1{,}097.37}=-4.58\%$

(d) Relationship: Bond price and required rate of return move in opposite directions. When the required return rises, future cash flows are discounted more heavily and the price falls (here 1 point rise gives a 4.58% fall); when it falls, price rises. When the required return is below the coupon rate the bond sells at a premium, equal to it at par, above it at a discount. The longer the maturity and the lower the coupon, the more sensitive the price.

Total issue is Rs 100 million: non-competitive Rs 15 million (15%) and competitive Rs 85 million (85%).

(a) Non-competitive bidders

They receive Rs 15 million face value of T-bills. In the American auction they are not allotted at their own price but pay the weighted average price of the accepted competitive bids, computed in (b), which is Rs 95 per Rs 100 face value.

(b) Competitive bidders

Bids are filled from the highest price downward until Rs 85 million is allotted:

In an American (discriminatory price) auction each successful bidder pays the price it bid. Bidder 4 is only partly filled because the issue is exhausted.

Weighted average price:

$\frac{30(96)+30(95)+20(94)+5(93)}{85}=\frac{8{,}075}{85}=\text{Rs }95$

(c) Yields of bidder 1 (price Rs 96, face Rs 100, 91 days)

$\text{Discount yield}=\frac{100-96}{100}\times\frac{360}{91}=15.82\%$

$\text{Bond equivalent yield}=\frac{100-96}{96}\times\frac{365}{91}=16.71\%$

Amounts in Rs million.

(a) Tier 1 capital

Common equity tier 1 (CET1):

Additional tier 1 capital = perpetual non-cumulative preference shares 50 + perpetual debt instruments 70 = Rs 120.

$\text{Tier 1 capital}=10{,}060+120=\text{Rs }10{,}180$

(b) Supplementary (Tier 2) capital and total capital

$\text{Total capital}=10{,}180+830=\text{Rs }11{,}010$

(The general loan loss provision of 700 is within the limit of 1.25% of credit risk weighted exposure.)

(c) Total risk weighted exposure

$65{,}000+16{,}000+3{,}000+200=84{,}200$

Adding the Pillar II adjustment of 3,000:

$\text{Total RWE}=\text{Rs }87{,}200$

(d) Capital adequacy ratios

$\text{CET1 ratio}=\frac{10{,}060}{87{,}200}=11.54\%\ (\text{min }6\%)$

$\text{Tier 1 ratio}=\frac{10{,}180}{87{,}200}=11.67\%\ (\text{min }8.5\%)$

$\text{Total capital ratio}=\frac{11{,}010}{87{,}200}=12.63\%\ (\text{min }11\%)$

All three ratios exceed the minimum NRB requirements, so ABC Bank has sufficient capital. The required total capital is $0.11\times87{,}200=959.2$, leaving a surplus of about Rs 2,051 million.

(e) Significance of capital adequacy

1. It provides a cushion to absorb unexpected losses, so the bank continues to operate.
2. It protects depositors and maintains public confidence.
3. It links capital with the risk taken, so risky banks must hold more capital and excessive risk-taking is discouraged.
4. It promotes the stability of the financial system and lowers the chance of bank failure and systemic crisis.
5. It is a measure of the bank's financial strength, and supports its growth, credit rating and ability to raise funds.
6. It aligns with international (Basel III) standards, making the bank acceptable to foreign partners.