Unit 1: Introduction

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FIN 252: Foundations of Financial
Markets and Institutions
Facilitator:
Ram Krishna Tiwari
BBS 4th Year

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Course Outline
 Lecture Hours: 150
 Full Marks: 100
 Pass Marks: 35
 Course Objective/s
 Lay the foundation of students on financial institutions
and markets by imparting the fundamentals concepts
and theories of financial markets and institutions.
 functioning of financial institutions such as depository
and non-depository financial institutions, the role of the
central bank, and the markets for government and
corporate securities.

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Course Details
 Unit 1: Introduction - LH 10
 Unit 2: Financial Institutions, Financial Intermediaries and Asset
Management Firms - LH 7
 Unit 3: Depository Institutions- LH 8
 Unit 4: The Central Bank and Monetary Policy - LH 10
 Unit 5: Insurance Companies - LH 15
 Unit 6: Investment Companies and Pension Funds - LH 15
 Unit 7: Determinants of Asset Prices and Interest Rates - LH 15
 Unit 8: Organization and Structure of Markets - LH 10
 Unit 9: Market for Government Securities - LH 10
 Unit 10: Markets for Common Stock - LH 10
 Unit 11: Market for Corporate Senior Securities - LH 10
 Unit 12: The Mortgage and Asset-backed Securities Markets - LH 10
 Unit 13: Risks of Financial Institutions - LH 10
 Project Work - LH 10

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About Financial Markets and
Institutions
 Important components of market economy.
 Fundamentals concepts and theories of;
 Financial markets and assets,
 Depository and non-depository financial institutions,
 Central banking and monetary policy,
 Assets price and interest rates,
 Organization and structure of markets,
 Government securities markets,
 Markets for corporate securities,
 Mortgage and assets backed securities, and
 Risk in financial institutions.

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1.Overview of financial assets: concept of financial assets,
debt versus equity instruments, the price of financial assets
and risk, financial assets versus tangible assets, the role of
financial assets;
2.Financial markets: concepts and role of financial markets,
classification of financial markets, market participants,
globalization of financial markets, classification of global
financial markets, motivation for foreign market and
Euromarkets;
3.The role of the government in financial markets:
justification for regulation, forms of regulation; and
4.Financial innovation: categorization of financial
innovations, and motivation for financial innovation.

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Concept of Assets
An asset, broadly speaking, is any
possession that has value in an exchange,
which can be classified as tangible or
intangible.
Tangible Assets
 Value is based on physical properties
 Examples include buildings, land, machinery
Intangible Assets
 Claim to future income
 Examples include various types of financial
assets

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Real versus Financial Assets
• Real Assets
• Used to produce goods and services: Property,
plants and equipment, human capital, etc.
• Financial Assets
• Claims on real assets or claims on real-asset
income

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Real versus Financial Assets
• All financial assets (owner of the claim) are
offset by a financial liability (issuer of the
claim)
• When all balance sheets are aggregated,
only real assets remain
• Net wealth of economy = Sum of real assets

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Real Assets vs. Financial Assets
Real assets:
 Possess productive capacity, hence are used to
produce goods and services
 Examples are property, plant & equipment, human
capital, etc.
Financial assets:
 Represents claims on income and other assets and
define the allocation of income or wealth
 Examples are shares of stocks, bonds, treasury
securities, etc
10

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Financial Assets
1. Fixed-income (debt) securities
a) Money market instruments
 Bank certificates of deposit, T-bills, commercial paper,
etc.
b) Bonds
c) Preferred stock
2. Common stock (equity)
 Ownership stake in entity, residual cash flow
3. Derivative securities
 Contract, value derived from underlying market condition
• Major Classes of Financial Assets or Securities

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Types of Financial Assets
Bank loans
Government
bonds
Corporate bonds
Municipal bonds
Foreign bond
Common stock
Preferred stock
Foreign stock

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Identify the Type of Asset by Putting
Cross (x)
Assets Real Financial
Plant and equipment X
Treasury bill
College education
A Rs 100 note
Patents
13

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Debt vs. Equity
 Debt Instruments
 Fixed rupees payments
 Examples include loans, bonds
 Equity Claims
 Rupees payment is based on earnings
 Residual claims
 Examples include common stock, partnership share

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Price of Financial Asset and Risk
The price or value of a financial asset is
equal to the present value of all expected
future cash flows.
 Expected rate of return
 Risk of expected cash flow

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Do you want to receive?
Option A
 Rs. 1000
 After 3 years
Option B
 Rs. 875 today
Applicable Interest rate 5%

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Calculation
Option A
 Calculate PV
PV = FV / (1 + i)n
= 1000/(1 + 0.05)3
= Rs. 863.84 today
Option B
 Rs. 875 today
Option B should
be accepted

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Types of Investment Risks
Purchasing power risk or inflation risk
Default or credit risk
Exchange rate or currency risk

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Role of Financial Assets
Transfer funds from surplus units to deficit
units.
Transfer funds so as to redistribute
unavoidable risk associated with cash flows
generated from both tangible and intangible
assets.
 Redistribute risk among people or institutions

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Key Points You Should Understand
Difference between tangible and financial
assets
Difference between debt and equity
Cash flow of a financial asset
Three types of risks associated with financial
asset
Two principal economic functions of financial
assets

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Overview of the financial markets

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Financial Markets
A financial market is a market where
financial assets are exchanged (i.e. traded).
not necessary for the creation and exchange
of a financial asset.
The market in which a financial asset trades
for immediate delivery is called the spot
market or cash market.

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Classification of financial markets
1. By nature of financial claim, e.g. Debt markets and
Equity markets.
2. By maturity of claim, e.g. Money market (short-term debt
instruments), Capital market (longer-maturity financial
assets).
3. By seasoning of claim: Primary market (dealing with
financial claims that are newly issued), Secondary market
(exchanging financial claims previously issued)
4. By immediate delivery or future delivery: Cash or Spot
market, Derivative markets
5. By organizational structure: Auction market, OTC market
or Intermediated market

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Primary markets versus secondary
markets
 Primary market – Households which are in
financial surplus, exchange their savings for
shares, debentures and securities of the
financial deficit sectors such as the companies
and governments
 Public issue of securities are made through
prospectus
 New issues of equity and debt are arranged in
the form of a new flotation, either publicly or
privately or in form of a rights offer, to existing
shareholders
 The transactions in the primary market result in
capital formation

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markets (contd.)
 Secondary market – securities which have
been issued in the past are traded
 Secondary market is called stock market or
stock exchange
 Owners of shares to sell their holdings readily
ensuring liquidity
 Secondary market enables investors to
continuously rearrange their assets if they so
desire by divesting themselves of such assets
while others can use their surplus funds to
acquire them
 Any trade of share subsequent to its primary
offering is called a secondary transaction

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markets (contd.)
 Initial buyer in the primary market may re-offer the
securities to any interested buyer at whatever price is
mutually satisfactory
 The stock exchange provides a market where such
mutually satisfactory prices may be determined
 The stock exchange offer opportunities primarily for
trading risk and boost liquidity
 The presence of an active secondary market actually
promotes the growth of the primary market and capital
formation because investors in the primary market are
assured that a continuous market exists and they can
liquidate their investment in the stock exchange
 The participants in the secondary market are linked by
formal trading rules and communication networks for
trading securities

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Money markets Vs capital markets
 Money markets
 to meet the short term investment needs (1 year or less)
 to earn a small positive rate of return on cash
 Highly liquid, minimal risk of principle loss
 money markets consist of unsecured interbank trading, short
term debt issuance, short-term secured lending
 Use of a temporary surplus of funds by banks or businesses
 Capital markets
 where borrowers raise cash for long-term investment needs
 generally riskier than money markets and
 capital market securities must promise to pay a higher rate of
return to attract funds
 savers willing to take the associated risk are attracted to these
markets

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Money markets Vs capital markets
Money
markets
• Interbank transaction
• Treasury bills: short-term debts of government
• Commercial paper: short-term liabilities of
prime business firms and finance companies
Capital
markets
• Ordinary share
• Preference share
• Debentures/Government securities

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Financial markets by type of
claim
Fixed income market
Residual claim
Debt instrument Preferred stock Common stock
Fixed amount claim
Equity (stock) market
Debt Market Common stock market
Source: Fabozzi and Modigliani (2010)

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Financial markets by maturity of
claim
Maturity 1 year
or less
Debt instruments Common stock and preferred stock
Money Market Capital market
Maturity greater
than 1 year
Source: Fabozzi and Modigliani (2010)

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Foreign exchange markets
 The majority of the world’s business involves international
business transactions
 As corporations and institutions have increased their
international transactions, foreign exchange risk has
become a major source of risk for many firms today and
much hedging with spot and forward foreign exchange
trades occurs
 International financial crisis effect domestic economy
 Remittance inflow effect due to foreign currency fluctuation
 Oil price effect the overall economy of the country

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Derivative security markets
 A derivative security is a contract which derives its value
from some underlying asset or market condition
 Main purpose of the derivatives markets is to transfer risk
between market participants.
 Hedgers
 enter derivatives contracts to reduce their risk exposure in the
underlying cash market (Eliminate the risk of price fluctuations)
 Speculators
 use derivative contracts to bet on price movements
 speculators gamble on price fluctuations and hope to profit
 Derivatives are highly leveraged instruments
 This allows hedgers to reduce risk with a low capital investment and
the leverage also allows speculators to attempt to earn high rates of
return with low capital investments

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Derivative security markets
 The two main types of derivatives markets
 Market for exchange traded derivatives
 Exchange traded derivatives are generally liquid and involve
no counterparty risk
 Over the counter (OTC) derivatives markets
 OTC contracts are custom contracts negotiated between two
counterparties and have default risk
 Long—Buyer of the contract, receive commodity in the future
 Short—Seller of the contract, provide commodity in the future
 Derivative security markets are the newest of the financial
security markets in the context of Nepal

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Economic Functions (Role) of
Financial Markets
1. The interactions of buyers and sellers in a financial
market determine the price of the traded asset. (Price
discovery process), (Determine price or required rate of
return of asset.)
2. Financial markets provide a mechanism for an investor
to sell a financial asset. A financial market offers liquidity.
The degree of liquidity is one of the factors that
characterize different markets. (Provide liquidity.)
3. It reduces the cost of transaction. Search costs and
information cost.(Reduce transactions costs, which
consists of search costs and information costs.)

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Financial Market Participants
 Households
 Business units (nonfinancial and financial
enterprises)
 National governments, federal, state, and local
governments
 Government agencies
 Supranational (such as the World Bank, the
European Investment Bank, and the Asian
Development Bank)
 Regulators

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Three economic functions of financial
markets
Ways that financial markets can be
classified
Market participants

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Globalization
 Globalization is a process of interaction and
integration among the people, companies, and
governments of different nations, a process driven
by international trade and investment and aided by
information technology.
 Globalization (or globalisation) is the process of
international integration arising from the
interchange of world views, products, ideas and
other aspects of culture.

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Globalization of Financial Markets
Factors that have led to the integration of financial
markets
1. Deregulation or liberalization of markets and
the activities of market participants in key financial
centers of the world.
2. Technological advances for monitoring world
markets, executing orders, and analyzing financial
opportunities
3. Increased institutionalization of financial
markets.

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Globalization of Financial Markets
Financial markets have shifted from
domination by retail investors (individuals)
to domination by financial institutions
(institutional investors).

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Globalization of Financial Markets and
Institutions
 Recent decades have witnessed the globalization of
financial markets to an unique degree
 The growth in foreign financial markets has 5 ongoing
causes:
1. Greater pool of savings in foreign countries
2. Better investment prospects outside of countries with large savings
3. The Internet has improved information availability on foreign markets
and securities
4. Low cost methods to invest in foreign securities have proliferated
(fast growth)
5. Deregulation around the world has allowed investors to purchase
more foreign securities.

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Classification of Global Financial
Markets
Internal Market
(also called national
market)
External Market
(also called international
market, offshore market,
and Euro market)
Domestic Market Foreign Market

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Markets
 National Market
 The National Market System (NMS) is the national system for
trading equities in the a Single Country. The System includes all
the facilities and entities which are used by broker-dealers to fulfill
trade orders for securities. This includes: major stock exchanges,
such as NYSE and NEPSE.
 Domestic Market
 A domestic market, also referred to as an internal market or domestic
trading, is the supply and demand of goods, services, and securities within
a single country. In domestic trading, a firm faces only one set of
competitive, economic, and market issues and essentially must deal with
only one set of customers, although the company may have several
segments in a market.
 South Korean Market
 Foreign Market
 Part of a nation's internal market, representing the mechanisms for issuing
and trading securities of entities domiciled outside that nation.

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Markets
 Euromarket
 The euromarket is the market that includes all of the European
Union member countries - many of which use the same currency,
the euro. All tariffs between Euromarket member countries have
been abolished, and import duties from all non-member countries
have been fixed for all of the member countries. The Euromarket
also has one central bank for all of the member countries, the
European Central Bank (ECB).

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Questions
Explain the differences between:
1. Domestic Market vs. Foreign Market
2. National Market vs. Euromarket

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Motivation for Using Foreign Markets and
Euromarkets
1. The fund-seeking corporation’s domestic market is not fully developed
and cannot satisfy its demand for funds on globally competitive
terms.(Limited fund availability in internal market)
2. There may be opportunities for obtaining a lower cost of funding than is
available in the domestic market.(Reduced cost of funds)
3. Diversifying funding sources

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Derivatives Market
Futures/forward contracts are obligations
that must be fulfilled at maturity.
Options contracts are rights, not obligations,
to either buy (call) or sell (put) the underlying
financial instrument.

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Role of Derivative Instruments
Protect against different types of investment
risks, such as purchasing power risk,
interest rate risk, exchange rate risk.
Advantages:
 Lower transactions costs
 Faster to carry out transaction
 Greater liquidity

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Three major factors that have integrated
financial markets
Institutionalization of financial markets
Internal and external markets
Motive to raise money outside of domestic
market
Two basic types of derivatives
Principal economic role of derivatives
Potential uses of derivatives

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The Regulation
Regulations are legal restrictions
circulated by government authority.
Financial system is among the most heavily
regulated sectors of the economy.
Banks are among the most heavily regulated
of financial institutions.
However,
Regulations sometimes can’t prevent financial
crisis.
The time and energy spent on regulatory compliance
activities are costly.

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Justification for Regulation
Create competitive market and fairness
Prevent market failure
Prevent fraud
Promote stability of financial institutions
Control level of economic activity
Restrict the activities of foreign concerns in
domestic markets and institutions

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Types of Regulation
 Disclosure regulation
 Financial activity regulation
 Regulation of financial institution
 Regulation of foreign participation

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Regulation in Nepal
Reasons for regulation
 Stock market crash of 1929, Great Depression
of 1930s, Asian Crisis of 1997, and Financial
Crisis of 2008
Regulation primarily by Nepal Rastra Bank,
Government, SEBON, Insurance Board, and
Regulatory Institutions

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Financial market regulation
 Financial markets are regulated by the Security Board of
Nepal (SEBO/N) in Nepal
 The primary purposes of regulations are
 to prevent fraud,
 to ensure performance as promised, and
 to ensure that the public has enough information to evaluate
the riskiness of an investment.
 the regulators do not attempt to ensure investors earn a
minimum rate of return
 to ensure full and fair disclosure of information on securities
issues to actual and potential investors (new issue legal
document “Prospectus”)
 monitors trading on the exchanges

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Financial market regulation (contd.)
 The primary purposes of regulations are…………………
 To ensure that stockholders and managers do not trade on the
basis of insider information
 An effort to reduce excessive price fluctuations
Current Regulations
1. NRB Act, 2058
2. BAFIA, 2063
3. Unified Directives
4. Foreign Currency related Act and Circulars

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Financial market regulation (contd.)
 Securities Allotment Guidelines, 2068
 Securities Exchange Act, 2006
 Membership of stock exchange and transaction bye-laws
1993
 Securities listing bye-laws 1996
 New issue management guidelines 1997
 Securities allotment guidelines 1997
 Compliance guidelines for securities brokers
 Securities registration and issue approval guidelines 2057
 Bonus share guidelines 2058
 Government securities transaction bylaws of SEBO 2062.
 Securities Registration and Issue Regulation, 2065
 Securities Registration and Issue Regulation, 2065
(First Amendment)
 Securities Issue Guidelines, 2065
See (http://sebon.gov.np/)

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Overview of the financial institutions

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Financial institutions
 Institution that perform the essential function of channeling
funds from those with surplus funds to those with shortages
of fund
 Savers typically desire a different type of claim than the
ultimate borrower wishes to offer
 Asset transformers, such as banks, offer low risk claims to
savers while granting higher risk, more illiquid investments
(e.g., loans) to the funds demanders.
 Other types of institutions have evolved to meet special
needs of savers such as life insurance firms to eliminate
certain risks, pension funds to transfer wealth through time,
mutual funds to pool investors’ savings, etc.

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Financial Institutions
A. Depositary Financial Institutions
1. Commercial Banks
2. Development Banks
3. Finance Companies (in Nepal only)
4. Micro-credit Development Banks
5. Saving Credit Cooperatives
6. NGOs (Financial Intermediaries)

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Financial Institutions
B. Non-Depositary Financial Institutions
1. Insurance Companies
- Life insurance companies
- Non-life insurance companies
2. Investment Companies
3. Employees Provident Fund
4. Citizen Investment Trust
5. Mutual Funds

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Flow of Funds in Financial Markets

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Categorization of financial
innovations
 Financial system/institutional innovations.
 Such innovations can effect the financial sector as a
whole, relate to changes in business structures, to the
establishment of new types of financial
intermediaries, or to changes in the legal and
supervisory framework. Important examples include
the use of the group mechanism to retail financial
services, formalizing informal finance systems,
reducing the access barriers for women, or setting
up a completely new service structure.
 For e.g. - Bancassurance

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innovations
Process innovations
 Such innovations cover the introduction of new
business processes leading to increased
efficiency, market expansion, etc. Examples
include office automation and use of
computers with accounting and client data
management software.

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innovations
Product innovations.
 Such innovations include the introduction of new
credit, deposit, insurance, leasing, hire
purchase, and other financial products.
Product innovations are introduced to respond
better to changes in market demand or to
improve the efficiency.

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Explanation for the existence of regulation
Goals sought in regulation
Major forms of regulation
financial innovation
Categorization of financial innovations
Motivation for financial innovation

Unit 1: Introduction

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