CHAPTER II

FINANCIAL MARKET

New Issues
market
Money (Primary
market)
Market
Securities
Market
Financial
markets Capital
Secondary
Market
Markets
Other
forms of
lending and
borrowing

A financial market refers to a marketplace where individuals, institutions, and governments engage in
buying and selling various financial instruments. It is a platform that facilitates the exchange of capital,
financial assets, and securities among buyers and sellers. The primary purpose of financial markets is to
enable the efficient allocation of resources and the transfer of risk.
Financial markets can take different forms, including: Stock Market, Bond Market, Foreign Exchange
Market, Money Market, Derivatives Market and Cryptocurrency Market. This market involves the trading
of digital currencies, such as Bitcoin, Ethereum, and other block chain-based assets.

Types of financial market

Primary market
A primary market is a financial market where new securities are issued to the public for the first time. In a
primary market, companies, governments, and other entities can raise capital by issuing stocks, bonds,
and other securities to investors. The primary market refers to the initial sale of securities by a company
to the public. This is typically done through an initial public offering (IPO) where the company issues
shares of stock to investors for the first time. The securities are sold through underwriting, where
investment banks and other financial institutions act as intermediaries between issuers and investors. The
Securities Board of Nepal (SEBON) is the regulatory body that oversees the primary market in Nepal.
Method of Issuing Securities
Public Offering: When a privately held company decides to raise capital by issuing securities to the
public, it is called public offerings. After Public offering, private company becomes public company.
After being public company, its shares are traded in stock exchanges.
There are two types of public Offering:
Initial Public Offering (IPO)
Further Public Offerings (FPO)
Direct Placement/ Private Placement: Direct Placement is the sale of an entire issue of securities to few
investors such as large banks, mutual funds, insurance companies, pension funds. It is different from
public offering. In public offering securities are open for any kind of investors while in direct placement,
securities are offered to s small number of institutions. Direct placement has advantage over public
offering of extensive, time consuming process and costly registration process. However, its disadvantages
are such that its share cannot be traded in secondary market and hence securities are less liquid.
Right offerings: A rights issue is an offering of rights to the existing shareholders of a company that gives
them an opportunity to buy additional shares directly from the company at a discounted price i.e.
subscription price. The number of additional shares that can be bought depends on the existing holdings
of the shareowners

Secondary Market
The market where the existing and pre developed securities are bought and sold is called secondary
market. Secondary Market is the market for trading securities between investors. The market where the
existing and pre developed securities are bought and sold is called secondary market. Secondary market
provides liquidity to the purchaser of the securities. Secondary market can be regarded as the center to
convert stocks, bonds, and other securities into cash immediately. In comparison to the primary market
there is a higher transaction of securities in the secondary market.
Secondary Market can be classified as Organized Securities Exchange and Over the counter market. In
Nepal, NEPSE is the Organized Secondary Exchange
Nepal Stock Exchange (NEPSE)
It is the only one organized stock market of Nepal. It is incorporated in 1993 under companies act and
operated under Securities Act. It started trading of securities since 1994. NEPSE works for the listing of
the companies. Listing means to register all the publicly traded securities in the secondary market.
NEPSE focuses on the capital formation and promotes the investors of the secondary markets. The
primary focus of NEPSE is to regulate the trading of the shares, bonds, mutual funds and other securities.
NEPSE works as the regulatory body and oversees the market operations, listed companies and securities
dealers.
NEPSE publishes four different types of indexes that reflect the behavior of stock market of Nepal.
They are: NEPSE index, NEPSE Float index, NEPSE Sensitive Index and NEPSE Sensitive Float Index
Long term financial securities
It refers to those instruments which are issued and traded in capital market. They are: Common stock,
Preferred stock, Long term debt, etc.
Common Stock
Common stock are those securities that represents the ownership of company. It is one of the major and
important source of financing. Common stock holders are the real owner of company.
Number of shares that is allowed to issue is known as authorized share.
Number of shares that is offered by company to sell is known as issued share.
Number of shares that have been repurchased by company is known as treasury stock.
e.g.
Authorized share = 100000
Issued share = 80000
Treasury stock = 20000
___________________
Outstanding share = 60000

Features
Par value
It is the recorded value of share of common stock in firm’s cooperative charter. Par value is stated price in
common stock certificates. The corporate charter specifies the par value of a share of common stock. In
Nepal Companies Act. 2063 (2006 A.D.) has given flexibility to set the par value. A company can set a
par value of Rs 50 each or any other higher amount divisible by the figure 10 as provided in the
memorandum of association and articles of association.
Maturity
Common stock has no maturity date. It exists as long as the firm does. Therefore, capital raised from
common stocks is also called fixed or permanent capital.
Claim on Income and Assets
Common stockholders have residual claim on income. Common stockholders are paid after satisfying
claims of creditors, bondholders and preferred stockholders. Residual income can be distributed to
common shareholders directly in the form of dividends or retained and reinvested by the firm. Just as
common stock has a residual claim on income, it also has residual claim on assets in case of liquidation.
When a firm is declared bankrupt, its assets are sold, and at first, the proceeds are distributed to
employees, the government, secured creditors, unsecured creditors, preferred stockholders and finally to
common stockholders. This residual claim on income and asset increases the risk to the common
stockholders.
Preemptive Rights
The preemptive right gives the existing shareholders right to purchase any new shares issued by the
company at subscribed price on pro-rata basis. Preemptive rights allow common stockholders to maintain
their proportionate ownership and control in the company. If the company sells new shares to the existing
stockholders, it is called a rights offering.
Voting Rights
Common stockholders can attend the annual general meeting and cast vote in person or by means of a
proxy. A proxy is a legal document giving one person the authority to represent on behalf of others
document which give permission to act for others.
Voting system where each common share carries one vote for each director to be elected is known as non-
cumulative voting system. Voting system in which stockholder can accumulate vote and cast all of them
for one director or divide them among various directors is called cumulative voting system.
Limited Liability
Although the common shareholders are the actual owner of the company and have residual claim on all
assets, their liability in case of the liquidation bankruptcy is limited to the amount of their investment. The
shareholder liability will not exceed the par value.

Equity Account in Balance Sheet

It consist common stock, additional paid in capital, retained earnings etc.
For e.g.

Common stock (100000 @100) 10000000

Additional paid in capital (share premium) 2000000
Retained earnings 8000000
Total shareholder equity 20000000
Book value per share 200

Advantages of Common Stock from the viewpoint of Issuer

1. Common stock is the source of permanent capital. Fund raised from common stock is available for use
as long as the company exists.
2. Common stock does not legally obligate the firm to pay dividend. Dividend payment is discretionary.
If a company generates sufficient earnings, it can pay dividend to common stockholders. In contrast to
bond interest, there is no legal obligation to pay dividends to common stockholders.
3. Common stock financing increases the borrowing capacity of the company. Because common stock
provides a cushion against losses of creditors, the sale of common stock generally increases the credit
worthiness of the firm. Thus, business firm with strong equity base is capable to obtain loan easily and
common stock strengthens the equity base of the firm.
4. Common stock is easily marketable than debt and preferred stock. Common stock appeals to certain
group of investors because (a) it typically carries a higher expected rate of return than does preferred
stock or debt, (b) Capital gains on the sale of common stock are subject to a lower personal income tax,
and (c) It provides the investor with a better hedge against unexpected inflation as common dividends
tend to rise during inflationary periods

Disadvantages of Common Stock Financing to the Issuer

1. Common stock is expensive source of long-term financing. Common stockholders expect a higher rate
of return than other investors, since the risk involved is also high. Moreover, flotation costs that include
underwriting commission, brokerage fee, and other expenses usually are higher than those for debt and
preferred stock.
2. New common shares may dilute the ownership and control of the existing shareholders because new
shareholders also get voting rights. Dilution of ownership assumes greater significance in case of closely-
held companies.
3. The sale of additional common stock dilutes the existing shareholders' primary earnings per share,
particularly if the assets acquired with the proceeds of the financing do not produce earnings immediately.
4. Common stock dividends are not tax deductible payments. The impact of this factor is reflected in the
relatively higher cost of equity capital as compared with debt capital.

Right offering
Methods of selling new common stocks to existing shareholders at subscribed price is known as right
offering. It protects from dilution of wealth and control power. Subscribed price is lower than market
price.

Preferred Stock
Preferred stock, also called preference share, represents the long-term source of financing. It occupies an
intermediate position between long-term debt and common stock in terms of claim on assets and dividend
payment. In the event of liquidation, a preferred stockholders' claim on assets comes after that of creditors
but before that of common stockholders. Similarly, preferred stock dividend is distributed after payment
of interest but before distribution of common stock dividend.
Preferred stock is a hybrid form of financing with combined features of both debt and common stock. It is
similar to debt in some respects and to common stock in others. Like bonds, preferred stock dividends are
fixed in amount and preferred stockholders have no voting right. Often, preferred stocks carry credit
ratings much like those of bonds and preferred stocks are often callable.
Preferred stock for which unpaid dividends do not accumulate is called non-cumulative preferred stock.
Preferred stock for which all unpaid dividends must be paid before payments of dividend to common
stock.
Features
PAR VALUE
Par value is stated price in the certificate of preferred stock. Like bonds, the preferred stocks always have
par value. This par value is important for two reasons. First, the par value shows the amount due to the
preferred stockholders in the event of liquidation or maturity. Second, the preferred stock dividend
frequently is expressed as a percentage of par value. Hence, par value is important to compute amount of
dividend.

FIXED DIVIDEND
Preferred stockholders get fixed amount of dividend. Preferred stock dividend may be expressed in
amount or stated as a percentage of par value. However, company can omit or postpone the preferred
stock dividend if company suffers loss.

MATURITY
Preferred stock, legally is ownership capital and forms a part of firm's total equity capital. A firm
generally, issues preferred stocks without specified maturity date but in recent years companies have also
issued preferred stocks with specified maturity

CUMULATIVE FEATURE
Most preferred stocks are cumulative in nature. It means the unpaid dividend in any year is carried
forward. Cumulative preferred stock requires such past unpaid preferred stock dividends to be paid before
any common stock dividends are declared and paid.

PARTICIPATING FEATURE
Only few preferred stocks have a participating feature, which allows the preferred stockholders to
participate with common stock in the residual earnings of the firm. The preferred stockholders might be
entitled to share equally with common stockholders if common stock dividend is beyond a certain amount
or there may be some specified formula. Virtually, preferred stocks are non-participating, hence preferred
stock dividend does not increase, even if the company's earnings increase.

VOTING RIGHTS
Unlike common stockholders, generally preferred stockholders do not have the right to vote for the
company's board of directors In other words, as preferred stockholders get prior claim on income and
assets, they not normally given a voice in management However, preferred stockholders a given special
voting right if the company omits its preferred stock dividends a specified period.
CLAIMS ON ASSET AND INCOME
Preferred stock bears its name because it usually has preference or priority over common stock with
regard to company's dividends and assets.
At the time of liquidation, preferred stockholders' claim is satisfied after the bondholders' claim is
satisfied. But they have prior claim before that of common stockholders. Similarly, preferred stockholders
also have a claim on income prior to common stockholders. Firm must pay its preferred stock dividends
before it pays common stock dividend.

CALL FEATURE
Like bonds, preferred stock is generally callable. A call provision gives the issuing firm the right to call
the preferred stock for redemption at a specified price before maturity date. The specified price at which
preferred stock is called is known as call price, which is usually higher than the par value. The amount in
excess of par value is termed as call premium. This call feature allows the issuing company a measure of
flexibility in its financing plan, but on the other hand, it increases the risk to the investors.

CONVERSION FEATURES
Preferred stock may contain conversion feature. A convertible preferred stock can be converted into
specified number of common stocks within specified period of time. This feature helps to attract potential
investors and reduce dividend rate.

SINKING FUND
In recent years, preferred stocks are issued with sinking fund provision. This provision requires that the
company should create a fund to retire preferred stock. A sinking fund provision ensures the orderly
retirement of the stock.

Advantages of Preferred Stock

The following are major advantages of preferred stock financing to the firm:
1. Preferred stock financing protects from dilution of control power. Because the preferred
stockholders do not have voting right. Thus, they do not have voice in the management of the company.
Hence, the control power of ordinary shareholders remains preserved
2. It increases the flexibility in capital structure, and dividend payment. Preferred stocks may have call
provision which increases the flexibility in capital structure. Besides, the dividend can be postponed if
earning is insufficient.
3. It protects from dilution in earnings. By issuing preferred stocks, the company can avoid the provision
of equal participation in earnings.
4. Preferred stock financing is less risky than long-term debt financing.
6. It is permanent source of capital. Typically, preferred stocks have no fixed maturity. It is a permanent
source of capital. However, if call provision is included, company can call preferred stock and redeem
them.

Disadvantages of preferred stock

1. Expensive source of long-term financing: Preferred stock financing is expensive to the
source of long-term financing because of two reasons:
i. The dividend rate on the preferred stock is higher than the interest rate payable on
debentures.
ii. Unlike interest, the preferred stock dividend is not tax-deductible expenses.

2. Static Dividend: The preferred stock dividend is fixed and the company must have a
commitment to pay this dividend. Although preferred stock dividends can be omitted,
they may have to be paid because of their cumulative nature. Thus, preferred dividends
are like fixed costs. The use of preferred stocks, like that of debt, increases financial risk
and thus cost of common equity.

3. Difficulty to sell in the market: Preferred Stock is difficult to sell in the market. Investors
may not like to invest in preferred stocks because they get only a fixed amount of
dividend even though the firms earning is too high. Besides, if the earning of the firm is
low or unstable investors may not get the preferred dividend. Hence, it is difficult to sell
stocks.
4. Limited Increase in Value: The share price of preferred stock usually remains fairly
steady, so you have little chance of profiting from an increase in share value when you
sell the stock. In fact, if interest rates increase, the value of your shares will decrease
because investors are more interested in higher-yielding bonds. They won’t be willing to
pay as much for a stock with lower dividend rates.
5. Increase in financial burden: Because most of the preference shares issued are
cumulative, the financial burden on the part of the company increases highly. The
company also reduces the dividend of the equity shareholders because of the reason that
it is essential on the part of the company to pay dividends to the preference shareholders.

Long term debt

Long-term debt is an important source of financing. It has initial maturity more than one year. But
typically it has maturity between 5 to 20 years, Bonds and term loan from financial institutions are two
major sources of long-term debt financing. The suppliers of debt capital are called creditors or lender.
Usually, they do not have voice in management and cannot exercise control over the company. Since
coupon payment or interest rate is fixed, they cannot participate in the residual earning of the company. In
liquidation, the bondholders and creditors have prior claim to that of preferred stockholders and common
stockholders.

In capital market, we find many types of long-term debt instruments: term loan bonds, secured and
unsecured notes, etc. In this section, we briefly discuss about bonds.
Bonds
Bonds are investment securities where an investor lends money to a company or a government for a set
period of time, in exchange for regular interest payments. Once the bond reaches maturity, the bond issuer
returns the investor’s money. Fixed income is a term often used to describe bonds, since your investment
earns fixed payments over the life of the bond.
Characteristics of bond
PAR VALUE
The par value is the stated face value of the bond, which is paid at maturity. It is also called maturity
value or face value or principal. It usually is set at Rs 1,000 per bond, although multiple of Rs 1,000 is
also used. But in Nepal, par value of corporate bonds must be Rs 1,000. The par value or principal
generally represents the amount of money the firm borrows and promises to repay on the maturity date.
Par value is used to work out annual coupon payment.

COUPON INTEREST RATE

Interest at the end of each period (year or six months). This amount is called fixed interest rate at which
bondholders are paid at the end of each period

MATURITY
Generally bonds are issued with finite maturity. Maturity date is the specified date on which the principal
amount (par value) is repaid. The number of year to maturity at the time a bond is issued is known as
original maturity. For e.g. Nepal SBI Bank issued "12.5% Nepal SBI Bank Debenture 2090" with 10
years maturity.

INDENTURE
An indenture is a legal document or contract that contains terms and conditions of bond issue. It includes
details of debt issue, description of property pledged (if any), the methods of principal repayment,
restrictions (or covenants) placed on the firm by the lenders, rights and responsibilities of both borrower
and lender.

CALL PROVISION
Special provision in the indenture that gives the issuer the right to call the bonds prior to maturity at call
price

SINKING FUND
Sinking fund provision is a special provision in a bond contract that facilitates the orderly retirement of
the bond. In some cases, the firm may be required to deposit money with trustee, which invests the funds
and then uses the accumulated sum to redeem the bonds at maturity.

Mutual funds
A mutual fund is a financial vehicle that pools assets from shareholders to invest in securities like stocks,
bonds, money market instruments, and other assets. Mutual funds give small or individual investors
access to professionally managed portfolios of equities, bonds, and other securities. There are two types
of mutual funds: Open ended mutual fund and close ended mutual fund.

Basis Open Ended Closed Ended

Buy In or Buy Out Investors can buy in and buy out Investors can buy in and buy out during
at any time limited period.

Maturity Period No fixed maturity period Maturity range from 3 years to 5 years

Listing on Stock Not Listed Listed on recognized stock Exchange

Exchange

Pricing Pricing is determined by Net Pricing is determined by Supply and

Assets Value Demand of Share/ stock

Lock in Period No Lock in period, investors can Once entered, investors has to stay for the
exit at any time entire period.

Advantages of Mutual funds

Advanced Portfolio Management
When you buy a mutual fund, you pay a management fee as part of your expense ratio, which is used to
hire a professional portfolio manager who buys and sells stocks, bonds, etc. This is a relatively small
price to pay for getting professional help in the management of an investment portfolio.
Dividend Reinvestment
As dividends and other interest income sources are declared for the fund, they can be used to purchase
additional shares in the mutual fund, therefore helping your investment grow.
Risk Reduction (Safety)
Reduced portfolio risk is achieved through the use of diversification, as most mutual funds will invest in
anywhere from 50 to 200 different securities—depending on the focus. Numerous stock index mutual
funds own 1,000 or more individual stock positions.
Convenience and Fair Pricing
Mutual funds are easy to buy and easy to understand. They typically have low minimum investments and
they are traded only once per day at the closing net asset value (NAV). This eliminates price fluctuation
throughout the day and various arbitrage opportunities that day traders practice.

Disadvantages of Mutual Funds

High Expense Ratios and Sales Charges
If you're not paying attention to mutual fund expense ratios and sales charges, they can get out of hand.
Be very cautious when investing in funds with expense ratios higher than 1.50%, as they are considered to
be on the higher cost end. Be wary of 12b-1 advertising fees and sales charges in general. There are
several good fund companies out there that have no sales charges. Fees reduce overall investment returns.
Management Abuses
Window dressing may happen if your manager is abusing their authority. This includes unnecessary
trading, excessive replacement, and selling the losers prior to quarter-end to fix the books.
Tax Inefficiency
Like it or not, investors do not have a choice when it comes to capital gains payouts in mutual funds. Due
to the turnover, redemptions, gains, and losses in security holdings throughout the year, investors
typically receive distributions from the fund that are an uncontrollable tax event.
Poor Trade Execution
If you place your mutual fund trade any time before the cut-off time for same-day NAV, you'll receive the
same closing price NAV for your buy or sell on the mutual fund. For investors looking for faster
execution times, maybe because of short investment horizons, day trading, or timing the market, mutual
funds provide a weak execution strategy.