Financial

Instruments and
Interest Rates
Chapter Two
Concept of Financial Instruments
• A financial instrument is a contract that represents a financial asset to one party and a
financial liability or equity to another. These instruments facilitate borrowing, lending,
investing, and risk management in financial markets.
• A financial instrument is a contractual agreement between two parties that holds
monetary value and can be created, traded, modified, or settled based on the parties'
requirements. In simple terms, any asset that has a capital value and can be traded in
financial markets is considered a financial instrument.
• These instruments can be divided into two types cash instruments and derivative
instruments or can be divided based on asset class like debt instrument or equity
instrument. The third unique category is of foreign exchange instruments.
• Debt and Equity instruments differentiated based on the type of claim that the holder
has on it. When the claim is on for a fixed amount of money, it is a debt instrument.
Debt instruments can be either short term less than one year or long term with tenure
greater than one year.
• In comparison to this equity, instruments obligate the issuer of the financial instrument
to pay the holder an amount only if profits have been earned and after the debt
payments are made. Typical examples of equity instruments are common stock or a
partnership share in the business. However, some securities fall in both these
categories and have attributes of both. One such example is preferred shares,
convertible bonds.
The general features of financial instruments are:
1. The financial instruments do not have any physical existence. They are intangible in
nature.
2. They can be used as a medium of exchange or can be converted into money at little
cost or risk.
3. The return from financial instrument may be either in the form of interest or
dividend or appreciation in value.
4. The rate of interest debt instruments and rate of dividend in preferred stock is fixed
but the rate of dividend on common stock is not fixed.
• The financial instrument are traded in financial market.
• The financial instrument are more liquid. It can be easily traded or converted into
cash as when required.

Thus, financial instrument is the written legal obligation of one party to transfer
something of value, usually money, to another party at some future date, under
certain conditions. Financial instruments be debt instruments, equity instruments, and
hybrid instruments.
Functions of Financial Instruments
• Transfers fund from surplus unit to deficit unit: The first function of financial
instrument is to transfer funds from those who have surplus funds to invest to those
who need a source of fund for financing tangible assets. Financial instrument link
deficit units with surplus unit by transfer funds.
• Redistribute the risk: The second function of financial instrument is to redistribute
the risk associated to the investment in tangible assets between different version.
Financial counterparties according to their preferences and risk instruments allow for
the transfer of risk. Like futures and insurance contracts allows one person to transfer
risk to another.
TYPES OF FINANCIAL INSTRUMENTS
Money market and capital market instruments:
• Money market instruments are financial instruments having less than one-year maturity period.
Treasury bill, certificate of deposit, commercial paper, bankers' acceptance etc. are short-term
securities.
• These are traded in the money market as and when required. These generally have a relatively high
degree of liquidity because of their short-term maturity. Money market instruments tend to have a
low expected return but also a low degree of credit (default) risk.
• Common types of money market securities include Treasury bills (issued by the U.S. Treasury),
commercial paper (issued by corporations), and negotiable certificates of deposit (issued by
depository institutions).
• Capital market instruments are financial instruments that have more than one year maturity period.
Common stock, preferred stock, bonds etc., are long-term securities. Common stocks do not have any
maturity period.

• Bonds and preferred stocks may be perpetual or redeemable. The perpetual securities have no specific
life but redeemable securities have certain life. Long-term securities are used to collect long term
financial resources or to formulate capital of the firm. This financial asset can be traded in capital
market only.
Money Market Instruments
a. Treasury bills
• Treasury bill is a short ternm securities issued by the central bank on the behalf of government. It
is a short term instruments of the government to collect public debt with a maturity of less than
one year.
• Generally, maturity period of T-bills may be 28 days or 91 days or 180 days or 270 days or 364
days. It is issued at discount price and matured at par value. This instrument cannot earn interest
but the discount is the earning of the holders.
• The tax is not charged by the government on the income of Treasury bill. Short-term obligations
issued by Nepal Rastra Bank (in context of Nepal) on the behalf of the government.
b. Federal funds
• Federal funds refer to excess reserves held by financial institutions, over and above the reserve
requirements of the central bank.
• Banks will borrow or lend their excess funds to each other on an overnight basis, as some banks find
themselves with too much reserves and others with too little. Federal funds are short-term funds
transferred between financial institutions usually for not more than one day.
• They are overnight borrowings between banks and other entities to maintain their bank reserves at
the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve
requirements and to clear financial transactions.
c. Repurchase agreement
• Repurchase agreement is selling a security under an agreement to repurchase it at a predetermined
date and rate. It is an agreement involving the sale of securities by one party to another with a
promise by the seller to repurchase the same securities from the buyer at a specified date and price.
• The reverse of the repo transaction is called 'reverse repo' which is lending of funds against buying
of securities with an agreement to resell the said securities on a mutually agreed future date at an
agreed price which includes interest for the funds lent. The difference between the price at which the
securities are bought and sold is the lender's profit or interest earned for lending the money.
• The terms of contract is in terms of a 'repo rate,' representing the money market borrowing/lending rate.
Repo rate is the annual interest rate for the funds transferred by the lender to the borrower. The repo rate
is usually lower than that offered on unsecured inter-bank rate as it is fully collateralized. The factors
which affect the repo rate are the creditworthiness of the borrower, liquidity of the collateral, and
comparable rates of other money market instruments.
d. Commercial paper
• Commercial paper is short-term unsecured promissory notes issued by a company to raise short-term
cash. It is an important instrument of money market. Generally, this paper can be issued by the
creditworthy firm. This is issued without any collateral.
• Hence it is unsecured short term instruments of money market. The interest rate on this paper is
comparatively below than the market rate. Its maturity period is less than 270 days. They are issued
in multiples of 100,000 or more.
• Generally, commercial' paper is sold on a discount basis. It means that the issuer issues at discount
and matures at face value in the due date.
e. Negotiable certificate of deposit
• Certificate of deposit (CDs) is the evidence of deposit in bank or saving and loan association for
specific period at specific rate of interest.
• It is simply an evidence of time deposit. It may be negotiable or non negotiable. Negotiable
certificate of deposit refers to unsecured, negotiable, short-term instruments in bearer form, issued
by commercial banks and development financial institutions.
• They are time deposits of specific maturity similar to fixed deposits (FDs). CDs are transferable and
tradable while FDs are not.
• Negotiable Certificate of Deposit (CD) is a special type of time deposit of a commercial [Link] CDs
typically have maturities of one to twelve months and are issued in denominations ranging from Rs. 1,00,000 to
Rs. 1million. CDs are sold only by the largest and most creditable banks and have a very low default risk. CDs
are generally sold at discount or pay coupon Interest paid at maturity.
f. Banker's acceptance
• Bankers acceptance is time draft payable to a seller of goods, with payment guaranteed by a bank. It
is a legal document that is accepted by the bank. This documernt can be used in internal and external
trade. The buyer requests its bank to issue a written promise on its behalf that ensures payment to the
seller.
• The written document promise authorizes the seller to draw a time document on the bank in payment
for the goods. Thus, the written promise becomes an unconditional liability of both the bank and the
buyer of the goods is known as banker's acceptance. The banker's acceptance specifies the amount of
money and the person to which the payment is due. It can be sold or discounted in the money
market.
• It is also sold at discount. It makes transactions between two parties in domestic market and foreign
market as well. It allows the parties to substitute the bank's creditworthiness for that who owes the
payment. It is widely used in international trade for payments that are due for a future shipment of
goods and services.
g. Call/notice money market
• Borrowing money without collateral from other banks for short period. Under call money market,
funds are transacted on overnight basis and under notice money market, funds are borrowed/lent for
a period between 2-14 days.

h. Eurodollars
• Eurodollars are a relatively new instrument. They are nothing more than U.S. dollar denominated
liabilities of foreign banks or offices of U.S. banks located in foreign countries. Eurodollars are
traded in Europe. American firms and banks can borrow in this market.. Banks use Eurodollars to
make domestic loans and investment. The loans are generally from one month to six months, and
transaction sizes are typically Rs. 10 million
Yield on Money Market Instruments
a. Discount yield (D): Yield on money market instrument is generally quoted on a bank discount
basis, not on a price basis Discount yield is the total return on money market instruments equal to the
change in value of an instrument based on a 360-day year without compounding the interest. It is the
return on investment generated by purchasing the instrument at a discount and then selling it par
when it matures.

b. Bond equivalent yield (BEY): Discount yield is commonly calculated for municipal treasury
bills (t-bills), zero-coupon bonds, commercial paper most money market instrunte and so on. The
quoted yield on a bank discount basis is not a meaningful measure of the returnform holding a
treasury bill for two reasons.
• First, the measure is based on a face value rather than the actual amount invested. Second, the yield is
annualized according to a 360 day rather than 365 day in a year, making it difficult to Compare
Treasury bill yields with Treasury notes and bonds, which pay interest on a 365 day basis, Hence, Bond
equivalent yield is calculated. Bond equivalent yield is also known as investment rate yield, equivalent
coupon yield.

c. Single-payment yield (SPY): Some money market securities pay interest only once, at
maturity. Quoted nominal interest rates on single-payment securities normally assume a 360-day year.
Therefore, to compare single-payment yields with bond equivalent yields, the quoted single- payment
yield must be converted into a bond equivalent yield.
d. Effective annual yield (EAY): Effective annual vield (EAY is annualized nominal rate of
interest based on a 365 days in a year. It akes into account compound interest earrning. Thus,
effective annual yield is the rate of interest that an investor can earn (or pay) in a year after taking
into consideration compounding.

e. Holding Period Return (HPR): The rate of return on investment for holding securities for a
certain prriod.
Capital Market Instruments
1. Common stock
• Common stock is the instrument issued by the firm to collect long term financial resources. It is also
known as equity stock or ordinary stock. It is a type of security that signifies ownership in a
corporation and represents a claim on part of the corporation's assets and earnings.
• For example, an owner of a corporation will have a stock certificate which provides evidence of his
or her ownership of a corporation. Being the owner of the company shareholders have to
participatein a profit and loss of a firm.
• The rate of dividend of the shareholders is not fixed. They have residual claim on income and assets.
They cannot participate directly in management and control of the firm. So, they elect their
representative in management and control individually known as director and collectively known as
board of directors.
Features of Common Stock
a. Par value: Par value is the stated price of shares. It is the face value of shares, Generally the
face value of share is Rs 100 in Nepal at present.

b. No maturity period: The maturity period of common stock is not fixed. The common
stocks are issued perpetual in nature. So, it has no naturity date. It exists as long as the firm
does. Therefore, financial resources of common stockS are also called permanernt liability
of the firm.

c. No fixed rate of dividend: The shareholders are actual owners of the firm. After fulilling
the all claims of outsiders the remaining income belongs to the stockholders. So, the rate of
dividend on common stock is not fixed. Common stockholders have residual claim on
income.
d. Residual claim on assets: The shareholders have residual claim on assets in case of
lhquidation. When a goes into bankruptcy, its assets are liquidated, and payables are paid on
priority employees, Government tax, secured creditors, unsecured creditors, preferred
stockholders and finally common stockholders. This residual claim of the common stock
makes it riskier than other securities.

e. Limited liabilities: The important feature is limited liability of shareholders. The

shareholders bear limited liability up to the face value of shares held by them. This means
personal property is not responsible for the debt of the firm. This feature may attract the
probable investors.

f. Voting right: Generally, shareholders are the actual owners of the firm. So, any
shareholders can use their vote on important matters of firm. The shareholders cast their
vote in annual general meeting of shareholders.
• Representative management and control: The shareholders are owner of the firm but they
cannot directly participate in management and control of the firm. So, they elect their
representative in management and control of the firm individually known as director and
collective known as board of directors. Generally, the minimum nIumber of board of director
is 7 members and maximum is 11 members. Among the elected board members one is
selected as chairperson.

• Preemptive right: Preemptive right is the right given to the existing stockholders regarding
right to purchase new share before it is offered to the public. Such right gives existing share
holder right to purchase the share on pro rata basis. It protects the dilution power of existing
share holder. The pre-emptive right has been carriedout through right offering.
2. Preferred Stock
• The preferred stock is another long term sources of fund. It is also called preference share. Preferred stock is
also a security issued by the firm to raise long term capital. Preferred stock is a type of stock that have
priority of payment of dividend and refund of capital over equity stock.

• The holder of the preferred stocks has two preferential rights. rights of preferred stock holders are: i)
preferred stock holders has priority over fixed rate of dividend before common stock in) they can claim their
capital before common stock holders at the time liquidation of firm.

• So, it has priority on the income and assets of the firm before common stock. It contains some features of
owners' capital and some features of debt capital. Like common stock, it is legally considered as ownership
capital and the dividend is paid off after-tax profit.

• On the other hand, it contains the fixed rate of dividends, call provision, redeemable or perpetual as like
bond. Hence, it is also called hybrid security
Features of Preferred Stock
a. Par value: Par value is stated price or face value per share. The memorandum of
association specifies the par value. Generally, the par value is Rs. 100 in Nepal. This value
is used to redeem the preferred stock at the end of its maturity period or at the time of
liquidation. Hence, this value is also important to determine the amount of dividend.

b. Fixed rate of dividend: The preferred stock dividend rate is fixed at the time it is issued.
So, preferred stockholders can get fixed amount of dividend every year. The preferred stock
dividend may cumulate if the firm is unable to pay the dividend in any year.

c. Maturity period: The preferred stock is the part of the owners' capital. A firm can issue
preferred stock with or without maturity period. But most of the firms issue redeemable
preferred stock. In Nepal, preferred stocks are issued with maturity period.
• Cumulative feature: Generally, the preferred stocks are issued with cumulative nature. This
feature cumulates the dividend if it is not paid any year due to loss. It means that the unpaid
dividend is carried forward to the next year. This feature protects the interest of preferred
stockholders and reduces the risk.

• Participating feature: Participating feature of preferred stock allows the preferred

stockholders to participate in the residual earnings of the firm. The preferred stockholders
may be participated in the remaining income of the firm after paid dividend to the common
stockholders. The most of the preferred stocks are issued with non-participating feature.
• Voting rights: Preferred stockholders do not have the general meeting of the firm. They
cannot meeting so,they cannot select the directors and give opinion on important issues.

• Call provision: Generally, preferred stock has call provision. This provision maturity period.
Firm has the right allows the firm to call the stock before its to call the preferred stock with in
the call period at call price, "The specified price with par value plus call premium at which the
preferred stock is called is known as call price.

• Convertible stock: Some preferred stock has the conversion feature. This feature allows
converting them into new preferred stock or common stock. lt can be converted into a
specified number of stocks with certain terms and conditions. This feature makes attractive to
potential investors.
3. Derivative Securities
• In financial terms, derivatives are the financial instruments - an agreement between two
people or two parties - that have a value determined by the price of assets underlying it. They
are the financial contracts with a value linked to the expected future price movements of the
asset it is linked to - such as a share or a currency. Derivatives are issued on the basis of
currencies, commodities, interest rates, stocks, governments bonds, corporate bonds, home
mortgages, or any combinations.

• The basic objective of the study of derivative securities can be nothing more than reducing the
business risk that might arise from stock price, commodity price, interest rate and exchange
rate fluctuation. Derivatives can insulate a firm from different such types of risks.
• Derivatives are financial instruments whose values are derived from other underlying assets.
Options, forward contract, futures and swaps are some of the examples derivative securities.
These securities serve as valuable means of mananaging financial risk created by financial
activities in the businesses.

• Thus, derivatives are the contracts between two parties to purchase or sell specific asset at
pre-determíned price on future date. All terms and conditions of transactions like price of the
assets, quantity, quality, date of delivery, method of delivery, etc. are pre-determined at
present and actual transaction takes place in future.
a. Options: An option is a contract that gives its holder the right to buy (or sell) an
asset at some predetermined price within a specified period of time. It is a contract
that gives the holder a right, without any obligation, to buy or sell an asset at an
agreed price on or before specified period of time. It is one of the derivative
securities, which gives the holder the right but not the obligation to buy or sell a
designated security at a specific price.
• In other words, option can viewed as an instrument that provides its holders the
right to buy or sell an asset at a pre- determined price on or before its expiration
date. The price at which option can be exercised : called an exercise price or a strike
price.
Characteristics of Option
a. Options are not free. The option premium is the value of the option.
b. Options have fixed maturity - they expire on a certain date (the expiration date).
c. Options can be exercised before expiration at a specified price called the exercise price or
striking price.
d. Options may or may not be exercised, depending on the difference between the market
value of underlying asset and the exercise price.
e. Options themselves do not affect the market value of the underlying asset.
f. American and European Option: An American option may be exercised any time up to and
including the expiration date. A European option may be exercised only on the expiration
date.
i. Call Options: A call option is one of the important types of option. It is an option to
purchase. Its holders have the privilege of purchasing or calling from a second party a
specified number of stocks at a stated price on or before a predetermined period. A call
option on a stock allows the holder of the option to buy (to call) a share of the underlying
stock at a specified price within a specified period.
i. The company whose shares can be bought
ii. The number of shares that can be bought
iii. The exercise price or strike price or contract price.
iv. The date (expiration date) when the right to buy expires.
ii. Put Option: A put is an option to sell. A put gives its holder the privilege of selling
or putting to the second party a fixed amount of some stock at a stated price on or
before predetermined date. A put option is essentially the opposite of a call option.
Instead of giving the holder the right to buy some asset, it gives the holder the right
to sell that asset for a fixed exercise price.
i. The company whose shares can be sold
ii. The number of shares that can be sold
iii. The selling price for those shares known as exercise price.
iv. The date (expiration date) when the right to sell expires.
b. Forward Contracts
• A forward contract is an agreement between a buyer and seller, at time, when there is a
contractual agreement that an asset will be exchanged for cash at some later date.
• In other words, forward contract is an agreement between two parties under which one party
agrees to buy an asset at a specific price on a specific future date and the other party agrees to
make the sales of the assets. With a forward contract, you obligate yourself to buy or sell are
asset at some date in the future at a particular price.
• The forward price is set so to current market value of the contract is zero, but this value may
become positive or negative as time goes by. Suppose expectations about the future assets'
price are revised upward so new forward contracts issued today are issued at a higher forward
price than yesterday.
• If you hold a contract to buy at the previous, lower forward price the market value of
your contract becomes positive. Forward contracts are always designed initially to
have a zero value, but as expectations change, their value can become positive or
negative.
i. Price of assets: The price of asset is fixed in present value.
ii. Transfer or delivery of assets: The transfer or delivery of assets will be done in future.
iii. Payment of Price: The payment will be made on the date of delivery of assets.
iv. Non Standardized: Forward contract may not be standardized. The terms of the contracts,
including the forward price, are set by the parties related to the contract through
negotiation.
v. Trading in exchange: Forward contracts are not listed and not transacted in stock
exchange.
vi. Credit and default risk: Unless both parties under forward contract are financially strong,
there is a danger that one party will default on the contract, especially if the price of the
commodity or asset changes significantly after the agreement is reached.
vii. Realization of gain or loss: Under forward contract, seller will gain if the price decreases
in future and buyer will gain if the price rises in future.
c. Future Contract
• Future contract is an agreement between a buyer and seller at present time that an very similar
to a forward contract. The difference is that whereas the price of a forward asset or
commodity will be exchanged for cash at some later date.
• As such, a futures Contract is contract is fixed over the life of the contract, price of futures
contracts are based on day to day, market to market price. This means the contract's price is
adjusted each day as the futures price for the contract changes.
• Therefore, daily cash flows pass between the buyer and seller in response to change in market
price. This can be compared to a forward contract where the whole cash payment from buyer
to seller occurs at the end of contract period.
d. Swaps
• Swaps are the agreement between two parties to exchange specific cash flows at specified
interval of time in the future. The agreement defines the dates when the cash flows are to be
paid and the way in which they are to be calculated.

• Swaps have an initiation date, a termination date, and, of course, the dates on which the
payments are to be made. Likes forward and futures contracts, swaps do not typically involve
cash up-front payment from one party to another.

• Thus, swaps have zero value at the start, which means that the present values of the two
streams of payments are the same. The date on which a payment occurs is called the
settlement date, and the period between settlement dates is called the settlement period. Swaps
are exclusively customized, over-the-counter instruments.
• Thus, the two parties are usually a dealer, which is a financial institution that makes markets
in swaps, and an end user, which is usually a customer of the dealer and might be a
corporation, pension fund, hedge fund, or some other organization.

• Like forward contracts, swaps are subjects to the risk that a given party could default.
Wherever possible the payments are netted, so that only a single amount is paid from one
party to the other. This procedure reduces the credit risk by reducing the amount of money
flowing between the parties.
Types of Swap
i. Interest Rate Swap
• The most common type of swap is interest rate swap, which consists the exchange of fixed
interest rate between two counter-parties of fixed rate interest for floating rate interest in
the same currency calculated by reference to a mutually agreed notional principal amount.
• At one time it is the physically passed between the counter- parties. Through this straight
forward swap structure, the counter parties are able to convert an underlying fixed rate
asset/liability into a floating rate asset / liability and floating rate asset/liability into a fixed
rate asset/liability.
• The majority of interest rate swap transactions are driven by the cost saving to be obtained
by each of the counter-parties or companies. These cost savings, which are often
substantial, result, form differentials in credit standing of the companies and other
structural considerations. A swap enables two companies to attain these gains, allowing
each to borrow more cheaply.
ii. Currency Swap
• In its simplest form, currency swap involves exchanging principal and interest payments in
another currency. This swap agreement requires the principal to be specified in each of the
two currencies. The principal amounts are usually exchanged at the beginning and at the
end of the life of the swap.
• Usually, the principal amounts are chosen to be approximately equivalent using the
exchange rate at the swap's initiation. A currency swap is much like an interest rate swap.
• A typical example might involve two corporations in two different countries for example
General Motors in the USA and Sony in Japan. General motors wishes to build an automobile
assembly plant in Japan and Sony wishes to build a television assembly plant in the USA.
Each company need funds in the currency of the country in which the investmnent is to be
made.

• However, each company can borrow relatively more cheaply in its own currency, because it
better known to investors at home (each company has a comparative advantage in its own
currency). A swap enables each to cut its borrowing costs while obtaining the funds in the
currency it needs.
iii. Commodity Swap
• A commodity swap, too, is much like an interest rate swap. One party makes a periodic
fixed payment; the other makes a payment that is pegged to the current price of some
commodity. For example, the fixed price payer in an oil swap might be a public utility that
wants to hedge against a possible rise in the price of oil. The floating-price payer might be
an oil company that wants to hedge against a possible fall in the price of oil.

iv. Equity Swap

• Another type of swap is known as equity swap. An equity swap is a swap in whick. the two
parties agree to exchange a series of payments, at least one of which is determined by the
return on a stock, stock portfolio, or stock index,
4. Mortgages:
• Mortgages are loans to individuals or businesses to purchase a home, land, or other real property.
Residential mortgages are obtained by individuals and families to purchase homes.
• Financial institutions serve as lenders by providing residential mortgages in their role as a
financial intermediary. They can pool deposits received from surplus units, and lend those funds
to an individual who wants to purchase a home.
• Before granting mortgages, they assess the likelihood that the borrower will repay the loan based
on certain criteria such as the borrower's income level relative to the value of the home.
5. Mortgage Backed Securities:
• Mortgage-backed security (MBS) is a type of asset-backed security collateralized by a pool of
mortgages. It is bonds secured by home and other real estate loans.
• It is made up of a bundle of mortgages purchased from the banks that issued them and then sold
to investors. When an investor buys a mortgage-backed security, he is essentially lending money
to home buyers. In return, the investor gets the rights to the value of the mortgage, including
interest and principal payments made by the borrower.
• Unlike other fixed income investments, which typically pay periodic interest and return principal
in one lump sum at maturity, MBS make interest and principal payments to investors on a
monthly basis.
6. Corporate bonds:
• Corporate bonds are long-term bonds issued by corporations. It is a debt instruments issued by the
firm to collect long term financial resources. The bond may be perpetual or redeemable. The
perpetual bond has no maturity period but the redeemable bond has the specific maturity period.
• The holders of the bonds are creditors of the firm. The firm must pay fixed rate of interest on the
bond each year until maturity. This is known as the coupon payment. At the end of its maturity, the
firm pays principal and interests both to the bondholders.
• Generally, the face value of a bond is Rs 1,000 in Nepal and interest is paid semi- annual. It is a
legal agreement between the firm and creditors. The indenture specifies the terms and conditions of
the bond issues. It contains description of the bonds, rights of the creditors, duties of the firm, and
the role of the trustee, etc.
• A trustee usually a commercial bank, is appointed by the bond issuer at the time of issue. The main
function of the trustee is to represent and protect the collective interest of the bondholders.
7. Treasury bonds and notes:
• Treasury bonds are long-term treasury security issued by the government. Treasury bonds, usually
referred to as T-bonds, have maturities exceeding 10- years.
• Treasury securities with mnaturities of 2-10 years are referred to as treasury notes. Holders receive a
semi-annual coupon and the repayment of the principal - also known as the face value upon maturity.
Treasury bonds are issued in the primary market through auction sales and they are marketable. In
other words, they can be traded in the secondary market.
• Treasury bonds are perceived to be free from default risk because they are issued by the government.
Furthermore, the yield on these securities is often treated as a proxy for risk-free interest rates.
Concept of Mutual Fund
• Mutual fund is a type of financial institution that issues shares to the public. The
money, which is received from shareholders is pooled and invested in a wide range of
stocks, bonds, or money market securities to meet specific investment objectives.
• Thus, a mutual fund is an institutional investor that manages the portfolio for
individual investor. Mutual funds is also known as investment company or indirect
investing.
• Close-ended funds are typically for investors looking for a fixed-term investment
where they are okay with holding their investment for a longer period.
• However, due to the listed nature, they can provide opportunities for trading on the
secondary market. Just be cautious of liquidity, as it’s not always easy to sell at the
desired price.
• Shree Harsha Mutual Fund (SHMF), Laxmi Equity Fund, Citizen Mutual Fund
(CMF), Prudential Mutual Fund
• Open-ended mutual funds are a popular type of mutual fund where investors can
buy or redeem units at any time, directly from the fund at its Net Asset Value (NAV).
These funds do not have a fixed number of units like closed-ended funds, and they
continuously issue and redeem units based on investor demand.
• Nabil Balanced Fund (NBALF), NIBL Capital Growth Fund (NIBLCGF), Laxmi
Equity Fund, Mega Capital Fund (MCF), Himalayan Equity Fund
 FINANCIAL INSTRUMENTS AVAILABLE IN NEPALESE
FINANCIAL SYSTEM
• The financial market in Nepal is relatively undeveloped. Limited Financial instruments are
available in Nepalese financial market. Major Financial instruments like Common Stock and
Debentures are traded in NEPSE and OTC markets.

• T-bills are frequently issued by Nepal Rastra Bank to help liquidity necessities of financial
institutions. In Nepal, the money market is still very infant in stage. Many of the instruments
which are popular in developed money market like commercial paper, bankers' acceptances,
have not yet entered the Nepalese money market.

• Only Nepal Rastra Bank and commercial banks are the players in the money market of
Nepal. There are no individuals and other companies involved in the money market of Nepal.
Followings are some of major money market instrument available in Nepal.
a. Treasury bills: Treasury bill is a major instruments of money market in Nepal, started in the
year [Link] bills are short-term instruments issued by Public Debt Department of
Nepal Rastra Bank on behalf of the government to meet short term financing requirements:.
• This instrument is used by the government to raise short-term furnds to bridge seasonal or
temporary gaps between its receipts (revenue and capital) and expenditure. It has term to
maturity ranging from 27 days to 364 days. The treasury bills in Nepal are issued on a
discounted basis. They are repaid at par on maturity.
• The difference between the amount paid by the tendered at the time of purchase (which is
less than the face value) and the amount received on maturity represents the interest
amount on T-bills and is known as the discount. Tax deducted at source (TDS) is not
applicable on T-bills.
• The treasury bills in Nepal are issued weekly or monthly especially the 52- weeks treasury
bills are issued bi-monthly i.e. twice a month. However the most common type of T-bill
used in Nepal is the 91-days, 182 days arnd 394 days T-bills.
b. Call/notice money market: The call money market is a market for very short-term
funds repayable on demand and with a maturity period varying between one day to a
fortnight. Call money is required mostly by banks. Commercial banks borrow
money without collateral from other banks to maintain a minimum cash balance
known as the cash reserve requirement (CRR). This inter-bank borrowing has led to
the development of the call money market.
c. Repos: Repo refers to a transaction in which a participant acquires immediate funds by
selling securities and simultaneously agrees to the repurchase of the same or similar
securities after a specified time at a specified price.
• Reverse repo is exactly the opposite of repo-a party buys a security from another party with
a commitment to sell it back to the latter at a specified time and price. It is traded at
discount. The difference between the price at which the securities are bought and sold is the
lender's profit or interest earned for lending the money. In Nepal, repos and reverse repos
are simply are practiced as money market management instruments used by the Central
Bank of Nepal.
• Whenever there is need for liquidity or cash injection in the market, NRB offers repos
through competitive bidding systems. Its objective is to ensure that the financial system and
market participants have enough funds for their operations and to reduce the liquidity
crunch'. Commercial banks, development banks and finance companies are eligible to
participate.
Capital Market Instruments available in Nepalese financial system
a. Common stock: Common stock also known as equity represents the ownership of a
[Link] is one of the most commonly traded financial instruments in Nepalese financial
market. Share of listed companies can be traded in NEPSE. At present, equity stock of 219
companies are listed. Most of them are stocks of bank and financial institutions.

b. Preferred stock: Preferred stock is security having prefererntial right to paymnent of

dividend and refund of capital. Holders of this type stock do not have voting rights while
electing members of Board of Directors. In context of Nepal, there is only one preferred
stock issued and listed in NEPSE. It was convertible preferred stock issued by Everest Bank
Limited.
c. Corporate bonds: Corporate bonds are debt instruments issued by private and public sector
companies, They are issued with maturity period ranging from two years to 15 years. 5-
Year and 7-year bonds are more popular in context of Nepal. Number of debenture issue in
Nepal has been significantly increased recently. All together 59 debentures has been issued
in Nepalese capital market. They are also traded in NEPSE.

d. Government securities: Government securities are issued by governmernt to fulfill the

budgetary deficit. Development Bonds, National Saving Bonds, Special Bonds and Citizen
Saving certificates are known as government securities in Nepal. 18 Government bonds are
listed at NEPSE.
e. Mutual fund: These are investment vehicles that allow you to indirectly investing in share
or bonds. It pools money from a collection of investors, and then invests that sum in
financial instruments available. Mutual funds can be also be traded in NEPSE in the context
of Nepal.
f. Derivatives instrument: Derivative instruments can be defined as instruments whose
characteristics and value can be derived from its underlying assets. The value of derivative
securities depends on the performance of different underlying assets in the future. Option,
futures, forward contracts, swap etc are some examples of derivatives. Derivative
instruments are traded in Comnmodity and Metal Exchange Nepal Limited (COMEN),
Nepal Derivative Exchange (NDEX), Wealth Exchange Nepal (WEX), Commodity Future
Exchange (CFX), and Everest Commodity Exchange (ECX). They are less popular among
the Nepali investors.
LOANABLE FUNDS THEORY OF INTEREST
• The term 'loanable funds' simply refers to the sums of money offered for lending and
demanded by consumers and investors during a given period. It is funds borrowed and lent in
an economy during a specified period of time i.e. the flow of money from surplus to deficit
units in the economy.
• An interest rate indicates the rate of return that a creditor receives when lending money, or the
rate that a borrower pays when borrowing money. Interest rate does not remain the same in
the market. It keep on changing over time. Interest rate movements have a direct effect on the
market values of securities.
• They affect the cost of funds to depository institutions and the interest received on somne
loans by financial institutions. Thus, financial institutions as well as individual attempt to
anticipate interest rate movemnents.
Demand of Loanable Funds
• Households commonly demand loanable funds: Households commonly demand
loanable funds to finance housing expenditures. In addition, they finance the
purchases of automobiles and household items.
• At any moment in time, households would demand a greater quantity of loanable
funds at lower rates of interest. In other words, they are willing to borrow more money
(in aggregate) at lower rates of interest. Thus, it can be concluded that there is an
inverse relationship between the interest rate and the quantifty of loanable funds
demanded.
• Businesses demand for loanable funds: Businesses demand loanable funds to invest
in long- term (fixed) and short-term assets. Long term assets (project) is evaluated by
comparing the present value of its cash flows to its initial investment, as follows:
Net present value= Present value of future cash flow - Net initial investment
• Projects with a positive net present value (NPV) are accepted because the pra value of
their benefits exceeds the costs. The required return to implement a given project wet
be lower if interest rates are lower because the cost of borrowing funds to support the
proi will be lower. Hence more projects will have positive NPVs, and businesses will
need a greatox amount of financing.
Government Demand for Loanable Funds
• Municipal (state and local) governments issue municipal bonds to obtain funds to
finance government deficit (excess expenditures over incomes from taxes and other
sources), The federal government and its agencies issue Treasury securities and
federal agency securities.
• The federal government's demand for funds is referred to as interest-inelastic or
insensitive to interest rates since federal governmenť's expenditure and tax policies are
generally thought to be independent of interest rates.
• In contrast, municipal governments sometimes postpone proposed expenditures if the
cost of financing is too high, implying that their demand for loanable funds is
somewhat sensitive to interest rates.
• Foreign Demand for Loanable Funds: Since the world has become a global village,
Can be borrowed and lent across the borders, Other things being equal, a larger
quantity forien funds will be demanded if their domestic interest rates are high relative
to foreign rates. The quantity of loanable funds demanded will be inversely related to
domestic interest rates.
Aggregate Demand for Loanable Funds
• The aggregate demand for loanable funds is the sum of the quantities demanded by the
separate sectors at any given interest rate. The aggregate demand for loanable funds is
inversely related to the prevailing interest rate because most of these sectors are likely
to demand a larger quantity of funds at lower interest rates (other things being equal).
Supply of Loanable Funds
• The term "supply of loanable funds" is commonly used to refer to funds provided to
financial markets by savers. Supply of loanable fund consists of household saving,
money creation by banking, negative hoarding of money balances (difference between
public demand and supply) and lending in domestic market by foreign firms.
• In general, the quantity of loanable funds supplied increases as interest rates rise.
Suppliers of loanable funds are willing to supply more funds if the interest rate is
higher, other things being equal. This means that the supply of loanable funds
schedule (also called the supply curve)
Equilibrium Interest Rate
• The aggregate supply of loanable funds is the sum of the quantity supplied by the separate
fund suppliers (e.g, households, businesses, governments, foreign agents) discussed above.

• Similarly, the aggregate demand for loanable funds is the sumn of the quantity demanded by
the separate fund [Link] aggregate quantity of funds supplied is positively related to interest
rates, while the aggregate quantity of funds demanded is inversely related to interest rates.

• At any interest rate above i, there is a surplus of loanable funds. The surplus of funds will
cause the interest rate to decrease. This phenomenon will cause the quantity of funds
demanded to increase and the quantity of funds supplied to decrease untila surplus of funds no
longer exists
• In contrary, if the prevailing interest rate is below i, there will be a shortage of
loanable funds. The shortage of funds will cause the interest rate to increase.
• This phenomenon will cause the quantity of funds supplied to increase and the
quantity of funds demanded to decrease until a shortage of funds no longer exists.
Thus, when a disequilibrium situation exists, market forces should cause an
adjustment in interest rates until equilibrium is achieved.
Factors Affecting the Interest Rate
a. Economic growth: During the improved economy, the business anticípates the good
return from investment. As such, they are more likely to undertake the new project.
As results, they need more fund and thus, borrow more funds, Thís will lead to
increase in interest rate in the market In contrary, an economic slowdown puts
downward pressure on the equilibrium interest rate.
b. Inflation: Inflation of the general price index of goods and services is defined as
the increase in indexes such as the consumer price índex (CPI) and the producer
price index (PPI). For the price of a goods and services over a given period of tíme.
c. Real interest rate: A real interest rate is the interest rate that would exist on a inflation were
expected over the holding period of a security. It reflects time preference of individual for
current versus future real consumption. The real interest rate on an investment is the
percentage change in the buying power of a rupee. The higher its time value of money or
rate of time preference, the higher the real interest rate will be.

d. Monetary policy: The central bank through the monetary policy can affect the supply of
loanable funds by increasing or reducing the total amount of deposits held at commercial
banks or other depository institutions. When the central bank increases the money supply, it
increases the supply of loanable funds. Consequently, this will place downward pressure on
interest rates. In contrary, when the central bank reduces the money supply, it decreases the
supply of loanable funds. Consequently, this will push interest rates downward.
e. Budget Deficit: A higher government deficit increases the quantity of loanable
funds demanded at any prevailing interest rate which causes rise in interest rate. A
lot of research has provided the evidence that higher budget deficits place upward
pressure on interest rates holding other factors constant.
Components of Interest Rate
a. Inflation: The first factor that affects interest rates is the actual or expected inflation
rate in the economy. The higher the level of actual or expected inflation, the higher
will be the level of interest rates.
b. Real Interest Rates: The real interest rate is the interest rate adjusted for inflation,
representing the true cost of borrowing or the true return on investment. Unlike the
nominal interest rate, which is the stated rate on a loan or investment, the real
interest rate accounts for changes in purchasing power due to inflation.
c. Liquidity risk premium: Liquidity refers to ability to convert into cash without a loss in
value. Investors that need a high degree of liquidity (because they may need to sell their
securities for cash at any moment) prefer liquid securities, even if they offer less interest
rate. . If a security is liquid, investors add a liquidity risk premium (LRP) to the interest rate
on the security. Thus, a less liquid security will lead to a higher interest rate

d. Default (Credit) risk premium: default risk refers to the possibility that the borrower will
fail to make the promised payment when they are due. Higher the default risk premium, the
higher will be interest rate to compensate for this default (or credit) risk exposure. Interest
on corporations bond is higher reflecting an additional interest rate risk premium for their
perceived probability of default. However, Government Treasury securities are assumed to
have no default risk since they are issued by the government, and the probability of the
government defaulting on its debt payments is practícally zero given its taxation powers and
its ability to print currency.
e. Maturity risk premium: Maturity risk is concerned with term to maturity. The term
structure of interest rates defines the relationship between the term to maturity and the
interest rate on debt securities at a specific moment in time keeping other factors, such as
risk, constant. The change in required interest rates as the maturity of a security changes is
called the maturity premiumn (MP). Generally, securities with higher maturity demands
higher rate.

f. Special provisions or covenants: Numerous special provisions or covenants that may be

mentioned into the contracts underlying the issuance of a security also affect the interest
rates on different securities. Some of these special provisions include the security's
taxability, convertibility, and call ability. For example, for investors, interest payments on
municipal securities are free of federal, state, and local taxes. Thus, the interest rate on
municipal bond is smaller than that on a comparable taxable bond.
Terms Structure of Interest Rate
• One of important factors that influence the interest rate on a bond is its term to
maturity: Bonds with identical risk, liquidity, and tax characteristics may have
different interest rates because the time remaining to maturity is different.
• Term of structure of interest rate defines the relationship between the annualized yield
and the term to maturity of debt securities at a specific moment in time while holding
other factors, such as risk, constant.
• Normal yield curve (upward sloping): Normal yield curve refers the yield curve obtained when
yield rises with increase in maturities
• Abnormal yield curve (downward sloping): Abnormal yield curve is the one where yield
decreases with increase in maturities
• Flat yield curve: The flat yield is the one in which the yield on short-term and long-term Treasuries
are similar. This means yields are unaffected by the time to maturity.
THEORIES OF YIELD CURVE
1. Pure Expectations Theory
• The first theory developed to explain the term structure of interest rates. It was developed by
Irving Fisher in 1930. According to pure expectations theory, the term structure of interest rates is
determined solely by expectations of interest rates. It states that current long terms rates are based
on current and expected future short-term rates. This means that the structure of interest rates at
any point of time is based on the markeť's expectation of future interest rates.
• The expectations theory can explain three different shapes for the yield curve. When investors
expect rates to increase in the future, the yield curve will be upward sloping. When investors
expect rates to remain constant, the yield curve will be flat. Finally, when investors expect rates to
fall, the yield curve will be downward sloping.
2. Liquidity Premium Theory
• The liquidity premium theory of the term structure of interest rates, is an extension of the
unbiased expectations theory. It is based on the idea that investors will hold long-term maturities
only if they are offered at a premium to compensate for future uncertainty in securitys value,
which increases with an asset's maturity.
• Short-term securities are normally considered to be more liquid because they are more likely to
be converted to cash without a loss in value. Since a shorter term securities have greater liquidity
and have less risk than long-termn securities, investors prefer short-term securities to long-term
less risk than long-termn securities, investors prefer short-term securities to long-term securities.
• This case, investors are willing to hold long-term securities only if they received additional
compensation for the lower degree of liquidity. Although long-term securities can be lquidated
prior to maturity, their prices are more sensitive to interest rate movements. The preference for
the more liquid short-term securities places upward pressure on the slope of a yield curve
3. Markets Segmentation Theory
• The markets segmentation theory states that investors and borrowers choose securites with
maturities that satisfy their forecasted cash needs. For instance, Pension funds ,and life insurance
companies may generally prefer long-term investments as their liabilities are longer term in nature
whereas commercial banks may prefer more short-term investments as their liabilities are shorter in
nature.
• Thus, according to markets segmentation theory, the choice of long-term versus short-term
maturities is determined more by investors needs than by their expectations of future interest rates.
• Accordingly, interest rates are determined by distinct supply and demand conditions within a
particular maturity segment. The market segmentatio theory assumes that investors and borrowers
are generally unwilling to shift from one maturihe sector to another without adequate compensation
in the form of an interest rate premium.
Determination of Interest Rate in Nepalese Financial Markets
• According to The classical theory Interest rate in the financial markets were determined by the interplay of the
supply of saving and the demand for investment. Therefore, the determination of interest rates depends on factors
that influence both demand for and supply of money.

• The demand factors can be individuals and companies' transactions, precautionary and speculative demand for
money. Whereas, the supply of money is determined by the central bank of an economy through monetary policy
using mainly three tools: open market operation, discount rate", and required reserve ratio).

• The central bank can affect the supply of loanable funds by increasing or reducing the total amount of deposit held
by commercial banks or their depository institutions. When the central bank increases the money supply, (the
loanable funds), which places downward pressure in interest rate.
• In the context of Nepal, prior to 1955, the Nepalese financial system was underdeveloped. It was
dominated by unorganized financial system generally driven by individuals, merchants and landlords.
Interest rate is regulated by the central bank during the early stage of financial market development
from 1955 to 1965.

• The central bank namely Nepal Rastra Bank (NRB) adopted a controlled interest rate determination
regime. The central bank gradually began to liberalize the determination of interest rate on a phase-wise
basis according to compatibility, eficiency and maturity of the banks and the financial institutions that
have developed in the country.
• On November 16, 1984 NRB initiated a limited flexibility to commercial banks to fix the interest rates.
Commercial banks were then allowed to offer interest rate on savings and time deposits to the extent of
1.5 and 1.0 percentage point above the minimum level.
• To create competitiveness in the banking sector thereby increasing efficiency, effective mobilization
and alocation of resources interest rates for deposit and lending were further liberalized except for the
priority sector lending, in which banks were not allowed to charge interest rate more than 15% on May
29, 1986.
• Controlled interest rate regime was completely abolished on August 31,1989. Banks and financial
institutions were now given full autonomny to determine their interest rates but for national interest
from the monetary stability view point, Nepal Rastra Bank can get in the way in guiding the banks and
financial institutions to relate interest rate to economic growth.
BASE INTEREST RATE, INTEREST RATE SPREAD, INTEREST
RATE CORRIDOR
• Base Interest Rate: Base rate is the rate at which the commercial banks lend funds to the public in
the form of Joans The base rate is also known as the bank rate or the base interest rate. It refers to the
minimum rate below which BFIS are not allowed to lend to the borrowers.

• The BFIs usually add a premium to the base rate in order to determine the interest rate. It includes Cost
of funds, Cost of liquidity (Cash Reserve Ratio, CRR and Statutory Liquidity Ratio, SLR), Cost of
operation.

• NRB introduced base rate for commercial banks in 2013 and for development banks and finance
companies in 2014 advising the BFIs not to lend, below the base rate. The base rate system also
facilitates BFIs in setting their adjustable interest rate as an effective reference.
• Interest Rate Spread: Banks charges the interest rate on its loan advanced to customers and provides interest
on deposit collected from depositor. Interest rate on its loan is normally higher than provides interest on deposit.
The difference between interest rates charged by banks on loans and the interest rates provided on deposits is
referred to the interest rate spread.

• In other words, it is the difference between the lending and borrowing interest rates of the bank. The larger the
interest rate spread, the higher the income the bank earns. Thus, the spread rate determines the banks earning
capability.

• For commercial banks, the income gained through interest rate spreads is their primary source of income.
However, the banks can't rampantly increase their spread by providing low rates to depositors and high rates to
lenders. They have to comply with the standards set by the regulator, Nepal Rastra Bank (NRB). Currently, the
spread rate is limnited to 4 49%, fn commercial banks in Nepal and 5.00 percent for "B" and "C" class financial
financial institutions as at mid July 2020. NRB has directed BFIs to publish their interest spread on a monthly
basis.
• Interest Rate Corridor: Simply, Interest rate corridor is the minimum and maximum interest rate
limit. It is monetary tools used to stabilize the interest rate. The main objectives to maintain the interest
rate within the certain limit. Interest rate corridor is a system for guiding short-term market interest rates
by the central bank. It consists of a rate at which the regulators lend to BFIs and a rate at which it takes
deposits from them.
• Interest rate corridor is the framework designed by the Central Bank to stabilize the short term interest
rates by implementing on short term monetary instruments like interbank rate, repo rate, treasury bills
and others by setting the upper limit and lower limit of the interest rate.
• The interest rate corridor plays arn important role in maintainiúng the balance between interest rates
and investors and depositors, since interest rates can fluctuate in the short term, which can have
detrimental effects on investors and depositors . was implemented in Nepal August 11, 2016.
IMPLICATION OF INFLATION AND TAX ON INTEREST RATE
• Changes in inflationary expectations can affect interest rates by affecting the amount of spending by households or
businesses. If households expects Inflation rate to increase in future households that supply funds may reduce their
savings at any interest rate level so that they can make more purchases now before prices rise.

• This behavior will lead to decrease in supply of loanable funds. In addition, households and businesses may be
willing to borrow more funds at any interest rate level so that they can purchase products now before prices
increase. This behavior will leads to increase in demand of loanable funds.

• As result, the new equilibrium interest rate is higher because of these shifts in saving and borrowing behavior. In
conclusion, when expected inflation rises, interest rates will rise.

• Taxes imposed by the government have significant effect on the returns earned by investors on financial assets. The
income from most securities - interest or dividends and capital gains - is subject to taxation at the specified rate.
This tax treatment reduces the investor's real income.