Financial Markets & Services 2024 Board Question Paper

Meaning of Financial System:

A financial system is a complex, integrated network comprising financial markets, financial institutions/intermediaries, financial instruments, payment mechanisms, and regulatory bodies (such as Nepal Rastra Bank and SEBON).

Core Economic Function:

It facilitates the efficient mobilization, pooling, and channeling of idle domestic savings from surplus economic units (households) to deficit economic units (businesses and government) for productive capital investment and economic growth.

Definition of Financial Intermediary with Example:

A financial intermediary is an institution that acts as a financial conduit between net savers (suppliers of funds) and net borrowers (demanders of funds) by issuing secondary financial claims to savers and purchasing primary claims from borrowers.

Practical Example:

A Commercial Bank (e.g., Nabil Bank Limited) collects small, highly liquid savings deposits from thousands of retail households (secondary claims) and aggregates those funds into large-scale, long-term project loans to hydroelectric corporations (primary claims).

The Central Bank with Reference to Nepal Rastra Bank (NRB):

A central bank is the apex statutory monetary and banking regulatory authority of a nation. In Nepal, Nepal Rastra Bank (NRB) was established in 2013 BS under the Nepal Rastra Bank Act, 2058.

Core Mandate of NRB:

• Formulation and execution of monetary and foreign exchange policies.
• Monopoly issuer of legal tender banknotes and coins.
• Maintaining domestic price stability and a favorable balance of payments.
• Regulating, licensing, and supervising banking and financial institutions (BFIs).
• Acting as the banker, economic advisor, and fiscal agent to the Government of Nepal, and serving as the Lender of Last Resort.

Definition of Capital Market and Instruments:

The capital market is the financial market dedicated to the issuance, trading, and allocation of long-term financial instruments with maturities exceeding one year.

Core Instruments:

• Equity Instruments: Common stock (ordinary shares) and preference shares.
• Long-Term Debt Instruments: Corporate debentures/bonds, Government Development Bonds, and municipal debt securities.

Meaning of Eurobond:

A Eurobond is an international bond issued by a multinational corporation, sovereign government, or international institution that is denominated in a currency other than the domestic currency of the country or market in which it is issued.

Key Example:

A US dollar-denominated bond issued by a Japanese conglomerate and sold to international investors in the London, Frankfurt, or Singapore financial markets. Eurobonds are typically bearer bonds and trade internationally over-the-counter.

Differences Between Health Insurance and Life Insurance:

Citizen Investment Trust (CIT — Nagarik Lagani Kosh):

Established under the Citizen Investment Trust Act, 2047, CIT is a premier statutory contractual financial institution and institutional investor in Nepal.

Major Operational Functions:

• Operates voluntary pension, provident fund, and gratuity schemes for civil servants, corporate staff, and the general public.
• Manages mutual funds, unit trusts, and investor savings plans.
• Serves as an institutional underwriter and debenture trustee in the Nepalese primary capital market.

Calculation of Bond Equivalent Yield (BEY) on Commercial Paper:

Given Data:

• Purchase Price (P) = Rs 380,000
• Face Value (F) = Rs 400,000
• Days to Maturity (D) = 180 days

---

Formula:

$$\text{Bond Equivalent Yield (BEY)} = \frac{F - P}{P} \times \frac{365}{D}$$

$$\text{BEY} = \frac{400,000 - 380,000}{380,000} \times \frac{365}{180} = \frac{20,000}{380,000} \times 2.02778 = 0.052632 \times 2.02778 = \mathbf{10.67\%}$$

(Using a 360-day year: $0.052632 \times \frac{360}{180} = \mathbf{10.53\%}$).

Calculation of Current Yield:

Given Data:

• Par Face Value = Rs 1,000
• Current Market Price (P0) = Rs 900
• Annual Coupon Interest (I) = Rs 100

---

Formula:

$$\text{Current Yield} = \frac{\text{Annual Coupon Interest}}{\text{Current Market Price}} \times 100\%$$

$$\text{Current Yield} = \frac{\text{Rs } 100}{\text{Rs } 900} \times 100\% = \mathbf{11.11\%}$$

Computation of Monthly Pension for Retired Government Employee:

1. Calculation of Total Service Period:

• Date of Appointment: Kartik 2, 2056 B.S.
• Date of Retirement: Kartik 2, 2081 B.S.
• Total Service Tenure = $2081 - 2056 = \mathbf{25\text{ Years}}$
• Last Monthly Salary = Rs 35,500

---

2. Statutory Pension Formula (Nepal Civil Service Regulations):

$$\text{Monthly Pension Amount} = \frac{\text{Total Service Period (Years)} \times \text{Last Monthly Salary}}{50}$$

$$\text{Monthly Pension} = \frac{25 \times \text{Rs } 35,500}{50} = \frac{\text{Rs } 887,500}{50} = \mathbf{\text{Rs } 17,750\text{ per month}}$$

Concept and Functions of Financial Markets:

1. Concept of Financial Markets

A financial market is an institutional mechanism and physical/digital arena that facilitates the exchange of financial assets, funds, and contracts (stocks, bonds, currencies, commodities) between buyers and sellers under transparent pricing rules.

---

2. Primary Functions of Financial Markets:

1. Mobilization and Allocation of Savings:
   • Aggregates fragmented surplus household savings and channels them directly into productive commercial and industrial ventures.
2. Price Discovery Mechanism:
   • Establishes transparent equilibrium prices for financial assets through the continuous interaction of demand and supply forces.
3. Liquidity Provision:
   • Provides ready secondary trading platforms where investors can instantly convert securities into cash with minimal price volatility.
4. Reduction in Search and Transaction Costs:
   • Eliminates prohibitive individual search and information costs by providing centralized trading venues and standardized disclosure information.
5. Risk Sharing and Diversification:
   • Enables businesses and individuals to hedge risks and reallocate investment exposure across diversified asset classes.

Concept and Objectives of Monetary Policy:

1. Concept of Monetary Policy

Monetary policy is the macroeconomic regulatory policy formulated and executed by a central bank (such as Nepal Rastra Bank) to control and regulate the total supply of money, interest rate levels, and credit availability in an economy to achieve sustainable macroeconomic goals.

---

2. Core Objectives of Monetary Policy:

1. Price Stability (Controlling Inflation):
   • Anchors domestic consumer inflation within manageable single-digit boundaries by absorbing excess liquidity during inflationary shocks.
2. Attaining High and Sustainable Economic Growth:
   • Ensures adequate bank credit flows to productive sectors (hydropower, tourism, agriculture, manufacturing) to spur industrialization and job creation.
3. External Sector and Exchange Rate Stability:
   • Maintains adequate foreign exchange reserves and preserves the stability of the exchange rate (such as the currency peg between the Nepalese Rupee and the Indian Rupee).
4. Financial System Stability:
   • Regulates systemic liquidity to prevent banking runs, insolvencies, and non-performing loan spikes, fostering public trust in depository institutions.

CDS and Clearing Limited (CDSC) and its Four Functions:

1. Overview of CDSC

CDS and Clearing Limited (CDSC) was established in 2010 as a wholly owned subsidiary of the Nepal Stock Exchange (NEPSE) under the Securities Act, 2063. It operates as the sole Central Depository of securities in Nepal, revolutionizing the capital market from physical paper certificates to computerized electronic scrips.

---

2. Four Major Functions of CDSC:

1. Electronic Depository Services (Demat Management):
   • Converts physical share certificates into electronic book-entry form (dematerialization) and maintains centralized beneficial ownership accounts via Depository Participants (DPs).
2. Clearing and Settlement of Secondary Market Trades:
   • Executes electronic clearing and settlement of securities and funds traded on NEPSE within the standardized T+2 rolling settlement cycle.
3. Administration of Corporate Actions:
   • Automatically credits bonus shares, rights shares, and cash dividends declared by listed companies directly into eligible shareholders’ Demat accounts and linked bank accounts (CASBA system).
4. Pledge and Transfer Registry:
   • Records electronic pledging and unpledging of shares against bank margin loans and registers transfers of ownership resulting from inheritance, family court partitions, or auction sales.

Major Money Market Instruments in Nepal:

The money market is the wholesale market for short-term, highly liquid, low-risk debt instruments with maturities of one year or less:

1. Treasury Bills (T-Bills):
   • Short-term sovereign promissory notes issued by Nepal Rastra Bank on behalf of the Government of Nepal to finance short-term fiscal deficits. Issued through Dutch auctions in tenors of 28 days, 91 days, 182 days, and 364 days at a discount to face value.
2. Interbank Call Money:
   • Very short-term loans (ranging from overnight to 7 days) negotiated among commercial banks to manage daily reserve deficits and statutory Cash Reserve Ratios (CRR).
3. Repurchase Agreements (Repos) and Reverse Repos:
   • Short-term liquidity injection (Repo) and liquidity absorption (Reverse Repo) tools utilized by NRB under the Interest Rate Corridor (IRC) framework.
4. Standing Liquidity Facility (SLF):
   • Short-term borrowing window provided by NRB to commercial banks against government securities to resolve temporary liquidity stresses.
5. Certificates of Deposit (CDs) and Commercial Paper:
   • Negotiable promissory notes issued by banks and highly rated corporations to fund seasonal working capital needs.

Differences Between Open-End Funds and Closed-End Funds:

Actuarial Risk and Return Analysis for Fewa Life Insurance Company:

1. Given Parameters:

• Number of Independent Policies ($n$) = 1,000
• Policy Face Value (Death Claim) = Rs 600,000
• Annual Premium Received per Policy = Rs 9,000
• Probability of Survival ($p$) = 0.99 (99%)
• Probability of Death Claim ($q = 1 - p$) = 0.01 (1%)

---

Part (a): Expected Net Revenue per Policy ($E(R)$)

$$\text{Expected Claim Payout per policy} = q \times \text{Policy Amount} = 0.01 \times 600,000 = \text{Rs } 6,000$$

$$E(R) = \text{Premium} - \text{Expected Claim} = 9,000 - 6,000 = \mathbf{\text{Rs } 3,000\text{ per policy}}$$

---

Part (b): Total Expected Net Revenue for Entire Portfolio

$$\text{Total Expected Net Revenue} = n \times E(R) = 1,000 \times \text{Rs } 3,000 = \mathbf{\text{Rs } 3,000,000}$$

---

Part (c): Standard Deviation for a Single Life Insurance Policy ($\sigma$)

For a single policy, outcomes are:

• If Client Survives (Prob 0.99): Net Cash Flow = $+9,000$ (Deviation from mean: $9,000 - 3,000 = +6,000$)
• If Client Dies (Prob 0.01): Net Cash Flow = $9,000 - 600,000 = -591,000$ (Deviation: $-591,000 - 3,000 = -594,000$)

$$\sigma^2 = [0.99 \times (6,000)^2] + [0.01 \times (-594,000)^2] = [0.99 \times 36,000,000] + [0.01 \times 352,836,000,000]$$

$$\sigma^2 = 35,640,000 + 3,528,360,000 = 3,564,000,000$$

$$\sigma = \sqrt{3,564,000,000} = \mathbf{\text{Rs } 59,699.25}$$

---

Part (d): Standard Deviation of the Entire Portfolio ($\sigma_{\text{Portfolio}}$)

Since the 1,000 policies are independent and identically distributed:

$$\sigma_{\text{Portfolio}} = \sqrt{n} \times \sigma = \sqrt{1,000} \times 59,699.25 = 31.622777 \times 59,699.25 = \mathbf{\text{Rs } 1,887,855.93}$$

(Note on Law of Large Numbers: Standard deviation per policy drops from Rs 59,699.25 to $\frac{1,887,855.93}{1,000} = \mathbf{\text{Rs } 1,887.86}$, demonstrating how pooling eliminates idiosyncratic risk).

Computation of Approximate Yield to Maturity (AYTM):

1. Given Data:

• Par Face Value (M) = Rs 1,000
• Years to Maturity (n) = 5 years
• Annual Coupon Rate = 10%
  $$\text{Annual Coupon Payment (I)} = 10\% \times \text{Rs } 1,000 = \mathbf{\text{Rs } 100}$$
• Current Yield (CY) = 9% = 0.09

---

2. Determine Current Market Price (P0):

$$\text{Current Yield} = \frac{I}{P_0} \implies 0.09 = \frac{100}{P_0} \implies P_0 = \frac{100}{0.09} = \mathbf{\text{Rs } 1,111.11}$$

(The bond sells at a premium because its coupon rate of 10% exceeds its yield).

---

3. Approximate Yield to Maturity (AYTM) Formula:

$$\text{AYTM} = \frac{I + \frac{M - P_0}{n}}{\frac{M + P_0}{2}}$$

$$\text{AYTM} = \frac{100 + \frac{1,000 - 1,111.11}{5}}{\frac{1,000 + 1,111.11}{2}} = \frac{100 + \left(\frac{-111.11}{5}\right)}{\frac{2,111.11}{2}} = \frac{100 - 22.222}{1,055.555} = \frac{77.778}{1,055.555} = \mathbf{7.37\%}$$

(Alternative formula using weighted average base $\frac{M + 2P_0}{3} = \frac{1,000 + 2,222.22}{3} = 1,074.07 \implies \frac{77.778}{1,074.07} = \mathbf{7.24\%}$).

Critical Evaluation of Credit Rating Agencies (CRAs):

1. Conceptual Framework

“Credit rating is not a recommendation to buy, hold or sell, but a well-informed opinion made available to the public.” A credit rating is an independent, objective evaluation of the creditworthiness of a debtor with respect to a specific debt security. It reflects the relative likelihood that the issuer will default on scheduled principal and interest payments.

---

2. Key Benefits of Credit Rating Agencies:

1. For Investors:
   • Mitigates information asymmetry by providing professional credit analysis.
   • Assists in risk-return profiling and portfolio risk management.
2. For Issuers:
   • Highly rated companies can lower their borrowing costs and issue debt at tighter credit spreads.
   • Broadens access to institutional investors (pension funds, insurance firms) with statutory rating floors.
3. For Regulators and Financial Markets:
   • Fosters market discipline, transparency, and liquidity in secondary corporate bond markets.

---

3. Core Factors Considered When Assigning Credit Ratings:

1. Business Risk & Market Standing:
   • Industry cyclicality, barriers to entry, market share, and customer concentration.
2. Financial Risk & Leverage Metrics:
   • Debt-to-Equity ratios, Interest Coverage Ratios (ICR), Debt Service Coverage Ratios (DSCR), and free cash flow generation.
3. Management Quality & Corporate Governance:
   • Leadership track record, integrity, transparency of accounting disclosures, and ownership structure.
4. Macroeconomic and Regulatory Environment:
   • Sovereign risk, foreign exchange volatility, inflation trends, and supportive government industrial policies.

Typology of Insurance Companies and the Regulatory Role of Nepal Insurance Authority:

1. Types of Insurance Companies

1. Life Insurance Companies:
   • Underwrite policies contingent upon human life, offering term life, whole life, endowment, and annuity plans (e.g., Nepal Life Insurance, National Life Insurance).
2. Non-Life (General) Insurance Companies:
   • Underwrite contracts of indemnity covering physical assets and liabilities against loss or damage: Property/Fire, Motor, Marine transit, Engineering, and Burglary insurance.
3. Reinsurance Companies:
   • Insure primary insurance companies against catastrophic cluster claims, absorbing systemic shocks (e.g., Nepal Reinsurance Company Limited, Himalayan Reinsurance).
4. Micro-Insurance Companies:
   • Specialized underwriters offering low-cost insurance products tailored for low-income rural households and smallholder farmers.

---

2. Regulatory Role of the Nepal Insurance Authority (Nepal Bima Pradhikaran):

Governed under the Insurance Act, 2079, the Authority functions as the apex autonomous regulatory body:

1. Licensing and Capitalization Enforcement:
   • Prescribes and enforces mandatory minimum paid-up capital requirements (Rs 5 billion for life insurers, Rs 2.5 billion for non-life insurers) to maintain solvency.
2. Policyholder Protection & Grievance Adjudication:
   • Protects policyholder rights against arbitrary claim repudiations, serving as a quasi-judicial court for claim dispute resolution.
3. Prudential Supervision & Solvency Monitoring:
   • Enforces risk-based capital (RBC) frameworks, investment guidelines, and premium pricing tariffs.
4. Market Development and Micro-Insurance Expansion:
   • Mandates commercial insurers to open branches in remote districts and underwrite agriculture and livestock policies.

Money Multiplier and Central Bank Open Market Operations:

1. Given Data:

• Central Bank Open Market Purchase (Reserves Injected, Delta R) = Rs 20 million
• Required Reserve Ratio ($r$) = 8% = 0.08
• Initial Money Supply = Rs 1,200 billion

---

Part (a): Total Demand Deposit Created

$$\Delta \text{Demand Deposits} = \frac{\Delta R}{r} = \frac{\text{Rs } 20\text{ million}}{0.08} = \mathbf{\text{Rs } 250\text{ million}}$$

---

Part (b): The Money Multiplier ($m$)

$$m = \frac{1}{r} = \frac{1}{0.08} = \mathbf{12.5}$$

---

Part (c): Definition of Money Multiplier

The money multiplier is the maximum numerical factor by which the total commercial bank money supply (demand deposits) expands in response to a one-unit injection of fresh monetary reserves by the central bank.

---

Part (d): New Level of Money Supply

$$\text{Expansion in Money Supply} = \text{Rs } 250\text{ million} = \text{Rs } 0.25\text{ billion}$$

$$\text{New Level of Money Supply} = 1,200\text{ billion} + 0.25\text{ billion} = \mathbf{\text{Rs } 1,200.25\text{ billion}}$$

---

Part (e): Interpretation of the Calculated Multiplier (12.5)

A money multiplier of 12.5 indicates that for every single rupee of fresh bank reserves injected by Nepal Rastra Bank through open market bond purchases, the commercial banking system generates Rs 12.50 of cumulative credit and demand deposits through the fractional reserve banking process.

Mutual Fund Valuation and Holding Period Return (Fund ABC vs. Fund XYZ):

Part (a): Net Asset Value (NAV) at the Beginning of the Period

$$\text{NAV} = \frac{\text{Total Assets} - \text{Total Liabilities}}{\text{Number of Units Outstanding}}$$

1. Fund ABC (Closed-End Fund):

   $$\text{NAV}_{\text{ABC}, 0} = \frac{\text{Rs } 90\text{ million} - \text{Rs } 2\text{ million}}{8\text{ million units}} = \frac{\text{Rs } 88\text{ million}}{8\text{ million}} = \mathbf{\text{Rs } 11.00\text{ per unit}}$$

2. Fund XYZ (Open-End Fund):

   $$\text{NAV}_{\text{XYZ}, 0} = \frac{\text{Rs } 55\text{ million} - \text{Rs } 1\text{ million}}{5\text{ million units}} = \frac{\text{Rs } 54\text{ million}}{5\text{ million}} = \mathbf{\text{Rs } 10.80\text{ per unit}}$$

---

Part (b): Holding Period Return (HPR) for Each Fund

1. Fund ABC (Closed-End): Traded at secondary market price ($P_0 = \text{Rs } 10$, $P_1 = \text{Rs } 12$, Dividend $D = \text{Rs } 1$):

   $$\text{HPR}_{\text{ABC}} = \frac{P_1 - P_0 + D}{P_0} = \frac{12 - 10 + 1}{10} = \frac{3}{10} = \mathbf{30.00\%}$$

2. Fund XYZ (Open-End): Transacted at Net Asset Value ($NAV_0 = \text{Rs } 10.80$, $NAV_1 = \text{Rs } 11.00$, Dividend $D = \text{Rs } 0.80$):

   $$\text{HPR}_{\text{XYZ}} = \frac{NAV_1 - NAV_0 + D}{NAV_0} = \frac{11.00 - 10.80 + 0.80}{10.80} = \frac{1.00}{10.80} = \mathbf{9.26\%}$$

---

Part (c): Adjusted Rate of Return Accounting for Transaction Fees

1. Fund ABC (1% Brokerage Cost on Purchase and Sale):

   • Purchase Cost per unit $= 10 \times (1 + 0.01) = \text{Rs } 10.10$
   • Net Sale Proceeds per unit $= 12 \times (1 - 0.01) = \text{Rs } 11.88$$\text{Return}_{\text{ABC}} = \frac{11.88 - 10.10 + 1.00}{10.10} = \frac{2.78}{10.10} = \mathbf{27.52\%}$$

2. Fund XYZ (2% Front-End Load Fee on Purchase):

   • Purchase Cost per unit $= 10.80 \times (1 + 0.02) = \text{Rs } 11.016$
   • Redemption Price per unit $= \text{Rs } 11.00$$\text{Return}_{\text{XYZ}} = \frac{11.00 - 11.016 + 0.80}{11.016} = \frac{0.784}{11.016} = \mathbf{7.12\%}$$

Comprehensive Financial Performance Analysis of City Bank (CB):

---

Part (a): Rupee Value of City Bank’s Earning Assets

Earning assets are interest-generating investments and loans:

• Demand deposits from other FIs: Rs 1,350
• Investments: Rs 4,050
• Federal funds sold: Rs 2,025
• Gross loans: Rs 15,525
  $$\mathbf{\text{Total Earning Assets}} = 1,350 + 4,050 + 2,025 + 15,525 = \mathbf{\text{Rs } 22,950}$$

---

Part (b): Bank’s ROA and Asset Utilization Ratio

1. Net Income Calculation:

   • Net Interest Income $= 2,600 - 1,650 = \text{Rs } 950$
   • Provision for loan losses $= -\text{Rs } 180$
   • Non-interest income $= +\text{Rs } 140$
   • Non-interest expense $= -\text{Rs } 120$
   • Taxes $= -\text{Rs } 90$$\mathbf{\text{Net Income}} = 950 - 180 + 140 - 120 - 90 = \mathbf{\text{Rs } 700}$$

2. Return on Assets (ROA):

   $$\text{ROA} = \frac{\text{Net Income}}{\text{Total Assets}} = \frac{\text{Rs } 700}{\text{Rs } 23,960} = \mathbf{2.92\%} \quad (\text{Industry Average} = 1.0\%)$$

3. Asset Utilization (AU) Ratio:

   $$\text{AU} = \frac{\text{Total Operating Income}}{\text{Total Assets}} = \frac{2,600 + 140}{23,960} = \frac{2,740}{23,960} = \mathbf{11.44\%} \quad (\text{Industry Average} = 10.0\%)$$

---

Part (c): Bank’s Spread

1. Average Rate Earned on Earning Assets:
   $$y = \frac{\text{Interest Income}}{\text{Earning Assets}} = \frac{2,600}{22,950} = 11.329\%$$
2. Interest-Bearing Liabilities: Small time deposits (10,800) + Jumbo CDs (3,200) + Fed funds purchased (2,250) $= \text{Rs } 16,250$.
3. Average Rate Paid on Interest-Bearing Liabilities:
   $$c = \frac{\text{Interest Expense}}{\text{Interest-Bearing Liabilities}} = \frac{1,650}{16,250} = 10.154\%$$
   $$\mathbf{\text{Spread}} = y - c = 11.329\% - 10.154\% = \mathbf{1.18\%} \quad (\text{Industry Average} = 2.3\%)$$

---

Part (d): Net Interest Margin (NIM)

$$\text{NIM} = \frac{\text{Net Interest Income}}{\text{Earning Assets}} = \frac{2,600 - 1,650}{22,950} = \frac{950}{22,950} = \mathbf{4.14\%} \quad (\text{Industry Average} = 11.0\%)$$

---

Part (e): Performance Evaluation & Additional Diagnostic Factors

• Performance Summary: City Bank outperforms industry peers on overall profitability (ROA of 2.92% vs. 1.0% IA) and Asset Utilization (11.44% vs. 10.0% IA) due to strict non-interest cost discipline. However, its Spread (1.18% vs. 2.3%) and NIM (4.14% vs. 11.0%) are substantially lower than industry norms, indicating elevated funding costs on term deposits and jumbo CDs.
• Additional Evaluative Dimensions (CAMELS Framework):
  1. Capital Adequacy: Core capital to risk-weighted assets ratio.
  2. Asset Quality: Non-performing loan (NPL) ratio and loan-loss reserve coverage.
  3. Liquidity Risk: Liquid assets to short-term deposit ratio.
  4. Sensitivity to Market Risk: Gap analysis measuring exposure to interest rate fluctuations.