Foundation of Financial Systems 2081 Board Question Paper

Meaning of Financial System

A financial system is the organized institutional structure comprising financial markets, institutions, instruments, rules, and regulatory bodies that facilitates the mobilization of savings from surplus units (households/savers) and channels them to deficit units (investors, businesses, and governments) for productive investment.

Capital Market

The capital market is the financial market arena dedicated to raising and trading long-term capital assets with original maturities exceeding one year (including common equity, preference shares, debentures, and government development bonds).

• It consists of the primary market for issuing new securities and the secondary market (NEPSE) for providing liquidity to existing investors.

Components of Bank Equity Capital (Core Tier-1 Capital)

Under NRB’s Capital Adequacy Framework, bank equity capital includes:

1. Paid-Up Common Equity Capital: Funds contributed by ordinary shareholders.
2. Share Premium: Excess amount received over the nominal par value of issued shares.
3. Statutory General Reserve: Mandatory reserve funded by annual allocations (minimum 20% of net profits).
4. Retained Earnings and Free Reserves: Accumulated undistributed corporate profits.

Concept of Non-Depository Institutions

Non-depository financial institutions are financial intermediaries that do not accept traditional demand, saving, or fixed deposits from the general public.

• Instead, they mobilize long-term funds by issuing contractual agreements, insurance policies, pension schemes, or investment units (e.g., Life & Non-Life Insurance companies, Citizen Investment Trust, Employee Provident Fund, and Mutual Funds).

Computation of NEPSE Index

The NEPSE Index is a market-capitalization-weighted (value-weighted) index computed using the following formula:

$$\text{NEPSE Index} = \frac{\text{Current Total Market Capitalization}}{\text{Base Market Capitalization}} \times \text{Base Index (100)}$$

$$\text{where } \text{Current Market Capitalization} = \sum (\text{Current Market Price per Share} \times \text{Listed Shares})$$

Meaning of Initial Public Offering (IPO)

An Initial Public Offering (IPO) is the initial sale of newly created equity shares by an unlisted corporate enterprise to the general public, enabling the company to mobilize equity capital and obtain an official listing on the stock exchange (NEPSE) under the regulatory oversight of SEBON.

Calculation of NAV per Share

Given Data:

• Market Value of Assets = Rs. 6,800,000
• Total Liabilities = Rs. 300,000
• Number of Shares Outstanding = 500,000 units

Formula:

$$\text{NAV per share} = \frac{\text{Total Assets} - \text{Total Liabilities}}{\text{Number of Shares Outstanding}}$$

Calculation:

$$\text{Net Assets} = 6,800,000 - 300,000 = \text{Rs. } 6,500,000$$

$$\text{NAV per share} = \frac{6,500,000}{500,000} = \mathbf{Rs.\; 13.00}$$

The NAV per share of XYZ mutual fund is Rs. 13.00.

Calculation of Return on Assets (ROA)

Given Data:

• Profit Margin (PM) = $12\% = 0.12$
• Asset Utilization (AU) = $0.6\text{ times}$

Formula:

$$\text{ROA} = \text{Profit Margin} \times \text{Asset Utilization}$$

Calculation:

$$\text{ROA} = 12\% \times 0.6 = \mathbf{7.20\%}$$

The bank’s Return on Assets (ROA) is 7.20%.

Calculation of Annual Yield on T-Bill

Given Data:

• Face Value ($F$) = Rs. 10,000
• Selling Price ($P$) = Rs. 9,750
• Days to Maturity ($t$) = 180 days
• Discount ($D$) = $F - P = 10,000 - 9,750 = \text{Rs. } 250$

1. Bank Discount Yield ($Y_{BD}$, 360-day year):

$$Y_{BD} = \frac{D}{F} \times \frac{360}{t} = \frac{250}{10,000} \times \frac{360}{180} = 0.025 \times 2 = \mathbf{5.00\%}$$

2. Bond Equivalent Yield ($Y_{BEY}$, 365-day year):

$$Y_{BEY} = \frac{D}{P} \times \frac{365}{t} = \frac{250}{9,750} \times \frac{365}{180} = 0.025641 \times 2.02778 = \mathbf{5.20\%}$$

Interest Rate Sensitivity Comparison

Given:

• Bank ABC Gap Ratio = 18% (0.18)
• Bank XYZ Gap Ratio = 24% (0.24)

Evaluation:

1. Under $\frac{\text{RSA}}{\text{RSL}}$ Definition:
   • Both banks are liability-sensitive ($< 1.0$).
   • Deviation from neutrality (1.0):
     • Bank ABC: $|1.0 - 0.18| = 0.82$
     • Bank XYZ: $|1.0 - 0.24| = 0.76$
   • Bank ABC has a greater mismatch from balanced rate sensitivity, meaning its net interest margin will fluctuate more sharply. Hence, Bank ABC is more sensitive.
2. Under $\frac{\text{Gap}}{\text{Total Assets}}$ Definition:
   • Bank XYZ (24%) has a higher gap proportion relative to total assets than Bank ABC (18%), making Bank XYZ more sensitive on total balance sheet exposure.

Comprehensive Solution: NRB Authority & Secondary Market Functions

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Part I: Major Functions, Duties, and Powers of Nepal Rastra Bank (NRB)

Under the Nepal Rastra Bank Act, 2058, NRB functions as the sovereign central bank and monetary authority:

1. Formulation and Implementation of Monetary Policy:
   • Formulates and executes annual monetary policies to manage domestic liquidity, maintain price stability, and manage the interest rate corridor (repo, reverse repo, and standing liquidity facility).
2. Sole Issuer of Currency (Banknotes and Coins):
   • Holds the exclusive monopoly on designing, printing, minting, and circulating legal tender currency in Nepal, maintaining adequate reserve backing (gold, foreign securities, and currency).
3. Banker, Financial Advisor, and Fiscal Agent to the Government:
   • Operates government treasury accounts, advises the Ministry of Finance on macroeconomic policy, and manages domestic public debt by auctioning Treasury Bills and Development Bonds.
4. Bankers’ Bank and Lender of Last Resort (LOLR):
   • Provides settlement accounts and rediscount facilities to commercial banks and acts as the lender of last resort during acute liquidity emergencies.
5. Regulation, Licensing, and Inspection of BFIs:
   • Issues licenses, issues unified prudential directives, and performs onsite and offsite supervision of Class ‘A’, ‘B’, ‘C’, and ‘D’ financial institutions.
6. Management of Foreign Exchange Reserves & Exchange Rate Policy:
   • Formulates foreign exchange policies, manages sovereign foreign currency reserves, and maintains the currency peg with the Indian Rupee (INR).

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Part II: Meaning and Functions of Secondary Markets

1. Meaning of Secondary Market

The secondary market (stock exchange) is that segment of the capital market where previously issued financial securities (stocks, bonds, debentures, mutual fund units) are traded among existing investors without involving the original corporate issuer. In Nepal, the secondary market is operated by the Nepal Stock Exchange (NEPSE).

2. Functions of Secondary Market

1. Continuous Liquidity and Marketability:
   • Transforms long-term, illiquid securities into immediate cash, assuring investors that they can exit or enter positions at any time.
2. Fair Price Discovery:
   • Determines transparent market prices based on real-time continuous forces of supply and demand through the automated trading system (NEPSE NOTS).
3. Capital Reallocation to Productive Enterprises:
   • Efficient secondary pricing signals which corporations are profitable and well-governed, guiding fresh capital allocation.
4. Economic Barometer:
   • Stock price indices reflect macroeconomic trends, political stability, and corporate profitability.
5. Investor Protection and Corporate Discipline:
   • Listed companies must disclose quarterly audited financials and material corporate information, promoting transparency.

Solution: Green Food Limited Rights Offering

Given Parameters:

• Capital to be raised = Rs. 2,000,000
• Current market price per share ($P_0$) = Rs. 200
• Subscription price per share ($P_s$) = Rs. 100 (par value)
• Existing shares outstanding ($N_0$) = 80,000 shares

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Part (a): Number of New Shares to be Issued ($S$)

$$S = \frac{\text{Funds to be Raised}}{\text{Subscription Price } (P_s)} = \frac{2,000,000}{100} = \mathbf{20,000\text{ new shares}}$$

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Part (b): Number of Rights Required to Purchase One New Share ($N$)

Each existing share receives one right.

$$N = \frac{\text{Existing Shares } (N_0)}{\text{New Shares } (S)} = \frac{80,000}{20,000} = \mathbf{4\text{ rights}}$$

(An investor must hold 4 rights to purchase 1 new share).

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Part (c): Theoretical Value of Each Right ($V_r$) when Stock is Rights-on

$$V_r = \frac{P_0 - P_s}{N + 1} = \frac{200 - 100}{4 + 1} = \frac{100}{5} = \mathbf{Rs.\; 20.00}$$

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Part (d): Theoretical Value of a Share Ex-Rights ($P_e$)

$$P_e = P_0 - V_r = 200 - 20 = \mathbf{Rs.\; 180.00}$$

(Verification: $P_e = \frac{(4 \times 200) + 100}{4 + 1} = \frac{800 + 100}{5} = \text{Rs. } 180.00$)

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Part (e): Theoretical Value of a Right when Stock Sells Ex-Rights at Actual Market Price of Rs. 185 ($P_e'$)

When the stock trades ex-rights, the value of a right ($V_r'$) is:

$$V_r' = \frac{P_e' - P_s}{N} = \frac{185 - 100}{4} = \frac{85}{4} = \mathbf{Rs.\; 21.25}$$

The theoretical value of the right under the new ex-rights market price is Rs. 21.25.

Solution: Himalayan Bank Limited Loan Loss Reserve Accounting

Initial Parameters:

• Beginning Reserve for Loan Losses (ALL) = Rs. 500 million
• Target Minimum Adequate Reserve = Rs. 475 million

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Part (a): Replenishing Reserve after Rs. 50 Million Charge-Off

1. When Rs. 50 million of uncollectible loans are charged off:
   $$\text{Reserve Balance} = \text{Beginning ALL} - \text{Gross Charge-off} = 500 - 50 = \text{Rs. 450 million}$$
2. The minimum adequate reserve target is Rs. 475 million.
3. The shortfall to be replenished:
   $$\text{Shortfall} = 475 - 450 = \text{Rs. 25 million}$$
4. Answer: Bank management should increase the accrued expense item (Provision for Loan Losses - PLL) by Rs. 25 million to restore the reserve to the minimum adequate level of Rs. 475 million.

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Part (b): Net Charge-Off Amount

• Gross Charge-offs = Rs. 100 million
• Recoveries = Rs. 50 million

$$\text{Net Charge-off (NCO)} = \text{Gross Charge-offs} - \text{Recoveries}$$

$$\text{Net Charge-off} = 100 - 50 = \mathbf{Rs.\; 50\text{ million}}$$

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Part (c): Provision for Loan Losses (PLL) for Current Year

1. Beginning Reserve = Rs. 500 million
2. Net Charge-off = Rs. 50 million
3. Reserve balance before current year provision:
   $$\text{Reserve before PLL} = 500 - 50 = \text{Rs. 450 million}$$
4. Target Minimum Adequate Reserve = Rs. 475 million.
5. Provision required to reach the minimum target:
   $$\text{PLL} = 475 - 450 = \mathbf{Rs.\; 25\text{ million}}$$

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Part (d): Reserve for Loan Losses

• After adding the current year’s provision of Rs. 25 million:
  $$\text{Final Ending Reserve for Loan Losses} = 450 + 25 = \mathbf{Rs.\; 475\text{ million}}$$
  (If the bank chooses to restore the reserve back to its original baseline of Rs. 500 million, the provision would be Rs. 50 million, and ending reserve would be Rs. 500 million).

Solution: NEPSE Stock Quote Interpretation for Nabil Bank Limited

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a. Meaning of ‘Open’, ‘High’, and ‘Low’

• Open (Rs. 596): The price at which the very first trade of NABIL shares was executed during the day’s trading session.
• High (Rs. 630 / recorded intraday up to 635): The maximum price at which NABIL stock was traded during regular trading hours.
• Low (Rs. 590): The lowest price at which NABIL stock was traded during the session.

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b. Closing Price on the Trading Day

• The stock closed at Rs. 635 per share.

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c. Maximum and Minimum Trading Prices

• Maximum Trading Price: Rs. 635 (or high of Rs. 630 recorded intraday).
• Minimum Trading Price: Rs. 590.

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d. Number of Shares Traded (Volume)

• The total volume of shares traded on the day was 123,432 shares.

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e. Total Value of Shares Traded (Turnover)

• The total monetary turnover on that trading day was Rs. 37,214,250 (approximately Rs. 3.72 crore).

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f. Price Movement Compared to Previous Day

• The stock price increased significantly:
  • Previous Close = Rs. 590
  • Current Close = Rs. 635
  • Net Increase = $635 - 590 = \mathbf{+Rs.\; 45\text{ per share}}$ (gain).

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g. Meaning of ‘Diff%’

• Diff% (+7.62%) indicates the percentage change in the closing price relative to the previous trading day’s closing price:
  $$\text{Diff\%} = \frac{\text{Current Close} - \text{Previous Close}}{\text{Previous Close}} \times 100\% = \frac{635 - 590}{590} \times 100\% = \mathbf{+7.627\% \approx +7.62\%}$$

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h. Explanation of ‘52 Weeks High-Low’ Quote

• 52 Weeks High (Rs. 775) & Low (Rs. 495):
  • Represents the highest price (Rs. 775) and lowest price (Rs. 495) at which NABIL shares traded over the preceding 52 weeks (one calendar year).
  • It provides investors with a historical reference of price volatility and cyclical trading range.

Short Notes: Capital Market Institutions and Services

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a. Ancillary Financial Services

Ancillary services provide vital operational, technological, clearing, and risk-management infrastructure that enables primary and secondary financial markets to function efficiently.

• Key services include:
  1. Depository and Clearing (CDS & Clearing Ltd.): Dematerializes share certificates and guarantees automated T+2 delivery-versus-payment settlement.
  2. Depository Participants (DPs): Banks and brokers opening demat and MeroShare accounts for public retail investors.
  3. Credit Verification & Ratings: Conducted by CIB, ICRA Nepal, and Care Ratings Nepal.

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b. Securities Board of Nepal (SEBON)

The Securities Board of Nepal (SEBON) is the apex statutory regulator of the securities market in Nepal, established under the Securities Act, 2063.

• Key Responsibilities:
  1. Regulating and licensing stock exchanges (NEPSE), brokers, merchant bankers, credit rating agencies, and mutual funds.
  2. Approving prospectuses for IPOs, FPOs, rights issues, and debenture offerings.
  3. Monitoring secondary market trading, investigating insider trading, market manipulation, and protecting investor rights.

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c. Credit Rating

Credit rating is an objective, formal evaluation of the creditworthiness of a borrower or a specific debt security (such as corporate bonds or debentures) conducted by a licensed independent rating agency.

• Rating Symbols: Employs standardized alphanumeric scales (e.g., [ICRANP] AAA representing highest safety, down to D representing default).
• Benefits: Helps corporate issuers price their debt securities accurately according to market risk and enables retail and institutional investors to make informed decisions without conducting expensive private investigations.

Analytical Discussion: Components of Financial System and Status of BFIs in Nepal

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Part I: Components of the Financial System

The financial system constitutes the institutional infrastructure that mobilizes savings and allocates capital across an economy:

1. Financial Institutions: Intermediaries mobilizing funds from savers to borrowers, divided into:
   • Depository Institutions: Commercial banks, development banks, finance companies, and microfinances.
   • Non-Depository Institutions: Insurance companies, contractual pension funds (EPF, CIT, SSF), and mutual funds.
2. Financial Markets: The channels through which funds and claims are exchanged:
   • Money Market: Short-term liquidity instruments (T-bills, interbank loans, repo, CDs).
   • Capital Market: Long-term equity and debt instruments (primary market via C-ASBA; secondary market via NEPSE).
3. Financial Instruments: Contractual debt, equity, hybrid, and derivative claims carrying monetary value.
4. Financial Regulators: Apex bodies enforcing prudential stability:
   • Nepal Rastra Bank (central bank and banking supervisor).
   • Securities Board of Nepal (capital markets).
   • Nepal Insurance Authority (insurance sector).
   • Department of Cooperatives (cooperatives).
5. Financial Infrastructure: Electronic payment switches (NCHL, RTGS, ConnectIPS), central securities depository (CDSC), and Credit Information Bureau (CIB).

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Part II: Current Status of Financial Institutions in Nepal

The financial sector of Nepal has undergone substantial structural transformation over the past decade, characterized by large-scale consolidation, rapid digital banking adoption, and emerging asset quality challenges.

1. Institutional Consolidation and Mergers

• Prompted by NRB’s mandatory paid-up capital hikes (minimum Rs. 8 billion for Class ‘A’ banks) and merger incentives, the number of institutions has consolidated dramatically:
  • Class ‘A’ Commercial Banks: Reduced from 32 to 20 banks through aggressive cross-mergers (e.g., Global IME-Bank of Kathmandu, Himalayan-Civil, Nabil-NBB).
  • Class ‘B’ Development Banks: Consolidated to 17 banks (largely national and provincial players).
  • Class ‘C’ Finance Companies: Consolidated to 17 institutions.
  • Class ‘D’ Microfinance: Consolidated through forced mergers to around 50-60 institutions.

2. Capitalization and Financial Soundness

• Capital Adequacy: The commercial banking sector maintains a Capital Adequacy Ratio (CAR) of around 12% to 13%, safely exceeding the Basel III minimum regulatory requirement of 11.0%.
• Credit and Deposit Mobilization: Total banking deposits exceed Rs. 6.5 trillion, while total private sector credit stands around Rs. 5.1 trillion, maintaining a comfortable Credit-to-Deposit (CD) ratio below the regulatory ceiling of 90%.

3. Deterioration in Asset Quality (NPL Pressures)

• Following the post-COVID-19 economic slowdown, high interest rate cycles, and real estate market stagnation:
  • Non-Performing Loans (NPL) in Class ‘A’ banks rose from below 1.5% historically to around 3.8% to 4.5% in recent quarters.
  • Microfinance institutions face heightened delinquency, loan write-offs, and borrower unrest.

4. Technological and Digital Transformation

• Nepal’s financial sector has achieved unprecedented digital penetration:
  • Mobile banking users exceed 23 million, and internet banking users exceed 1.8 million.
  • Real-Time Gross Settlement (RTGS), national payment switches, and QR-code retail transactions have reduced cash transactions significantly.

5. Crisis in the Cooperative Sector

• Unregulated saving and credit cooperatives have experienced widespread liquidity crises, promoter embezzlement, and deposit defaults, exerting indirect pressure on the formal banking system and prompting calls for a second-tier regulatory authority.

Solution: Balance of Payments (BOP) Analysis for FY 2023/24 (First Nine Months)

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Part (a): Meaning of Balance of Payments (BOP) and Balance of Trade (BOT)

1. Balance of Payments (BOP):
   • A comprehensive, systematic statistical accounting record of all economic and financial transactions conducted between the residents of a country and the rest of the world over a specified time period. It includes the Current Account, Capital Account, and Financial Account.
2. Balance of Trade (BOT):
   • A sub-component of the current account that records exclusively the monetary value of merchandise exports (goods sold) and merchandise imports (goods bought).

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Part (b): Net of Goods and Services Account

$$\text{Net Goods and Services} = \text{Total Credit} - \text{Total Debit}$$

$$\text{Net Balance} = 440,000 - 2,800,000 = \mathbf{-Rs.\; 2,360,000\text{ million}}$$

This represents an alarming net deficit of Rs. 2,360,000 million (Rs. 2.36 trillion) in goods and services trade.

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Part (c): Net of Primary Income and Secondary Income Accounts

1. Net Primary Income:

   $$\text{Net Primary Income} = 65,500 - 31,250 = \mathbf{+Rs.\; 34,250\text{ million}}$$
   (A surplus of Rs. 34,250 million from net cross-border employee compensation and investment income).

2. Net Secondary Income:

   $$\text{Net Secondary Income} = 1,410,000 - 9,675 = \mathbf{+Rs.\; 1,400,325\text{ million}}$$
   (A massive surplus of Rs. 1,400,325 million or Rs. 1.40 trillion, reflecting large inflows of workers’ remittances).

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Part (d): Accounts Contributing to Increase the Current Account Deficit

The accounts creating massive debits are:

1. Merchandise Goods Account: Incurred a massive deficit of Rs. 2,195,000 million ($305,000 - 2,500,000$), caused by overwhelming imports of petroleum products, vehicles, iron/steel, electronic gadgets, and consumer goods against meager domestic export production.
2. Services Account: Generated a deficit of Rs. 165,000 million ($135,000 - 300,000$), driven by substantial outflows for foreign education tuition and travel expenditures abroad.

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Part (e): Accounts Contributing to Decrease the Current Account Deficit

The accounts providing substantial surpluses to offset the trade deficit are:

1. Secondary Income Account: Produced an extraordinary net surplus of Rs. 1,400,325 million, almost entirely composed of personal remittances transferred through formal banking channels by Nepalese migrant workers in the Gulf, Malaysia, and OECD nations.
2. Primary Income Account: Added a net positive inflow of Rs. 34,250 million from earnings on foreign exchange reserves and returns on international investments.

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Part (f): Trade Deficit or Surplus and Macroeconomic Meaning

$$\text{Trade Balance} = \text{Goods Exports (Credit)} - \text{Goods Imports (Debit)}$$

$$\text{Trade Balance} = 305,000 - 2,500,000 = \mathbf{-Rs.\; 2,195,000\text{ million}}$$

Macroeconomic Meaning:

• Nepal recorded a Merchandise Trade Deficit of Rs. 2,195,000 million (approximately Rs. 2.195 trillion) in just nine months.
• This indicates an import-to-export ratio of more than 8.2 to 1 (Nepal imports more than eight rupees’ worth of goods for every one rupee exported).
• It highlights Nepal’s acute structural trade vulnerability and its heavy dependence on foreign remittance inflows to avoid a foreign currency liquidity crisis.

Solution: Determinants of Interest Rates and Term Structure Analysis

Given Parameters:

• Real risk-free rate ($k^*$) = $2.0\%$
• Expected Inflation:
  • Year 1: $I_1 = 5.0\%$
  • Year 2: $I_2 = 6.0\%$
  • Year 3 and thereafter: $I_t = 7.0\%$ for all $t \ge 3$
• Maturity risk premium ($MRP$) for maturities $\le 3$ years = $0\%$

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Part (a): Yield on 2-Year Treasury Securities ($T_2$)

1. Average Inflation Premium over 2 Years ($IP_2$):
   $$IP_2 = \frac{I_1 + I_2}{2} = \frac{5.0\% + 6.0\%}{2} = 5.50\%$$
2. Yield:
   $$T_2 = k^* + IP_2 + MRP_2 = 2.0\% + 5.50\% + 0 = \mathbf{7.50\%}$$

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Part (b): Yield on 3-Year Treasury Securities ($T_3$)

1. Average Inflation Premium over 3 Years ($IP_3$):
   $$IP_3 = \frac{I_1 + I_2 + I_3}{3} = \frac{5.0\% + 6.0\% + 7.0\%}{3} = \frac{18.0\%}{3} = 6.00\%$$
2. Yield:
   $$T_3 = k^* + IP_3 + MRP_3 = 2.0\% + 6.00\% + 0 = \mathbf{8.00\%}$$

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Part (c): Yield on 4-Year Treasury Securities ($T_4$)

1. Average Inflation Premium over 4 Years ($IP_4$):
   $$IP_4 = \frac{5.0\% + 6.0\% + 7.0\% + 7.0\%}{4} = \frac{25.0\%}{4} = 6.25\%$$
2. Given $MRP_4 = 0.75\%$:
   $$T_4 = k^* + IP_4 + MRP_4 = 2.0\% + 6.25\% + 0.75\% = \mathbf{9.00\%}$$

The yield on 4-year Treasury securities is 9.00%.

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Part (d): Why Yields on Long-Term Securities are Usually Higher than Short-Term Securities

1. Maturity Risk Premium (MRP): Longer-term bonds carry greater interest rate price risk. When interest rates rise, longer-dated bond prices fall much more steeply; investors demand an extra premium to bear this duration risk.
2. Expectation of Rising Future Inflation: In growing economies, inflation is generally projected to rise over time, requiring higher nominal yields to guarantee a positive real return.
3. Liquidity Preference Theory: Investors prefer liquidity and flexibility; committing funds for 10 or 20 years incurs an opportunity cost that borrowers must compensate with higher yields.

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Part (e): Determinants of Nominal Interest Rates

The nominal quoted interest rate on any debt security ($k$) is determined by five fundamental components:

$$k = k^* + IP + DRP + LP + MRP$$

1. Real Risk-Free Rate ($k^*$): The theoretical base interest rate on a completely default-free security when zero inflation is expected.
2. Inflation Premium ($IP$): The average expected rate of inflation over the life of the security, compensating investors for eroded future purchasing power.
3. Default Risk Premium ($DRP$): Extra yield compensating investors for the risk that the borrower may fail to pay scheduled interest or principal (corporate bonds vs. Treasuries).
4. Liquidity Premium ($LP$): Added yield charged if an asset cannot be rapidly converted to cash at fair market value without significant transaction cost.
5. Maturity Risk Premium ($MRP$): Yield increment compensating lenders for the higher market price volatility of longer-term bonds caused by interest rate fluctuations.