Chapter 2: Markets and Transactions

April 24, 2022April 24, 2022 Study Notes NepalPosted in 4th YearTagged bbs 4th year, Markets and Transactions, solution, study notes nepal

Table of Contents

Very Short Question Answer

1. State the roles of an investment banker.

Investment bankers play .a number of roles in the primary market. One of the primary roles of an investment banker is to work as an intermediary between issuing corporations and investors through initial public offerings (IPOs). Similarly, they provide underwriting services for new issues. Investment bankers also play the advisory role for their clients on taking the company public, on raising capital through alternative means and on fixing the offering price of securities.

2. Explain the meaning of public offerings of securities.

Public offering of securities refers to the issue of securities by corporations for public investors to raise new capital. Public offerings of securities can be initial public offerings (IPOs), further public offerings (FPOs) and right offerings. When the security issue has to cover wide range of investing public to satisfy new capital requirement, companies go for public offerings of securities. IPOs are the first time offering of securities for public. A private held company can become a publicly held company by raising new capital thorough IPOS. FPOS are additional public issue of shares to satisfy further capital need of the company. Right offerings are also additional issues of securities but are intended to sale to the existing shareholders.

3. Give some examples of broker markets.

A broker market is the secondary market where buyers and sellers of securities are brought together through security brokers. These brokers work as the intermediary between buyers and sellers of securities in the secondary market on fee basis and do not invest their own capital. The examples of broker market include organized stock exchanges, futures exchanges, option exchanges, etc.

4. Initial margin and maintenance margin requirement for your margin purchase account are 70 percent and 25 percent. If your actual margin is 25 percent, do you receive a margin call? Explain.

If actual margin in the account is 25 percent, we do not receive a margin call because it is equal to the maintenance margin. If actual margin falls below 25 percent, we will receive a margin call.

Short Question Answer

1. Describe the functions of commission brokers, floor brokers, and floor traders.

A commission broker is the person on an exchange who trades securities on behalf of a brokerage firm or investor. S/he makes trades as directed by the client, or may have some flexibility in the trades s/he makes. S/he is paid commission for her/his services. The commission is a percentage value of each transaction the broker makes. A commission broker is usually an employee of a member firm of an organized securities exchange who executes orders for the firm or its customers on the exchange floor. Orders flow to the commission broker from the firm’s trading desk or from its registered representatives.

On the other hand, a floor broker is an independent member of an exchange who is authorized to execute trades on the exchange floor on behalf of clients. A floor broker is a middleman who acts giving them the best access possible to the exchange floor. A floor broker’s an agent for clients, indirectly clients typically include institutions and wealthy people such as financial service firms, pension funds, mutual funds and traders. A floor broker’s primary responsibility is best execution of client order. To achieve this objective, s/he must continuously assess numerous factors including market information, market conditions, prices and orders. Once a floor broker receives a buy or sell order for specific securities, s/he will attempt to get the most competitive rate for the client. The floor broker does this by proceeding to the trading post on the exchange floor, where the specialists for the stock is located, and bids against other brokers and traders to get the best price for the stock purchase or sale. Upon completing the transaction, the floor broker notifies the client through the client’s registered representative. A floor broker differs from commission broker in that the commission broker is an employee of a member firm, while the floor broker is an independent member of the exchange.

A floor trader is an exchange member who executes transactions from the floor of the exchange exclusively for her/his own account. They fulfill an important role in stock market by assuming risk on their own capital to trade stocks thereby providing liquidity and narrowing bid-ask spread. A floor trader is subject to screening process before s/he can trade on the exchange. The floor trader must abide by trading rules similar to those of the exchange specialists who trade on behalf of others. Floor traders are occasionally referred to as registered competitive traders and individual liquidity providers. The people who operate as floor traders are in an open outcry system has slowly been replaced by automated trading systems and computers that work in the same fashion as humans without interaction of people buying and selling stocks. A floor trader is different from a floor broker Floor trader trades as principal for her/his own account, whereas the floor broker acts as agent for client.

2. Describe the trading mechanism of security market in Nepal.

Security market in Nepal is growing in terms of number of listed companies, volume of trading, amount of transactions and the trading mechanism is being more and more compatible to the best practices adopted in the developed markets. Nepal stock exchange (NEPSE) is only the organized securities market in Nepal. Initially, since the inception of NEPSE until 2007, NEPSE adopted open outcry system for trading the securities. However, in recent period buy and sell transactions of securities in NEPSE is conducted according to the semi-automated trading system. The trading of securities in NEPSE takes place according to the auction process. The trading mechanism of security market in Nepal can be described as follows:

Placing order: For buying and selling securities in NEPSE, the investors have to place order with licensed brokers by filling up the order form. The investors should fill up necessary information about transaction in the order form. Information required are name of company, type of security, number of shares, buy or sell price and the time period applicable for buying or selling. Once the orders are placed, the investors will get the ordering slip containing order registration number.
Trading hours: Initially, the trading hours fixed for securities transactions were 12:00 Noon to 15:00 pm. However, the trading hour of NEPSE has been recently extended from 11:00 am to 15:00 pm. All regular trading for board lot are conducted during this period.
Price regulation: The NEPSE has set the price change limit to protect the investors from aimless price fluctuations of the securities during the trading hour. According to the price regulation, the opening price of any day should not increase or decrease by more than 5 percent of the previous trading day’s closing price. Once the transactions are done within this price range, the price can be changed within a limit of 2 percent in each consecutive transaction.
Execution of order: After placing the orders, the member-broker of NEPSE transmit the order to the trading floor of NEPSE for execution through online mechanism. NEPSE has fixed board lot and odd lot trading. A board lot consists of trading of 10 shares in a lot if the face value is Rs 100 and 100 shares of a board lot if the face value of Rs 10. All transactions during regular hours should be conducted for at least one board lot. The transactions of less than 10 shares are permitted only on odd lot trading hours. In the process of executing order, the buying broker will post the highest bid price along with her/his code number in the buying column and the selling broker will post the lowest offer price with code number in the selling column. Orders will be executed when the prices for buy and sell orders match together. Upon the execution of order, it is recorded in the exchange and notice of execution will be sent to buyers and sellers through their respective brokers.
Settlement: After the execution of order, the transaction must be settled within 3 days of order execution. The settlement refers to the exchange of shares ownership and cash payment. For the settlement of transactions in speed, the NEPSE has initiated dematerialized form of ownership holdings and transfer and it has initiated the service of Central Depository Services and Clearing Company to make the transaction settlement prompt.
Brokerage commission: Investors have to pay a determined brokerage commission for each transaction to the broker. The brokerage commission rate of shares transaction is fixed as a percentage of value of shares traded. It ranges from minimum 0.7 percent to maximum 1 percent of the value of transaction.

3. What are the mechanisms to settle the selling transaction in a stock exchange?

Following mechanism is adopted to execute and settle a selling transaction in a stock exchange.

Selection of a broker: For executing selling transaction, the selling investor should select a competitive broker licensed by the stock exchange. The brokers must be selected on the basis of service quality.
Placing the sell order: After selecting the broker, the selling investors should place a sell order with the broker. For this purpose the seller should fill sell order form stating the relevant information such as name of companies, types and quantity of securities to be sold, price condition for sale, etc.
Execution of order: As per the sale order specified by seller, the broker will take the order to exchange floor by quoting the price and the order will be executed when the price condition is matched.
Sending contract slip: After execution of sell order, the broker will send a contract slip to the seller specifying the details of order executed which contains the information about number of securities sold, selling price and the time of order executed.
Settlement: After the execution of order, the transaction must be settled within 3 days of order execution. The settlement refers to the exchange of shares ownership and cash payment. For the settlement of transactions in speed, the NEPSE has initiated dematerialized form of ownership holdings and transfer and it has initiated the service of Central Depository Services and Clearing Company to make the transaction settlement prompt.

4. What are the difference between organized market and OTC market?

Organized market and OTC market are two popular forms of secondary market. The basic differences between these two forms of markets are as follows:

Organized Market	OTC Market
An organized market is the physical location where securities are traded under some established rules and regulation through the license brokers.	An OTC market is not a central physical location. It is collection of members and securities dealers who are connected with their client through well established communication mechanism
An organized market deals with the trading of securities which are listed in it.	Listing requirement is not compulsory in the OTC market.
An organized market provides floor for trading of securities. No trading is allowed outside the floor of exchange.	OTC trading provides no trading floor. Trading can take place using communication networks
Organized market requires the strict financial disclosure by its members and listed companies	Disclosure requirement for OTC market is not as strict as that of organized market.

5. Discuss the role of Nepal Stock Exchange for the development of capital market in Nepal.

Nepal Stock Exchange, commonly known as NEPSE, is the only one example of organized capital market in Nepal. It was incorporated under the company act and being operated under Securities Exchange Act, 1983. The main objective of the incorporation of NEPSE is to impart free marketability and liquidity to the government and corporate securities by facilitating transactions in its trading floor through member, market intermediaries, such as broker, market makers, etc. NEPSE has started trading of securities since January 13, 1994. It is the public company funded by Government of Nepal, Nepal Rastra Bank, Nepal Industrial Development Corporation and members of NEPSE. Nepal government holds majority (58.66 percent) ownership in NEPSE. Nepal Rastra Bank, Nepal Industrial Development Corporation, and NEPSE members have 34.6 percent, 6.12 percent and 0.62 percent ownership, respectively.

The important roles of Nepal Stock Exchange for the development of capital market in Nepal are as follows:

Listing of securities and provision of liquidity: NEPSE provides facility of listing the securities issued by corporations. This helps to bring the securities in secondary markets transactions. The automated trading system adopted by NEPSE facilitates the execution of buy and sell orders of investors through securities brokers
Supervision and monitoring: NEPSE supervises and monitors the actions of its members, licensed brokers and listed corporations. The listed corporations are required to submit financial statements with NEPSE to disclose financial performance of the corporations publically.
Settlement of transaction: NEPSE also facilitates the settlement of transactions timely that takes place between buyers and sellers through securities brokers. The settlement takes place in the form of exchange of cash and security’s certificate.
Provision of OTC market: NEPSE also operates over-the-counter market for those securities which are not listed or which have been de-listed from the NEPSE.

6. Discuss how secondary markets are regulated?

Securities markets in Nepal are being regulated by Securities Board of Nepal (SEBON) under Securities Act, 2063. As per this Act, the major functions, duties and power of SEBON are as follows:

To register securities and approve prospectus of public companies;
To provide license to operate stock exchanges;
To provide license to operate securities businesses;
To permit the operation of collective investment schemes and investment fund program;
To draft regulations, issue directives, and approve bylaws of stock exchanges;
To supervise and monitor stock exchanges and securities business activities;
To take enforcement measures to ensure market integrity;
To review reporting of issuer and listed companies, and securities businesspersons, to conduct research, study and awareness programs related to securities market;
To coordinate and cooperate with other domestic as well as international securities related regulatory agencies; and
To formulate policies and programs relating to securities markets and advise the Government of Nepal as and when required.

The work of enhancing the investors’ confidence in the securities markets through effective regulation with active formulation of legal infrastructure, improvement in organization and governance practice, and adequate use of information technology has been more demanding to SEBON. The regulatory provisions of securities market were not so strong before the proclamation of Securities Act, 2063. After the proclamation of this act, SEBON, in the process of implementation, has come up with several regulations since 2064. Some of them are: Securities Board of Nepal Regulation, 2064, Stock Exchange Operation Regulation 2064, Securities Businesspersons Regulation 2064 and so on. These regulations specifically enhance the regulatory authority of SEBON and give way for induction of additional securities businesspersons and establishment of new stock exchange.

As a main securities law of the country, Securities Act, 2063 has provisions relating to formation of Securities Board, provisions of registration and issuance of securities, provisions relating to stock exchange, provisions relating to license to carry on securities business, provisions relating to collective investment schemes, provisions relating to regulation, monitoring, inspection of securities market and securities businesses, provisions of offenses relating to insider trading of securities and so on. For the effective implementation of regulation practices, several regulations, bylaws, and guidelines have been proclaimed and enacted.

7. Assume that you sell short 1,000 shares of GBIME stock for Rs. 120 per share. Your short margin account requires you to maintain 50 percent initial margin and 30 percent maintenance margin.

What is the initial value of debt and equity in your short margin account?
If stock price increases to Rs. 150 per share, what will be the value of equity, debt and actual margin in your short margin account?
Do you receive a margin call if stock price increases to Rs. 150? Justify your answer by calculating the stock price of which you receive the margin call? [3+3+]

SOLUTION

Given:

Number of shares sold short (N) = 1,000 shares

Short selling price (Po) = Rs 120

Initial margin requirement (IM) = 0.50

Maintenance margin requirement (MM) = 0.30

1. The initial value of debt:

Initial debt = N x Po= 1,000 × Rs 120 = Rs 120,000

Initial value of equity: Initial equity = IM × N× Po = 0.5 × 1,000 × Rs 120 = Rs 60,000

Total assets = Rs 120,000+ Rs 60,000 = Rs 180,000

Debt= N x P₁= 1,000 Rs 150 = Rs 150,000

2. If stock price increases to Rs 150 per share (that is, P₁ = Rs 150):

Equity = Total assets – Debt = Rs 180,000 – Rs 150,000 = Rs 30,000

Actual margin = Equity / Debt = Rs 30,000 / Rs 150,000 = 0.20 or 20%

3. Yes, we receive a margin call if stock price increases to Rs 150 because actual margin is less than the maintenance margin.

Margin call price = 1 + IM / 1 + MM × Po

=1.5 / 1.3 x Rs 120 = Rs 138.46

There will be no margin call until the stock price remains below Rs 138.46. However, if stock price increase above Rs 138.46, we will receive a margin call.

8. Radhika Trader opens a brokerage account and purchases 300 shares of Sital Dreams at Rs. 40 per share. She borrows Rs. 4,000 from her broken to help pay for the purchase. The interest rate on the loan is 8%.

What is the margin in Radhika’s account when she first purchases the stock?
If the share price falls to Rs. 30 per share by the end of the year, what is the remaining margin in her account? If the maintenance margin requirement is 30%, will she receive a margin call?
What is the rate of return on her investment?

SOLUTION

Given:

Position – long

Number of Share (N) = 300 Shares Beginning Price (Po) = Rs. 40

Loan Amount = Rs. 4,000

Interest rate on loan (i) = 8%

1. Margin or initial equity = ?

Initial equity = Total value of assets – Loan 300 x Rs 40 – Rs. 4,000 = Rs. 8,000

Initial margin= Initial equity / Assets = Rs 8000 /Rs 12000 = 0.6667 or 66.67%

2. If share price falls (P₁) = Rs. 30

Equity = Total value of assets – loan = N x P₁ – Rs. 4,320

= Rs. 300 x 30 Rs. 4,320 = Rs. 4,680

Working note:

New Loan = Old loan x (1 + Interest rate) = Rs. 4,000 x (1 + 0.08) = Rs. 4,320

The percentage margin = Rs.4,680 / Rs.9,000 = 0.52 or 52%

Therefore, the investor will not receive a margin call since the actual margin is highest than maintenance margin.

3. The rate of return on the investment

= Ending equity- Beginning equity /Beginning equity

=Rs.4,680 – Rs. 8,000. /Rs.8,000

=-0.415 or-41.5%

Long Answer Question

1. Distinguish between primary market and secondary market and describe the role of Securities Board of Nepal in regulating these markets. [10+10]

Primary market and secondary market are two important types of securities markets. They differ from each other on the following ground.

Primary Markets	Secondary Markets
A primary market is the market for raising new capital by the corporations.	A secondary market deals with trading of outstanding securities among investors themselves.
Proceeds from selling of securities in primary markets go to the issuing corporation.	Proceeds from buying and selling of securities in secondary markets do not go to the original issuer. The proceeds flow between investors to investors.
In primary markets, the issuer could sell securities to the investing public directly or with the help of investment bankers and other financial intermediaries.	In secondary markets, securities are bought or sold among investors through securities brokers.
The existence of primary markets facilitates raising new capital for the corporations.	The existence of secondary markets facilitates to improve liquidity of outstanding securities.

Role of Securities Board of Nepal in Regulating Capital Market

Securities markets in Nepal are being regulated by Securities Board of Nepal (SEBON) under Securities Act, 2063. As per this Act, the major functions, duties and power of SEBON are as follows:

To register securities and approve prospectus of public companies;
To provide license to operate stock exchanges;
To provide license to operate securities businesses;
To permit the operation of collective investment schemes and investment fund program;
To draft regulations, issue directives, and approve bylaws of stock exchanges;
To supervise and monitor stock exchanges and securities business activities;
To take enforcement measures to ensure market integrity;
To review reporting of issuer and listed companies, and securities businesspersons, to conduct research, study and awareness programs related to securities market;
To coordinate and cooperate with other domestic as well as international securities related regulatory agencies; and
To formulate policies and programs relating to securities markets and advise the Government of Nepal as and when required.

2. Explain the trading mechanism in NEPSE. In what way securities Exchange Board, Nepal regulates securities market in Nepal?

Placing order: For buying and selling securities in NEPSE, the investors have to place order with licensed brokers by filling up the order form. The investors should fill up necessary information about transaction in the order form. Information required are name of company, type of security, number of shares, buy or sell price and the time period applicable for buying or selling. Once the orders are placed, the investors will get the ordering slip containing order registration number.
Trading hours: Initially, the trading hours fixed for securities transactions were 12:00 Noon to 15:00 pm. However, the trading hour of NEPSE has been recently extended from 11:00 am to 15:00 pm. All regular trading for board lot are conducted during this period.
Price regulation: The NEPSE has set the price change limit to protect the investors from aimless price fluctuations of the securities during the trading hour. According to the price regulation, the opening price of any day should not be increase or decrease by more than 5 percent of the previous trading day’s closing price. Once the transactions are done within this price range, the price can be changed within a limit of 2 percent in each consecutive transaction.
Execution of order: After placing the orders, the member-broker of NEPSE transmit the order to the trading floor of NEPSE for execution through online mechanism. NEPSE has fixed board lot and odd lot trading. A board loat consists of trading of 10 shares in a lot if the face value is Rs 100 and 100 shares of a board lot if the face value of Rs 10. All transactions during regular hours should be conducted for at least one board lot. The transactions of less than 10 shares are permitted only on odd lot trading hours. In the process of executing order, the buying broker will post the highest bid price along with her/his code number in the buying column and the selling broker will post the lowest offer price with code number in the selling column. Orders will be executed when the prices for buy and sell orders match together. Upon the execution of order, it is recorded in the exchange and notice of execution will be sent to buyers and sellers through their respective brokers.
Settlement: After the execution of order, the transaction must be settled within 3 days of order execution. The settlement refers to the exchange of shares ownership and cash payment. For the settlement of transactions in speed, the NEPSE has initiated dematerialized form of ownership holdings and transfer and it has initiated the service of Central Depository Services and Clearing Company to make the transaction settlement prompt.
Brokerage commission: Investors have to pay a determined brokerage commission for each transaction to the broker. The brokerage commission rate of shares transaction is fixed as a percentage of value of shares traded. It ranges from minimum 0.7 percent to maximum 1 percent of the value of transaction.

Securities markets in Nepal are being regulated by Securities Board of Nepal (SEBON) under Securities Act. 2063. As per this Act, the major functions, duties and power of SEBON are as follows.

To register securities and approve prospectus of public companies;
To provide license to operate stock exchanges;
To provide license to operate securities businesses;
To permit the operation of collective investment schemes and investment fund program;
To draft regulations, issue directives, and approve bylaws of stock exchanges;
To supervise and monitor stock exchanges and securities business activities;
To take enforcement measures to ensure market integrity;
To review reporting of issuer and listed companies, and securities businesspersons, to conduct research, study and awareness programs related to securities market;
To coordinate and cooperate with other domestic as well as international securities related regulatory agencies; and
To formulate policies and programs relating to securities markets and advise the Government of Nepal as and when required.

3. Describe the different types of securities markets and the regulations governing securities markets in Nepal.

Financial markets can be divided into different types. One way to classify the financial markets is to distinguish between primary market and secondary market. Another classification is based on life span of the securities traded in the market. They are money market and the capital market.

Primary Market and Secondary Market

Primary market refers to the market where new securities are issued for the purpose of obtaining capital. In other words, it is the market in which corporations raise new capital. Primary market is also called the “new issue market” because securities are issued for the first time in this market. Corporations or government institutions can raise funds from the primary market through making a new issue of stocks or bonds. All proceeds from the issue in this market go to issuing corporation. In issuing securities, the corporation could take the services of investment bankers and securities dealers. They assist issuing corporations selling securities in the market.

Secondary market refers to the market where securities that have already been issued are traded. Once a security has been purchased for the first time by an investor in the primary market, the same security can be sold to another investor in the secondary market. Thus, the existence of secondary market provides the liquidity of financial assets. People are attracted towards primary markets because of the existence of secondary markets. In secondary market, the proceeds from sale of securities do not go to the issuing corporation since the transactions occur between investors.

Secondary market may be classified as organized securities exchange and over-the-counter (OTC) market. In Nepal, Nepal Stock Exchange (NEPSE) is the organized secondary market where securities are traded daily.

Money Market and Capital Market

Money market is the market for short-term, highly liquid securities. The instruments traded in the money market have short maturity period ranging from few days to a year. Financial assets like treasury bills, certificate of deposit, commercial paper and bankers’ acceptance are some of the short-term securities traded in the money market. These money market instruments are actively traded in primary as well as secondary market. Money market is used to raise funds to finance current assets such as inventory, accounts receivable, etc.

Capital market is a market for financial assets which have long or indefinite maturity. Capital market provides long term debt and equity finance for the government and the corporate sectors. All long-term securities issued by corporations and government such as common stock, preferred stock, corporate bonds, government bonds are the instruments of capital market. These capital market instruments are also traded in both primary as well as secondary market. Capital market instruments are not as liquid as money market instruments because of longer maturity. Capital market is used to raise fund which is required to finance fixed assets such as land and building, plant and machinery, etc.

Broker Market and Dealer Market

Broker markets consist of the organized exchanges where buy and sell orders of investors are executed through the licensed brokers. The organized exchanges may be the stock exchanges, futures exchanges and option exchanges. In case of Nepal, the Nepal Stock Exchange (NEPSE) is the only one national stock exchange. Particularly, it is the only one dominant broker market in Nepal.

Dealer market is a security market mechanism wherein multiple dealers post prices at which they are agreed to buy or sell a specific security. In a dealer market, securities dealers are designated as market makers. They provide liquidity and transparency by electronically displaying the prices at which they are willing to make a market in a security. A security dealer posts both the price at which it will buy the security, known as bid price, and the price at which it will sell the security, known as ask price.

Regulations Governing Securities Markets in Nepal.

Securities markets in Nepal are being regulated by Securities Board of Nepal (SEBON) under Securities Act, 2063. As per this Act, the major functions, duties and power of SEBON are as follows:

To register securities and approve prospectus of public companies;
To provide license to operate stock exchanges;
To provide license to operate securities businesses;
To permit the operation of collective investment schemes and investment fund program;
To draft regulations, issue directives, and approve bylaws of stock exchanges;
To supervise and monitor stock exchanges and securities business activities;
To take enforcement measures to ensure market integrity;
To review reporting of issuer and listed companies, and securities businesspersons, to conduct research, study and awareness programs related to securities market;
To coordinate and cooperate with other domestic as well as international securities related regulatory agencies; and
To formulate policies and programs relating to securities markets and advise the Government of Nepal as and when required.

Chapter 2: Markets and Transactions

Very Short Question Answer

1. State the roles of an investment banker.

2. Explain the meaning of public offerings of securities.

3. Give some examples of broker markets.

4. Initial margin and maintenance margin requirement for your margin purchase account are 70 percent and 25 percent. If your actual margin is 25 percent, do you receive a margin call? Explain.

Short Question Answer

1. Describe the functions of commission brokers, floor brokers, and floor traders.

2. Describe the trading mechanism of security market in Nepal.

3. What are the mechanisms to settle the selling transaction in a stock exchange?

4. What are the difference between organized market and OTC market?

5. Discuss the role of Nepal Stock Exchange for the development of capital market in Nepal.

6. Discuss how secondary markets are regulated?

7. Assume that you sell short 1,000 shares of GBIME stock for Rs. 120 per share. Your short margin account requires you to maintain 50 percent initial margin and 30 percent maintenance margin.

8. Radhika Trader opens a brokerage account and purchases 300 shares of Sital Dreams at Rs. 40 per share. She borrows Rs. 4,000 from her broken to help pay for the purchase. The interest rate on the loan is 8%.

Long Answer Question

1. Distinguish between primary market and secondary market and describe the role of Securities Board of Nepal in regulating these markets. [10+10]

2. Explain the trading mechanism in NEPSE. In what way securities Exchange Board, Nepal regulates securities market in Nepal?

3. Describe the different types of securities markets and the regulations governing securities markets in Nepal.

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