INTRODUCTION TO

FINANCIAL SYSTEM
Rabin Dahal
Ratna Rajya Laxmi Campus
Padma Kanya Multiple Campus
Concept of Financial System
 Consists of
 Financial Institutions
 Financial Markets
 Financial Instruments
 Regulatory Bodies
The function is to channel funds from sectors that have a surplus to
industries that have a shortage of funds
Composition of Nepalese Financial System

FINANCIAL INSTITUTIONS
FINANCIAL MARKETS
FINANCIAL INSTRUMENTS
FINANCIAL INSTITUTIONS/INTERMEDIARIES
OF NEPAL
REGULATORY INSTITUTIONS
Nepal Rastra Bank
INSURANCE COMPANIES
Nepal Insurance Authority Life Insurance Companies
NRB LICENSED INSTITUTES Non-Life Insurance Companies
Commercial Banks Re-Insurance Companies
Development Banks
DEPOSIT AND CREDIT
Finance Companies GUARANTEE FUND
Microfinance Companies EMPLOYEE PROVIDENT FUND
COOPERATIVES CITIZEN INVESTMENT FUND
NEPAL INFRASTRUCTURE INVESTMENT INTERMEDIARIES
DEVELOPMENT BANK MUTUAL FUNDS
MISHKIN CLASSIFICATION
DEPOSITARY INSTITUTIONS
 Commercial Banks
 Thrift Institutes
 Credit Unions
CONTRACTUAL SAVING INSTITUTIONS
 Life Insurance Companies
 Casualty Insurance Companies
 Pension Fund
INVESTMENT INSTITUTIONS
 Mutual Fund
 Money Market Mutual Fund
 Investment Banks
FINANCE COMPANIES
MADURA CLASSIFICATIONS
Depositary Institutes Non-Depositary
Institutes
Commercial Banks
Finance Companies
Saving Institutions
Mutual Funds
Credit Unions
Securities Firms
Insurance Companies
Pension Funds
Saunders and Cornett Classifications
Commercial Banks
Thrifts
Insurance Companies
Securities Firms and Investment Banks
Finance Companies
Investment Funds
Pension Funds
FinTechs
Financial Markets

Financial
Market

Market Foregin
Nature of Maturity of Seasoning Derivative
Organizatio Exchange
Claim Claim of Claim Market
n Market

Money
Debt Primary Spot Market
Market

Over-the-
Capital
Equity Secondary Counter
Market
Market
Debt and Equity Market
DEBT MARKET
The most common method is through the issuance of a debt
instrument, such as a bond or a mortgage, which is a contractual
agreement by the borrower to pay the holder of the instrument
fixed amounts at regular intervals (interest and principal payments)
until a specified date (the maturity date) when the final payment is
made.
The maturity of a debt instrument is the number of years (term)
until that instrument’s expiration date
A debt instrument is short-term if its maturity term is less than a
year and long-term if its maturity term is ten years or longer.
Debt instruments with a maturity term between one and ten years
are said to be intermediate-term.
EQUITY MARKET
The second method of raising funds is through the issuance of
equities, such as common stock, which are claims to share in the
net income (income after expenses and taxes) and the assets of a
business.
If you own one share of common stock in a company that has
issued one million shares, you are entitled to 1 one-millionth of the
firm’s net income and 1 one-millionth of the firm’s assets.
Equities often make periodic payments (dividends) to their holders
and are considered long-term securities because they have no
maturity date.
In addition, owning stock means that you own a portion of the firm
and thus have the right to vote on issues important to the firm and
to elect its directors.
COMPARISION
The main disadvantage of owning a corporation’s equities rather
than its debt is that an equity holder is a residual claimant; that is,
the corporation must pay all its debt holders before it pays its equity
holders.
The advantage of holding equities is that equity holders benefit
directly from any increases in the corporation’s profitability or asset
value because equities confer ownership rights on the equity
holders.
Debt holders do not share in this benefit, because their interest
payments are fixed.
 Primary and Secondary Market
PRIMARY MARKET
Primary markets are those where users of capital (like corporations)
raise money through the issuance of new securities like stocks and
bonds.
Users of the funds lack the internally generated funds (like retained
earnings) to support new projects or expanded production needs.
As a result, in order to raise more money, the fund users issue
securities on external primary markets.
In exchange for the funds (money) that the issuer or user of the fund
needs, new issues of financial instruments are sold to the initial
suppliers of funds (such as households).
The investment bank recruits the initial public buyers of the securities
for the funds user and offers the securities issuer (the funds user)
advice on the securities issue (such as the offer price and number of
The funds user avoids the risk and expense of developing a market
for its securities on its own by issuing primary market securities
with the assistance of an investment bank.
Issues of equity by companies going public for the first time, such
as when they permit their equity—shares—to be publicly traded on
stock markets, are examples of primary market financial
instruments.
These initial public offerings (IPOs) are the common name for these
new issues.
Use of Funds
Underwriting with Initial Supplier of
(Corporations
Investment Bank Funds (Investors)
Issuing debt/equity

Financial Instruments flow

Funds Flow
SECONDARY MARKET
Once financial instruments such as stocks are issued in primary
markets, they are then traded—that is, rebought and resold—in
secondary markets.
Sellers of secondary market financial instruments are economic
agents in need of funds.
Secondary markets provide a centralized marketplace where
economic agents know they can transact quickly and efficiently.
When an economic agent buys a financial instrument in a
secondary market, funds are exchanged, usually with the help of a
securities broker acting as an intermediary between the buyer and
the seller of the instrument.
The original issuer of the instrument (user of funds) is not involved
in this transfer.
Secondary markets offer buyers and sellers liquidity—the ability to
turn an asset into cash quickly at its fair market value—as well as
information about the prices or the value of their investments.
Increased liquidity makes it more desirable and easier for the issuing
firm to sell a security initially in the primary market.
Further, the existence of centralized markets for buying and selling
financial instruments allows investors to trade these instruments at
low transaction costs.

Economic Economic Agents

Agents(Investors) Financial Markets (Investors) wanting
Wanting to Sell to buy

Financial Instruments flow

Funds Flow
Money Market and Capital
Market
MONEY MARKET
Money markets are markets that trade debt securities or
instruments with maturities of one year or less.
In the money markets, economic agents with short-term excess
supplies of funds can lend funds (i.e., buy money market
instruments) to economic agents who have short-term needs or
shortages of funds (i.e., they sell money market instruments).
The short-term nature of these instruments means that fluctuations
in their prices in the secondary markets in which they trade are
usually quite small.
CAPITAL MARKET
Capital markets are markets that trade equity (stocks) and debt (bonds)
instruments with maturities of more than one year.
The major suppliers of capital market securities (or users of funds) are
corporations and governments.
Households are the major suppliers of funds for these securities.
Given their longer maturity, these instruments experience wider price
fluctuations in the secondary markets in which they trade than do money
market instruments.
Corporate stocks or equities represent the largest capital market instrument,
followed by mortgages, Treasury securities, and corporate bonds.
Exchange and Over-the-Counter Market
EXCHANGE MARKET
One method to organize a secondary market is exchanges, where
buyers and sellers of securities (or their agents or brokers) meet in one
central location to conduct trades.
The New York Stock Exchange, Nepal Stock Exchange, and American
Stock Exchanges for stocks and the Chicago Board of Trade for
commodities (wheat, corn, silver, and other raw materials) are examples
of organized exchanges.
OVER-THE-COUNTER MARKET
The other method of organizing a secondary market is to have an over-
the-counter (OTC) market, in which dealers at different locations who
have an inventory of securities stand ready to buy and sell securities
“over the counter “to anyone who comes to them and is willing to accept
their prices.
Because over-the-counter dealers are in computer contact and know the
prices set by one another, the OTC market is very competitive and not
Derivative Market
A derivative security realizes its value from the value of the asset,
which forms the basis of the derivative contract.
The asset whose value determines the value of the derivative
contract is known as the underlying asset.
The value of the derivative product will change depending on the
changes in the value of the underlying asset.
The derivative derives its value from the performance of something
else, a factor as we described it.
That “something else” is often referred to as the underlying asset.
The term underlying asset, however, is somewhat confusing and
misleading.
For instance, the underlying asset might be a stock, bond, currency,
or commodity, all of which are assets.
The underlying “asset,” however, might also be some other random
element such as the weather, which is not an asset.
A derivative market is a systematic system and process of a present
contract between two counterparties i.e. buyer and sellers for the
trading of financial assets of a specific quantity, quality, price,
places and date of delivery in the future.
The derivative market is also known as the present contract but
future transaction market.
It is the financial market for derivatives, financial instruments like
futures contract or options which are derived from other forms of
assets.
 Foreign Exchange Market
The FX markets exist whenever and wherever financial transactions are
conducted that are denominated in a foreign currency.
The FX markets facilitate the exchange of value from one currency to
another and allow market participants to buy and sell foreign currencies.
There is an enormous demand to buy and sell foreign currencies, arising
from:
 financial flows associated with international trade in goods and
services
cross-border capital transactions involving the investment and the
borrowing of funds
Speculative transactions aimed at profiting from favorable movements
in future exchange rates
Central bank transactions within the FX markets
SPOT MARKET
The spot market involves almost the immediate purchase or sale of
foreign exchange.
Typically, cash settlement is made in two business days (excluding
holidays of either the buyer or the seller).
FORWARD MARKET
In accordance with spot trading, there is also a forward foreign
exchange market.
The forward market involves contracting today for the future
purchase or sale of foreign currency.
The forward price may be same as the spot price, but usually it is
higher (at premium) or lower (at discount) than spot price.
THEORIES OF EXCHANGE RATE
In effective foreign markets, investors will not be able to make
abnormal profits.
Only when the forex markets are inefficient will speculators or
arbitrageurs be able to consistently earn large profits without risk.
Arbitrage activity would ensure that inequalities in the exchange
rate are eliminated in a forex market with a large number of traders
having low-cost access to information.
It would also ensure that the exchange-adjusted prices of
comparable goods and financial assets are the same in the world.
Basically, here we deal with two Theories of Exchange Rate
Interest Rate Parity
Purchasing Power Parity
Interest Rate Parity
Interest rate parity means that, after adjusting for risk, investors
should anticipate receiving the same return on their security
investments across all nations.
It acknowledges that when you make investments outside of your
home country, you are impacted by both investment returns and
changes in exchange rates.
It acknowledges that when you make investments outside of your
home country, you are impacted by both investment returns and
changes in exchange rates.
Likewise, if the foreign currency you receive loses value, your
overall return will be lower.
Assumption
Interest rate parity works fairly well in the international capital
markets where no restrictions exist for the flow of funds from one
country to another and no tax asymmetries exist.
Suppose that the interest rate on a one-year bond (rupee-
denominated) in Nepal is 14 percent while a similar bond (HK $-
denominated) in Hong Kong pays 9 per cent interest. The spot rate
for HK $ is HK $ 0.1522/Rs. and the 1-year forward rate is HK $
0.1455/Rs. If you have a choice of investment, which one should
you choose?
You may notice that Rs. is trading at a forward discount.
(Alternatively, HK $ is trading at a forward premium relative to Rs.).
Let us assume that you have HK $ 1,000. If you invest HK $ 1,000 in
Hong Kong, at the end of one year you will receive HK $ 1,000 × 1.09
= HK $ 1,090. Alternatively, you can exchange HK $ 1,000 for the
Nepalese rupees at the spot rate; you will receive: 1,000/0.1522 =
Rs. 6,570.30. You can invest Rs. 6,570.30 at 14 percent for one year.
At maturity, you will receive: `6,570.30 × 1.14 = `7,490.14. You can
sell the Nepalese rupees forward and immediately receive HK $: Rs.
7,490.14 × 0.1455 = HK $ 1,090.
Both investments are of equal value. What you gain on the interest
rate differential, you lose on the exchange rate differential. In other
words, there is a parity between the interest rates and exchange
rates, or simply interest rate parity. Thus:
The Interest rate parity characterizes the relationship between
interest rates and exchange rates of two countries.
It states that the exchange rate of two countries will be affected by
their interest rate differential.
In other words, the currency of a high-interest-rate country will be at
a forward discount relative to the currency of a low-interest-rate
country and vice versa.
This implies that the exchange rate (forward and spot) differential will
be equal to the interest rate differential between the two countries.

Where,
Interest rate parity states that the high interest rate on a currency is
offset by the forward discount and that the low-interest rate is offset by
the forward premium.
Arbitrage will ensure that this happens.
Suppose that in the example above, the 1-year forward exchange rate
is HK $ 0.1512 (instead of HK $ 0.1455). Then, on selling the Nepalese
rupees forward, you will get HK $: `7,490.14 × 0.1512 = HK $
1,132.51. Thus, it is more profitable for you to invest in Nepalese. You
can also borrow Hong Kong, convert it into Nepalese rupees at the spot
rate, and invest in Nepal. Suppose you borrowed HK $ 1,00,000 for one
year and invested in Nepal, the following are the consequences:
You borrow HK $ 1,00,000 at 9 percent for one year. After one year,
you will have to pay: HK $ 1,00,000 × 1.09 = HK $109,000.
You convert HK $ 1,00,000 into Rs. at the spot rate. You will receive:
HK $ 1,00,000/0.1522 = Rs. 6,57,030
You invest Rs. 6,57,030 at 14 per cent interest for one year. At the end
of one year, you will receive: Rs. 6,57,030 × 1.14 = Rs. 7,49,015.
You sell Rs. 7,49,015 at a 1-year forward rate of HK $0.1512 to receive
after one year an assured amount of HK $: Rs. 7,49,015 × 0.1512 = HK
$ 1,13,251.
After returning (principal plus interest) HK $ 1,09,000, you will be left
with a profit of HK $ 1,13,251 – HK $ 1,09,000 = HK $ 4,251. This is the
arbitrage profit.
If you can make a riskless arbitrage profit, others will also. The arbitrage
activity should result in the following effects:
The HK $ interest rate will increase as arbitrageurs borrow HK$.
The spot rate of Nepalese rupees against Hong Kong $ will appreciate
as arbitrageurs demand rupees against HK $.
The interest rate in Nepal will tend to fall as arbitrageurs invest rupees
The forward rate of rupees against HK $ will depreciate as arbitrageurs
sell rupees against HK $.
The opportunity to make arbitrage profit will be, thus, eliminated soon.
The equilibrium will be reached in terms of interest rate parity, and the
Purchasing Power Parity
The purchasing power parity (PPP) equation states that exchange rates and
prices of goods adjust so that identical goods cost the same amount in
different countries.
This relationship is also called the law of one price.
Let us consider an example, ABC ordered a sophisticated cell phone from
the US which cost USD 1200 at the US market. The same cell phone cost Rs.
132,000 in Nepal, then purchasing power parity implies that the exchange
rate is Rs 110/USD.
Let the price of commodity in home country is denoted by and price in the
foreign country is denoted by , the equation for purchasing power is
denoted by

The major assumptions of purchasing power parity are:

Purchasing power parity assumes there is the absence of
transportation cost or transaction cost and no import restrictions.
PPP assumes that market forces will eliminate conditions where
the same products sell at different prices in foreign markets.
To explain the second assumption, let us consider an example,
suppose the exchange rate between NRs and USD is Rs. 110/USD. If
the cellphone costs USD 120 in the USA and Rs. 15000 in Nepal. The
importers make a profit of 1800 per unit. This trading between the
USA and Nepal leads to the purchase of cell phones in the USA and
selling them in Nepal. It creates demand for cell phones in the USA,
which increases the price of a cell phone in the USA. On the other
hand, it increases the supply of cell phones in Nepal which will lead
to a fall in the price of cellphone in Nepal. This will automatically
correct PPP.
Over-valuation and Under valuation
We can find out whether the local currency is overvalued or
undervalued by comparing the implied exchange rate to the actual
exchange rate.
We can say that the local currency is undervalued or overvalued on
the basis of the implied exchange rate and actual exchange rate.
If the actual exchange rate is greater than the implied exchange
rate, it implies the undervaluation of the local currency.
Similarly, if the actual rate is less than the implied exchange rate, it
suggests that the local currency is overvalued to the given foreign
currency.
In the case of direct quotation, percent of overvaluation and under
valuation is based on the actual exchange rate.
The overvaluation and undervaluation percent is worked out as
follows:

Where,
Financial Instruments
A 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 specified conditions.
Let’s analyze this definition.
A financial instrument is a written legal obligation that is subject to
government enforcement. The enforceability of the obligation is an important
feature of financial instruments.
A financial instrument obligates one party to transfer something of value,
usually money, to another party. By party, it means a person, company, or
government. Usually, the financial instrument specifies that payments will be
made.
The financial instrument specifies that payment will be made at some future
dates.
A financial instrument specifies conditions under which a payment will be
made. Some agreements specify payment only when certain events happen.
Certificates of Deposits
A certificate of deposit is a short-term debt instrument sold by a
depository institution that pays annual interest payments equal to a
fixed percentage of the original purchase price.
In addition, at maturity, the original purchase price is also paid back.
Certificates of deposit come in two forms, negotiable and
nonnegotiable.
A negotiable CD can be sold by the initial depositor on the open
market before maturity, whilst a non-negotiable CD must be held by
the depositor until maturity.
The vast majority of certificates of deposit are issued with less than a
year to maturity, with three and six-month deposits being the most
common types, and the minimum term is seven days.
Bonds
A bond is a long-term debt instrument.
Governments or corporations, normally, issue bonds.
A bond is also called fixed-income security as it gives periodic
interest.
Corporations issue bonds to finance investment projects.
The government issues bonds when they need funds to cover budget
deficits.
When a corporation or government issues bonds, it is borrowing
money from those who buy the bonds.
The issuer receives funds immediately and pays the buyers back in
the future.
Because bond issuer owe money to bond purchasers, bonds are also
called debt-securities.
Features of Bonds
Face Value: Face value is called par value. A bond/debenture is
issued at the face or par value, which is, normally, Rs. 100 or Rs.
1,000. Interest is paid on the face value, whether debentures are
issued at par, premium, or discount.
Interest Rate: The interest rate is fixed and known to the investor.
Interest is tax-deductible to the firm that issues it. Interest is paid
quarterly, half-yearly, annually, or at the time of redemption. The
interest rate is also called the coupon rate. The interest rate is
mentioned on the face of the certificate.
Maturity: A bond/debenture is issued for a specified period of time.
It is repaid on maturity.
Redemption Value: The value, that a bondholder/debenture
holder will get on maturity, is called redemption value. It can be
redeemed at par or at a premium or at discount.
Market Value: A bond/debenture may be traded in the stock
exchange. It can be bought or sold at the market value. Market
value may be different from par value or redemption value.
Risk: The risk in holding a government bond is lower than the risk
associated with the debenture issued by a company. So, if both
carry same rate of interest and other terms such as redemption
period and value of security remain the same, debenture would be
quoted in stock exchange at a lower price, compared to a bond of
the same face value.
Equity
‘Equities’ is a commonly used alternative name for company shares,
though strictly it should be used only for ordinary shares.
Ordinary shares give their holders claims to variable future income
streams, paid out of company profits and commonly known as
dividends. The owners of equity stock are legal owners of the firm.
The law requires that the company provides them with specified
information in the annual report and accounts and that the firm must
hold an annual general meeting at which the directors’ conduct of
the firm’s affairs is subject to approval by such shareholders, each of
whom has a number of votes matching the size of his shareholding.
They are entitled to a share only in those profits which remain after
bondholders and preference shareholders have been paid; if the firm
goes into liquidation, shareholders have a claim on any remaining
assets only after prior claimants have been paid.
Obviously, therefore, ordinary shareholders are exposed to much
greater risk than are bondholders
However, they also face the prospect of greater benefits.
Remember that a shareholding is a part ownership of the firm. In
normal circumstances, the monetary value of the firm will grow as a
result of both real expansion and inflation.
If the value of the whole firm increases, so too must the value of the
shares in it. In the long run, the value of shares should increase
where the value of bonds will not.
Derivatives
Derivative securities, which are more appropriately termed
derivative contracts, are assets that confer certain on their owner
certain rights or obligations as the case may be.
These contracts owe their availability to the existence of markets
for an underlying asset or a portfolio of assets on which such
agreements are written.
In other words, these assets are derived from the underlying asset.
If we perceive the underlying asset as the primary asset, then such
contracts may be termed as derivatives, because they are derived
from such assets.
Forward Contract
A forward contract provides the holder of the contract the right to
buy or sell the underlying asset at a future time at a price that is
agreed upon at the time of entering into the contract.
Typically, forward contracts are short-term contracts and are non-
negotiable, and the two parties that enter into the contract will have
to fulfill their obligations when the contract expires.
Forward contracts are usually entered into by private parties and,
hence, are called over-the-counter contracts.
One of the parties to a forward contract assumes a long position
and agrees to buy the underlying asset on a certain specified future
date for a certain specified price.
The other party assumes a short position and agrees to sell the
asset on the same date for the same price.
ABC Bakery entered into a forward contract with Sakti Sugars, a
sugar manufacturer, on January 1 to buy sugar on March 31 at Rs.
30,000 per 1,000 kg. There will be no cash exchange on January 1;
however, on March 31, ABC Bakery will pay Rs. 30,000, irrespective
of the price of sugar in the market, and Shakti Sugars will deliver
1,000 kg of sugar to the bakery. This contract will be binding on
both parties, and both will have to honor their commitments.
Future Contracts
A futures contract provides the holder of the contract the right to
buy or sell the underlying asset at a future time at a price that is
agreed upon at the time of entering into the contract.
Although a futures contract is similar to a forward contract, futures
contracts are negotiable and either party to the contract has the
right to transfer the contract obligation to a third party any time
before the expiry of the contract.
These contracts are traded on futures exchanges.
Futures contracts can either be written on real assets or financial
assets.
If they are written on real assets, they are called commodity
futures, and if they are written on financial assets, they are called
financial futures.
Assume that Sujal Foods needs 5,000 kg of cocoa on March 31 to
meet the requirements of the production of chocolate in April. On
January 1, Sujal Foods entered into a futures contract in cocoa. If
the futures contract is designed for buying 1,000 kg of cocoa, Sujal
Foods will buy five cocoa futures contracts on January 1. The
futures price on January 1 indicates the price at which Sujal Foods
can purchase cocoa on March 31. If the futures price is RS. 40,000,
it means that Sujal Foods will pay RS. 40,000 to buy 1,000 kg of
cocoa; in other words, Sujal Foods is fixing a liability of RS. 200,000
to buy 5,000 kg of cocoa. On March 31, when the contract matures,
Sujal Foods will pay RS. 200,000, and the seller of the futures will
deliver 5,000 kg of cocoa to Sujal Foods.
Options
An options contract gives the holder the right to buy or sell the
underlying asset on or before the maturity date of the contract.
The major difference between options contracts and forward or
futures contracts is that the holder of forward or futures contracts
will have to fulfil the obligations under the contract, irrespective of
whether the position in the contract results in a gain or a loss.
However, the options contract holder has the option of not having
to fulfill the obligations under the contract if the position results in a
loss.
An options contract is more valuable than a futures contract and
consequently requires an initial investment at the time of entrance.
Options can be traded in options exchanges or options can be
contracted between private parties, in which case they are known
as over-the-counter options.
Assume that Sujal Foods needs 5,000 kg of cocoa on March 31 to meet the
requirements of production of chocolate in April. However, the price of
cocoa is volatile and can either increase or decrease. Thus, Sujal faces the
risk of price fluctuations. If the price is expected to increase, it would like to
settle on a lower price. On the other hand, if the price decreases, it would
like to buy at the lower price. To accomplish this, on January 1, Sujal will
enter into an options contract in cocoa with a strike price of NR 38,000. If
the options contract is designed for buying 1,000 kg of cocoa, Sujal will buy
five cocoa options contracts on January 1. On March 31, Sujal will decide on
whether or not to exercise the option and buy cocoa at NR 38,000. If the
price of cocoa in the market is more than NR 38,000, Sujal will exercise the
option and buy cocoa at NR 38,000. However, if the market price for cocoa
is less than NR 38,000, Sujal will buy cocoa in the market at the prevailing
market price instead of exercising the option. Since an option holds value
to the option buyer, the buyer will have to pay the option seller a certain
amount of money, known as option premium, which is determined in the
options market at the time of entry into the option contract.
There are two types of option contract
CALL OPTION
Options contracts that give the holder the right to acquire the underlying
asset are known as call options.
If the buyer of such an option were to exercise his right, the seller of the
option is obliged to deliver the underlying asset as per the terms of the
contract.
The buyer pays a fee (premium) for his right.
PUT OPTION
There exist options contracts that give the holder the right to sell the
underlying asset.
These are known as put options. In the case of such contracts, if the holder
were to decide to exercise his option, the seller of the put is obliged to
take delivery of the underlying asset.
The put option seller is paid a premium for taking on the risk associated
with the obligation.
Swaps
A swap is a contractual agreement between two parties to
exchange cash flows calculated on the basis of pre-specified terms
at predefined points in time.
The cash flows being exchanged represent interest payments on a
specified principal amount, which are computed using two different
yardsticks.
One interest payment may be computed using a fixed rate of
interest, whereas the other may be based on a variable benchmark
such as the T-bill rate
A swap in which both payments are denominated in the same
currency is referred to as an interest rate swap.
There also exist swaps where two parties exchange cash flows
denominated in two different currencies. Such swaps are referred to
as currency swaps.
BHP, an Australian company, may want to borrow Nepalese rupees
to invest in Nepal, while Deevya Enterprises may be planning an
investment in Australia that requires Australian dollars. In such a
scenario, both firms may find it convenient to borrow money in their
own currencies and then swap the loans. Hence, BHP will borrow
Australian dollars in Australia, and Deevya Enterprises will borrow
Nepalese rupees in Nepal, and then the two firms will swap the
loans so that BHP will pay interest on the Nepalese rupee loan and
Deevya Enterprises will pay interest on the Australian dollar loan.
ROLE OF FINANCIAL SYSTEM AND ECONOMIC GROWTH

In particular, financial systems:

Produce information ex ante about possible investments and
allocate capital
Monitor investments and exert corporate governance after
providing finance
Facilitate the trading, diversification, and management of risk
Mobilize and pool savings
Ease the exchange of goods and services