Financial

Markets Analysis

Dakito Alemu, Ph.D

Tenkir Seifu. Ph.D
 Learning Objectives
To prepare students for their future careers, Financial Markets Analysis course provides the
following features:

• A unifying analytic framework that uses a few basic principles to organize students’ thinking.
These principles include:
Asymmetric information (agency) problems
Conflicts of interest
Transaction costs
Supply and demand
Asset market equilibrium
Efficient markets
Measurement and management of risk
Encourages students to understand the connection between the theoretical concepts and their real-world applications
Enhancing students’ analytical abilities and concrete problem-solving skills,
Prepares students for successful careers in the financial services industry or successful interactions with financial
institutions
 Financial Markets Analysis

CHAPTER 1
OVERVIEW OF FINANCIAL
MARKETS
 Brainstorming Questions
1) What is a financial system?
2) Why Study Financial Markets?
3) Why do Financial Institutions Exist?
The financial system is the process by which money
flows from savers/lender to users/borrowers.
The financial system channels trillions of dollars per year from
savers to people with productive investment opportunities.
Well-functioning financial markets and financial intermediaries are
crucial to economic health.
COMPLIED BY DAKITO ALEMU (PHD)
What is a financial system?

A financial Financial System

system matches the
needs of savers
a system that directly through
brings savers and financial markets
borrowers in an or indirectly
economy directly through financial
or indirectly. institutions.
 The Financial System

Borrower-
Spenders

Lender-
Savers

In the absence of financial markets, you would both be stuck with the status quo, and both of you would be worse
7 off.
Suppliers and Demanders of Funds
Government Business Individuals

• Federal, state and • Investments in • Some need for

local projects & production of loans (house,
operations goods and auto)
• Typically, net services • Typically, net
demanders of • Typically, net suppliers of funds
funds demanders of
funds

Borrower-Spenders Lender-Savers
9
The most important financial institution in the financial system is the central
bank, the government agency responsible for the conduct of monetary policy
 Regulation of the Financial System
The financial system is among the most heavily
regulated sectors of the American economy.
The government regulates financial markets for two
main reasons:
1) to increase the information available to investors
and
2) to ensure the soundness of the financial system.
TABLE 2.3 Principal Regulatory Agencies of the U.S. Financial System
Regulatory Agency Subject of Regulation Nature of Regulations
Securities and Organized exchanges Requires disclosure of information,
Exchange and financial restricts insider trading
Commission (SEC) markets
Commodities Futures market Regulates procedures for trading in
Futures Trading exchanges futures markets
Commission (CFTC)
Office of the Federally chartered Charters and examines the books of
Comptroller of the commercial banks federally chartered commercial banks
Currency and imposes restrictions on assets they
can hold
National Credit Federally chartered Charters and examines the books of
Union credit unions federally chartered credit unions and
Administration imposes restrictions on assets they
(NCUA) can hold
State banking State-chartered depos- Charter and examine the books of state-
and insurance itory institutions chartered banks and insurance compa-
commissions nies, impose restrictions on assets they
can hold, and impose restrictions
on branching
Federal Deposit Commercial banks, Provides insurance of up to $250,000
Insurance mutual savings for each depositor at a bank, examines
Corporation (FDIC) banks, savings and the books of insured banks, and
loan associations imposes restrictions on assets they
can hold
Federal Reserve All depository Examines the books of commercial banks
System institutions that are members of the system, sets
reserve requirements for all banks
Office of Thrift Savings and loan Examines the books of savings and loan
Supervision associations associations, imposes restrictions on
assets they can hold
Capital Market
Authority
Art 3. Establishment of the Capital Market Authority
The Ethiopian Capital Market Authority.. Authority

An autonomous Federal Government regulatory Authority

Accountable to the PM

Head Office: Addis Ababa

Art 3/5: Objective of the Authority: Protect Investors

Ensure the existence of a capital market ecosystem

Reduce systemic risk by ensuring the integrity of the capital market and transactions
Promote the development of the capital market by creating enabling environment for long term
investments
Central Bank
 Central Bank’s Role
Monetary policy involves the management of:
a) interest rates and
b) the quantity of money, also referred to as the money supply (defined as anything that
is generally accepted in payment for goods and services or in the repayment of debt).
Because monetary policy affects interest rates, inflation, and business cycles, all of
which have a major impact on financial markets and institutions
The three basic tools of monetary policy are
1) open market operations,
2) discount policy, and
3) reserve requirements.
Open market operations are the primary tool used by the Fed to control interest rates.
 National Bank of Ethiopia (NBE)
Vision of NBE
To be one of the strongest and most reputable central banks in
Africa.
Mission of NBE
1) To maintain price and exchange rate stability,
2) to foster a sound financial system and
3) undertake such other functions as are conducive to the
economic growth of Ethiopia.
 Goals of NBE
Goal 1: Carry out extensive and sound institutional transformation tasks.
Goal 2: Maintain price and exchange rate stability.
Goal 3: Maintain adequate international reserves.
Goal 4: Improve the soundness of the financial system.
Goal 5: Play a decisive role in economic research and policy advice to
the Government.
Goal 6: Create efficient Payment System.
Goal 7: Improve the currency management of the Bank.
Why Study Financial
Markets?
 Why Study Financial Markets?
Financial markets are crucial in our economy.
1) Channel funds from savers to investors, promoting economic efficiency.
2) Capital markets are one of the most powerful drivers of economic growth
and wealth creation
3) Financial markets are critical for producing an efficient allocation of capital
(wealth, either financial or physical, that is employed to produce more wealth), which
contributes to higher production and efficiency for the overall economy.
4) Financial markets that are operating efficiently improve the economic welfare
of everyone in the society.
Note: Poorly performing financial markets are one reason that many countries
in the world remain desperately poor (Frederic S. Mishkin & Stanley G. Eakins, 2012)
Preamble
 Why capital Market?
Establishment of capital market in Ethiopia will support
the development of the national economy through
1)Mobilizing capital,
2)Promoting financial innovation, and
3)Sharing investment risks
 With a global size of USD 178 trillion
(nearly 50%) out of 360.1 trillion (Securities
Financial Industry and Financial Markets Association SIFMA,
2019),capital markets are one of the most
powerful drivers of economic growth and
Market wealth creation
Unfortunately, many emerging markets
Facts and developing economies enjoy only a
small portion of the benefits offered by
capital markets.
Excluding China, only about 11% of
equity and debt issuances were placed
by companies located in emerging
markets in 2019
 Why Do Financial Institutions
Exist?

Why are financial intermediaries so crucial to well-

functioning financial markets?
Type of Intermediary 1980 1990 2000 2009
Depository institutions (banks)
Commercial banks 1,481 3,334 6,469 10,045
Savings and loan associations and mutual
savings banks 792 1,365 1,218 1,253
Credit unions 67 215 441 884
Contractual savings institutions
Life insurance companies 464 1,367 3,136 4,818
Fire and casualty insurance companies 182 533 862 1,360
Pension funds (private) 504 1,629 4,355 5,456
State and local government retirement funds 197 737 2,293 2,673
Investment intermediaries
Finance companies 205 610 1,140 1,690
Mutual funds 70 654 4,435 7,002
Money market mutual funds 76 498 1,812 3,269
TABLE 2.1 Primary Assets and Liabilities of Financial Intermediaries
Primary Liabilities
Type of Intermediary (Sources of Funds) Primary Assets (Uses of Funds)
Depository institutions (banks)
Commercial banks Deposits Business and consumer loans,
mortgages, U.S. government
securities, and municipal bonds
Savings and loan Deposits Mortgages
associations
Mutual savings banks Deposits Mortgages
Credit unions Deposits Consumer loans
Contractual savings institutions
Life insurance companies Premiums from policies Corporate bonds and mortgages
Fire and casualty insur- Premiums from policies Municipal bonds, corporate
ance companies bonds and stock, U.S. govern-
ment securities
Pension funds, govern- Employer and employee Corporate bonds and stock
ment retirement funds contributions
Investment intermediaries
Finance companies Commercial paper, Consumer and business loans
stocks, bonds
Mutual funds Shares Stocks, bonds
Money market Shares Money market instruments
mutual funds
 Investment Banks
Despite its name, an investment bank is not a bank or a financial
intermediary in the ordinary sense; that is, it does not take in deposits
and then lend them out.
Instead, an investment bank is a different type of intermediary that helps
a corporation issue securities.
First it advises the corporation on which type of securities to issue (stocks or
bonds);
then it helps sell (underwrite) the securities by purchasing them from the
corporation at a predetermined price and reselling them in the market.
Investment banks also act as deal makers and earn enormous fees by helping
corporations acquire other companies through mergers or acquisitions.
 Basic Facts About Financial Structure
Throughout the World
1) Stocks are not the most important source of external financing for businesses.
2) Issuing marketable debt and equity securities is not the primary way in which
businesses finance their operations
3) Financial intermediaries, particularly banks, are the most important source of
external funds used to finance businesses.
4) Only large, well-established corporations have easy access to securities markets to
finance their activities.
5) Financial Intermediaries Reduce Transaction Costs
important feature of financial markets is that they have substantial transaction and information costs
6) Financial institutions are what make financial markets work.
Without them, financial markets would not be able to move funds from people who save to people who have productive investment opportunities.
They thus play a crucial role in improving the efficiency of the economy.
 1. Stocks are not the most important source
of external financing for businesses.
Because so much attention in the media is focused on the
stock market, many people have the impression that stocks
are the most important sources of financing for American
corporations.
However, the stock market accounted for only a small
fraction of the external financing of American businesses in
the 1970–2000 period: 11%
 2. Issuing marketable debt and equity securities is not the
primary way in which businesses finance their operations.

Bonds are a far more important source of financing than

stocks in the United States (32% versus 11%).
However, stocks and bonds combined (43%), which make up the total
share of marketable securities, still supply less than one-half of the
external funds corporations need to finance their activities.
The fact that issuing marketable securities is not the most important
source of financing is true elsewhere in the world as well.
 3. Indirect finance, which involves the activities of financial intermediaries, is
many times more important than direct finance, in which businesses raise
funds directly from lenders in financial markets.
Direct finance involves the sale to households of marketable securities such as
stocks and bonds.
The 43% share of stocks and bonds as a source of external financing for American
businesses actually greatly overstates the importance of direct finance in our
financial system.
Since 1970, less than 5% of newly issued corporate bonds and commercial paper
and less than one-third of stocks have been sold directly to American households.
The rest of these securities have been bought primarily by financial intermediaries
such as insurance companies, pension funds, and mutual funds.
These figures indicate that direct finance is used in less than 10% of the external
funding of American business.
 4. Financial intermediaries, particularly banks, are the most
important source of external funds used to finance businesses

the primary source of external funds for businesses throughout the world comprises
loans made by banks and other nonbank financial intermediaries such as insurance
companies, pension funds, and finance companies (56% in the United States, but more
than 70% in Germany, Japan, and Canada).
In other industrialized countries, bank loans are the largest category of sources of
external finance (more than 70% in Germany and Japan and more than 50% in
Canada).
Thus, the data suggest that banks in these countries have the most important role in
financing business activities.
In developing countries, banks play an even more important role in the financial
system than they do in the industrialized countries.
 5. The financial system is among the most
heavily regulated sectors of the economy.
The financial system is heavily regulated in the United States
and all other developed countries.
Governments regulate financial markets primarily to promote
the provision of information, and to ensure the soundness
(stability) of the financial system.
6. Only large, well-established corporations have easy
access to securities markets to finance their activities

Individuals and smaller businesses that are not well

established are less likely to raise funds by issuing
marketable securities.
Instead, they most often obtain their financing from
banks.
 7. Collateral is a prevalent feature of debt
contracts for both households and businesses.
Collateral is property that is pledged to a lender to guarantee payment in the
event that the borrower is unable to make debt payments.
Collateralized debt (also known as secured debt to contrast it with unsecured
debt, such as credit card debt, which is not collateralized) is the predominant
form of household debt and is widely used in business borrowing as well.
The majority of household debt in the United States consists of collateralized
loans
 8. Debt contracts typically are extremely complicated legal
documents that place substantial restrictions on the behavior of the
borrower
Many students think of a debt contract as a simple IOU that can be written on
a single piece of paper.
The reality of debt contracts is far different, however.
In all countries, bond or loan contracts typically are long legal documents with
provisions (called restrictive covenants) that restrict and specify certain
activities that the borrower can engage in.
 Banks: Indirect Finance
Financial institutions (financial intermediaries): firms that help channel funds
from savers to investors
Funds also can move from lenders to borrowers by a second route called indirect
finance because it involves a financial intermediary that stands between the
lender-savers and the borrower-spenders and helps transfer funds from one to the
other.
A financial intermediary does this by borrowing funds from the lender-savers and
then using these funds to make loans to borrower-spenders.
Banks: financial institutions that accept deposits and make loans
The process of indirect finance using financial intermediaries, called financial
intermediation, is the primary route for moving funds from lenders to borrowers.
 Sources of External Funds for Nonfinancial Businesses: A Comparison of the United States with
Germany, Japan, and Canada
%
100
United States
90 Germany

80 Japan
Canada
70

60

50

40

30

20

10

0
Bank Loans Nonbank Loans Bonds Stock

o Bank Loans is made up primarily of loans from depository institutions;

o Nonbank Loans is composed primarily of loans by other financial intermediaries;
o Bonds category includes marketable debt securities such as corporate bonds and commercial paper; and
o Stock consists of new issues of new equity (stock market shares).
 Financial Markets: Direct Financing
Scheme
Financial markets perform the essential economic function of
channeling funds from households, firms, and governments that
have saved surplus funds by spending less than their income to
those that have a shortage of funds
Financial markets: markets where people and firms trade two kinds
of assets
Currencies
Securities – claims on future income flows,
e.g. stocks and bonds
Bonds
issued by corporations to raise funds for investment, or by the
government
promise predetermined payments to buyers at specified times in the
future
also called fixed-income securities

represent debt: the buyers are lending to the issuers

Sample Bond certificate
 Grand Ethiopian Renaissance Dam Bond

Ato Baro Abay Tana

Grand Ethiopian Renaissance Dam Bond
(Continued)
Stocks
also called equities

shares of ownership in corporations,

who sell them to raise funds for investment

riskier than bonds, because the income comes from corporate

profits, which are unpredictable
 Sample Share Certificate

BY DAKITO ALEMU (PHD) & TAMIRAT ACCA

Functions of Financial
Markets
Functions of Financial Markets
 1) Price Determination
The prices of financial instruments traded in the
financial market are determined by the market
forces, i.e., demand and supply.
Financial market provides the vehicle by which
the prices are set for both financial assets
which are issued newly and for the existing
stock of the financial assets.
 2) Funds Mobilization
Funds available from the lenders/investors will get
allocated among the funds demanders through the
financial markets
Businesses raise funds by issuing financial
instruments in the financial market.
So, the financial market helps in the mobilization of
the investors’ savings.
 3 ) Liquidity
Financial market provides an opportunity for the
investors to sell their financial instruments
Investors can sell their securities readily and
convert them into cash in the financial market
In the absence of financial market, the investor will
be obligated to hold the financial securities until the
conditions to sell arise
 4) Risk sharing
Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
Allows for diversification, the distribution of wealth among many
assets
Losses or low returns on some assets offset by higher returns on
others
An easy way to diversify:
buy shares of mutual funds, financial firms that buy and hold many
different stocks and bonds
 5) Easy Access
Financial market platform provides the
potential buyer and seller easily
This helps to save their time and money
in finding the potential buyer and seller.
 6) Capital Formation
Financial markets provide the channel
through which the new investors’
savings flow in the country, which aids
in the country’s capital formation.
◦ Capital formation is the net accumulation of capital goods, such as
equipment, tools, transportation assets, and electricity, during an
accounting period
 7) Reduction in Transaction Costs and
information asymmetry
The traders require information for
transacting
Financial market provide different types of
information to the traders.
In this way, the financial market reduces
the cost of the transactions.
 Asymmetric information:
when one party in a
transaction has more
Asymmetric information than the other
Information party
e.g., a firm selling securities
knows more about its
prospects than the buyers
Two types of asymmetric information:

adverse selection

moral hazard
Importance of Financial
Markets (macro & Micro level)
 A) Well-developed financial markets are a
driver of economic growth, and thereby
Importance of yield positive effects on employment.
Financial There exists positive correlation between financial market
Markets development and economic growth.
Financial markets mobilize additional savings into the
(Macro-Level) economy, making more capital available to companies,
which may then in turn create jobs.
Some evidence exists that capital markets are associated
with higher productivity levels as the allocation of
resources becomes more efficient
 B) Besides economic growth, well-
regulated and supervised capital markets
Importance may enhance financial stability.
of Financial Domestic capital markets provide access to long-term,
Markets… local currency financing that helps companies,
governments and investors to manage inflation and
macro-level foreign exchange risks.
Further, there is empirical evidence that:
1) equity markets can reduce corporate
leverage and curb insolvency risks, while
2) bond markets can serve as a “spare tire”
in times of banking distress.
 C) On a microlevel, well-developed
financial markets constitute an
Importance of important source of financing for
Financial corporations.
Financial markets can provide an attractive alternative
Markets… financing (give companies access to larger volumes of
On a micro-level funding, longer maturities and, potentially, better
economic terms). Thus reducing overall funding costs.
Financial markets allow companies to diversify their
funding sources
Equity markets in particular have been found to
be key to the financing of new businesses
 d) From the investors’ perspective,
Importance of financial markets offer investment
Financial opportunities and risk management
Markets tools.
..Micro-level Financial markets can offer more attractive investing
opportunities in terms of their return than bank
(From the deposits, albeit with a higher risk.
investors’ Capital markets can provide investors with a
diversified portfolio, which contributes to risk
perspective) management.
Well-developed financial markets also provide risk
management tools through the derivatives markets
Types of Financial
Markets
 Types of Financial Markets
Criteria Types of Financial Markets

1. Nature of Claims Debt Market Vs Equity Markets

2. Freshness of Claims Primary Vs Secondary Markets

3. Structure or Organization of Claims Exchange Vs Over-the-Counter (OTC)

4. Maturity of Claims Traded Money Market Vs Capital Market

64
COMPLIED BY DAKITO ALEMU (PHD)
1) Nature of Claim

Debt •
•
•
Debt securities are traded in debt market
Debt Claims are the most commonly traded security.
Debt Securities can be short term or long term

Market •
•
Examples are treasury bills, bonds or mortgages
At the end of 2009, the value of debt instruments was $52.4 trillion

• The most common equity security is stock or share

Equity • Equity security makes the buyer owner of the issuer’s
enterprise.
• Equity securities entitles the holder to earn dividend, and held
Market primarily to be sold and resold
• At the end of 2009, the value of equities was $20.5 trillion.

66
Debt Markets & Interest Rates

Debt markets allow governments, corporations, and individuals to

borrow.
Borrowers issue a security, called a bond, offering interest and
principal over time.
The interest rate is the cost of borrowing.
Understanding interest rates is beneficial for borrowers and
lenders.
 The Stock Market
The stock market is the market where common stock (or just
stock) are traded.
Companies initially sell stock (in the primary market) to raise
money. After that, the stock is traded among investors.
The stock market receives the most attention from the
media.
Investors closely watch the stock market.
 Market Value of Debt Vs Equity
The total value of equities in the United States has typically
fluctuated between $4 trillion and $20 trillion since the early 1990s,
depending on the prices of shares.
Although the average person is more aware of the stock market
than any other financial market, the size of the debt market is often
substantially larger than the size of the equities market:
At the end of 2009, the value of debt instruments was $52.4
trillion, while the value of equities was $20.5 trillion.
Stock Prices as Measured by the Dow
Jones Industrial Average, 1950–2016

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/DJIA.

2) Freshness of Claim
Primary • Securities issued initially or
fresh securities are traded
Market

Secondary • Second hand securities are traded

Market
71
 Primary Market
The market for the trading of new securities, for the first time.
Where the financial instruments are sold by their issuers to the
investors
The primary markets for securities are not well known to the public
because the selling of securities to initial buyers often takes place
behind closed doors.
An important financial institution that assists in the initial sale of
securities in the primary market is the investment bank.
It does this by underwriting securities: It guarantees a price for a
corporation’s securities and then sells them to the public.
 Private placements Vs public offerings
Securities can be issued via private placements or public
offerings.
1.Private placements: are restricted to institutional and other
sophisticated investors and have limited price disclosure and
trading activity.
2.Public Offering: securities issued under a public offering are
accessible by all, including retail investors, and are traded on
regulated markets with sufficient pre- and post trade price
transparency
 Secondary Market
Are the market for old securities (already-issued securities are traded between investors)
Securities which are previously issued in the primary market are traded here.
It covers both stock exchange and over-the-counter market.
The New York Stock Exchange and NASDAQ (National Association of Securities Dealers
Automated Quotation System), in which previously issued stocks are traded, are the best-
known examples of secondary markets,
Other examples of secondary markets are foreign exchange markets, futures markets, and
options markets.
Securities brokers and dealers are crucial to a well-functioning secondary market.
1. Securities brokers are agents of investors who match buyers with sellers of
securities;
2. Securities dealers link buyers and sellers by buying and selling securities at
stated prices.
 Important functions of Secondary Markets
Nonetheless, secondary markets serve two important functions.
First, they make it easier and quicker to sell these financial instruments to raise cash; that is,
they make the financial instruments more liquid.
The increased liquidity of these instruments then makes them more desirable and thus
easier for the issuing firm to sell in the primary market.
Second, they determine the price of the security that the issuing firm sells in the primary
market.
The investors who buy securities in the primary market will pay the issuing corporation no
more than the price they think the secondary market will set for this security.
The higher the security’s price in the secondary market, the higher the price that the
issuing firm will receive for a new security in the primary market, and hence the greater
the amount of financial capital it can raise.
3) Structure of Market
• Secondary markets can be organized in two ways.
• One method is to organize exchanges, where buyers and sellers
Securities of securities (or their agents or brokers) meet in one central
location to conduct trades.
Exchange • The New York 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.
• The other method of organizing a secondary market is to have an over-
thecounter (OTC) market, in which dealers at different locations who
Over- 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
the- prices.
• In OTCs securities are traded with out an organized trading location
Counter • OTC is an electronic network over which transactions are conducted.
• the OTC market is very competitive and not very different from a market
• with an organized exchange.
76
4) Maturity of Claims
Money • The money market is a financial market in which
only short-term debt instruments (generally those
with original maturity of less than one year) are
Market traded;

Capital • Capital market is the market in which longer-term debt

(generally with original maturity of one year or greater)

Market and equity instruments are traded.

77
 Capital markets are:
Financial markets where people buy and sell long-term
debt or equity securities.
Are venues where savings and investments are channelled
between those who supply and those who demand capital.
Capital
Capital market securities, such as stocks and long-term
Markets bonds, are often held by financial intermediaries such as:
a) insurance companies and
b) pension funds, which have little uncertainty about the amount
of funds they will have available in the future.
 The Money Markets
The term “money market” is a misnomer.
Money (currency) is not actually traded in the money markets.
The securities in the money market are short term with high liquidity; therefore, they
are close to being money.
Low default risk
Mature in one year or less from their issue date, although most mature in less than 120
days
Money market securities are usually more widely traded than longer-term securities
and so tend to be more liquid
Corporations and banks actively use the money market to earn interest on surplus funds that they
expect to have only temporarily.
1.1. The money markets.
The money market is not actually a physical market but is the term used to describe the
trading between financial institutions, primarily done over the telephone.

The main areas of trading include:

The discount market where bills of exchange are traded.

The inter-bank market where banks lend each other short-term funds.

The eurocurrency market where banks trade in all foreign currencies, usually in
the form of certificates of deposit. The need for this
trading arises when, for instance, a UK company
borrows funds in a foreign currency from a UK bank.

The certificate of deposit market where certificates of deposit are traded.

The local government market where local authorities trade in debt instruments.

The inter-company market where companies lend directly between themselves.

The finance house market where short-term loans raised by finance houses are
traded.

These markets are for short-term lending and borrowing where the maximum term is
normally one year.

Companies requiring medium term (one to five years) capital will generally raise these funds
through banks.
1. Money market interest rates
Different financial instruments offer different interest rates. In order to understand why this is,
it is necessary to appreciate the factors which determine the appropriate interest rate for a
particular financial instrument.

1.1. The factors which determine interest rates:

(a) The general level of interest rates in the economy.
(b) The level of risk:
The higher the level of risk the greater return an investor will expect. For instance, an
investor in a building society is taking very little risk and hence receives only a small
return. Conversely, a purchaser of shares is taking a significant risk and hence will
expect a greater return. This is known as the risk-return trade off.
The additional return required before someone would be indifferent between investing
in an equity share or a deposit account will differ from individual to individual, as we all
have a different attitude to risk. Therefore the relationship between risk and return is
different for each individual.
(c) The duration of a loan:
If it is assumed that in the long-term interest rates are expected to remain stable then
the longer the length of the loan the higher the interest rate will be. This is quite simply
because lending money in the longer term has additional risk for the lender as for
instance the risk of default increases.
(d) The need for the financial intermediaries to make a profit:
For instance, a depositor at a building society will receive a lower rate of interest than a
borrower will be charged.
(e) Size:
If a large sum of money is lent or borrowed, there are administrative savings; hence a
higher rate of interest can be paid to a lender and a lower rate of interest can be
charged to a borrower than would normally be the case.
 The Foreign Exchange Market
The foreign exchange market is where international currencies
trade and exchange rates are set.
The market has a daily volume around $5 trillion!
The fluctuations matter!
In recent years, we have found that importing is expensive,
due to a weakening Birr relative to the dollar.
When the Birr strengthens, foreign purchase of domestic
goods falls.
Financial Market
Operations
 Financial market operations
Financial markets rely on professional intermediaries, and
require a series of market infrastructures, including:
1) Trading platforms
2) Clearing houses and central securities depositories,
and
3) A financial markets-specific legal and regulatory
framework backed by government supervision and
enforcement
Financial market operation..
Capital Market Participants
Main players in the capital market Include:
1) Capital market services providers,
2) Issuers of capital market products,
3) Security exchanges
4) Securities depository & clearing companies
Are Financial Markets
Efficient?
 Are Financial Markets Efficient?
Theoretically, the efficient market hypothesis should be a powerful
tool for analyzing behavior in financial markets.
But to establish that it is in reality a useful tool, we must compare the
theory with the data.
Does the empirical evidence support the theory?
Though mixed, the available evidence indicates that for many
purposes, this theory is a good starting point for analyzing
expectations.
 The Efficient Market Hypothesis
To more fully understand how expectations affect securities prices, we need to look
at how information in the market affects these prices.
To do this we examine the efficient market hypothesis (also referred to as the
theory of efficient capital markets), which states that prices of securities in financial
markets fully reflect all available information.
The efficient market hypothesis states that current security prices will fully reflect all
available information because in an efficient market, all unexploited profit
opportunities are eliminated. The elimination of unexploited profit opportunities
necessary for a financial market to be efficient does not require that all market
participants be well informed
The evidence on the efficient market hypothesis is quite mixed.
Early evidence on the performance of investment analysts and mutual funds, whether stock prices reflect publicly
available information, the random-walk behavior of stock prices, or the success of so-called technical analysis, was
quite favorable to the efficient market hypothesis.
However, in recent years, evidence on the small-firm effect, the January effect, market overreaction, excessive
volatility, mean reversion, and that new information is not always incorporated into stock prices suggests that the
hypothesis may not always be entirely correct.
The evidence seems to suggest that the efficient market hypothesis may be a reasonable starting point for evaluating
behavior in financial markets, but it may not be generalizable to all behavior in financial markets.
The stock market crashes of 1987 and 2000 have convinced many financial economists that the stronger version of
the efficient market hypothesis, which states that asset prices reflect the true fundamental (intrinsic) value of
securities, is not correct.
Efficient Market Hypothesis
The rate of return for any position is the sum of the capital gains
(Pt+1 − Pt) plus any cash payments (C):
At the start of a period, the unknown element is the future price:
Pt+1.
But, investors do have some expectation of that price, thus
giving us an expected rate of return.
1. The Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH) considers whether market prices reflect all information
about the company. Three potential levels of efficiency are considered.

(a) Weak-form efficiency:

Share prices reflect all the information contained in the record of past prices. Share
prices follow a random walk and will move up or down depending on what information
about the company next reaches the market.
If this level of efficiency exists it should not be possible to forecast price movements by
reference to past trends.
(b) Semi-strong form efficiency:
Share prices reflect all information currently publicly available. Therefore the price will
alter only when new information is published.
If this level of efficiency has been reached, price movements could only be forecast if
unpublished information were known. This would be known as insider dealing.
(c) Strong-form efficiency:
Share prices reflect all information, published and unpublished, that is relevant to the
company.
If this level of efficiency has been reached, share prices cannot be predicted and gains
through insider dealing are not possible as the market already knows everything!
Given that there are still very strict rules outlawing insider dealing, gains through such
dealing must still be possible and therefore the stock market is at best only semi-strong
form efficient.
1.1. The level of efficiency of the stock market has implications for financial
managers:
(a) The timing of new issues:
Unless the market is fully efficient the timing of new issues remains important. This is
because the market does not reflect all the relevant information, and hence advantage
could be obtained by making an issue at a particular point in time just before or after
additional information becomes available to the market.
(b) Project evaluation:
If the market is not fully efficient, the price of a share is not fair, and therefore the rate of
return required from that company by the market cannot be accurately known. If this is
the case, it is not easy to decide what rate of return to use to evaluate new projects.
(c) Creative accounting:
Unless a market is fully efficient creative accounting can still be used to mislead
investors.
(d) Mergers and takeovers:
Where a market is fully efficient, the price of all shares is fair. Hence, if a company is
taken over at its current share value the purchaser cannot hope to make any gain unless
economies can be made through scale or rationalisation when operations are merged.
Unless these economies are very significant an acquirer should not be willing to pay a
significant premium over the current share price.
(e) Validity of current market price:
If the market is fully efficient, the share price is fair. In other words, an investor receives a
fair risk/return combination for his investment and the company can raise funds at a fair
cost. If this is the case, there should be no need to discount new issues to attract
investors.
1.1. Yield curves
The yield of a security will alter according to the length of time before the security matures.
This is known as the term structure of interest rates.

If, for example, a graph were drawn showing the yield of various government securities
against the number of years to maturity, a yield curve such as the one below might result.

Yield
%

Years to maturity

It is important for financial managers to be aware of the shape of the yield curve, as it
1.1. The shape of the curve can be explained by the following:
(a) Expectations theory:
If interest rates are expected to increase in the future, a curve such as that above may
result. The curve may invert if interest rates are expected to decline. Everything else
being equal, a flat curve would result if interest rates are not expected to change.
(b) Liquidity preference theory:
Yields will need to rise as the term to maturity increases, as by investing for a longer
period the investor requires compensation for deferring the use of cash invested. The
longer the period for which they are deprived of cash, the more compensation they
require
(c) Segmentation theory:
Different investors are interested in different segments of the yield curve. Short-term
yields, for example, are of interest to financial intermediaries such as banks. Hence the
shape of the yield curve in that segment is a reflection of the attitudes of the investors
active in that sector. Where two sectors meet there is often a disturbance or apparent
discontinuity in the yield curve as shown in the above diagram.
Efficient Market Hypothesis
The Efficient Market Hypothesis views the expectations as equal
to optimal forecasts using all available information.
Assuming the market is in equilibrium, expected returns equal
required returns.
Re = R*
Put these ideas together: efficient market hypothesis
Rof = R*
Efficient Market Hypothesis
Rof = R*
This equation tells us that current prices in a financial market will
be set so that the optimal forecast of a security’s return using all
available information equals the security’s equilibrium return.
Financial economists state it more simply: A security’s price fully
reflects all available information in an efficient market.
Example: The Efficient Market
Hypothesis
Suppose that a share of Microsoft had a closing price yesterday of $90, but
new information was announced after the market closed that caused a revision
in the forecast of the price for next year to go to $120. If the annual
equilibrium return on Microsoft is 15%, what does the efficient market
hypothesis indicate the price will go to today when the market opens? (Assume
that Microsoft pays no dividends.)
0.15 = ($120 − Pt) / Pt, or Pt = $104.35
Rationale Behind the Hypothesis
When an unexploited profit opportunity arises on a security, investors
will rush to buy until the price rises to the point that the returns are
normal again.
In an efficient market, all unexploited profit opportunities will be
eliminated.
Not every investor need be aware of every security and situation.
As long as a few keep their eyes open for unexploited profit
opportunities, they will eliminate the profit opportunities that
appear because in so doing, they make a profit.
Rationale Behind the Hypothesis
Why efficient market hypothesis makes sense
If Rof > R* → Pt ↑ → Rof ↓
If Rof < R* → Pt ↓ → Rof ↑
Until Rof = R*
All unexploited profit opportunities eliminated
Efficient market condition holds even if there are uninformed, irrational participants in
market
EMH: Implications
A strong view of EMH states that (1) expectations are rational, and
(2) prices are always correct and reflect market fundamentals.
This has three important implications:
One investment is just as good as any other (stock picking is
pointless)
Prices reflect all information
Cost of capital can be determined from security prices, assisting
in capital budgeting decisions
Regulation of Financial Markets

Main Reasons for

Regulation

Ensure the
Increase
Soundness of
Information to
Financial
Investors
Intermediaries
Regulation Reason: Increase Investor
Information
Asymmetric information in financial
markets means that investors may
be subject to adverse selection and
moral hazard problems that may
hinder the efficient operation of
financial markets and may also keep
investors away from financial
markets.
The Securities and Exchange
Commission (SEC) requires
corporations issuing securities to
disclose certain information about
their sales, assets, and earnings to
the public and restricts trading by
the largest stockholders (known as
insiders) in the corporation.
Regulation Reason: Increase Investor Information (2 of 2)

Such government regulation can reduce

1. adverse selection and moral hazard problems in financial
markets and
2. increase their efficiency by increasing the amount of
information available to investors.
Regulation Reason: Ensure Soundness of Financial
Intermediaries
Providers of funds (depositors) to financial intermediaries may not
be able to assess whether the institutions holding their funds are
sound or not.
If they have doubts about the overall health of financial
intermediaries, they may want to pull their funds out of both sound
and unsound institutions, which can lead to a financial panic.
Such panics produces large losses for the public and causes serious
damage to the economy.
 Internationalization of Financial Markets
The growing internationalization of financial markets has become an important trend.
Before the 1980s, U.S. financial markets were much larger than financial markets outside the United
States, but in recent years the dominance of U.S. markets has been disappearing.
By 2006 the London and Hong Kong stock exchanges each handled a larger share of initial public
offerings (IPOs) of stock than did the New York Stock Exchange
Likewise, the portion of new corporate bonds issued worldwide that are initially sold in U.S. capital
markets has fallen below the share sold in European debt markets in each of the past two years.
The extraordinary growth of foreign financial markets has been the result of both large increases in the pool of
savings in foreign countries such as Japan and the deregulation of foreign financial markets, which has enabled
foreign markets to expand their activities.
American corporations and banks are now more likely to tap international capital markets to raise
needed funds, and American investors often seek investment opportunities abroad.
Similarly, foreign corporations and banks raise funds from Americans, and foreigners have become
important investors in the United States.
A look at international bond markets and world stock markets will give us a picture of how this
globalization of financial markets is taking place.
 Financial Crises
At times, the financial system seizes up and produces financial crises,
major disruptions in financial markets that are characterized by sharp
declines in asset prices and the failures of many financial and
nonfinancial firms.
Financial crises have been a feature of capitalist economies for hundreds of
years and are typically followed by the worst business cycle downturns.
From 2007 to 2009, the U.S. economy was hit by the worst financial crisis since the Great
Depression.
Defaults in subprime residential mortgages led to major losses in financial institutions, producing
not only numerous bank failures, but also leading to the demise of Bear Stearns and Lehman
Brothers, two of the largest investment banks in the United States.
 Stage One: Initiation of Financial Crisis
Financial crises can begin in several ways:
1) Mismanagement of financial liberalization or innovation,
2) Asset price booms,
◦ Many nineteenth-century U.S. financial crises were precipitated by increases in interest rates, either when interest rates shot up in
London, which at the time was the world’s financial center, or when bank panics led to a scramble for liquidity in the United States that
produced sharp upward spikes in interest or

3) a general increase in uncertainty caused by failures

of major financial institutions.
◦ U.S. financial crises have usually begun in periods of high uncertainty, such as just after the start of a recession, a crash in
the stock market, or the failure of a major financial institution.
STAGE ONE
Deterioration in
Initiation Asset Price Increase in Increase in
Financial Institutions’
of Financial Decline Interest Rates Uncertainty
Balance Sheets
Crisis

Adverse Selection and Moral

Hazard Problems Worsen

STAGE TWO
Economic Activity
Banking
Declines
Crisis

Banking
Crisis

Adverse Selection and Moral

Hazard Problems Worsen

Economic Activity
Declines

STAGE THREE
Unanticipated Decline
Debt
in Price Level
Deflation

Adverse Selection and Moral

Hazard Problems Worsen

Economic Activity
Declines
 1) Mismanagement of Financial
Liberalization or Innovation
It is the seeds of a financial crisis are often sown when countries engage in financial
liberalization, the elimination of restrictions on financial markets and institutions, or the
introduction of new types of loans or other financial products.
In the long run, financial liberalization promotes financial development and encourages a
well-run financial system that allocates capital efficiently. However, financial liberalization has
a dark side: in the short run, it can prompt financial institutions to go on a lending spree,
called a credit boom.
Unfortunately, lenders may not have the expertise, or the incentives, to manage risk
appropriately in these new lines of business.
Even with proper management, credit booms eventually outstrip the ability of institutions—
and government regulators—to screen and monitor credit risks, leading to overly risky
lending.
 2) Asset Price Boom and Bust
Prices of assets such as shares and real estate can be
driven well above their fundamental economic values by
investor psychology (dubbed “irrational exuberance” by
Alan Greenspan when he was Chairman of the Federal
Reserve).
The rise of asset prices above their fundamental
economic values is an asset-price bubble.
 Housing Prices Housing Prices and the Financial Crisis of 2007–2009
(Case-Shiller Index,
2006, Q2 = 100)
100.0

90.0

80.0

70.0

60.0
2002 2003 2004 2005 2006 2007 2008 2009
Stage Two: Banking Crisis
Deteriorating balance sheets and tougher business
conditions lead some financial institutions into
insolvency, when net worth becomes negative. Unable to
pay off depositors or other creditors, some banks go out
of business.
If severe enough, these factors can lead to a bank panic,
in which multiple banks fail simultaneously.
 Stage Three: Debt Deflation
If, however, the economic downturn leads to a sharp decline in
prices, the recovery process can be short-circuited.
In this situation, shown as Stage Three in the above Figure, a
process called debt deflation occurs, in which a substantial
unanticipated decline in the price level sets in, leading to a
further deterioration in firms’ net worth because of the increased
burden of indebtedness.
 Causes of the 2007–2009 Financial
Crisis
Financial Innovation in the Mortgage Markets
Before 2000, only the most creditworthy (prime) borrowers could obtain residential mortgages.
Agency Problems in the Mortgage Markets
The mortgage brokers that originated the loans often did not make a strong effort to evaluate whether the
borrower could pay off the loan, since they would quickly sell the loans to investors in the form of security.

Asymmetric Information and Credit Rating Agencies

Credit rating agencies, who rate the quality of debt securities in terms of the probability of default, were
another contributor to asymmetric information in financial markets.
The rating agencies advised clients on how to structure complex financial instruments, like CDOs, at the
same time they were rating these identical products.
The rating agencies were thus subject to conflicts of interest because the large fees they earned from
advising clients on how to structure products that they were rating meant that they did not have
sufficient incentives to make sure their ratings were accurate.
 Effects of the 2007–2009 Financial Crisis
Consumers and businesses alike suffered as a result of the 2007–
2009 financial crisis.
The impact of the crisis was most evident in five key areas:
1) the U.S. residential housing market,
2) financial institution balance sheets,
3) the shadow banking system,
4) global financial markets, and
5) the headline-grabbing failures of major firms in the financial industry.
 Effects of the 2007–2009 Financial Crisis
Deterioration in Financial Institutions’ Balance Sheets The decline in U.S.
housing prices led to rising defaults on mortgages.
As a result, the value of mortgagebacked securities and CDOs collapsed, leading
to ever-larger write-downs at banks and other financial institutions.
With weakened balance sheets, these banks and other financial institutions
began to deleverage, selling off assets and restricting the availability of credit to
both households and businesses.
Dynamics of Financial Crises in Emerging
Market Economies
 Dynamics of Financial Crises in Emerging
Market Economies
The dynamics of financial crises in emerging market economies—
economies in an early stage of market development that have recently
opened up to the flow of goods, services, and capital from the rest of
the world—have many of the same elements as those found in
advanced countries like the United States, but with some important
differences.
The following Figure outlines the key stages and sequence of events in
financial crises in these emerging market economies that we will
address in this section.
STAGE ONE
Deterioration in
Initiation Asset Price Increase in Increase in
Financial Institutions’
of Financial Decline Interest Rates Uncertainty
Balance Sheets
Crisis

Fiscal Adverse Selection and Moral

Imbalances Hazard Problems Worsen

STAGE TWO
Foreign Exchange
Currency
Crisis
Crisis

Adverse Selection and Moral

Hazard Problems Worsen

STAGE THREE
Economic Activity
Full-Fledged
Declines
Financial
Crisis

Banking
Crisis

Adverse Selection and Moral

Hazard Problems Worsen

Economic Activity
Declines
 Stage One: Initiation of Financial Crisis
In contrast to crises in advanced economies triggered by a number of different
factors, financial crises in emerging market countries develop along two basic paths:
1) one involving the mismanagement of financial liberalization (the
seeds of a financial crisis) or
2) globalization and the other involving severe fiscal imbalances.
The first path of mismanagement of financial liberalization/globalization is the most common
culprit. For example, it precipitated the crises in Mexico in 1994 and many East Asian crises in 1997

Severe Fiscal Imbalances

The second path through which emerging market countries experience a financial crisis is
government fiscal imbalances that entail substantial budget deficits that governments need to
finance
 Stage Two: Currency Crisis
Deterioration of Bank Balance Sheets Triggers Currency Crises
When banks and other financial institutions are in trouble, governments have a limited number of options.
Defending their currencies by raising interest rates should encourage capital inflows.
If the government raises interest rates, banks must pay more to obtain funds. This increase in costs decreases bank
profitability, which may lead them to insolvency.
Thus, when the banking system is in trouble, the government and central bank are now between a rock and a hard place:
a) If they raise interest rates too much they will destroy their already weakened banks and further weaken their
economy.
b) It they don’t, they can’t maintain the value of their currency.
Severe Fiscal Imbalances Trigger Currency Crises
We have seen that severe fiscal imbalances can lead to a deterioration of bank balance sheets, and so can help produce a currency crisis
along the lines described immediately above.
Fiscal imbalances can also directly trigger a currency crisis. When government budget deficits spin out of control, foreign and domestic
investors begin to suspect that the country may not be able to pay back its government debt and so will start pulling money out of the
country and selling the domestic currency.
Recognition that the fiscal situation is out of control thus results in a speculative attack against the currency, which eventually results in
its collapse.
 Stage Three: Full-Fledged Financial Crisis
Emerging market economies denominate many debt contracts in foreign currency (dollars)
leading to currency mismatch, in contrast to most advanced economies that typically
denominated debt in domestic currency.
An unanticipated depreciation or devaluation of the domestic currency (for example, pesos) in
emerging market countries, increases the debt burden of domestic firms in terms of domestic
currency.
That is, it takes more pesos to pay back the dollarized debt. Since most firms price the goods
and services they produce in the domestic currency, the firms’ assets do not rise in value in
terms of pesos, while the debt does.
The depreciation of the domestic currency increases the value of debt relative to assets, and
the firm’s net worth declines.
The decline in net worth then increases adverse selection and moral hazard problems
described earlier. A decline in investment and economic activity then follows
Thank you
QUESTIONS?