FI&M Lecture note on chapter 4

CHAPTER FOUR
FINANCIAL MARKET IN THE FINANCIAL SYSTEM

4.1 The organization and structure of markets

4.1.1 The organization of markets

A Market is an institutional mechanism where suppliers and demanders meet to exchange

goods and services; or a place or event at which people gather in order to buy and sell
things. Exciting with many different functions, the financial system fulfills its various roles
mainly through markets where financial claims and financial services are traded (though
in some least-developed economies government dictation and even barter are used).
These markets may be viewed as channels through which moves a vast flow of loanable
funds that continually being drawn upon by demanders of funds and continually being
replenished by suppliers of funds. Filled with a desire to lend or to borrow, the end users of
most financial systems are faced with a choice between two broad approaches:

 Firstly, they may decide to deal directly with another, which is costly, risky,
inefficient, consequently; and not very likely.
 Alternatively, borrowers and lenders may decide to deal via intermediaries. In this
case, lenders have an asset – a bank deposit or contribution to a life insurance or
pension fund – which cannot be traded but can only be returned to the
intermediary. Similarly, intermediaries create liabilities, typically in the form of loans
for borrowers. These remain in the intermediaries balance sheets until they are
repaid.

Intermediaries themselves will also make use of markets, issuing

security to finance some of their activities and buying shares and
bonds as part of their asset portfolio.

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Financial markets serve the following basic functions:

 Borrowing and Lending: Financial markets permit the transfer of funds (purchasing
power) from one agent to another for either investment or consumption purposes.
 Price Determination: Financial markets provide vehicles by which prices are set
both for newly issued financial assets and for the existing stock of financial assets.
 Information Aggregation and Coordination: Financial markets act as collectors and
aggregators of information about financial asset values and the flow of funds from
lenders to borrowers.
 Risk Sharing: Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
 Liquidity: Financial markets provide the holders of financial assets with a chance to
resell or liquidate these assets.
 Efficiency: Financial markets reduce transaction costs and information costs

4.1.2 The Structure of Markets

a) Factor markets: - are markets where consuming units sell their labor,
management skill, and other resources to those producing units offering the
highest prices. I.e. this market allocates factors of production (Land, labor and
capital – and distribute incomes in the form of wages, rental income and so
on to the owners of productive resources.
b) Product market: - are markets where consuming units use most of their
income from the factor markets to purchase goods and services i.e. this
market includes the trading of all goods and services that the economy
produces at a particular point in time.
c) Financial markets: - There are markets in which flow of funds, flow of
financial services, income and financial claims is affected i.e. essentially;
financial markets have three main tasks. These are:
1. They determine the nature of credit available at a macroeconomic
level;
2. They attract savers and borrowers; and
3. They set interest rate and security prices.
What Types of Financial Market Structures Exist?
The costs of collecting and aggregating information determine to a large extent, the types
of financial market structures that emerge.

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These structures take four basic forms; namely: Auction Markets; Over-the-counter
markets; Organized Exchanges; and Intermediation Financial Markets.
a) Auction Markets
An auction market is some form of centralized facility (or clearing house) by which buyers
and sellers, through their commissioned agents (brokers), execute trades in an open and
competitive bidding process. The "centralized facility" is not necessarily a place where
buyers and sellers physically meet. Rather, it is any institution that provides buyers and
sellers with a centralized access to the bidding process.

All of the needed information about offers to buy (bid prices) and offers to sell (asked
prices) is centralized in one location which is readily accessible to all buyers and sellers, e.g.,
through a computer network.

An auction market is typically a public market in the sense that it open to all agents who
wish to participate. Auction markets can either be call markets - for which bid and
asked prices are all posted at one time, or continuous markets - for which bid and
asked prices can be posted at any time the market is open and exchanges take place on a
continual basis.

b) Over-the-counter markets:
An over-the-counter market has no centralized mechanism or facility for trading. Instead,
the market is a public market consisting of a number of dealers spread across a region, a
country, or indeed the world, who make the market in some type of asset. That is, the
dealers themselves post bid and asked prices for this asset and then stand
ready to buy or sell units of this asset with anyone who chooses to trade at
these posted prices. The dealers provide customers more flexibility in trading than
brokers, because dealers can offset imbalances in the demand and supply of assets by
trading out of their own accounts. Many well-known common stocks are traded over-the-
counter through NASDAQ (National Association of Securities Dealers' Automated
Quotation System).

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c) Organized Exchanges
The financial markets, such as the New York Stock Exchange, which combines auction and
OTC market features, are called Organized Exchanges. Specifically, organized
exchanges permit buyers and sellers to trade with each other in a centralized
location, like an auction.

However, securities are traded on the floor of the exchange with the help of specialist
traders who combine broker and dealer functions. The specialists broker trades but also
stand ready to buy and sell stocks from personal inventories if buy and sell orders do not
match up.

d) Intermediation Financial Markets:

An intermediation financial market is a financial market in which financial intermediaries
help transfer funds from savers to borrowers by issuing certain types of financial assets to
savers and receiving other types of financial assets from borrowers.

The financial assets issued to savers are claims against the financial intermediaries, hence
liabilities of the financial intermediaries, whereas the financial assets received from
borrowers are claims against the borrowers, hence assets of the financial intermediaries.

4.2 Formation of Financial Markets within the Financial System

Depending on the characteristics of financial claims being traded and the needs of
different investors, the flow of funds through financial markets around the world may be
divided into different segments. These include: The Money Market and Capital Market;
Primary and Secondary Markets; Open and Negotiated Markets as well as Spot; Futures,
Forward, and Option Markets. In addition to these, there can be Debt and Equity Markets.
Furthermore, there can be International, Domestic, and Foreign Exchange Markets too.
4.3 The Money Market versus the Capital Market
One of the most important divisions in the financial system is between money market and
the capital market. The money market is designed for the making of short-term loans.

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It is the institution through which individuals and institutions with temporary surpluses of
funds meet the needs of borrowers who have temporary funds shortages (deficits).
Thus, the money market enables economic units to manage their liquidity positions. By
conventions, a security or loan maturing within one year or less is considered to be a money
market instrument. One of the principal functions of the money market is to
finance the working capital needs of corporations and to provide governments
with short-term funds in lieu of tax collections. The money market also supplies
funds for speculative buying of securities and commodities.

In other words, the money market is the global financial market for short-
term borrowing and lending. It provides short-term liquid funding for the
global financial system. The money market is a sector of the capital market
where short-term obligations such as treasury bills, commercial paper and
bankers' acceptances are bought and sold.

A money market consists of financial institutions and dealers in money or credit who wish
to either borrow or lend. Participants borrow and lend for short periods of time, typically
up to twelve months. Money market trades in short term financial instrument commonly
called "paper". This contrasts with the capital market for longer-term funding, which is
supplied by bonds and equity.

In contrast, the capital market is designed to finance long-term investments by

businesses, governments and households. Trading of funds in the capital market makes
possible the construction of factories, highways, schools, and homes. Financial instruments in
the capital market have original maturities of more than one year and range in size from
small loans to multimillion Birr credits.

The capital market includes the stock market, the bond market. Securities trading on
organized capital markets are monitored by the government; new issues are approved by
authorities of financial supervision and monitored by participating banks. This market
brings together all the providers and users of capital.

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The capital markets consist of the primary market, where new issues are distributed to
investors, and the secondary market, where existing securities are traded. So it is the
market in which corporate equity and longer-term debt securities (those maturing in more
than one year) are issued and traded. It consists of a market for medium to long-term
financial instruments; financial instruments traded in the capital market include shares,
and bonds issued by the government, state governments, corporate borrowers and
financial institutions.

Who are the principal suppliers and demanders of funds in the money market
and the capital market?

In the money market, commercial banks are the most important institutional supplier of
funds (lender) to both business firms and governments. Non-financial business corporations
with temporary cash surpluses also provide substantial short-term funds to the money
market. On the demand-for-funds side, the largest borrower in the money market is the
Treasury Department, which borrows billions of Birr frequently. Other governments
around the world are very often among the leading borrowers in their own domestic
money markets. The largest and best-known corporations and securities dealers are also
active borrowers in money markets around the world. Due to the large size and strong
financial standing of these well-known money market borrowers and lenders, money
market instruments are considered to be high-quality ,”near money” IOUs (promises to
pay).

Quite the reverse, the principal suppliers and demanders of funds in the
capital market are more varied than in the money market. Families and
individuals, for example, tap the capital market when they borrow to finance a new
home. Governments rely on the capital market for funds to build schools and highways
and provide essential services to the public.

The most important borrowers in the capital market are businesses of all sizes that issue
long-term IOUs to cover the purchase of equipment and the construction of new facilities.

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Ranged against these many borrowers in the capital market are financial institutions, such
as insurance companies, mutual funds, security dealers, and pension funds that supply the
bulk of capital market funds.

4.4 Primary versus Secondary Markets

The global financial markets may also be divided into primary markets and secondary
markets. Primary Market, also called the new issue market, is the market for issuing new
securities. Many companies, especially small and medium scale, enter the primary market
to raise money from the public to expand their businesses.
They sell their securities to the public through an initial public offering. The securities
can be directly bought from the shareholders, which is not the case for the secondary
market.

 The primary market is a market for new capitals that will be traded over
a longer period.
In the primary market, securities are issued on an exchange basis. The underwriters, that is,
the investment banks, play an important role in this market: they set the initial price range
for a particular share and then supervise the selling of that share. Investors can obtain news
of upcoming shares only on the primary market. The issuing firm collects money, which is
then used to finance its operations or expand business by selling its shares. Before selling a
security on the primary market, the firm must fulfill all the requirements regarding the
exchange. After trading in the primary market the security will then enter the secondary
market, where numerous trades happen every day.
The primary market accelerates the process of capital formation in a country's economy.
The primary market excludes several other new long-term finance sources, such as loans
from financial institutions. Many companies have entered the primary market to earn
profit by converting its capital, which is basically a private capital, into a public one,
releasing securities to the public. This phenomena is known as "public issue" or "going
public."
 A company's new offering is placed on the primary market through an
initial public offer.

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Firms raise new capital in a primary market transaction by issuing new securities (stocks or
bonds) once, and these securities subsequently trade in the secondary market
forever. Initial public offering (IPO) is stock issued for the very first time to the public when
a company "goes public." The holders of these stocks can have the following rights:

Preemptive rights - on issuance of additional share allows existing investors to maintain

their ownership position (as a percentage) when new stock is issued. Without this right
investors would have their ownership interest diluted.

Rights of offering - allow existing stockholders to buy additional shares in the company
at a subscription price that is generally lower than the market price. Rational stock holders
will either exercise the right or sell it. Those who let it expire will find out that the market
value of their remaining holding shrinks-the market price will almost certainly drop when
the rights are exercised since the subscription price is much lower than the market price.

In contrast, the secondary market deals in securities previously issued. Its chief function is
to provide liquidity to security investors-that is, provide an avenue for converting financial
instruments into ready cash. If you sell shares of stock or bonds you have been holding for
some time to a friend or call a broker to place an order for shares currently being traded
on the stock exchanges, you are participating in a secondary-market transaction.

In other words, Secondary Market is the market where, unlike the primary market, an
investor can buy a security directly from another investor in lieu of the issuer. It is also
referred as "after market". The securities initially are issued in the primary market, and
then they enter into the secondary market. All the securities are first created in the primary
market and then, they enter into the secondary market. In other words, secondary market
is a place where any type of used goods is available. In the secondary market shares
are maneuvered from one investor to other. That is, one investor buys an asset
from another investor instead of an issuing corporation. So, the secondary market
should be liquid.

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Secondary market for equity serves two purposes: Marketability and Share
Price Valuation:
1. Marketability - allows buyers in the primary market to subsequently sell shares. It
would be hard to sell stock in primary market if there wasn't a secondary market.
2. Share price valuation - active trading in secondary markets establishes a true/fair
market value of stock.

Domestic versus Global Financial Markets:

Eurocurrencies are currencies deposited in banks outside the country of issue. For
example, eurodollars, a major form of eurocurrency, are U.S. dollars deposited in foreign
banks outside the U.S. or in foreign branches of U.S. banks. That is, eurodollars are dollar-
denominated bank deposits held in banks outside the U.S.

An international bond is a bond available for sale outside the country of its issuer.
Example of an International Bond: a bond issued by a U.S. firm that is available for
sale both in the U.S. and abroad.

A foreign bond is an international bond issued by a country that is denominated in a

foreign currency and that is for sale exclusively in the country of that foreign currency.
Example of a Foreign Bond: a bond issued by a U.S. firm that is denominated in
Japanese yen and that is for sale exclusively in Japan.

A Eurobond is an international bond denominated in a currency other than that of the

country in which it is sold. More precisely, it is issued by a borrower in one country,
denominated in the borrower's currency, and sold outside the borrower's country.
Example of a Eurobond: Bonds sold by the U.S. government to Japan that are
denominated in U.S. dollars.

4.5 Spot versus Derivative Market

We may or two business days). If you pick up the telephone and instruct your broker to
purchase X-Corporation shares at today’s price, this is a spot market transaction also
distinguish between spot markets, futures or forward markets, and option markets. A spot
market is one in which assets or financial services are traded for immediate delivery
(usually within one. You expect to acquire ownership of X-Corporation shares within a
matter of minutes.

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A future or forward market, on the other hand, is designed to trade contracts calling
for the future delivery of financial instruments.

Forward contract is an agreement whereby buyers and sellers agree to exchange

something with a predetermined time and price. Future contract is an agreement in which
Buyers and sellers simply agree to buy and sell in the future at a given price and time. For
example, you may call your broker and ask to purchase a contract from another investor
calling for delivery to you of Birr 1 million in government bonds six months from today. The
purpose of such a contract would be to reduce risk by agreeing on a price today rather
than waiting six months, when government bond prices might have risen.

Finally, options markets also offer investors in the money and capital markets an
opportunity to reduce risk. These markets make possible the trading of options on selected
stocks and bonds, which are agreements (contracts) that give an investor the right to
either buy from or sell designated securities to the writer of the option at a guaranteed
price at any time during the life of the contract.

Options Basics: What Are Options?

An option is a contract that gives the buyer/seller the right, but not the obligation, to buy
or sell an underlying asset at a specific price on or before a certain date. An option, just like
a stock or bond, is a security. It is also a binding contract with strictly defined terms and
properties.
Still confused? The idea behind an option is present in many everyday situations.
Example, that you discover a house that you'd love to purchase. Unfortunately, you have
not the cash to buy the house. You talk to the owner and negotiate a deal that gives you
an option to buy the house in three months for a price of $200,000. The owner agrees, but
for this option, you pay a premium of $3000.
1. it’s discovered that the house is actually the true birthplace of Elvis! As a result, the
market value of the house increases to $1 million. Because the owner sold you the option,
he is obligated to sell you the house for $200,000. At the end, you stand to make a profit
of $797,000 ($1 million - $200,000-$3,000).
2. While touring the house, you discover not only that the walls are chock-full of asbestos,
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but also that the ghost of Henry VII haunts the master bedroom; furthermore, a family of
super-intelligent rats have built a fortress in the basement. Though you originally thought
you had found the house of your dreams, you now consider it worthless. On the upside,
because you bought an option, you are under no obligation to go through with the sale.
Of course, you still lose the $3,000 price of the option.
This example demonstrates two very important points. First, when you buy an option, you
have a right but not an obligation to do something. You can always let the expiration date
go by, at which point the option becomes worthless. If this happens, you lose 100% of your
investment, which is the money you used to pay for the option. Second, an option is merely
a contract that deals with an underlying asset. For this reason, options are called a
derivative, which means an option derives its value from something else. In our example,
the house is the underlying asset. Most of the time, the underlying asset is a stock or an
index. Options can be either put option or call option.
Options can be Put or Call
A call gives the holder the right but not obligation to buy an asset at a certain price within
a specific period of time. Calls are similar to having a long position on a stock. Buyers of
calls hope that the stock will increase substantially before the option expires.
A put gives the holder the right but not obligation to sell an asset at a certain price within
a specific period of time. Puts are very similar to having a short position on a stock. Buyers
of puts hope that the price of the stock will fall before the option expires.

There are four types of participants in options markets depending on the position they
take:
1. Buyers of calls 3. Buyers of puts
2. Sellers of calls 4. Sellers of puts
People who buy options are called holders and those who sell options are called writers;
furthermore, buyers are said to have long positions, and sellers are said to have short
positions.
Here is the important distinction between buyers and sellers:
-Call holders and put holders (buyers) are not obligated to buy or sell. They have the
choice to exercise their rights if they choose.

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-Call writers and put writers (sellers), however, are obligated to buy or sell. This means that
a seller may be required to make good on a promise to buy or sell.
4.5.1 Forward Contract vs Futures Contract
A forward contract is an agreement between two parties to buy or sell an asset (which
can be of any kind) at a pre-agreed future point in time and at a pre-agreed price. A
futures contract is a standardized contract, traded on a futures exchange, to buy or sell
a certain underlying instrument at a certain date in the future, at a specified price. So
while the date and price are decided in advance in forward contract, a futures contract is
more unpredictable. They also differ in the forms that a futures contract is standardized
while a forward contract is made to the customer's need.

Standardization and exchange based trading of futures is the underlying reason for most
of the differences between a forward and future transaction. Even though it may be
intuitive that future trades are more constrained than forward trades and should hamper
efficient markets, the standardization of the contracts stimulates futures market and
enhances liquidity.

In contrast to forward contracts in which a bank or a brokerage is usually the counterparty

to the contract, there is a buyer and seller on each side of a futures trade. The futures
exchange selects the contract it will trade.

4.6. Debt versus Equity Markets

The issue of Debt market and Equity market has become very important in the modern
day financial context as a lot of companies are in need of generating money that allows
them to execute a wide variety of financial activities like initiation, expansion and
acquisition. The question of equity and debt financing has been an important one for the
business establishments for a considerable period of time now.

Since it is necessary to have a continuous stream of finances coming in the company for
various purposes these financial options have become very important.

Thus, it is obvious that the business enterprises need to be aware of the various implications
of these two sources of financing and make a decision after carefully reviewing their own
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needs as well as strengths and weaknesses. Debt instruments are particular types of
securities that require the issuer (the borrower) to pay the holder (the lender) certain fixed
dollar amounts at regularly scheduled intervals until specified time (the maturity date) is
reached, regardless of the success or failure of any investment projects for which the
borrowed funds are used.

A debt instrument holder only participates in the management of the debt

instrument issuer if the issuer goes bankrupt.
An example of a debt instrument is a 30-year mortgage. In contrast, equity is a security
that confers on the holder an ownership interest in the issuer.
There are two general categories of equities: "preferred stock" and "common stock."

i. Common stock shares issued by a corporation are claims to a share of the assets of a
corporation as well as to a share of the corporation's net income -- i.e., the corporation's
income after subtraction of taxes and other expenses, including the payment of any debt
obligations. This implies that the return that holders of common stock receive depends on
the economic performance of the issuing corporation. Holders of a corporation's common
stock typically participate in any upside performance of the corporation in two ways:

By receiving a share of net income in the form of dividends; and

By enjoying an appreciation in the price of their stock shares.

However, the payment of dividends is not a contractual or legal requirement. Even if net
earnings are positive, a corporation is not obliged to distribute dividends to shareholders.

For example, a corporation might instead choose to keep its profits as retained earnings to
be used for new capital investment (self-financing of investment rather than debt or
equity financing). Consequently, these shareholders at most risk losing the purchase price of
their shares, a situation which arises if the market price of their shares declines to zero for
any reason.

ii. Preferred stock shares are usually issued with a par value (e.g., $100) and pay a
fixed dividend expressed as a percentage of par value. Preferred stock is a claim

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against a corporation's cash flow that is prior to the claims of its common stock
holders but is generally subordinate to the claims of its debt holders. In addition,
like debt holders but unlike common stock holders, preferred stock holders generally do
not participate in the management of issuers through voting or other means unless the
issuer is in extreme financial distress (e.g., insolvency). .

4.7 Foreign Exchange Markets (FX)

Money represents purchasing power, but usually only in one country. Alternatively,
different countries have different currency and the settlement of all business transactions
within a country is done/ preferred local currency. For instance, $, £, or € have no
purchasing power in Ethiopia. The foreign exchange market provides a forum where the
currency of one country is traded for the currency of another country. Exchanging one
currency for another takes place in the FX market; (converting purchasing power from one
currency into another). The exchange rate is just the price of one currency in terms of
another currency. For instance, a rate of Br. 27 per US $ implies that one US dollar costs Birr
27.
FX market deal with a large volume of funds and a large number of currencies belonging
to various countries. For this reason, FX market is not only worldwide market but also is
world's largest financial market. Though there are foreign exchanges markets in all
countries, London, New York and Tokyo are the nerve center of foreign exchange
activity. FX is an OTC (over-the-counter) market. FX OTC market is international
network of bank currency traders, non-bank dealers, FX brokers, linked by computers,
phone lines, telex machines, automated quotation systems, etc. The communication
system of FX dealers is extremely advanced, sophisticated and reliable.

 Function and structure of FX markets

Trading in the foreign exchange market is mainly to facilitate international trade and
international investment - the buying and selling of foreign goods, services and financial
assets- think of the three functions of money:

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 Unit of account, medium of exchange and store of value. Foreign goods are
usually priced in foreign currency - German wine/beer is priced in euro for
example. The unit of account is the euro; the medium of exchange is the
euro. American liquor distributors need euro to buy the German wine/beer. Also,
American investors may consider the euro as a better store of value than the US
dollar. They could buy a certificate of deposit from a German bank denominated
in euro, instead of putting money in a U.S. bank. Or American investors want to
buy stock of a company in UK, Brazil or Turkey. They need foreign currency to buy
foreign assets.
Definition of Foreign Currency related Terms
 A foreign currency note: is any currency cash note, other than the domestic
currency (ETB) used as a legal tender in the country of issue.
 Exchange Rate: is the price of a currency (number of units of currencies that
buys one unit of another currency). The relationship between the values of
two currencies is called an exchange rate.
 Foreign Exchange Market: It is the market in which individuals, firms, and
banks buy and sell foreign currencies or foreign exchange.
 The spot rate: is exchange rate quoted for transactions that require either
immediate delivery or delivery within two days.
 Forward Exchange Rate: is the rate paid for delivery at some agreed-
upon future date-usually 30, 90, or 180 days from the day the transaction is
negotiated. The forward rate can be at either a premium or a discount to the
spot rate.
 Bid: a price at which traders are willing to buy foreign currency (Buying
rate).This is a rate that foreign exchange bureaus use to purchase foreign
currencies and to effect export transactions.
 Offer: a price at which traders are willing to sell foreign currency (Selling/Ask
Price). This is a rate that foreign exchange bureaus use to sale foreign currencies
and to effect import transactions.
 Spread: difference between bid and offer price. This is profit margin for the trader.
 Cross rate: exchange rate between non–local currencies (foreign currency against
foreign currency).
Foreign Currency Rate Systems: There are two forex systems, fixed and floating.
A. Fixed Exchange Rate System: Under a fixed exchange rate regime, the
government sets the exchange rate it wants. The official, chosen fixed rate is called the
par value or central value.

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 Devaluation: Deliberate downward adjustment/reduction in currency value by

a country’s government or monetary authority.
 Revaluation: An upward change in currency value.
B. Floating Exchange Rate System: Under floating exchange rate system, the rate
moves in response to supply and demand caused by international trade and
international investing activities. Market forces generate changes in the value of
currency known as currency appreciation or depreciation.
 Depreciation: decline/fall in value of a currency’s due to market forces.
 Appreciation: increase in currency’s value due to demand & supply side factors.

Foreign Currency Quotations:

 Direct Quote: The direct exchange rate (DER) is the number of local currency
units (LCUs) needed to acquire one foreign currency unit (FCU). In our country case,
the number of ETB per unit of foreign currency.
 Indirect Quote: the number of units of foreign currency per ETB. It is the
reciprocal of the direct exchange rate. It can be viewed as the number of foreign
currency units that 1 ETB can acquire.

Example 1: If the current exchange rate of Dollar per Pound is $1.5054/£, then what is the
exchange rate of British Pound per U.S. Dollar?
Example 2: Suppose the exchange rate between the German Deutsche Mark (DM) and
the U.S. Dollar ($) is DM/$ = 2.500 or DM 2.500. What is the $/DM exchange rate?
Example 3: Suppose the exchange rate between the German Deutsche Mark & the U.S.
Dollar rises from DM/$ = 2.000, or DM 2.000/$, to DM 2.500/$.
How much the U.S. Dollar appreciated in percent relative to the German Deutsche Mark?

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