CHAPTER THREE

INTEREST RATES IN THE FINANCIAL SYSTEM

3.1) Introduction to the Interest Rate;
The interest rate is defined as the proportion of an amount loaned which a lender charges as interest to
the borrower, normally expressed as an annual percentage. It is the rate that a bank or other lender charges
to borrow its money, or the rate a bank pays its savers for keeping money in an account. Interest rates are
commonly used for personal loans and mortgages, though they may extend to loans for the purchase of
cars, buildings and consumer goods. Lenders typically offer lower interest rates to borrowers who are
low-risk, and higher rates to high-risk borrowers. Interest rate is a rate of return paid by a borrower of
funds to a lender, or a price paid by a borrower to lender for the right to make use of funds for a specified
period. Thus, it is one form of yield on financial instruments.
Interest rates vary depending on borrowing or lending decision. This variation of interest rate can affect
personal decisions such as whether to consume or save whether to purchase bonds or put funds in to a
saving account. Interest rate also affects the economic decisions of business and households such as
whether to use their funds to invest in new equipment for factories or to save their money in a bank. In
order to explain the determinants of interest rates in general, the economic theory assumes there is some
particular interest rate, as a representative of all interest rates in an economy. Such an interest rate usually
depends upon the topic considered, and can represented by, example, interest rate on government short-
term or long-term debt, or the base interest rate of the commercial banks, or a short-term money market
rate. In such a case it is assumed that the interest rate structure is stable and that all interest rates in the
economy are likely to move in the same direction.
3.2) The Real and Nominal Interest Rates;
The interest rate is the amount of interest that must be paid. It is expressed as a percentage of the amount
that is borrowed or gained as profit. Interest rates are a fundamental part of financial economics. They
help us evaluate and compare different investments or loans over time.
(1) Nominal interest rates; are the interest rates actually observed in financial markets. Nominal interest
rates (interest rates) directly affect the value (price) of most securities traded in the money and
capital markets, both at home and abroad. They are interest rates that we use in everyday discussion
and which we see quoted in advertisements, in the media and in official announcements. The rates of
interest quoted by financial institutions are nominal rates, and are used to calculate interest payments
to borrowers and lenders. The nominal interest rate describes the interest rate without any correction
for the effects of inflation. Thus, the advertised or stated interest rates we see on bonds, loans or bank
accounts are usually a nominal one. This rate shows you the actual price you are paid (or have to pay)

Page 1 of 18
 if you lend (or borrow) money. Simply, it shows you by how much the amount of money you have in
your bank account increases over time.
(2) Real interest rate; is the interest rate that would exist on a security, if no inflation were expected
over the holding period (example, a year) of a security. The real interest rate on an investment is the
percentage change in the buying power of a dollar. As such, it measures society’s relative time
preference for consuming today rather than tomorrow. It is defined as the nominal interest rate minus
the expected rate of inflation. It is a better measure of the incentives to borrow and lend than the
nominal interest rate, and it is a more accurate indicator of the tightness of credit market conditions
than the nomina1 interest rate. It is a measure of the anticipated opportunity cost of borrowing in
terms of goods and services forgone. When the real interest rate is low, there are greater
incentives to borrow and fewer incentives to lend.
The distinction between real and nominal interest rates is important because the real interest rate, which
reflects the real cost of borrowing, is likely to be a better indicator of the incentives to borrow and lend. It
appears to be a better guide to how people will be affected by what is happening in credit markets. The
real interest rate is more accurately defined from the Fisher equation, named for Irving Fisher, one of the
great monetary economists of the twentieth century. The Fisher equation states;

3.3) The Behavior of Interest Rate;

3.3.1) Determinants of Asset Demand;
The following four factors affect asset demand;
(1) Wealth; the total resources owned by the individuals. The effect of changes in wealth on the quantity
demanded on an asset can be summarized as income or wealth increase, the quantity of demand of an
asset also increases, and the remaining factors are constant or unchanged.
(2) Expected return; is the return expected over the next period on one asset relative to alternative
assets. As expected return increase, the quantity demand of an asset also increase when the other asset
of expected return are constant. Expected returns are average weights of all returns. Weights are the
probabilities of occurrence of return.
Where;

Page 2 of 18
Example-1; what is the expected return on the Abay bond if the return is 12% 2/3 of the time and 8% 1/3
of the time? Assume, the givens; R1 = 12%, P1 = 2/3/= 0.67, R2 = 8%, and P2 = 1/3 = 0.333;
Solutions;
( ) ( )
( ) ( )

(3) Risk; the degree of uncertainty associated with the return on one asset relative to alternative assets.
Most people are risk averse, especially in their financial decisions, everything else being equal; they
prefer to hold the less risky asset. Generally, other factors are constant, as risk on an asset rises, its
quantity demanded will fall. Risk can be measured by using standard deviation. Standard deviation is
the gap between two or more returns.

Example-2; what is the standard deviation of the return on the fly air lines stock company having 15%
return half the time and 5% return half the time making it expected return is 10% and feet on the ground
bus company having 10% fixed return. Which company’s return is highly risky? Assume the givens for
fly air lines company - R1 = 15%, P1 = ½ = 0.5, R2 = 5%, P2 = ½ = 0.5, ER = 10%, and for feet on the
ground bus company - R1 = 10%, P1 = 100% = 1, ER =? and δ2 =?
Solutions;
For fly air lines company; For feet on the ground bus company;

= 1 x 10% = 10%

(4) Liquidity; the ease and speed with which an asset can be turned in to cash relative to alternative
assets. It affects the demand for an asset is how quickly it can be converted in to cash at low cost. The
more the liquid an asset is the more desirable and the greater will be the quantity demanded, the
remaining factors are unchanged. Generally, all the determining factors can be assembled in to the
theory of asset demand, which states that holding all of the other factors constant;
(a) The quantity demanded of an asset is positively related to wealth.
(b) The quantity demanded of an asset is positively related to its excepted return relative to alternative
assets.
(c) The quantity demanded of an asset is negatively related to the risk of its return relative to
alternative assets.
(d) The quantity demanded of an asset is positively related to its liquidity relative to alternative assets.

Page 3 of 18
 3.3.2) The Term Structures of Interest Rates;
The Interest rate structure is the relationships between the various rates of interest in an economy on
financial instruments of different lengths (terms) or different degrees of risk. The term structure of
interest rates refers to the relationship between the yields and maturities of a set of bonds with the same
credit rating. It refers to the relationship between market rates of interest on short- term and long-term
securities. It is the interest rate difference on fixed income securities due to differences in time of
maturity. It is, therefore, also known as time-structure or maturity-structure of interest rates which
explains the relationship between yields and maturities of the same type of security. It is the relationship
between interest rates or bond yields and different terms or maturities. When graphed, the term structure
of interest rates is known as a yield curve, and it plays a central role in an economy. The term structure
reflects expectations of market participants about future changes in interest rates and their assessment
of monetary policy conditions.

The term structure of interest rates shows the various yields that are currently being offered on bonds of
different maturities. It enables investors to quickly compare the yields offered on short-term, medium-
term and long-term bonds. If two securities are identical in every respect except maturity, it is likely that
they will sell in the market at different prices (or yields or interest rates). Generally, their prices will
change in the same direction. If the short-term securities rise in price, the long-term securities will also
rise in price. People generally hold both short-term securities and they adjust their holdings of securities
depending on the relative yields. Usually the long term securities tend to fluctuate more in price than the
short-term securities, even though their yields do not fluctuate as much.

A yield curve is a graph that depicts the relationship between the yields on fixed income securities with
different maturities or it is a plot of the yield on bonds with differing term to maturity but the same risk,
liquidity and tax consideration and it describes the term structure of interest rates for particular types of
bonds such as government bonds. A debt security’s yield to maturity (interest rates) represents the annual
rate of return earned on a security purchased on a given day and held to maturity. Therefore, Yield curve
shows the relationships between the interest rates payable on bonds with different lengths of time to
maturity, that is, it shows the term structure of interest rates. Yield curve is the relationship between the
debt’s remaining time to maturity and its yield to maturity. It shows the pattern of annual return on debts
of equal quality and different maturities. It is a graphical depiction of the term structure of interest rates.
A yield curve is a graph that plots the yields of similar-quality bonds against their maturities, ranging
from shortest to longest. The yield curve can be classified as upward yield curve, downward yield
curve and flat yield curve slopes;

Page 4 of 18
(a) Normal curve; also called upward curve; if short-term yields are lower than long-term yields, the
curve slopes upward and the curve is called a positive or normal yield curve. Thus, yield curve is
upward slope when the long term interest rates are above the short term interest rates or when short
term borrowing costs are cheaper than the long term borrowing costs.
(b) Downward curve; also called negative yield curve or inverted yield curve; if short-term yields are
higher than long-term yields, the curve slopes downwards and the curve is called a negative or
inverted yield curve. Thus, yield curve is downward when the long term interest rates are below the
short term interest rates or when the long term borrowing costs are cheaper than the short term
borrowing costs.
(c) Flat yield curve; a flat term structure of interest rates exists when there is little or no variation
between short and long-term yield rates. Thus, yield curve is flat slope when the short term and long
term interest rates are the same or when the borrowing costs for both short term and long term loans
are the same.
The shape of the yield curve may affect the firms financing decisions. A financial manager who faces a
downward sloping yield curve is likely to rely more heavily on cheaper, long term financing; when the
yield curve is upward sloping, the manager is more likely to use cheaper, short term financing. Although a
variety of other factors also influences the choice of loan maturity, the shape of the yield curve provides
useful insights in to future interest rates expectations. Yield curve take on different shapes at different
times, a good theory of the term structure of interest rates must explain the following three
important empirical facts;
(a) Interest rates on bonds of different maturities move together overtime;
(b) When short term interest rates are low, yield curve are more likely to have an upward slope; and
when short term interest rates are high, yield curves are more likely to downward slope be inverted;
(c) Yield curves almost always slope upward;
The shape of the curve changes over time. Investors who are able to predict how term structure of interest
rates will change can invest accordingly and take advantage of the corresponding changes in bond prices.
Generally, when the term structure of interest rates curve is positive, this indicates that investors desire
a higher rate of return for taking the increased risk of lending their money for a longer time period.
Many economists also believe that a steep positive curve indicates investors expect higher
future inflation (and thus higher interest rates), and that a sharply inverted yield curve means investors
expect lower inflation (and interest rates) in the future. A flat curve generally indicates investors are
unsure about future economic growth. Graphically, the normal curve, negative curve and flan curve had
been presented as follow;

Page 5 of 18
 Upward yield curve Downward yield curve Flat yield curve

Three theories have been explained the term structure interest rates, that the relationship among interest
rates on bonds of different maturities reflected in yield curve patterns; (a) the expectation theory; (b) the
liquidity preference theory; and (c) the market segmentation theory.
(A) Expectation theory; suggests that the yield curve reflects investor’s expectation about future interest
rates and inflation. Higher future rates of expected inflation will result in higher long term interest
rates (upward sloping yield curve), the opposite occurs with lower future rates. This widely accepted
explanation of the term structure can be applied to the securities of any issuer. Generally, under the
expectation theory;
(1) An increasing inflation (2) A decreasing inflation expectations (3) A stable inflation
expectation result in an results in a downward sloping yield expectation results
upward sloping yield curve; curve; and in a flat yield curve.
(B) Liquidity preference theory; suggests that for any given issuer, long term rates tend to be higher
than short term rates. This is based on two behavioral facts;
(1) Investors perceive less risk in short term securities than in long term securities and are therefore
willing to accept lower yield on them. The reason is that short term securities are more liquid and
less responsive to general interest rate movements.
(2) Borrowers are generally willing to pay a higher rate for long term than for short term financing.
By looking in funds for a longer period of time, they can eliminate the potential adverse
consequences of having to roll over short term debt at unknown costs to obtain long term financing.
Investors tend to require a premium for trying up funds for longer periods, whereas borrowers is generally
willing to pay a premium to obtain long term financing. These preferences of lenders and borrowers cause
the yield curve to tend to be upward sloping. Simply, stated that longer maturities tend to have higher
interest rate than shorter maturities.
(C) Market segmentation theory; suggests that the market for loans is segmented on the basis of
maturity and that the supply and demand for loans within each segment determines its prevailing
interest rates. In other words, the equilibrium between suppliers and demanders of short term funds
such as seasonal business loans, would determine prevailing short term interest rates and the
equilibrium between suppliers and demanders of long term funds such as real estate loans, would

Page 6 of 18
 determines prevailing long term interest rates. The slope of the yield curve would be determined by
the general relationship between the prevailing rates in each market segments. Simply, stated that
lower rates in the short term segment and high rate in the long term segment causes the yield curve to
be upward slopping. The opposite occurs for high short term rates and low long term rates.
All the three theories of term structure have merits from them can conclude that at any time, the slope of
the yield curve is affected by;
(1) Inflationary (2) Liquidity (3) The comparative equilibrium of supply and demand
expectation preference and in the short and long term markets segments.
Upward slopping yield curve result from higher future inflation expectations, lender preferences for
shorter maturity loans and greater supply of short term loans than long term loans relative to demand. The
opposite behavior would result in a downward slopping yield curve. At any time, the interaction of these
three forces determines the prevailing slope of the yield curve.
3.3.3) The Risk Structure of Interest Rates;
Bonds with the same term to maturity have different interest rates. The relationship among these interest
rates is called the risk structure of interest rate. The risk structures of interest rates are explained by three
factors that (a) default risk, (b) liquidity and (c) tax consideration;
(A) Default risk; is occurs when the issuer of the bond is unable or unwilling to make interest payments
when promised or payoff the face value when the bond matures. Default free bond is a bond without
default risk. Risk premium is the spread between the interest rates on bonds with default risk and
default free bond, which indicates how much additional interest people must earn in order to be
willing to hold that risky bonds. A bond with default risk will always have a positive risk premium;
therefore, as a bond’s default risk increases the risk premium on that bond also rises.
(B) Liquidity; a liquid asset is one that can be quickly and cheaply converted in to cash if the need arises.
The more the liquid an asset is, the more desirable holding everything else constant. Example, Canada
bonds are the most liquid of all long term bonds because they are so widely traded that they are the
easiest to sell quickly and the cost of selling them is low. Corporate bonds are not as liquid because
fewer bonds for any one corporation are traded; thus it can be costly to sell these bonds in an
emergency because it may be hard to find buyers quickly. Therefore, the greater liquidity of bonds
also explained that the interest rates are lower than interest rates on less liquid bonds.
(C) Tax consideration; some countries, certain government bonds are taxable. In the U.S, for example,
interest payments on municipal bonds are exempt from federal incomes taxes and these bonds have
had lower interest rates than U.S treasury bonds. Therefore, is a bond has a favorable tax treatment;
its interest rates will be lower. The tax exempt status of a bond becomes a significant advantage when
income tax rates are very high.

Page 7 of 18
 3.4) The Theories of Interest Rates;
Borrowers and lenders think mostly in terms of real interest rates. There are two economic theories
explaining the level of real interest rates in an economy; (1) the loanable funds theory; and (2) liquidity
preference theory.
(A) Loanable funds theory of interest rate;
In an economy, there are a supply of loanable funds (i.e. credit) in the capital market by households,
business, and governments. The higher the level of interest rates, the more such entities are willing to
supply loan funds; the lower the level of interest, the less they are willing to supply. These same entities
demand loanable funds, demanding more when the level of interest rates is low and less when interest
rates are higher. The extent to which people are willing to postpone consumption depends upon their time
preference. The time preference describes the extent to which a person is willing to give up the
satisfaction obtained from present consumption in return for increased consumption in the future.

The term loanable fund simply refers to the sums of money offered for lending and demanded by
consumers and investors during a given period. The interest rate in the model is determined by the
interaction between potential borrowers and potential savers. Loanable funds are funds borrowed and
lent in an economy during a specified period of time, that the flow of money from surplus units to deficit
units in the economy. The loanable funds theory was formulated by the Swedish economist Knut
Wicksell in the 1900s. According to him, the level of interest rates is determined by the supply and
demand of loanable funds available in an economy’s credit market (that, the sector of the capital markets
for long-term debt instruments). This theory suggests that investment and savings in the economy
determine the level of long-term interest rates. Short-term interest rates, however, are determined by an
economy’s financial and monetary conditions. According to the loanable funds theory for the
economy as a whole;
Demand for loanable funds = net investment + net additions to liquid reserves;
Supply of loanable funds = net savings + increase in the money supply;
Given the importance of loanable funds and that the major suppliers of loanable funds are commercial
banks; the key role of this financial intermediary in the determination of interest rates is vivid. The central
bank is implementing specific monetary policy; therefore it influences the supply of loanable funds from
commercial banks and thereby changes the level of interest rates. As central bank increases (decreases)
the supply of credit available from commercial banks, it decreases (increases) the level of interest rates.
(B) Liquidity preference theory of interest rate;
Saving and investment of market participants under economic uncertainty may be much more influenced
by expectations and by exogenous shocks than by underlying real forces. A possible response of risk-

Page 8 of 18
averse savers is to vary the form in which they hold their financial wealth depending on their expectations
about asset prices. Since they are concerned about the risk of loss in the value of assets, they are likely to
vary the average liquidity of their portfolios. A liquid asset is the one that can be turned into money
quickly and without loss of its monetary value. Liquidity preference is a preference for holding financial
wealth in the form of short-term, highly liquid assets rather than long-term illiquid assets, based
principally on the fear that long-term assets will lose capital value over time.

Liquidity preference theory explains how interest rates are determined based on the preferences of
households to hold money balances rather than spending or investing those funds. Money balances can be
held in the form of currency or checking accounts, however it does earn a very low interest rate or no
interest at all. A key element in this theory is the motivation for individuals to hold money balance despite
the loss of interest income. Money is the most liquid of all financial assets and, of course, can easily be
utilized to consume or to invest. The quantity of money held by individuals depends on their income
level, and consequently, for an economy the demand for money is directly related to an economy’s
income. There is a trade-off between holding money balance for purposes of maintaining liquidity and
investing (lending) funds in less liquid debt instruments in to earn a competitive market interest rate. The
difference in the interest rate that can be earned by investing in interest-bearing debt instruments and
money balances represents an opportunity cost for maintaining liquidity. The lower the opportunity cost,
the greater the demand for money balances; the higher the opportunity cost, the lower the demand for
money balance. According to the liquidity preference theory, the level of interest rates is determined
by the supply and demand for money balances. The money supply is controlled by the policy tools
available to the country’s Central Bank.
3.5) Factors Affecting Structure of Interest Rate Determinations;
Interest rates are partly based on economic factors that shift over time. These factors are;
(1) Supply and demand; when you think of interest rates as a price for borrowing money, it makes sense
that they would be affected by supply and demand. In lending, an increase in the demand for money,
or a decrease in the supply of money held by lenders, will cause interest rates to go up. For example,
if a lot of people started pulling all of their money out of their checking and savings accounts that
would decrease the supply of money those banks have to lend to borrowers, which would likely raise
interest rates at those banks. Conversely, a decrease in the demand for money, or an increase in the
supply of money, will lower interest rates as lenders try to attract more borrowers.
(2) Inflation; inflation is when the prices of goods and services rise, which decreases the purchasing
power of money. Inflation can be good for people carrying debt, since it lowers the value of each
dollar you owe, but by the same token it’s terrible for lenders. If the money a lender receives has less

Page 9 of 18
 value than the money it originally lent due to inflation, it’s going to raise interest rates to account for
the difference.
(3) Federal funds rate; the interest rate that financial institutions charge one another for short-term loans
is called the federal funds rate. When the economy is slow, the federal reserve can lower the federal
funds rate to encourage more borrowing, and when the economy is growing too fast, which
can trigger large increases in inflation, the federal reserve can raise the federal funds rate to
discourage borrowing. The interest rates that these big financial institutions charge one another
creates a baseline that influences the prime rate, or the interest rate that banks charge to their best
customers who have the lowest possible risk of defaulting on their loans, which in turn affects the
interest rates for everyone else.
(4) Credit scores; your credit scores impact many different parts of your life, but your ability to easily
get new credit is probably the most obvious. Since credit scores are supposed to represent your
creditworthiness, lenders look intensively at your credit scores and credit history to determine how
risky you are to lend to. High credit scores, which you can get by paying your bills on time and
keeping a low credit utilization ratio, indicate that you’re good at paying off your debts, so the risk of
lending to you is low. If your credit scores aren’t great, though, the lender views you as less likely to
pay back your entire loan, so it will charge you a higher interest rate to make up for that risk or just
reject you outright.
(5) Loan amount and duration; while it may seem unfair that simply requesting a lot of money or a
long repayment term can increase your interest rate; they both make a loan more difficult to pay back.
Borrowing larger amounts of money means larger monthly loan payments, and taking out a loan with
longer repayment terms not only makes the loan more vulnerable to inflation (note that this doesn’t
apply to a loan with a fixed rate), but it also increases the chance that you will face some adversity in
your life that may negatively impact your ability to pay the debt. To reduce these factors, before you
take out a loan, ask yourself how much money you really need to borrow, and figure out the shortest
possible amount of time in which you could realistically pay off the debt.
(6) Guarantee; is an agreement to settle a debt in an alternate way in case the borrower defaults.
Guarantees can take several different forms, such as collateral, cosigners or a personal guarantee, and
adding a guarantee of some kind to a loan can reduce interest rates since they lower the lender’s risk.
Before you add a guarantee to a loan to reduce your interest rate, be sure you thoroughly read and
understand the agreement you’re making, as some of them can have unusual terms. Additionally,
some types of loans have preexisting policies regarding guarantees, such as auto loans, which use the
vehicle you’re buying as collateral, so you won’t always have a choice on whether or not to guarantee
a loan. Securing a low interest rate can turn a loan from a heavy burden into a breeze.

Page 10 of 18
 CHAPTER FOUR
FINANCIAL MARKETS IN THE FINANCIAL SYSTEM
4.1) Introduction to the Financial Markets;
Financial markets are markets in which funds are transferred from people who have a surplus of
available funds to people who have a shortage of available funds. A financial market is a place in which
financial assets are bought or sold. Financial markets facilitate the flow of funds and thereby facilitate
financing and investing by households, firms, and government agencies.
A financial market is a market where buyers and sellers trade commodities, financial securities, foreign
exchange, and other freely exchangeable items (fungible items) and derivatives of value at low
transaction costs and at prices that are determined by market forces. Financial Market refers to a
marketplace, where creation and trading of financial assets, such as shares, debentures, bonds, derivatives,
currencies, etc. take place. It plays a crucial role in allocating limited resources, in the country’s economy.
It acts as an intermediary between the savers and investors by mobilizing funds between them.
4.2) The Role of Financial Markets in the Financial System;
The following are the functions of financial markets;
(1) Enhancing income; financial markets allow lenders earn interest or dividend on their surplus
invested funds, thus contributing to the enhancement of the individual and the national income
(2) Transfer of resources; financial markets facilitate the transfer of real economic resources from
lenders to ultimate borrowers.
(3) Productive usage; financial markets allow for the productive use of the funds borrowed, thus
enhancing the income and the gross national production.
(4) Capital formations; financial markets provide a channel through which new savings flow to aid
capital formation of a country.
(5) Price determination; financial markets allow for the determination of the price of the traded
financial asset through the interaction of buyers and sellers, that through demand and supply. The
interactions of buyers and sellers in a financial market determine the price of the traded assets;
or equivalently, the required return on a financial asset is determined. The inducement for firms
to acquire funds depends on the required return that investors demand, and it is this feature of
financial markets that signals how the funds in the economy should be allocated among financial
assets. This is called the price discovery process.
(6) Provide a mechanism for investor to sell a financial asset; because of this feature, it is said that a
financial market offers liquidity, an attractive feature when circumstances either force or motivate an
investor to sell. In the absence of liquidity, the owner will be forced to hold a debt instrument until it

Page 11 of 18
 matures and an equity instrument until the company is either voluntarily or involuntarily liquidated.
While all financial markets provide some form of liquidity, the degree of liquidity is one of the
factors that characterize different markets.
(7) It reduces the search and information costs of transacting; search costs represent explicit costs,
such as the money spent to advertise the desire to sell or purchase a financial asset, and implicit costs,
such as the value of time spent in locating counterparty. The presence of some form of organized
financial market reduces costs. Information costs are those entailed with assessing the investment
merits of financial assets that is the amount and the likelihood of the cash flow expected to be
generated. In an efficient market, prices reflect the aggregate information collected by all market
participants.
4.3) Participants of the Financial Markets in the Financial System;
The participants of financial market can be broadly grouped in to two; (a) lenders, and (b) borrowers.
(A) Lenders (surplus unit); it includes individuals and corporations with capital in excess of their
current requirement.
(1) Individual savers; a person lends money when he or she puts money in a saving or fixed account
at a bank; contributes in a pension plan; pays premiums to an insurance company; invest in a
government bonds; or invest in a company shares.
(2) Firms or Companies; those having surplus cash which is not needed for a short period of time,
they may seek to make money from their cash surplus by lending it through short term market
called money market.
(B) Borrowers (deficient units); includes individuals, companies, central or local government, public
corporations or institutions with different investment opportunities (expansion, replacement, additions
or making new investment), but lack adequate internal capital to finance their investment.
(1) Individual borrowers; borrow money via banker’s loans for short term needs or longer term
mortgage to help finance a house purchases.
(2) Government; borrow to finance their deficit and to on behalf of nationalized industries, local
authorities, municipalities and other public sectors.
(3) Municipalities and local authorities; may borrow in their own name as well as receiving fund
from national governments.
(4) Companies; firms those having deficit of fund needs money to finance their business operation.
(5) Public corporations; these may include governmental owned service providers with customer
charging basis, such as, public enterprise, utility companies, etc.

Page 12 of 18
 4.4) The Classification of Financial Markets in the Financial System;
Different financial markets serve different types of customers or different parts of the country. Financial
markets also vary depending on the maturity of the securities being traded and the types of assets used to
back the securities. For these reasons it is often useful to classify markets along the following dimensions;
4.5.1) Based on the Origin – (Primary and Secondary Market);
(1) Primary market; is a market in which newly-issued securities are sold to initial buyers by the
corporation or government borrowing the funds. Securities available for the first time are offered
through the primary market. That is, in the primary market, companies interact with investors directly
while in the secondary market investors interact with themselves. The securities offered may be a new
type for the issuer or additional amounts of a security used frequently in the past. The company
receives the money and issues new security certificates to the investors. The traditional middleman in
the primary market is called an investment banker. Investment banking firms play an important role
in many primary market transactions by underwriting securities, that they guarantee a price for a
corporation’s securities and then sell those securities to the public. That is, it buys the new issue form
the issuer at an agreed upon price and hopes to resell it to the investing public at a higher price.
Usually, a group of investment bankers joins to underwrite a security offering and form what is called
an underwriting syndicate. Companies raise new capital in the primary market through;
(a) Public issue or offering; the established companies may sell new securities directly to the
general public, that to individuals and institutions.
(b) Right issue; offering of securities may be made only to the existing shareholders. Thus, when
securities are offered only to the company’s existing shareholders, it is called right issue.
(c) Private placement; instead of public issue of securities, a company may offer securities
privately only to a few selected investors. This is referred to as private placement. The
investment bankers may act as a finder, that is, it locates the institutional buyer for a fee.
(2) Secondary market; which is also known as the aftermarket, is the financial market where
previously issued securities and financial instruments such as stock and bonds are bought and sold.
Secondary market is a market where already issued or existing or outstanding financial assets are
traded among investors. In the secondary market the issuer of the asset does not receive funds from
the buyer unlike primary market. Rather, the existing issue changes hands and funds flow from the
buyer of the asset to the seller in secondary market. The following are the economic functions of
secondary markets for the issuers (benefits to the issuers);
(a) Provides regular information about the value of the security. For example, higher value of shares
indicates- higher goodwill (public image) from the investors’ point of view, good management of

Page 13 of 18
 funds raised from earlier primary markets by the firm.
(b) Help determining fair prices based on demand and supply forces and all available information.
The following are the economic functions of secondary markets for the investors (benefits to
investors /buyers or security holders);
(a) Secondary market offers them high liquidity for their assets as well as information about their
assets fair market values.
(b) It helps investors feel confidence that they can shift from one financial asset to another. Thus, by
keeping the cost of both searching and transaction costs low, secondary market encourages
investors to purchases financial assets.
(c) They can sell their shares at readily available (d) Provide marketability and liquidity for
market. investors
4.5.2) Based on the maturity of security– (Money and Capital Market);
Another way of distinguishing between financial markets is on the basis of the maturity of the securities
traded in each market. It classified as money and capital market.
(1) Money market; is a financial market in which only short-term debt instruments, that is maturity of
less than one year, are traded. The money market is where short-term debts such as treasury bills
(TB), commercial paper, banker’s acceptance, are bought and sold. Participants borrow and lend for
short periods of time, typically up to one year. Money market is the term designed to include the
financial institutions which handle the purchase, sale and transfers of short term credit instruments. It
includes the entire machinery for the channelizing of short term funds. Money market securities are
usually more widely traded than longer-term securities and so tend to be more liquid. The general
characteristics of a money market are;
(a) Short term funds are (b) Funds are traded for maximum period of one year.
borrowed and lent
(c) Dealings may be (d) No fixed place for conduct of operations, the
conducted with or without transaction being conducted even over the horizontal
the help of brokers. and therefore there is an essential need for the presence
of well-developed communications system.
(2) Capital market; is the market in which long-term debt and equity instruments, which maturity is
greater than a year, are traded. It is the market in which intermediate or longer-term debt, generally
those with original maturity of more than one year, and equity instruments are traded. In capital
market, firms commonly issue securities such as stocks and bonds to finance their long-term
investments in corporate operations and the government also issues debt securities in this market.
Institutional and individual investors purchase securities with funds that they wish to invest for a
longer time. Even though stocks do not have maturities, they are classified as capital market securities

Page 14 of 18
 because they provide long-term funding. The New York Stock Exchange, where the stocks of the
largest U.S. corporations are traded, is a prime example of a capital market. However, when
describing maturity of debt securities in capital market, “intermediate term” means 1 to 10 years,
and “long term” means more than 10 years.
4.5.3) Based on the financial claim – (Equity/stock and Bond/debt market);
Another way of classifying financial markets is based on the type of claim associated with the fund
transferred through the transaction in that market. It can classify as equity and debt market.
(1) Equity market; which is also known as stock market, is a financial market in which shares are
issued and traded through changes. It is the market for trading equity instruments. Stocks are
essentially securities that are a claim on the earnings and assets of a corporation. Example of an
equity instrument would be common stock shares, such as those traded on the New York Stock
Exchange. If the transaction gives ownership title to the buyer of the instrument, the market is termed
as equity market. In this case, the buyer of the financial asset will be one of the owners of the firm
and unlike in the case of debt market he will not expect a predetermined return. He will rather expect
to get a series returns in terms of dividend and capital gain. Thus, unlike the buyer of a debt
instrument, his return will depend on the profitability of the firm and in case of bankruptcy he will
have a residual claim like the other owners of the firm.
(2) Debt market; which is also known as bond market or credit market, is a financial market in which
the investors are provided with issues or bonds and trading of debt securities. Debt market is the
market where debt instruments are traded. Debt instruments are assets that require a fixed payment to
the holder, usually with interest. Examples of debt instruments include bonds (government or
corporate) and mortgages. If the transaction represents a simple borrowing and does not give
ownership title to the buyer of the security, the market is termed as debt market. For example, a
firm may raise fund by issuing a debt instrument, such as a bond or a mortgage, which is a contractual
agreement by the borrower to pay the holder of instrument fixed dollar amounts at regular intervals
(interest and principal payments) until a specified date (the maturity date), when a final payment is
made. The buyer of the debt instrument will then will get his money with some return. In cases of loss
or bankruptcy, he will have first claim over the assets of the firm. This means, if the firm that issues
the instrument went bankrupt and could not pay its debt, the holder of the instrument has the right to
enforce the firm to liquidate its assets and get his money. On the other hand, the holder of the
instrument will not have ownership title over the firm and hence his return will not depend on the
profitability of the firm.

Page 15 of 18
 4.5.4) Based on the time of delivery – (Spot and Future Markets);
Financial markets can also be classified based on the timing of the contract and the transaction as spot
and future markets.
(1) Spot Markets; are markets where the transaction is made at the time of lag-on the spot. If the
operation is of daily nature, it is called spot market or current market. It handles only spot transactions
or current transactions in foreign exchange. For example, if we consider a spot foreign exchange
market, the exchange will be made at the time of agreement except for some short time lag in delivery
like hours or maximum of 2 days.
(2) Future Markets; are markets where the contract is made today and transaction or delivery is made
in a future time specified in the contract. They are markets where future contracts are traded. They are
markets where future contracts are traded. Future contracts are contracts which are agreements to
deliver items on a specified future date at a price specified today but not paid until delivery. To use
the same example of a foreign exchange market, a buyer and a seller may agree today to transact a
foreign currency after some time say three months at rate they fix now. Future markets are important
to avoid risk arising from fluctuations in the spot market
4.5.5) Based on the market structure – (Auction and Over the Counter);
Financial markets can also be classified based on the structure of the market as auction and over the
counter markets.
(1) Auction market; which is also called open outcry market, is where some transactions are carried
out on a trading floor, by a method known as open outcry. This type of auction is used in stock
exchange and commodity exchanges where traders may enter “verbal” bids and offers
simultaneously. In auction market, buyers enter competitive bids and sellers submit competitive
offers at the same time. The price at which stock trades represented the highest price that a buyer is
willing to pay and the lowest price that a seller willing to accept.
(2) Over the Counter (OTC) market; is not physically existing market as that if stock exchange, but
transactions between traders are made electronically through network of computers. It is also called
the market for unlisted stocks. It includes trading in all stocks not listed on one of the exchanges. It
can also include trading in listed stocks, which is referred to as the third market. It is not a formal
organization with membership requirements or a specific list of stocks deemed eligible for trading. In
theory, any security can be traded on the OTC market as long as a registered dealer is willing to make
a market in the security (willing to buy and sell shares of the stock). There is tremendous diversity in
the OTC market because it imposes no minimum requirements. Stocks that trade on the OTC range
from those of small, unprofitable companies to large, extremely profitable firms. As any stock can be

Page 16 of 18
 traded on the OTC as long as someone indicates a willingness to make a market whereby the party
buys or sells for his or her own account acting as a dealer. This differs from most transactions on the
listed exchanges, where some members act as brokers who attempt to match buy and sell orders.
Therefore, the OTC market is referred to as a negotiated market, in which investors directly negotiate
with dealers.
4.5.6) Other Classifications-(Derivatives, Foreign exchange and Commodity
Market);
(1) Derivative markets; are a market in which derivatives securities are bought and sold. What is a
derivatives security? A derivative security is a security whose value depends on the values of other
more basic underlying securities. Some contracts give the contract holder either the obligation or the
choice to buy or sell a financial asset. Such contracts derive their value from the price of the
underlying financial asset. Consequently, these contracts are called derivative instrument. The
derivative securities are also known as contingent claims. Very often, the variables underlying the
derivative securities are the prices of traded securities. For example, a stock option is a derivative
security whose value is contingent on the price of a stock. The following are the important derivative
securities;
(a) Forward contract; is a derivative security, which is an agreement to buy or sell an asset at certain
future time for certain price. The contract is usually between either two financial institutions or a
financial institution and one of its corporate clients. It is not traded on a stock exchange. One of the
parties to a forward contract assumes a long position and agrees to buy the underlying security on
certain specified future date for certain specified price. The other party assumes a short position and
agrees to sell the asset on the same date for the same price. A forward contract is settled at maturity.
The holder of the short position delivers the security to the holder of the long position in return for
cash equal to the delivery price.
(b) Option contract; defined marketable securities that give their owner the right but not the
obligation to buy or sell a stated number of shares at a fixed price within a per-determined time
period. So, it is a contract which involves the right to buy or sell securities at specified prices within
a stated time. Options provide the investors with the opportunity to hedge investments in the
underlying shares and share portfolios and can, thus, significantly reduce the overall risk related to
investments. In addition, options contract increase liquidity.
(c) Future contracts; is an agreement between two parties to buy or sell an asset at certain price at
certain time in the future. The futures contracts are normally traded on an exchange. The most
important feature of futures contract is that, as the two parties to the contract do not necessarily

Page 17 of 18
 know each other, the exchange also provides a mechanism which gives the two parties a guarantee
that the contract will be honored.
The Distinction Between Futures and Options;
Futures; Options;

(2) Foreign Exchange Market (FOREX); different countries have different currencies and the
settlement of all business transactions with in a country is done in the local currency. However, the
foreign exchange market provides a forum where the currency of one country is traded for the
currency of another country. Example, suppose an Ethiopian importer import goods from the USA
and has to make payments in US Dollars. To do so, an Ethiopian importer has to purchase US Dollars
in the foreign exchange market and make payment to US firm or importer. Therefore, the foreign
exchange market is a market where foreign currencies are bought and sold. Since foreign exchange
market deals with a large volume of funds as well as a large number of currencies (belonging to
various countries), it is not only worldwide market but also the world’s largest financial market.
Foreign exchange markets are the markets in which traders of foreign currencies transact most
efficiently and at the lowest cost. As a result, foreign exchange markets facilitate foreign trade, the
raising of capital in foreign markets, the transfer of risk between participants, and speculation on
currency values. A foreign exchange rate is the price at which one currency (example, the U.S. dollar)
can be exchanged for another currency (example, the Swiss franc) in the foreign exchange markets.
(3) Commodity market; is a physical or virtual marketplace for buying, selling, and trading raw or
primary products. Commodity market deals with the trading of commodities (agricultural and
industrial products; such as precious metals). The commodity market is a market where traders buy
and sell commodities. Commodities are raw materials or primary agricultural products. In other
words, things that farmers, mining companies, and oil and gas companies produce or extract.

Page 18 of 18