CHAPTER ONE

AN OVERVIEW OF THE FINANCIAL SYSTEM

Objectives: - At the end of these unit students should be able to:-

 Explain financial system and its components.
 Identify the role of financial sector on the economy
 Explain classification of financial asset its role & properties
 Explain financial market, role classification & its participants
 Identify how lending and borrowing in the financial system is performed

1. Introduction

The financial sector mobilizes savings and allocates credit across space and time. It provides not
only payment services, but more importantly products which enable firms and households to
cope up with economic uncertainties by hedging, pooling, sharing, and pricing risks. An efficient
financial sector reduces the cost and risk of producing and trading goods and services and thus
makes an important contribution to raising standards of living.

Financial systems can reduce information and transaction costs that arise from an information
asymmetry between borrowers and lenders. In credit markets an information asymmetry arises
because borrowers generally know more about their investment projects than lenders.

The financial system consists of financial market, financial institutions, financial instruments,
financial services and regulations. The impact of the financial system on the real economy is
subtle and complex. Thus, the direct impact of financial institutions on the real economy is
relatively minor. Nonetheless, the indirect impact of financial markets and institutions on
economic performance is important. Therefore, this chapter focuses on definition and
components of financial system, their role in the economy, various types of financial assets,
market participants and lending and borrowing process in the system.

2. Financial system and its components

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The financial system is the system that allows the transfer of money between savers and
borrowers. Financial system is a system that aims at establishing and providing a regular,
smooth, effective and efficient linkage between depositors and investors. Financial system is a
set of complex and closely connected instructions, agents, practices, markets, transactions,
claims and liabilities relating to financial aspects of an economy.

Components of the financial system are financial Institutions, regulatory bodies, intermediaries,
banks, non-financial institutions, financial Markets, Capital Markets, Equity/Stock Market, Debt
Market, Derivative Market, Money Markets, Financial Instruments and financial services

It comprises a set of complex and closely interconnected financial institutions, financial markets,
instruments, services, practices, and transactions the supervisory bodies responsible for their
regulation. Financial System (or financial sector or financial infrastructure) includes all savings
and financial opportunities and financial institutions which provide savings and financing
opportunities.

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2.1. Users of financial system

The end-users of the system are households, business firms and government whose desire is to
lend and to borrow.

Structures Savings Real Investment (Non-financial)

Households Personal income- Purchase of durables, purchase of home,

spending on apartments etc…
consumption

Businesses Total sales-operating Purchase of equipments + Purchase of

expenses + Non-cash Inventory + Construction of new
expenses Business facilities etc…

Government. Receipt from budget- Construction new public facilities etc…

recurrent expenditure

The end-users of most financial systems have a choice between three broad approaches to
link excess fund units and deficit units.
1. Without using financial institutions and financial markets: - savers and lenders may
decide to deal directly, though this, is costly, risky, inefficient and, consequently, not very
likely.
2. Use one or more organized financial markets. In these markets, lenders buy the liabilities
issued by borrowers. If the liability is newly issued, the issuer receives funds directly from
the lender. More frequently, however, a lender will buy an existing liability from another
lender. In effect, this re-finances the original loan, though the borrower is completely
unaware of this ‘secondary’ transaction. The best-known markets are the stock exchanges
in major financial centers such as London, New York and Tokyo. These and other markets
are used by individuals as well as by financial and non-financial firms.
3. Borrowers and lenders may decide to deal via institutions or ‘intermediaries’. In this
case lenders have an asset–a bank or building society deposit, or contributions to a life
assurance 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

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 borrowers. These too remain in the intermediaries’ balance sheets until they are repaid.
Intermediaries themselves will also make use of markets, issuing securities to finance some
of their activities and buying shares and bonds as part of their asset portfolio.

What activities are performed in a given financial system?

Channels funds from lenders to borrowers: - Financial systems are crucial to the allocation of
resources in a modern economy. They channel household savings to the corporate sector and
allocate investment funds among firms. They allow inter temporal smoothing of consumption by
households and expenditures by firms and enable households and firms to share risks. These
functions are common to the financial systems of most developed economies. Yet the form of
these financial systems varies widely (en.wikipedia.org).

Provides a means of making payments: - In most cases this is the responsibility of deposit-
taking institutions (or a subset of them). Such institutions are usually members of a network (a
‘clearing system’) and accept instructions from their clients to make transfers of deposits to the
accounts of other clients. Traditionally this was done by issuing a paper instruction (a ‘cheque’)
but today it is done increasingly by electronic means.
Creates liquidity and money: - Liquidity is the ability to buy or sell an asset quickly and at a
known price. Liquidity requires marketability and price continuity, which, in turn, requires
depth. Marketability: refers to likelihood (probability) of being sold quickly. The expected
price should be fairly certain, based on the recent history of transaction prices and current bid-
ask quotes. Price continuity: which means that prices do not change much from one transaction
to the next unless substantial new information becomes available. Depth: which means that
numerous potential buyers and sellers must be willing to trade with securities (Many
participants)

Provides financial services in order to avoid uncertainty: - mostly such service is carried out
by insurance companies.
Portfolio diversification: - Pension funds, unit trusts and investment trusts all offer savers the
opportunity to accumulate a diversified portfolio of financial assets.
3. The role of financial sectors in the economy

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The basic function of the economic system is to allocate scarce resources –land, labor,
managerial skill and capital-to produce goods and services needed by the society. The high
standard of living depends on the nation’s economy. Any economic system must combine inputs-
labor, land, and other natural resources, managerial skill and capital in order to produce outputs-
in the form of goods and services. Therefore, the economy generates the flow of production
(goods and services) in return for a flow of payments in the form of money.

In modern economy households provide labor, managerial skills, land and natural resources.
Households are the consuming units of goods and services. Business firms and governments also
pay for income in the form of salaries, wages, rents royalties, dividends and others. Business
firms and governments are producing units. Most income received by the households is spent to
purchase of goods and services. Therefore, the financial system and the economy are highly
interrelated.

Therefore, the primary task of financial institutions is to move scarce loanable funds from those
who save to those who borrow for consumption and investment by making funds available for
lending and borrowing, the financial system provides the means where by modern economy
grow and increases the standard of living much of the credits thus obtained goes to purchase of
equipment, machinery, construction of dams, bridges, highways, factories and schools, and etc…
without the financial system and the credit it supplies, the economy will not grow as fast as
possible. The financial system determines both the cost of credit and how much credit will be
available to pay for goods and services we purchased daily.

The financial system has a powerful impact upon the health of nation’s economy. When credit
becomes costly and less available, total spending for goods and services generally falls. As a
result unemployment rises and the economic growth slows down. On the other hand, when the
cost of credit declines and loanable funds become more readily available, the opposite will
happen.

Overall roles the financial system plays in the economic development of a country

1. Savings: The ability by which claims to resources are set aside and become available for the
other purposes.

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2. Finance: The activity by which claims to resources are either assembled and placed in the
hands of investors. or Loans: - Money in deposit accounts, like savings accounts, is used to
provide loans for a wide range of projects to people and businesses. Mortgages, car loans and
student loans are financed largely by deposits in banks, savings institutions and credit unions.

3. Investment: The activity by which resources are actually committed to production.

 The process of saving, finance and investment involves financial institutions, markets and
instruments and services.
 Above all, supervision, control and regulation are equally important. Thus, financial
management is an integral part of the financial system.

 Economic growth and development of any country depends upon the strength of its
financial system.
 Thus, a financial system can be said to play a significant role in the economic growth of a
country by mobilizing the surplus funds and utilizing them effectively for productive
purposes.

The function of financial system can be simply illustrated as follows

 Saving mobilization
 Capital Formation
 Investment
 Economic growth
 Improved living standard of citizens

FINANCIAL ASSETS: ROLE AND PROPERTIES

An asset is any possession that has value in an exchange. An asset can be classified as tangible
and intangible. A tangible asset is one whose value depends on particular physical properties
example buildings, land and machinery. Intangible assets, are in contrast, represent legal
claims to some future benefit. Their value bears no relation to the form, physical or otherwise,

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in which these claims are recorded. Financial assets are intangible assets the typical benefit or
value is a claim to future cash. An entity that has agreed to make future cash payments is called
the issuer of financial asset. The owner of the financial asset is investor. In this course we will
use the terms financial asset, financial instrument, and security interchangeably.
Examples of financial assets
• A loan by Dashen Bank (investor) to an individual (issuer/borrower) to purchase a car
• A Treasury bond issued by National Bank of Ethiopia
• A bond issued by the government of Ethiopia (for the Grand Renaissance Dam)
• A bond issued by A.A City Municipal
• share of common stock issued by Abyssinia Bank, e.t.c

4.1. Tangible (Real) assets Vs Financial assets:

Financial assets have some contrasting features with real assets. Some of the differences are;
1. Material wealth of the society is determined by the productive capacity of its economy –the
goods and services that can provide to its members. This productive capacity is the function
of the real assets of the economy-land building, equipment and machine, knowledge, workers
etc. nevertheless, financial assets such as stocks and bonds do not directly contribute to the
productive capacity of the economy. Shares of stock are no more than sheets of papers. They
do not represent society’s wealth.
2. Real assets appear only on the left side (asset side) of the balance sheet. The financial assets
appear always on both sides of the balance sheet.

Owner Issuer

Assets Liability

3. Financial assets are created and destroyed in the ordinary course of business Eg. When loans
are paid off both the financial asset and financial liability cease to exist. In contrast, real
assets are destroyed only by accident or wear out over time.
4. Real assets are income –generating assets, where as financial assets define the allocation of
income or wealth among investors. Individuals can choose either consuming their

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 endowments of wealth today or investing for the future. When they invest for the future they
may choose to hold financial assets, the money a firm relieves when it issues securities (sell
them to investors) is used to purchase real assets. Ultimately then, the returns of financial
assets comes from the income produced by the real assets that are financed by the issuance of
securities. In this way, it used to view financial assets as a means by which individual hold
their claims on real assets.
5. The physical condition of financial assets is not relevant in determining their market value
(price). A stock certificate is not more or less valuable. Whereas, physical conditions (size,
quality quantity) are so much important while determining value of real assets.

4.2. The role of financial assets

Financial assets have two economic functions.
1. Transferring funds from those who have surplus to invest to those who need funds to
invest in an intangible asset.
2. Transferring funds in such a way as to redistribute the unavoidable risk associated with
the Cash flow generated by tangible assets among those seeking and those providing the
funds. (shifting of risk)

4.3. Properties of financial assets

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 1. Money ness
2. Divisibility and denomination
3. Reversibility
Properties of 4. Cash flow
5. Term to maturity
Financial 6. Convertibility
7. Currency
Assets 8. Liquidity
9. Return predictability
10.Complexity and
11.Tax status

1. Moneyness: - In any economy money consists of currency and all forms of deposits that
permit check writing. Other assets, though are not money, are very close to money in the
sense that they can be transformed into money without cost, delay or risk. They are referred
to as near money. They include time and savings deposit and security issued by government
called Treasury bill. Moneyness is a clearly a desirable property for investors.
2. Divisibility: - Divisibility relates to minimum size in which a financial asset can be
liquidated and exchanged for money. Smaller the size, the more the financial asset is
divisible. A financial asset such as deposits can typically infinitely divisible but other
financial assets have varying degrees of divisibility depending on their denominations.
3. Reversibility: - refers to the cost of investing in financial assets and then getting out of it and
back into cash again. Consequently, reversibility is called turnaround cost or round trip cost.
A financial asset such as deposit with a bank is highly reversible because there is no cost for
adding to or withdrawing from it. For financial assets trade in organized markets or with
market-makers, the relevant round trip cost is the so called ask–bid spread. The spread
charged by the market maker varies from one asset to another reflecting primarily the amount
of risk that the market maker is assuming by ”making” a market.
Market making risk can be related to two forces
1. The variability of price as measured by some measure of dispersion.
2. The bid-ask spread charged by the market maker, what is commonly referred to as
thickness of the market.

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4. Cash flow :- The return that an investor will realize by holding financial assets depends on
all cash distributions that the financial asset will pay to its owners; this includes dividends on
shares and coupon payments (interests) on bonds. The return also includes the repayment of
principal on debt security and the expected sale price of a stock.
5. Convertibility: - Some assets are convertible into other assets. In some cases conversion
takes place within the same class of assets. For example, a bond is converted into another
bond. In other situations the conversion spans classes. Example:- A corporate convertible
bond is converted to equities. Preferred stocks can be converted to common stocks.
6. Currency:- With increased globalization of financial markets securities are issued in
different countries. Volatility of exchange rates has significant impact on cash flow.
7. Liquidity:- How much the sellers stand to lose if they wish to sell immediately against
engaging in costly and time consuming search. Liquidity depends on
 Nature of asset-who issues it, how much etc.,
 Quantity of the assets
 Whether the market is thick (a market with large participants) or thin (a market with
small participants)
8. Term to Maturity:- For a bond, the date on which the principal is required to be repaid. It is
the length of period until the date at which the instrument is scheduled to make its final
payment. The time until last cash flow.
9. Return Predictability:- This depends on the risk-return profile of an asset, Nominal return
and real returns.
10. Complexity:- Some financial assets are complex in the sense that they are actually
combination of two or more simpler assets. A complex asset is one that provides options for
the issuer or the investor, or both, and so represents a combination of simpler assets.
11. Tax status:- Taxes differ from financial asset to financial asset depending on
the type of issuer, the length of the time asset held, the nature of owner etc., Pension funds,
coupon payments on municipal bonds are generally free of taxation.

Financial markets: role, classifications and participants

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A financial market is a market where financial assets are exchanged (traded). Although the
existence of a financial market is not a necessary condition for the creation and exchange of a
financial asset, in most economies financial assets are created and subsequently traded in some
type of financial market. Those participants with receive more money than they spend are
referred to as surplus units (investors). Those participants who spend more money than they
receive are referred to as deficit units (borrowers).
5.1. Role of Financial Markets
Financial markets provide three economic functions.
1. The interactions of buyers and sellers in a financial market determine the price of the traded
asset. Or, equivalently they determine the required return on a financial asset. As the
inducement for firms to acquire funds depends on the required return that investors demand,
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 recovery process.
2. Financial markets provide a mechanism for an investor to sell a financial assets. 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. If there were not liquidity, the
owner would be forced to hold a debt instrument until it 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,
3. It reduces the cost of transacting. There are two costs associated with transaction. These are
search costs and information costs. Search cost represent explicit costs, such as money spent
to advertise one’s intention to sell or purchase a financial asset, and implicit costs such as the
value time spent in locating a counter party. The presence of some form of organized market
reduces search costs. Information costs are costs associated with assessing the investment
merits of a financial asset, the amount and the likelihood of cash flow expected to be
generated. In an efficient market, prices reflect the aggregate information collected by all
market participants.
5.2. Classification of Financial Markets
1. By the type of financial claim:

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a) Debt Market:- The debt market is the financial market for fixed claims (debt instruments)
and the most common method of getting fund. A contractual agreement by the borrower to
pay the holder of the instrument fixed amount of money at regular intervals (I + P) until a
specified date, when a final payment is made.
Debt market classification based on time period
 Short-term: If its maturity is less than a year
 Intermediate-term: if its maturity is between one and ten years
 Long-term: if its maturity is ten years or longer
b) Equity market:- The equity market is the financial market for residual claims (equity
instruments).
 Are claims to share in the net income and net assets of a business?
 Make periodic payments (dividends) to their holders and are considered long-term
securities because they have no maturity date.
 Owning stock means that you own a portion of the firm and thus have the right to vote on
issues important to the firm and to elect its directors.
2. By the maturity of claims
a) Money market:- The market for short term financial claims is referred to as the money
market, and only short-term debt instruments (generally those with original maturity of less
than one year) are traded. Money market Short-term securities have smaller fluctuations in
prices than long-term securities, making them safer investments. As a result, corporations
and banks actively use the money market to earn interest on surplus funds that they expect to
have only temporarily

b) Capital market:- The market for long term financial claims is called the capital market.
Longer term debt (generally those with original maturity of one year or greater) and equity
instruments are traded. Capital market securities, such as stocks and long-term bonds, are
often held by financial intermediaries such as insurance companies and pension funds, which
have little uncertainty about the amount of funds they will have available in the future.
Capital Market- for long-term funds
i. Primary Market
ii. Stock Market

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 iii. Bond Market
3. Based on whether the claims represent new issues or outstanding issues:
a) Primary Market:- Is a financial market in which new issues of a security are sold to initial
buyers by the corporation or government agency borrowing the funds. Investment bank
(underwrites) new securities: it guarantees a price for corporation’s securities and then sells
them to the public.
c) Secondary market:- is a financial market in which securities that have been previously
issued can be resold. Ex- The NSE & ASE and National Association of Securities Dealers’
Automated Quotation System (NASDAQ). Other examples are foreign exchange markets,
forward markets, futures markets, and options markets. Brokers match buyers with sellers of
securities; Dealers link buyers and sellers by buying and selling securities at stated prices
Secondary markets serve two important functions.
i. The increased liquidity of these instruments then makes them more desirable and
thus easier for issuing firm to sell in the primary market.
ii. Determine the price for primary equities.
4. By the timing of delivery;
a) Cash or Spot market:- A cash or spot market is one where the delivery occurs
immediately and
b) Forward or future market:- A forward or futures market is one where the delivery
occurs at a pre determined time in the future. (derivative market)
5. By the nature of its organizational structure:
a) Exchange Traded market:- An exchange traded market is characterized by a centralized
organization with standardized procedures.
b) Over the counter market:- An over the counter market is a decentralized market with
customized procedures.
Secondary markets can be organized in two ways
One is to organize exchanges, where buyers and sellers of securities (or their agents or brokers)
meet in the central location to conduct trades. Examples: The New York and American stock
exchanges for stocks, the Chicago Board of Trade for Commodities (wheat, corn, silver, and
other raw materials) and Ethiopian Commodities Exchange are examples of organized
exchanges.

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The other method is to have OTC market, in which dealers at different locations who have an
inventory of securities stand ready to buy and sell securities “over the counter” Because over-
the-counter sellers are in computer contact and know the prices set by one another, the OTC
market is very competitive and not very different from a market with an organized exchange.
Many common stocks are traded over-the-counter, although the largest corporations usually have
their shares traded at organized stock exchanges such as the New York Stock Exchange. The
U.S. government bond market, with a larger trading volume than the New York Stock Exchange,
is set up as an over-the-counter market. Other over-the-counter markets include those that trade
other types of financial instruments such as negotiable certificates of deposit, federal funds,
banker’s acceptances, and foreign exchange.

5.3. Market Participants

Participants in the national and global financial markets that issue and purchase financial claims
include
 Household,
 Business entities (corporations & partnership),
 National governments,
 National government agencies,
 State and local government, and
 Supranational (such as World Bank and the European investment bank)
 Regulators of financial market
6. Lending and borrowing in the financial system
Business firms, households and government play a wide variety of roles in modern financial
systems. It is quite common for an individual or institution to be a lender of funds in one period
and borrower in the next, or to do both simultaneously like financial intermediaries such as
banks, insurance companies etc which operates on both side of financial markets, borrowing
funds from customers by issuing attractive financial claims and simultaneously making loans
available to other customers.

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NB: each business firm, household or unit of government active in the financial system must
conform to the following identity.
R-E =FA-D
Current revenue –expenditures out of current revenue =change in holding FAs-change in
debt & equity outstanding
If our current expenditure (E) exceeds our current revenue (R), we usually make up the
difference by,
1. Reducing our holdings of financial assets (-FA). Eg by drawing money out of saving
account.
2. Issuing debt or stock(+D) or
3. Using some combination of both.
If our receipts (R) in the current period are larger than current expenditures (E), we can
1. Build up our holdings of our financial assets (+FA).Eg placing money in saving account,
purchasing new shares of stock or debt.
2. Pay off some outstanding debt or retire stock previously issued by our business firm(-D)
or
3. Do some combination of both.
It follows that for any given period of time (day, week, month, and year) the individual economic
unit must fall into one of the three groups.
1. Deficit budget unit(DBU) or net borrower of funds = E>R and so D>FA
2. Surplus budget unit(SBU) or net lender of funds = R>E and thus FA > D
3. Balance budget unit(BBU) = R=E and thus FA = D
N.B A net lender of funds is really a net supplier of funds to the financial system. It
accomplishes this function by purchasing financial assets, paying off debt, or retiring equity
(stocks). In contrast, a net borrower of funds is a net demander of funds from the financial
system, selling financial assets, issuing new stock or debt. The government and the business
sector of the economy tend to be net borrowers while the household sector composed of all
families and individuals tend to be net lender (supplier) of funds.

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 CHAPTER TWO
FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM

Objectives: - At the end of these unit students should be able to:-

 Define financial institution
 Explain functions of financial institutions
 Explain financial intermediaries and their role
 Classify depository and non-depository financial institutions
 Explain the principal risks of financial industries

2.1.Financial institutions
Institutions which permit indirect lending include both deposit-taking and non-deposit-
taking institutions. Financial institutions are the firms that provide access to the financial
markets; they sit between savers and borrowers and so are known as financial
intermediaries. A financial institution acts as an agent that provides financial services for
its clients. In general, financial institutions serve as intermediaries by channeling the
savings of individuals, business, and governments into loans and investments. The
primary suppliers of funds to financial institutions are individuals; the primary demanders
of funds are firms and governments.

[1]
 1.1. Financial institutions and capital transfer

If an individual wanted to make a loan to IBM or General Motors, for example, he or she
would not go directly to the president of the company and offer a loan. Instead, he or she
would lend to such companies indirectly through financial intermediaries, institutions that
borrow funds from people who have saved and in turn make loans to others.

Financial systems are never static. They change constantly in response to shifting
demands from the public, the development of new technology, and change in law and
regulations. Competition in the financial market place forces financial institutions to
respond to public need by developing better and more convenient financial service. The
growth of industrial centers with enormous capital investment need and the emergence of
a huge middle class of savers have played major roles in the gradual evolution of the
financial system.
The transfer of funds from savers to borrowers can be accomplished by three different
ways:
1. Direct finance
2. Semi-direct finance
3. Indirect finance

1. Direct Finance

With the direct financing technique, borrowers and lenders meet each other and exchange
funds in return for financial assets without the help of a third party to bring them
together. Here, deficit units (DSUs) and surplus units(SSUs) exchange money and
financial claims directly (to each other) without the involvement of intermediaries –
DSUs issue financial claims on themselves and sell them for money in financial markets
to SSUs. The SSUs hold the financial claims in their portfolios as interest bearing assets.

The claims issued by the DSU are called direct claims and are typically sold in direct
credit markets, such as the money or capital markets: Direct financing gives SSUs an
outlet for their savings, which provides an expected return, and DSUs no longer need to

[2]
postpone current consumption to forgo promising investment opportunities for lack of
funds. Thus, direct credit markets increase the efficiency of the financial system.

Direct method is the simplest method of carrying out financial transactions. However, it
has some limitations. For one thing, both borrowers and lenders must desire to exchange
the same amount of fund at the same time. Most importantly, the lender must be willing
to accept the borrower’s financial assets, which may be too risky or too slow to mature.
There must be want coincidence between the SBU and DBU.

Another problem is that both lenders and borrowers must frequently incur substantial
information cost simply to find each other.

2. Semi – Direct Financing

In early history of financial systems, a new form of financial transaction called semi
direct finance appears. To aid in the search process of bringing buyers and sellers
together, a number of market specialists exist. Some individuals and business firms
become security brokers and dealers whose essential function is to bring the surplus unit
and the deficit unit together, thereby reducing information costs.

Brokers are different from dealers in that a broker is merely an individual or financial
institution who provides information concerning possible purchases and sales of
securities. Either a buyer or a seller of securities may contact a broker, whose job is
simply to bring buyers and sellers together. Brokers do not actually buy or sell securities;
they only execute their clients’ transaction at the best possible price. They act merely as
matchmakers, bringing SSUs and DSUs together. Their profits are derived by bringing a
commission fee for their services.

A dealer also serves as an intermediary between buyers and sellers, but the dealer
actually acquires the seller’s securities in the hope of marketing them at a later time at a
favorable price.

A dealer’s primary function is to “make a market” for a security. Dealers do this by

carrying an inventory of securities from which they stand ready either to buy or sell

[3]
particular securities at stated prices. For example, a dealer making a market in a stock
might offer to buy shares from investors at Br. 100.00 and sell shares to other investors at
Br. 103.50. The bid price is (Br. 100.00) the highest price offered by the dealer to
purchase a given security; the ask price (103.50) is the lowest price at which the dealer is
willing to sell the security. The dealer’s gross profit is the Br. 3.50 differences between
the bid and the ask price, which is called the bid-ask spread.

Semi direct finance is an improvement over direct finance in a number of ways. It lowers
the information cost for both savers and borrowers. Usually, a dealer will split up a large
issue of primary securities in to smaller units affordable by even buyers of modest means
and, thereby, expand the flow of saving in to investment. In addition brokers and dealers
facilitate the development of secondary market in which securities can be offered for
resale.

Problems with the semi-direct financing: the ultimate lenders still winds up holding the
borrower securities and therefore, the lender have to be willing to accept the risk,
liquidity and maturity characteristics of the borrower financial assets. i,e there still must
be a fundamental coincidence of wants between surplus and deficit- budget units for
semi-direct financial transaction, to take place.

3. Indirect Financing

Flows can be indirect if financial intermediaries are involved. Financial intermediaries

transform financial claims in ways that make them more attractive to the ultimate
investor. Their fundamental role in the financial system is to serve both ultimate lenders
and borrowers but in much more complete way than brokers and dealers do. They
generally carry low risk of default.

The limitation of both direct and semi-direct financing stimulated the development of
indirect finance carried out with the help of financial intermediaries. Financial
intermediaries issue securities of these own-secondary securities to ultimate lenders and
at the same time accept financial assets from borrowers.

[4]
2.2. Functions of Financial Institutions
Financial institutions provide a service as intermediaries of the capital and debt markets.
These institutions provide services related to one or more of the following:
 Transforming financial assets acquired through the market and constituting them
into a different, and more widely preferable, type of asset-which becomes their
liabilities.
 Exchanging of financial assets on behalf of customers (Broker & dealer
functions)
 Exchanging of financial assets for their own account
 Assisting in the creation of financial assets for their customers, & then selling
those financial assets to other market participants(underwriting)
 Providing investment advice to other market participants.
 Managing the portfolios of other market participants.
2.3. Financial intermediaries and their roles
In a world of perfect financial markets there would be no need for financial
intermediaries (middlemen) in the process of lending and/or borrowing (Costless
transactions, Securities can be purchased in any denomination and Perfect information
about the quality of financial instruments).
A financial intermediary is defined as a bank when it performs both savings
mobilisation and lending. If a financial intermediary is only active on “one side of the
balance sheet” (i.e. it offers deposits but does not lend out to the public, or it offers loans
but gets funding from sources other than private savings) it is classified as a
non-bank financial intermediary. Many financial institutions play the role of a financial
intermediary. Services provided by financial intermediaries
• Information • Intergenerational Wealth
• Liquidity Transfer
• Reduced Transaction Costs
• Transmission of Monetary Policy
• Credit Allocation
• Payment Services

[5]
 Financial Intermediation: The Flow of Funds and Primary Securities

Funds Surplus Units Brokers Funds Deficit Units

Funds Surplus Units Dealers Funds Deficit Units

Funds Surplus Units Underwriters Funds Deficit Units

Investment Banks

Funds Surplus Units Mutual Funds Funds Deficit Units

Funds Surplus Units Banks Funds Deficit Units

Funds Surplus Units Insurance Companies Funds Deficit Units

Role of financial intermediaries (economic functions):

1. Transfer funds from savers to depositors: - funds transfer from surplus units to deficit
units through financial markets directly or indirectly through financial institutions.
2. Maturity intermediation: - In the absence of a CB, the borrower would have to borrow for
a short term, or find an entity that is willing to invest for the length of the loan sought, and/or
investor who makes deposits in the bank would have to commit funds for longer length of
time than they want. The CB by issuing its own financial claims in essence transforms a
longer-term asset into a shorter-term one by giving the borrower a loan for the length of time
sought and the investor/depositor a financial asset for the desired investment horizon.
3. Reducing risk via diversification: - Attaining cost-effective diversification in order to
reduce risk by purchasing the financial assets of financial intermediary is an important
economic benefit.
4. Reducing the cost of contracting; and information processing:- reduce cost of writing
loan contracts (contracting cost) , cost of time to process the information about the financial
asset & its issuer or cost of acquiring such information (information processing costs) and
cost of enforcing the terms of the loan agreement. All this activities requires professionals the
employment of such professionals is cost effective for financial intermediaries.
5. Providing a payment mechanism: - Most transactions made today are not done with cash.
Instead payments are made using checks, credit cards and electronic transfer of funds. These
methods for making payments called payment mechanisms are provided by certain financial
intermediaries.

[6]
2.4. Classifications of Financial Institutions
2.4.1. Depository and non-depository financial institutions.
Depository institutions are financial intermediaries that accept deposits from individuals and
institutions and make loans. These institutions make direct loan to the entities and invest in
securities. Their income is generated from the loans they make and the securities they purchased
(interest spread or margin) and fee income. depository institution can accommodate withdrawal
and loan demand: by attracting additional deposit, Use existing securities as collateral for
borrowing from federal agency or other financial institution such as investment bank, and Raise
short term funds in the monetary market. Depository financial institutions include; Commercial
banks, saving and loan associations, saving banks and Credit unions.
2.4.1.1. Commercial banks
Commercial banks are owned by private investors (stockholders), or by companies (bank
holding companies). Commercial banks are “for profit” organizations their objective is to make a
profit. Commercial banks provide numerous services in our financial system. These can be
classified as follows
a) Individual banking: - encompasses consumer lending, residential mortgage lending,
consumer installment loans, credit card financing, automobile financing, brokerage services,
student loans, and individual oriented financial investment services. Interest income and fee
income are generated from mortgage lending and credit card financing. Fee income is
generated from brokerage services.
b) Institutional banking: - Loans to nonfinancial corporations, financial corporations and
governmental entities.
c) Global banking:- It is in the area of global banking that banks began to compete head to
head with investment banking (or securities) firms. Global banking covers a broad range of
activities involving corporate financing and capital market and foreign exchange products
and services. Corporate financing: - involves first is procuring of funds for a bank’s
customers and the second one is that advice on strategies for obtaining funds, corporate
restructuring, and acquisitions. Capital market and foreign exchange products and services
involve transactions where the bank acts as a dealer or a broker in a service. Most global
banking activities generate fee income rather than interest income.

[7]
Sources of funds for banks:
1. Deposits:-
 Demand deposits (checking account) pay no interest and can be withdrawn upon demand.
 Saving deposit pay interest, typically below market rates, don not have specific maturity,
and usually can be withdrawn upon demand.
 Time deposit also called certificate of deposit, have a fixed maturity date and pay either a
fixed or floating interest rate.
2. Non-deposit borrowing: - includes borrowing from the Federal Reserve through the
discount window and borrowing by issuance of securities in the money and bond markets.
3. Issuing common stock
4. Retained earnings.

Regulators of commercial banks: - Because of the special role that commercial banks play in
the financial system, banks are regulated & supervised by federal & state government entities.

2.4.1.2. Saving and Loan Association (S&Ls)

S&Ls are either mutually owned or have corporate stock ownership. Mutually owned means
there is no stock outstanding, so technically the depositors are the owners. Like banks, the S&Ls
may be chartered under either state or federal statute. At the federal level, the primary regulator
of S&Ls is the federal saving and loan associations agency.
2.4.1.3.Saving Banks
Saving banks are institutions similar to, though much older than, S&Ls. They can be either
mutual owned (mutual saving banks) or stockholder owned. Asset structures of saving banks are
similar with that of S&Ls. The principal assets of saving banks are residential mortgages. The
principal sources of funds for saving banks are deposits. It offers similar deposits with S&Ls but
the ratio of deposit with that its total asset is greater than S&Ls. Deposits can be insured by
either the bank insurance fund or savings association insurance fund.
2.4.1.4. Credit Unions
They are either cooperative or mutually owned. The members deposit is called shares and the
distribution paid to the members is in the form of dividends, not interest. They are the only
financial institutions that are tax-exempt and can be chartered either by the states or by the

[8]
federal government. The principal sources of funds for saving banks are deposits. It offer similar
deposits with S&Ls but the ratio of deposit with that its total asset is greater than S&Ls.
Deposits can be insured by either the bank insurance fund or savings association insurance fund.
2.4.2. Non-depository institutions.
Non depository Institutions are institutions that serves as an intermediary between savers and
borrowers, but does not accept deposits. It includes financial service corporations, insurance
companies, investment banks, investment companies, mutual fund and exchange trade funds.
2.4.2.1.Financial Services Corporations:
Financial Services Corporation is in the lending or financing business, but they are not
commercial banks. One well known financial service corporation is GE capital, the finance unit
of the General Electric Corporation. GE capital provides commercial loans, financing programs,
commercial insurance, equipment leasing, and other services in over 35 countries around the
world. GE capital also provides credit services to more than 130 million customers that range
from retailers, auto dealers, consumers offering products and services from credit cards to debt
consolidation to home equity loans.
2.4.2.2.Insurance Companies
Insurance companies sell insurance to individuals and businesses to protect their investments.
They collect premium and hold the premium in reserves until there is an insured loss and then
pay out claims to the holders of the insurance contracts. Later, these reserves are deployed in
various types of investments including loans to individuals, businesses and the government.
2.4.2.3.Investment banks
Are specialized financial intermediaries that help companies and governments raise money and
provide advisory services to client firms on major transactions such as mergers. Firms that
provide investment banking services include Bank of America, Goldman Sachs, Morgan Stanley
and JP Morgan Chase.
2.4.2.4.Investment companies
Investment companies are financial institutions that pool the savings of individual savers and
invest the money in the securities issued by other companies purely for investment purposes.
2.4.2.5.Mutual Funds and Exchange Traded Funds (ETFs)
Mutual funds are professionally managed according to a stated investment objective.
Individuals can invest in mutual funds by buying shares in the mutual fund at the net asset value

[9]
(NAV). NAV is calculated daily based on the total value of the fund divided by the number of
mutual fund shares outstanding. Mutual funds can either be load or no-load funds. The term load
refers to the sales commission that you pay when acquiring ownership shares in the fund. These
commissions typically range between 4.0 to 6.0%. A mutual fund that does not charge a
commission is referred to as a no-load fund.
An exchange-traded fund (ETF) is similar to a mutual fund except that the ownership shares in
the ETF can be bought and sold on the stock exchange. Most ETFs track an index, such as the
Dow Jones Industrial Average and generally have relatively low expenses.
Mutual funds and ETFs provide a cost-effective way to diversify and reduce risk. If you had only
$10,000 to invest, it would be difficult to diversify since you will have to pay commission for
each individual stock. However, by buying a mutual fund that invests in S&P 500,you can
indirectly purchase a portfolio that tracks 500 stocks with just one transaction.

Hedge funds:- are similar to mutual funds but they tend to take more risk and are generally
open only to high net worth investors. Management fees also tend to be higher for hedge funds
and most funds include an incentive fee based on the fund’s overall performance, which typically
runs at 20% of profits.
Private Equity Firms:- Private equity firms include two major groups: Venture capital (VC)
firms and Leveraged buyout firms (LBOs).
a) Venture capital firms raise money from investors (wealthy individuals and other financial
institutions) that they then use to provide financing for private start-up companies when they
are first founded.
b) Leveraged buyout firms acquire established firms that typically have not been performing
very well with the objective of making them profitable again and selling them. An LBO
typically uses debt to fund the purchase of a firm.
2.5. Risks in Financial Industry
Financial institutions face the following risks;

1. Credit or default risk: - is the risk that a direct debt security issuer will not pay as agreed,
thus affecting the rate of return on a loan or security.
2. Interest rate risk: - is the risk of fluctuations in a security's price or reinvestment income
caused by changes in market interest rates.

[10]
3. Liquidity risk: - is the risk that the financial institution will be unable to generate sufficient
cash flow to meet required cash outflows.
4. Foreign exchange risk: - is the risk that foreign exchange rates will vary in the future
affecting the profit of the financial institution.
5. Political risk: - is the cost or variation in returns caused by actions of sovereign
governments or regulators.

[11]
 CHAPTER 3
Interest Rate Determination and Bond valuation
Introduction
The financial markets make saving possible by offering the individual saver a wide menu of
choices where funds may be placed at attractive rates of return. By committing funds to one or
more securities, the saver, in effect, becomes a lender of funds. The financial markets also make
borrowing possible by giving the borrower a channel through which securities can be issued to
lenders. And the financial markets make investment and economic growth possible by providing
the funds needed for the purchase of machinery and equipment and the construction of buildings,
highways, and other productive facilities.

Clearly, then, the acts of saving and lending and borrowing and investment are intimately linked
through the financial system. And one factor that significantly influences all of them is the rate
of interest. The rate of interest is the price a borrower must pay to secure scarce loanable funds
from a lender for an agreed up on period. It is the price of credit.
Theory of Interest Rate
There is not one interest rate in any economy for there are thousands of different interest rates in
the financial system. Even Securities issued by the same borrower will often carry a variety of
interest rates. In later sections the most important factors that cause rates to vary among different
securities are examined in detail. In this section our focus is upon those basic forces that
influence the level of all interest rate. We will assume in this section that there is one
fundamental interest rate in the economy known as the pure or risk- free rate of interest, which is
a component of all rates. In this section, we present the three most influential theories of the
determination of the interest rate: Fisher’s theory, loanable funds theory, and Keynes’s liquidity
preference theory.
1.1 Fisher’s Classical Approach
One of the oldest theories concerning the determinants of the risk- free interest rate is the
classical theory of interest rates. Irving Fisher analyzed the determination of the level of the
interest rate in an economy by inquiring why people save (that is, why they do not consume all
their resources) and why others borrow. Saving is the choice between current and future

1
consumption of goods and services. Individuals save some of their current income in order to be
able to consume more in the future.

A chief influence on the saving decision is the individual’s marginal rate of time preference,
which is the willingness to trade some consumption now for more future consumption. The
classical theory of interest assumed that individuals have a definite time preference for current
over future consumption. A rational individual, it was assumed, would always prefer current
enjoyment of goods and services over future enjoyment. Therefore, the only way to encourage an
individual or family to consume less now and save more was to offer a higher rate of interest on
current savings.

Another influence on the saving decision is income. Generally, higher current income means the
person will save more, although people with the same income may have different time
preferences. The third variable affecting saving is the reward for savings, or the rate of interest
on loans that savers make with their unconsumed income. As the interest rate rises, each person
becomes willing to save more, given that person’s rate of time preference.

The total savings (or the total supply of loans) available at any time is the sum of every body’s
savings and a positive function of the interest rate. Business, household, and government saving
are important determinants of interest rates according to the classical theory of interest, but not
the only ones. The other critical rate determining factor in the classical theory is investment
spending by business firms (demand for investment).

Businesses require huge amounts of funds each year for the purchase of equipment, machinery,
and inventories and to support the construction of new buildings and other physical facilities.
Firms will direct borrowed resources to projects in order of their profitability, starting with the
most profitable and proceeding to those with lower gains. The gain from additional projects, as
investment increases, is the marginal productivity of capital, which is negatively related to the
amount of investment. In other words, as the amount of investment grows, additional gains
necessarily falls as more of the less profitable projects are accepted.

2
The maximum that a firm will invest depends on the rate of interest, which is the cost of loans.
The firm will invest only as long as the marginal productivity of capital exceeds or equals the
rate of interest. In other words, firms will accept only projects whose gain is not less than their
cost of financing. Thus, the firms demand for borrowing is negatively related to the interest rate.
If the rate is high, only limited borrowing and investment make sense. At a low rate, more
projects offer a profit, and the firm wants to borrow more.

The classical theory argues that the equilibrium rate of interest is determined by two forces: (1)
the supply of savings, derived mainly from households, and (2) the demand for investment
capital coming mainly from the business sector.

Look at Figure 3-1. The demand curve is downward sloping because the demand for investment
capital is inversely ( negatively ) related to interest rate , whereas the supply curve is upward
sloping because the supply of savings is positively related to interest rate.

Interest rate
S

I
E

D
Savings /investment
QE

Figure 3-1: The Equilibrium rate of interest in the classical Theory

As shown in the figure, the equilibrium rate of interest ( I E ) is found at the intersection of the
demand curve (D) and supply curve ( S) . The equilibrium level of savings (which is the same as

3
the equilibrium level of investment capital) is given as Q E. QE reflects the size of investment
capital or savings at the rate of interest I E.

Limitations of the classical Theory of interest

The classical theory sheds considerable light on the factors affecting interest rates. However, it
has some serious limitations. The central problem is that the theory ignores several factors other
than saving and investment which affect interest rates. For example, commercial banks have the
power to create money by making loans to the public. When borrowers repay their bank loans,
money is destroyed. The amount of money created or destroyed affects the total amount of credit
available in the financial market place and therefore must be considered in any explanation of the
factors determining interest rates.

In addition, the classical theory assumes that interest rates are the principal determinants of the
quantity of savings available. Today, economists recognize that income is far more important in
determining the volume of saving. Finally, the classical theory contends that the demand for
borrowed funds comes principally from the business sector. Today, however, both consumers
and governments are important borrowers, significantly affecting credit availability and cost.

1.2 The Loanable Funds Theory

The Fisher’s classical theory neglects certain practical matters, such as the power of the
government (in concert with depository institutions) to create money and the government’s often
large demand for borrowed funds, which is frequently immune to the level of the interest rate.
Expanding Fisher’s theory to encompass these situations produces the loanable funds theory of
interest rates.

-
This view argues that the risk–free interest rate is determined by the interplay of two forces the

demand and the supply of loanable funds. The demand for loanable funds consists of demand for
funds by firms, governments, and households (or individuals) which carry out a variety of
economic activities with those funds. This demand is negatively related to the interest rate
(except for the government’s demand, which may frequently not depend on the level of the
interest rate). The supply of loanable funds stems from firms, governments, banks and

4
individuals. Supply is positively related to the level of interest rates, if all other economic factors
remain the same. With rising rates, firms and individuals save and lend more, and banks are
more eager to extend more loans. (A rising interest rate probably does not significantly affect the
government supply of savings.) The intersection of the supply and demand functions sets the
equilibrium interest rate level and the equilibrium level of loans . In equilibrium, the demand
for funds equals the supply of funds.

1.3 The Liquidity preference theory

The liquidity preference theory, originally developed by John Maynard Keynes, analyzes the
equilibrium level of the interest rate through the interaction of the supply of money and the
public’s aggregate demand for holding money. In the theory of liquidity preference, only two

-
outlets for investor funds are considered bonds and money.

For Keynes, money is equivalent to currency and demand deposits, which pay little or no
interest but are liquid and may be used for immediate transactions. Bonds include long–term,
interest– paying financial assets that are not liquid and that pose some risk because their prices
vary inversely with the interest rate level. Bonds may be liabilities of governments or firms.

Keynes observed that the public demands money for three different purposes (motives). The
transactions motive represents the demand for money in order to purchase goods and services.
Because inflows and outflows of money are not perfectly synchronized in timing or amount,
businesses, households, and governments must keep some money simply to meet daily expenses.
Some money also must be held as a reserve for future emergencies and to cover extra ordinary
expenses. This precautionary motive arises because we live in a world of uncertainty and
cannot predict exactly what expenses or opportunities will arise in the future. The third motive
for holding money- the speculative motive stems from uncertainty about the future prices of
bonds. The total demand for money in the economy is simply the sum of transactions,
precautionary, and speculative demands.

The demand for money is a negative function of the interest rate. At a low rate, people hold a lot
of money because they do not lose much interest by doing so and because the risk of a rise in

5
rates (and a fall in the value of bonds) may be large. With a high interest rate, people desire to
hold bonds rather than money.
For Keynes, the supply of money is fully under the control of the central bank. Moreover, the
money supply is not affected by the level of the interest rate. Thus, the supply of money appears,
in Figure 3-2, as the vertical line, MS.

Rate of interest
Ms Supply of money

iE
Total demand for money

D
O
Quantity of money demanded and supplied
Figure 3-2

As shown in figure 3-2, the equilibrium rate of interest is found at point iE where the quantity of
money demanded by the public equals the quantity of money supplied. Above this equilibrium
rate, the supply of money exceeds the quantity demanded, and some businesses, households, and
units of government will try to dispose of their unwanted money balances by purchasing bonds.
The prices of bonds will rise, driving interest rates down toward equilibrium at iE. On the other
hand, at rates below equilibrium, the quantity of money demanded exceeds the supply. Some
decision makers in the economy will sell their bonds to raise additional cash, driving bond prices
down and interest rates up toward equilibrium.

6
Bond Valuation and yield on a Bond
Overview

Bond valuation refers to the determination of the fair market value of a bond. Under an efficient
market, this value reflects the market price of the bond. The interest rate on a loan is the annual
rate of return promised by the borrower to the lender as a condition for a obtaining the loan.
However, that rate is not necessarily a true reflection of the yield or rate of return actually earned
by the lender during the life of the loan.

2.1. Bond valuation

The true or correct price of a bond equals the present value of all cash flows that the holder of the
bond expects to receive during its life. The cash flows from the bond include the annual interest
payment and its final sales price (or par value for bonds held until maturity). In general, the
correct price for a bond can be expressed as follows:

CF1 CF2 CF3 CFN

VB =   
(1  r ) 1  r  1  r 
1 2 3
1  r N

Where VB = the price of the bond

CFt = the cash flow in year t (t=1, 2, 3, - - -, N)
N = maturity of the bond
r = appropriate discount rate

For coupon bonds, because the annual interest payment is constant, the formula can be restated
as:
C C C C M
VB =    
1  r  1  r  1  r 
1 2 3
1  r  1  r N
N

Where C = annual coupon payment

7
 M = maturity (Par) value
Using the annuity formula, this can be rearranged to give:

1
1
VB == C
1  r N 
M
r 1  r N

The above formula assumes that the discount rate is constant through out the
life of the bond. However, if yearly market interest rates differ from year to year,
the formula for VB is:

C C CM
VB =  
1  r1  1  r1 (1  r2 ) 1  r1 (1  r2 )    (1  rN )
Where rt is the yearly market interest rate (discount rate) for year t.

Example
Suppose an investor purchases a four-year bond with a face value (par value) of Br. 1,000
which pays coupon interest of 10 percent annually. Assume that the one–year rates for the next
four years are: r1 = 0.07; r2 = 0.08; r3= 0.09; r4 = 0.10. What is the value of the bond?

100  100 100 1,100

VB =  
1.07 1.07 (1.08) (1.07)1.08(1.09) 1.07 1.080.09(1.10)
VB = Br. 1053.28

If the bond is perpetual one, then its value is the annual coupon payment ( C ) divided by
market interest rate assuming that the rate is constant through out its life. Let us see how this is
so. Assume VPB denotes the value of the perpetual bond.

8
 C C C M
VPB =   
1  r  1  r 
1 2
1  r  1  r N
N

Using the annuity formula, this can be rearranged to give:

1
1
1  r N M
VPB = C 
r 1  r N

Since (1+r)N is a very large number as N goes to infinitive, then

1 M
, ≈ 
1  r  1  r N
N

C
Thus, VPB ≈
r

Example
Suppose you purchased a perpetual bond with par value of Br. 1000 that pays coupon interest of
10 percent annually. Suppose the market interest rate on similar bonds is 8 percent and this rate
is expected to prevail for many years to come. What is the value of the bond?

Annual coupon payment (C) =Br. 1000 X 0.10

C =Br. 100
100
VPB =  Br1,250
0.08

In the absence of transaction costs, the following relation ships hold true in bond valuation:
1. If coupon interest rate is greater than market interest rate, the bond will be highly
demanded and sells above par value. Such bonds are said to be sold at a premium.

9
2. If coupon interest rate is less than the market interest rate then the bond will be sold
below par value. This is because the bond is less attractive as its coupon payment is lower
than what the market is paying. Such bonds are said to be sold at a discount.
3. If coupon interest rate equals market interest rate the bond will have neither premium nor
discount and such bonds trade at par.
2.2 Measures of the Rate of Return or Yield
There are different measures of the rate of return or yield on a bond. The following
paragraphs present these different measures:

Coupon Rate
One of the best known measures of the rate of return on a debt security is the coupon rate .
The coupon rate is the contracted rate which the security issuer agrees to pay at the time a
security is issued. If for example , a company issues a bond with a coupon rate printed on its
face of 9 percent , the borrower has promised the investor annual interest payment of 9
percent of the bond’s par value.

The coupon rate is not an adequate measure of the return on a bond or other debt security
unless the investor purchases the security at a price equal to its par value, the borrower makes
all of the promised payments on time, and the investor sells or redeems the bond at its par
value. However, the prices of bonds fluctuate with market conditions; rarely will a bond trade
exactly at par.

Current Yield
Another popular measure of the return on a loan or security is its current yield. This is simply
the ratio of the annual income (coupon interest) generated by the bond to its current market
value. Thus, a bond selling in the market for Br. 1000 and paying an annual coupon payment
of Br. 100 would have a current yield calculated as follows:

Current yield = Annual income = Br. 100= 0.10 or 10%

Market Price of Security Br. 1000

10
Like the coupon rate, the current yield is usually a poor reflection of the rate of return actually
received by the lender or investor. It ignores the stream of actual and anticipated payments
associated with a loan or security and the price at which the investor will be able to sell or
redeem it.

Yield to Maturity
The most widely accepted measure of the rate of return on a bond or security is its yield to
maturity. The yield to maturity is the rate which equates the purchase price of a bond or other
financial asset (P) with the present value of all its expected annual net cash inflows. In general
terms,

CF1 CF2 CFN

P=  
1  y  1  y 
1 2
1  y N

Where y is the Yield to maturity and each CF represents the expected annual cash flows from the
bond, presumed to last for N Years.

Example
Assume an investor is considering the purchase of a bond due to mature in 20 Years, carrying a
10 Percent coupon rate. This security is available for purchase at a current market price of Br.
850. If the bond has par value of Br. 1,000 which will be paid to the investor when the security
reaches maturity, the bond’s yield to maturity, y, may be found by solving,

Br .100 Br .100 Br .100 Br .1000

Br. 850 =   
1  y  1  y 
1 2
1  y 20 1  y 20

By trial and error, the value of y (Yield to maturity) is found to be 12 percent.

11
Unlike the current Yield, the yield to maturity measure considers the time distribution of
expected cash flows from a security or other financial asset. Of course, the yield–to-maturity
measure does assume the investor will hold a security until it reaches final maturity. Moreover,
yield to maturity is not an appropriate measure for those securities which are perpetual
instruments, and even for some bonds, because the investor may sell them prior to their
termination date. Another Problem is that this measure assumes all cash flowing to the investor
can be reinvested at the computed yield to maturity.

Holding period Yield

A slight modification of the Yield-to-Maturity formula results in a return measure for those
situations where an investor holds a bond security or other financial asset for a time and then
sells it to another investor in advance of the asset’s maturity. This so-called holding Period Yield
is simply,

CF1 CF2 CFm

P=  
1  h  1  h 
1 2
1  h m

Where h is the holding Period Yield, and the total length of the investor’s holding Period covers
m time Periods.

Thus, the holding Period Yield is simply the rate of discount ( h ) equalizing the market price of
a financial asset ( p ) with all net cash flows between the time the asset is purchased and the time
it is sold ( including the selling price ) . If the asset is held to maturity, its holding period yield
equals its yield to maturity.

Example
Suppose an investor is contemplating the purchase of a corporate bond, Br. 1000 par value with a
coupon rate of 10 percent. To simplify the problem, assume the bond pays interest just once each
year. Currently the bond is selling for Br. 900. The investor plans to hold the bond to maturity,
which occurs in five years. What is the holding period yield? What is the yield to maturity?

12
Solutions
The current market price of the bond is Br. 900 while the par Value is Br.1000.Since the bond is
trading at a discount; the initial guess should be 12 percent (a rate higher than 10 percent). To
determine how accurate a guess it is, we need to calculate the present value of the bond’s cash
inflows.

100 100 100 100 1,100

P =    
1.12 1
1.12 2
1.12 3
1.12 4
1.125

P = Br. 927.90

This value is higher than br.900. Thus, for the present value of the cash inflows to become 900,
the next trial should be at a higher rate. Let us check it at 14 percent.

100 100 100 100 1100

p=    
1.14 1.14 1.14 1.14 1.145
1 2 3 4

P=Br. 862.70

This value is lower than Br 900. This shows that the holding period yield is between 12 percent
and 14 percent. The use of linear interpolation helps us to determine the bond's approximate
holding period yield. Thus, the holding period yield (h) is:

Discount rate PV of bond

12% 927.90 27.90

2% h 900 65.20
14% 862.70

13
  27.90 
h= 12% +   X 2%
 65.20 
h= 12% + 0.86%
h= 12.86%
Since the bond is held until maturity, the holding period yield is equal to the bond’s yield to
maturity. Hence, the yield to maturity of the bond is 12.86 percent.

Approximate average annual yield

This formula simply assumes that,

Approximate average annual yield=Average annual income from the security
Average amount of funds invested in the security
In the case of a bond, for example, the approximate yield would be composed of annual interest
income plus (minus) the average amount of price appreciation (depreciation) which occurs each
year. The average amount of funds invested can be represented by the simple arithmetic average
of the purchase price and the expected selling price of the security. That is:
Approximate average annual yield= Annual interest income + Price appreciation
(Or depreciation)
Years remaining until
Sold
Purchase price +Selling price
2

To illustrate the use of this formula, suppose an investor is considering the purchase of a bond
with a current market price of Br. 900, a coupon rate of 10 percent, and the bond will be sold or
redeemed in 10 years at an expected price of Br. 1,000. Assume the par value is 1000. The
approximate expected yield would be

Approximate average annual = Br. 100+ (Br.1000-900)

Yield on bond 10 = Br 110
Br.900 +Br 1000 Br 950
2
= 11.58%

14
Note that the investor expects a price appreciation of Br.100 over the remaining life of this bond
because it sells currently for Br.900 and will be redeemed in 10 years for Br. 1000. The average
gain in price, therefore, is Br.10 per year.

The same formula may be used in the case of a bond that is expected to experience a depreciation
in price between time of purchase and time of sale. Suppose an investor wishes to purchase a
Br.1000 par value bond currently selling for Br. 1200 with a coupon rate of 10 percent. If the
bond matures in 10 years and is held to maturity,

Approximate
Average annual = Br.100 + (Br. 1000-Br. 1200)
Yield on bond 10
Br. 1200 +Br. 1000
2
= Br. 80 = 7.27%
Br. 1100

Yield- Price Relationships

The foregoing yield-to-maturity and holding period yield formulas illustrate a number of
important relationships between bond prices and yields or interest rates which prevail in the
financial system. One of these important relationships is:
The prices of a security and its yield or rate of return are inversely related. A rise in
yield implies a decline in price; conversely, a fall in yield is associated with a rise in
the security's price.

Determinants of the Structure of Interest Rate

The Base Interest Rate

The securities issued by the US. department of the treasury, popularly referred to as Treasury
securities or simply treasuries, are backed by the full faith and credit of the US. government.

15
Consequently, market participants throughout the world view them as having no credit risk. As a
result, historically the interest rates on Treasury securities have served as the bench mark interest
rates throughout the US economy, as well as in international capital markets.
Treasury securities are typically issued on an auction basis according to regular cycles for
securities of specific maturities. Current Treasury practice is to issue all securities with maturities
of one year or less as discount securities. These securities are called treasury bills. All securities
with maturities of two years or longer are issued as treasury coupon securities.

The most recently auctioned treasury issues for each maturity are referred to as an on-the-run or
current coupon issues. Issues auctioned prior to the current coupon issues are typically referred
to as off-the-run issues; they are not as liquid as on-the-run issues, and ,therefore, offer a higher
yield than the corresponding an on-the-run treasury issue. The minimum interest rate or base
interest rate that investors will demand for investing in a non-treasury security is the yield
offered on a comparable maturity for an on-the-run treasury security.

The Risk Premium

Market participants talk of interest rates on non-treasury securities as "trading at a spread" to a
particular on-the-run treasury security (or a spread to any particular benchmark interest rate
selected). For example, if the yield on a 15-year non-treasury security is 8% and the yield on a
15-year treasury security is 6%, the spread is 2%. This spread reflects the additional risks the
investor faces by acquiring a security that is not issued by the US government and, therefore, can
be called a risk premium. Thus, we can express the interest rate offered on a non-treasury
security as:

Base interest rate + spread

Or equivalently,
Base interest rate + risk premium

Turning to the spread, the factors that affect it are:

1. The type of issuer
2. The issuer's perceived credit worthiness

16
 3. The term to maturity of the instrument
4. Provisions that grant either the issuer or the investor the option to do something
5. The taxability of the interest received by investors and
6. The expected liquidity of the issue.

Types of issuers
Debt securities can be issued by governments, government agencies, municipal governments,
corporations (domestic and foreign) and foreign governments. The risk premium depends on the
nature of the issuing entity.

Perceived credit worthiness of issuer

Default risk or credit risk refers to the risk that the issuer of a bond may be unable to make
timely principal or interest payments. Securities having higher default risk will have a higher risk
premium than securities having lower default risk.

Term to maturity
The volatility of a bond's price is dependent on its maturity. More specifically, with all other
factors constant the longer the maturity of a bond, the greater the price volatility resulting from a
change in market yields. Thus, securities having long term maturities trade at a higher risk
premium than those with short term maturities.

Inclusion of options
It is not uncommon for a bond issue to include a provision that gives either the bond holder and
/or the issuer an option to take some action against the other party. An option that is included in a
bond issue is referred to as an embedded option. Some of the types of options in a bond issue
include call provision, put provision and conversion provisions.

The presence of these embedded options has an effect on the spread of an issue relative to a
Treasury security and the spread relative to otherwise comparable issues that do not have an
embedded option. In general, market participants will require a larger spread over a comparable
treasury security for an issue with an embedded option that is favorable to the issuer (e.g. a call

17
option) than for an issue without such an option. In contrast, market participants will require a
smaller spread over a comparable treasury security for an issue with an embedded option that is
favorable to the investor (for example, put option and conversion option).

Taxability of interest
The interest income generated from security is taxable unless it is exempted by law. The yield on
tax exempt securities is less than those that are not, provided that both have the same maturity.

The yield on a taxable bond after tax is equal to:

After-tax yield = pretax yield X (1-marginal tax rate)

For example, suppose a taxable bond issue offers a yield of 10% and is acquired by an investor facing a
marginal tax rate of 40%. The after- tax yield would then be:

After-tax yield= 0.1 X (1-0.4) =0.06= 6%

Alternatively, we can determine the yield that must be offered on a taxable bond issue to give the same
after tax yield as a tax-exempt issue. This yield is called the equivalent taxable yield and is determined as
follows:

Equivalent taxable yield= tax-exempt yield

(1-marginal tax rate)

For example, consider an investor facing a 40% marginal tax rate who purchases a tax-exempt issue with
a yield of 6% .The equivalent taxable yield is then:

Equivalent taxable yield = 0.06 = 0.1 = 10%

(1-0.4)

Notice that the lower the marginal tax rate, the lower the equivalent taxable yield. Thus, in our previous
example, if the marginal tax rate is 25% rather than 40%, the equivalent taxable yield would be 8% rather
than 10%, as shown below:

Equivalent taxable yield = 0.06 = 0.08 = 8%

18
 (1-0.25)

Expected liquidity of an issue

Bonds trade with different degrees of liquidity. The greater the expected liquidity with which an issue will
trade, the lower the yield that investors would require. Treasury securities are the most liquid securities in
the world. The lower yield offered on treasury securities relative to non-treasury securities reflects to a
significant extent, the difference in liquidity. Even with in the Treasury market, some differences in
liquidity occur, because on-the-run issues have greater liquidity than off-the-run issues.

19
 CHAPTER 4
Financial Markets in the Financial System
Introduction
In order to finance their operations as well as expand, business firms must invest capital in
amounts that are beyond their capacity to save in any reasonable period of time. Similarly,
governments must borrow large amounts of money to provide the goods and services that the
people demand of them. The financial markets permit both business and government to raise the
needed funds by selling securities. Simultaneously, investors with excess funds are able to invest
and earn a return, enhancing their welfare.
A financial market, like any market, is just a way of bringing buyers and sellers together. In
financial markets, it is financial assets such as debt and equity securities that are bought and sold.
Financial markets differ in detail, however. The most important differences concern the types of
securities that are traded, how trading is conducted, and who the buyers and sellers are.
Financial markets are absolutely vital for the proper functioning of capitalistic economies, since
they serve to channel funds from savers to borrowers. Furthermore, they provide an important
allocative function by channeling the funds to those who can make the best use of them –
Presumably, the most productive.
In fact, the chief function of a financial market is to allocate resources optimally . In this chapter,
we will discuss the different types of financial markets.
Section 1: Primary versus Secondary Markets
Overview
Financial markets function as both primary and secondary markets for securities. The term
primary market refers to the original sale of securities by governments and corporations.
The secondary markets are those in which these securities are bought and sold after the original
sale. Equities are, of course, issued solely by corporations. Debt Securities are issued by both
governments and corporations. In this section, we will discuss the basic differences between
primary and secondary markets in detail.
Primary market
A primary market is one in which a borrower issues new securities in exchange for cash from an
investor (buyer). The issuers of these new securities receive cash from the buyers of these new
securities, who in turn receive financial claims that previously did not exist.
If the issuer is selling securities for the first time, these are referred to as initial public offerings
(IPOs). Alternatively, a primary market sale may be a seasoned offering, in which the firm
already has securities trading in the secondary markets. In general, the primary market involves
the distribution to investors of newly issued securities by central governments, its agencies,
municipal governments and corporations. The participants in the market place that work with
issuers to distribute newly issued securities are called investment bankers. Investment bankers
perform one or more of three functions: (1) advising the issuer on the terms and the timing of the
offering; (2) Buying the securities from the issuer; and (3) distributing the issue to investors.
Once the original buyers sell the securities, they trade in secondary markets. It is in the
secondary market where already issued financial assets are traded. Out standing securities may

1
trade repeatedly in the secondary market, but the original issuers will be unaffected in the sense
that they receive no additional cash from these transactions.
The Underwriting Process
Underwriting securities can be undertaken in various ways including the bought deal for the
underwriting of bonds, the auction process for both stocks and bonds, and rights offering for
underwriting common stock. This section presents the auction process for underwriting
securities.
Auction Process
In this method, the issuer announces the terms of the issue, and interested parties submit bids for
the entire issue. It is more commonly referred to as a competitive bidding underwriting. For
example, suppose that a public utility wishes to issue Br. 100 million of bonds. Various
underwriters will form syndicates and bid on the issue. The syndicate that bids the lowest yield
(i.e., the lowest cost to the issuer) wins the entire Br. 100 million bond issue and then reoffers to
the public.
In a variant of the process, the bidders indicate the price they are willing to pay and the amount
they are willing to buy. The security is then allocated to bidders from the highest bid price
(lowest yield in the case of a bond) to the lower ones (higher yield in the case of a bond) until the
entire issue is allocated.
Example
Suppose that an issuer is offering Br. 500 million of a bond issue, and nine bidders submitted the
following yield bids:
Bidder Amount (in millions) Bid Yield
A Br. 150 5.1 %
B 110 5.2
C 90 5.2
D 100 5.3
E 75 5.4
F 25 5.4
G 80 5.5
H 70 5.6
I 85 5.7
Secondary markets
A secondary market transaction involves one owner or creditor selling to another. It is therefore
the secondary markets that provide the means for transferring ownership of corporate securities.
Although a corporation is only directly involved in a primary market transaction (when it sells
securities to raise cash ) , the secondary markets are still critical to large corporations. The reason
is that investors are much more willing to purchase securities in a primary market transaction
when they know that those securities can later be resold if desired.
Thus, the existence of well–functioning secondary markets, where investors come together to
trade existing securities, assures the purchasers of primary securities that they can quickly sell
their securities if the need arises. Of course, such sales may involve a loss, because there are no

2
guarantees in the financial markets. A loss, however, may be much preferred to having no cash at
all if the securities can not be sold readily.
The key distinction between a primary market and a secondary market is that, in the secondary
market, the issuer of the assets does not receive funds from the buyer. Rather, the existing issue
changes hands in the secondary market, and funds flow from the buyer of the asset to the seller.
Section 2: Money market
Overview
The money market, like all financial markets, provides a channel for the exchange of financial
assets for money. However, it differs from other parts of the financial system in its emphasis
upon loans to meet purely short-term cash needs. The money market is the mechanism through
which holders of temporary cash surpluses meet holders of temporary cash deficits. It is
designed, on the one hand , to meet the short-run cash requirements of corporations, financial
institutions, and governments, providing a mechanism for granting loans as short as overnight
and as long as one year to maturity. At the same time, the money market provides an investment
outlet for those units ( principally corporations, financial institutions and governments) that hold
surplus cash for short periods of time and wish to earn at least some return on temporary idle
funds. The essential function of the money market, of course, is to bring these two groups in to
contact in order to make borrowing and lending possible. In this section we will discuss the
different types of financial instruments that trade in the money market.
Treasury Bills
Treasury bills are issued by the treasury department of the government and backed by the full
faith and credit of the government. As a result, treasury bills carry no risk of default. The market
for treasury bills is the most liquid market in the world.
A treasury bill is a discount security. Such securities do not make periodic interest payments.
The security holder receives interest instead at the maturity date, when the amount received is the
face value (maturity value or par value) which is larger than the purchase price. For example,
suppose an investor purchases a 182-day Treasury bill that has a face value of Br. 100,000 for
Br. 96,000. By holding the bill until the maturity date, the investor will receive Br. 100,000; the
difference of Br. 4000 between the proceeds received at maturity and the amount paid to
purchase the bill represents the interest.
Bid and offer Quotes on Treasury Bills
The convention for quoting bids and offers is different for Treasury bills and Treasury coupon
securities. Bids and offers on Treasury bills are quoted in a special way. Unlike bonds that pay
coupon interest, Treasury bill values are quoted on a bank discount basis, not on a price basis.
The annualized yield on a bank discount basis expressed as a decimal (Y) is computed as
follows:
Y= D X 360
F t
Where D = Discount, which is equal to the difference between the face value and the price.
F= Face value
t= number of days remaining to maturity.

3
As an example, a Treasury bill with 100 days to maturity, a face value of Br. 100,000 and selling
for Br. 97,569 would be quoted at 8.75% on a bank discount basis:

D= Br. 100,000 – Br. 97,569

= Br. 2,431
Therefore:
Y= Br.2, 431 X 360
Br. 100,000 100
= 8.75%
Given the yield on a bank discount basis, the price of a Treasury bill is found by first solving the
formula for Y, for the discount as follows:

D = Y x F x t / 360
The price is then:
Price = F- D
Price = F - YFt
360
Price= F (1 – Yt )
360
Example:
You want to purchase a 180 day Treasury bill with a face value of Br. 100,000 and a yield on a
bank discount basis of 8%.What is the price of the Treasury bill? What is the birr return on this
bill?

Price = 100,000(1 - (0.08 X 180))

360
Price = Br. 96,000
Return (discount) = Br. 100,000 – Br. 96,000
= Br 4,000
The return (yield) on a treasury bill is measured based on face value rather than actual amount
invested. Thus, Y is not a true reflection of the return actually earned on a treasury bill.
Commercial Paper
Commercial paper is a short-term unsecured promissory note that is issued in the open market
and represents the obligation of the issuing corporation. The issuance of commercial paper is an
alternative to bank borrowing for large corporations (non financial and financial) with strong
credit ratings.
Commercial paper, like treasury bills, is a discount instrument. Despite the fact that the
commercial paper market is larger than markets for other money market instruments, secondary
trading activity is much smaller. The yield on commercial paper is higher than treasury bills for
the same maturity. There are three reasons for this. First, unlike treasury bills, the investor in
commercial paper is exposed to credit risk. Second, interest on treasury bills is exempted from

4
tax; however, interest on commercial paper is taxable. To offset this tax advantage, commercial
paper should offer higher yield. Third, commercial paper is less liquid than treasury bills.
Bankers Acceptances
Simply put, a bankers acceptance is a vehicle created to facilitate commercial trade transactions.
The instrument is called a bankers acceptance because a bank accepts the ultimate responsibility
to repay a loan to its holder. Bankers acceptances are sold on a discounted basis just as treasury
bills and commercial paper. The major investors in bankers acceptances are money market
mutual funds and municipal entities.

Investing in bankers acceptances exposes the investor to credit risk. This is the risk that neither
the borrower nor the accepting bank will be able to pay the principal due at the maturity date.
The market interest rates that acceptances offer investors reflect this risk- bankers acceptances
have higher yields than treasury bills. The higher yield relative to treasury bills also includes a
premium for relative illiquidity.
Certificate of Deposits (CDs)
A certificate of deposit (CD) is a financial asset issued by a bank or thrift that indicates a
specified sum of money has been deposited at the issuing depository institution. CDs are issued
by banks and thrifts to raise funds for financing their business activities. A CD bears a maturity
date and a specified interest rate and can be issued in any denomination.
A CD may be non–negotiable or negotiable. In the former case, the initial depositor must wait
until the maturity date of the CD to obtain the funds. If the depositor chooses to withdraw funds
prior to the maturity date, an early withdrawal penalty is imposed. In contrast, a negotiable CD
allows the initial depositor (or any subsequent owner of the CD) to sell the CD in the open
market prior to the maturity date. Unlike treasury bills, commercial paper , and bankers
acceptances, yields on CDs are quoted on an interest bearing basis. CDs with a maturity of one
year or less pay interest at maturity . For purposes of calculating interest , a year is treated as
having 360 days.
Repurchase Agreements
A repurchase agreement is the sale of a security with a commitment by the seller to buy the
security back from the purchaser at a specified price at a designated future date. Basically, a
repurchase agreement is a collateralized loan, where the collateral is a security. When the term of
the loan is one day, it is called an ‘’ overnight repo ‘’, a loan for more than one day is called a ‘’
term repo’’
Example
Suppose a bank enters a reverse repurchase agreement in which it agrees to buy treasury
securities from one of its correspondent banks at a price of Br. 10,000,000 with the promise to
sell these securities back at a price of Br. 10,008,548 (Br. 10,000,000 plus interest of Br. 8,548)
after five days. The yield on this repo to the bank is calculated as follows:
iRA = Br.10,008,548 - Br. 10,000,000 X 360
Br. 10,000,000 5
= 6.15%
Where iRA = Yield on repurchase agreement

5
Section 3: Equity Market
Overview
Equity security is a certificate of ownership in a corporation–residual claim against both the
assets and the earnings of a business firm. Corporate stock grants the investor no promise of
return as debt does but only the right to share in the firm’s net assets and net earnings, if any.
Corporate stock is unique in one other important respect. Debt securities are intimately bound up
with the process of moving funds from ultimate savers to ultimate borrowers in order to support
investment and economic growth. In the stock market, however, the bulk of trading activity
involves the buying and selling of securities already issued rather than the exchange of financial
claims for new capital. In this section, we take a close look at the basic characteristics of
corporate stock, the markets where that stock is traded, valuation and returns of stocks and
pricing efficiency of the stock market.
Where Stock Trading Occurs
The four major types of markets on which stocks are traded are referred to as follows:
First market-trading on exchanges of stocks listed on an exchange.
Second market- trading in the OTC market of stocks not listed an on exchange.
Third market-trading in the OTC market of stocks listed on an exchange.
Fourth market- Private transactions between institutional investors who deal directly with each
other without utilizing the services of a broker-dealer intermediary. These types of markets are
discussed below
Organized Exchanges
Stock exchanges are formal organizations, approved and regulated by the Securities and
Exchange Commission (SEC). These exchanges are physical locations where members assemble
to trade. Stocks that are traded on an exchange are said to be listed stocks. That is, these stocks
are individually approved for trading on the exchange by the exchange. The trading mechanism
on exchanges is the auction system, which results from the presence of many competing buyers
and sellers assembled in one place.
In the United States, there are two national stock exchanges: (1) the New York stock exchange
(NYSE), commonly called the Big Board, and (2) the American stock Exchange (AMEX or
ASE), also called the curb. National stock exchanges trade stocks of not only U.S corporations
but also non-U.S. corporations. In addition to the national exchanges, there are regional stock
exchanges in Boston, Chicago (called the Midwest exchange), Cincinnati; San Francisco (called
the pacific coast exchange). Regional exchanges primarily trade stocks from corporations based
within their region.
The OTC Market
The OTC market is called the market for unlisted stocks. It results from geographically dispersed
traders or market-makers linked to one another via telecommunication systems. That is, there is
no trading floor. This trading mechanism is a negotiated system where by individual buyers
negotiate with individual sellers.
The large majority of securities bought and sold around the globe, especially debt securities are
traded over-the-counter (OTC) and not on organized exchanges. All money market instruments
are traded in the over-the-counter markets, as are the large majority of government bonds and

6
corporate bonds. While most common stocks are traded on exchanges, an estimated one quarter
to one third of all stocks are traded OTC. The U.S. OTC market is regulated by a code of ethics
established by the National Association of Security Dealers (Self-regulatory organization), a
private organization that encourages ethical behavior among its members. Trading firms or their
employees who break NASD’S regulations may be fined, suspended, or thrown out of the
organization. One of the most important contributions of NASD has been the development of
NASDAQ (the National Association of Security Dealers Automated Quotations system).
NASDAQ displays bid and ask prices for OTC-traded securities on video screens connected
electronically to a central computer system. All NASD member firms trading in a particular
stock report their bid-ask price quotations immediately to NASDAQ. This nationwide
communications network allows dealers, brokers, and customers to determine instantly the terms
currently offered by major securities dealers.
The Third Market: Trading In Listed Securities off the Exchange
The market for securities listed on a stock exchange but traded over the counter is known as the
third market. Broker and dealer firms not members of an organized exchange are active in this
market. The original purpose of the third market was to supply large blocks of shares to
institutional investors, especially mutual funds, and pension funds.
The third market provides additional competition for the organized exchanges, especially the
New York stock exchange. Moreover, along with the other over-the-counter markets, the third
market has been a catalyst in reducing brokerage fees and promoting trading efficiency.
The Fourth Market
It is not necessary for two parties to a transaction to use an intermediary. That is, the services of
a broker or a dealer are not required to execute a trade. The direct trading of stocks between two
customers with out the use of a broker is called the fourth market. This market grew for the same
reasons as the third market-the excessively high minimum commissions established by the
exchanges.
Prices and Returns of Equity Securities
The valuation process for an equity instrument involves finding the present value of an infinite
series of cash flow on the equity discounted at an appropriate interest rate. Cash flows from
holding equity come from dividends paid out by the firm over the life of the stock, which in
expectation can be viewed as infinite since a firm (and thus the dividends it pays) has no defined
maturity or life. Even if an equity holder decides not to hold the stock forever, he or she can sell
it to someone else who in a fair and efficient market is willing to pay the present value of the
remaining (expected) dividends to the seller at the time of sale.
The price or value of a stock ( P0 ) is generally calculated as: (The stock is assumed to be held
forever )
P0 = D1 + D2 + . . . + D ∞
(1+Ks) 1
( 1+Ks ) 2 ( 1+Ks )∞

Where Dt = Dividend Paid out to Stockholders at the end of the year T (t= 1, 2…)
Ks = required rate of return on equity.
If the stock is expected not to be hold forever, the formula can be modified as follows:

7
 D1 D2 DN PN
  .....  
 
P0 =
1  K s  1  K s 
1 2
1 K5
N
1  K s N
Where PN = Final sales pr ice of the stock.
Example
You are considering the purchase of a stock that you expect to own for the next three years. The
required rate of return on the stock is 16.25 percent and you expect to sell it for Br. 45 in three
years time. You also expect the stock to pay an annual dividend of 1.5 on the last day of each of
the next three years. What is the price of the stock?
1.5 1.5 46.5
Po=  
1.1625 1.1625 1.16253
1 2

Po = Br. 32
If the current market price and the cash flows from the stock are known, the expected return on
the stock can be calculated in different ways depending on the pattern of cash flows.
In the above example, if the current market price of the stock was known to be Br. 32, the
expected return on the stock can be determined by trial and error. The expected rate of return is
simply the discount rate that equates the present value of the cash flows from the stock to its
current market price.
Thus,
1.5 1.5 46.5
32 =  
1  K s  1  K s  1  Ks 3
2

By trial and error, the expected return ( Ks) is found to be 16.25 percent.
As stated above, the price or value of a stock is equal to the present value of its future dividends (
Dt), whose values are uncertain. This requires an infinite number of future dividend values to be
estimated, which makes the general formula above difficult to use for stock valuation and
expected return calculation. Accordingly, assumptions are normally made regarding the expected
pattern of the uncertain flow of dividends over the life of the stock. Three assumptions that are
commonly used include ( 1) Zero growth in dividends over the ( infinite ) life of the stock (2) a
constant growth rate in dividends over the (infinite ) life of the stock, and ( 3) supernormal ( or
non – Constant ) growth in dividends .
Zero Growth in Dividends
Zero growth in dividends means that dividends on a stock are expected to remain at a constant
level forever. Thus, D1 = D2= …. = D ∞ = D. Accordingly, the equity valuation formula can be
written as follows:
P0 = D
Ks
Thus, the expected return ( Ks ) in this case will be:Ks = D
P0
Where P0 = Price or value of stock
D = constant annual dividend
Ks = required returns on stock
Example

8
A stock you are evaluating is expected to pay a constant dividend of Br. 5 per year for many
years to come. The expected rate of return on the stock is 12 percent. What is the value (Price) of
this stock?
P0 = Br. 5 = Br. 41.67
0.12
Constant Growth in Dividends
Constant growth in dividends means that dividends on a stock are expected to grow at a constant
rate, g, and each year into the future. Thus, D1=D0( 1+g )1, D2 = Do(1+g )2,...,D∞= Do ( 1+ g )
∞.Accordingly, the equity valuation formula can now be written as follows:
P0 = Do( 1+g )1 + Do ( 1+g)2 +- - -+ Do ( 1+g )∞
( 1+ Ks )1 ( 1+ Ks )2 ( 1+ Ks )∞
Or
Po = Do ( 1+g ) = D1
Ks – g Ks – g
This formula can be generalized as follows:
P t = Dt + 1
Ks-g
This equity valuation formula can also be rearranged to determine a rate of return on the stock if
it were purchased at a price, P0.
Ks = Do ( 1+g ) + g = D1 + g
Po Po
Example
A stock you are evaluating paid a dividend of Br 3.50 at the end of last year. Dividends have
grown at a constant rate of 2 percent per year over the last 20 years and this constant growth rate
is expected to continue in to the indefinite future. The required rate of return on the stock is 10
Percent. What is the value of this stock?
Po= Do ( 1+g ) = 3.5 X ( 1.02) =Br. 44.625
Ks – g 0.1- 0.02
The investor would be willing to pay no more than Br. 44.63 for this stock.
To illustrate the calculation of the expected return on a stock, consider the following example. A
stock you are evaluating paid a dividend at the end of last year of Br. 4.80. Dividends have
grown at a constant rate of 1.75 percent per year over the last 15 years and this constant growth
rate is expected to continue in the future. The stock is currently selling at a price of Br. 52 per
share. What is the expected rate of return on this stock?
Ks = 4.8 ( 1.0175 ) + 0.0175
52
= 11.14 Percent
Section 4: Debt Market
Overview:
Equity (stocks) and debt (notes, bonds, and mortgages) instruments with maturities of more than
one year trade in capital markets. In the previous section, we have already discussed the equity
(stock) market. This section presents the debt market specially the bond market as the mortgage

9
market is left for advanced levels. Bonds are long-term debt obligations issued by corporations
and government units. Proceeds from a bond issue are used to raise funds to support long–term
operations of the issuer (e.g., for capital expenditure projects). In return for the investor’s funds,
bond issuers promise to pay a specified amount in the future on the maturity of the bonds ( the
face value ) plus coupon interest on the borrowed funds ( the coupon rate times the face vale of
the bond). If the terms of the repayment are not met by the bond issuer, the bond holder
(investor) has a claim on the assets of the bond issuer.
Bond Markets
Bond markets are markets in which bonds are issued and traded. They are used to assist in the
transfer of funds from individuals, corporations, and government units with excess funds to
corporations and government units in need of long–term debt funding. Bond markets are
traditionally classified in to three types: (1) Treasury notes and bonds, (2) Municipal bonds, and
(3) corporate bonds.
Treasury Notes and Bonds
Treasury notes and bonds (T-notes and T– bonds) are issued by the Treasury department of the
government and are used to finance the government deficits or expenditures.
Like T-bills, T–notes and bonds are backed by the full faith and credit of the U.S. government
and are, therefore, default risk free. As a result, T–notes and bonds pay relatively low rates of
interest (yields to maturity) to investors. T-notes and bonds, however, are not completely risk
free. Given their longer maturity ( i.e., duration ) , these instruments experience wider price
fluctuations than do money market instruments as interest rates change ( and thus are subject to
interest rate risk). Further , many of the older issued bonds and notes- ‘’ off-the-run issues’ may
be less liquid than newly issued bonds and notes – ‘’ on-the-run ‘’ issues – in which case they
may bear an additional premium for illiquidity risk .
In contrast to T- bills, which are sold on a discount basis from face value, T–notes and T-bonds
pay coupon interest (semiannually). Further, T – bills have an original maturity of less than one
year. Treasury notes have original maturities from 2 to 10 years, while T-bonds have original
maturities from over 10 to 30 years.
Municipal Bonds
Municipal bonds also called ‘’ munis ‘’ are securities issued by state and local governments to
fund either temporary imbalances between operating expenditures and receipts or to finance
long-term capital outlays for activities such as school construction, public utility construction, or
transportation systems. Tax receipts or revenues generated from a project are the source of
repayment on municipal bonds.
Municipal bonds are attractive to household investors since interest payments on municipal
bonds (but not capital gains) are exempt from federal income taxes. As a result, the interest
borrowing cost to state or local government is lower, because investors are willing to accept
lower interest rates on municipal bonds relative to comparable taxable bonds such as corporate
bonds.
Example
To illustrate the comparison of municipal bonds and fully taxable corporate bond rates, suppose
you can invest in taxable corporate bonds that are paying a 10 percent annual interest rate or

10
municipal bonds that pay 8 percent annual interest rate. If your marginal tax rate is 28 percent,
the after-tax or equivalent tax exempt rate of return on the taxable bond is:
10% (1 - 0.28) = 7.2%
Thus, the comparable interest rate on municipal bonds of similar risk would be 7.2 percent. In
our example, the municipal bond is paying 8 percent which is greater than 7.2 percent. Thus, you
should invest in the municipal bond since it pays a higher return than the taxable corporate
bonds.
The secondary market for municipal bonds is thin (i.e.; trades are relatively infrequent). Thin
trading is mainly a result of a lack of information on bond issuers, as well as special features
(such as covenants) that are built into those bond’s contracts. Information on municipal bond
issuers (particularly of smaller government units) is generally more costly to obtain and evaluate.
Corporate Bonds
Corporate bonds are all long-term bonds issued by corporations. There are two secondary
markets in corporate bonds: the exchange market (e.g., the NYSE) and the over-the –counter
(OTC) market.
BOND Market Participants
Bond markets bring together suppliers and demanders of long-term funds. We have just seen that
the major issuers of debt market securities are federal, state, and local governments and
corporations. The major purchasers of capital market securities are households, businesses,
government units, and foreign investors.
Section 5; Derivative Securities Market
Overview
A derivative security is a financial security whose payoff is linked to another, previously issued
security. Derivative securities generally involve an agreement between two parties to exchange a
standard quantity of an asset or cash flow at a predetermined price and at a specified date in the
future. As the value of the underlying security to be exchanged changes, the value of the
derivative security changes. Derivative securities markets are the markets in which derivative
securities trade.
As major market, the derivative securities markets are the newest of the financial security
markets. Derivative securities include forward and futures contracts, option contracts, swap
agreements, and cap and floor agreements. This section will be devoted to the discussion of
forward contracts, futures contracts and option contracts. The other derivative instruments are
left for advanced levels.
Forwards and Futures
To present the essential nature and characteristics of forward and futures contracts and markets,
we compare them with spot contracts.
Spot Markets
A spot contract is an agreement between a buyer and a seller at time 0, when the seller of the
asset agrees to deliver it immediately and the buyer agrees to pay for that asset immediately.
Thus, the unique feature of a spot market is the immediate and simultaneous exchange of cash
for securities.
Forward Markets.

11
A forward contractual is a contractual agreement between a buyer and a seller at time 0 to
exchange a pre-specified asset for cash at some later date. Market participants take a position in
forward contracts because the future (spot) price or interest rate on an asset is uncertain. Such a
contract lets the market participant hedge the risk that future spot prices on an asset will move
against him or her by guaranteeing a future price for the asset today.
Forward contracts often involve underlying assets that are non-standardized, because the terms
of each contract are negotiated individually between the buyer and the seller. As a result, the
buyer and seller involved in a forward contract must locate and deal directly with each other in
the over–the-counter market to set the terms of the contract rather than transacting the sale in a
centralized market (such as a futures market exchange). Because of the presence of secondary
market trading, it has become increasingly easy to get out of a forward position by taking an
offsetting forward position in the secondary market. Secondary market activity in forward
contracts has made them more attractive to firms and investors that had previously been reluctant
to get locked into a forward contract until expiration. However, secondary trading activity for
forward contracts is thin.
Futures Markets
A futures contract, like a forward contract, is an agreement between a buyer and a seller at time 0
to exchange a prespecified asset for cash at some later date. Thus, a futures contract is very
similar to a forward contract. The difference relates to where they trade. A future contract is
traded on an organized exchanges such as the New York Futures Exchange (NYFE), where as a
forward contract is an OTC instrument. Another difference is that a futures contract involve
underlying assets that are standardized as to delivery date and quality of the deliverable whereas
a forward contract is usually nonstandardized because the terms of each contract are negotiated
individually between buyer and seller. Also unlike futures contracts, there is no clearing house
for trading forward contracts, and secondary markets are often non–existent or extremely thin.
Finally, the parties in a forward contract are exposed to credit risk because either party may
default on the obligation. Credit risk is minimal in the case of futures contracts because the
clearing house associated with the exchange guarantees the other side of any transaction.
Pricing of Futures contracts
The theoretical futures Price ( F) is calculated using the following formula:
F = P + P(r - y)
Where F = Futures Price (Br.)
P= Cash (spot) market Price (Br)
r=borrowing or lending rare (%)
y= cash yield (%)
Example
Suppose that in the cash market Asset XYZ is Selling for Br. 100 and the asset pays the holder (
with certainty ) Br. 12 Per year in four Quarterly Payments of Br. 3 and the next quarterly
payment is exactly three months from now. The futures contract requires delivery three months
from now and the current three–month interest rate at which funds can be loaned or borrowed is
8% Per year. What is the theoretical price of the futures contract?
Solution

12
F= P + P(r-y)
F=P + Pr - Py
F= 100 + (8% x Br. 100 x 3/12) -3
F=100 + 2-3
F=Br.99
Thus, the theoretical futures Price is Br. 99.
Options Contracts
There are two parties to an option contract: the buyer and the writer (also called the seller). In an
option contract, the writer of the option grants the buyer of the option the right , but not the
obligation , to purchase from or sell to the writer something at a specified price within a
specified period of time ( or at a specified date ) . The writer grants this right to the buyer in
exchange for a certain sum of money, which is called the option price or option premium. The
price at which the underlying (that is, the asset or commodity) may be bought or sold is called
the exercise price or strike price. The date after which an option is void is called the expiration
date or maturity date.
When an option grants the buyer the right to purchase the underlying from the writer (seller), it is
referred to as a call option, or simply, a call. When the option buyer has the right to sell the
underlying to the writer, the option is called a put option , or simply, a put.
The timing of the possible exercise of an option is an important characteristic of the contract.
There are options that may be exercised at any time up to and including the expiration date. Such
options are referred to as American options. Other options may be exercised only at the
expiration date; these are called European options.
Section 6: Foreign Exchange Market
Overview
The foreign exchange markets are among the largest markets in the world. The purpose of the
foreign exchange markets is to bring buyers and sellers of currencies together. It is essentially an
over-the-counter market, with no central trading location and no set hours of trading. Prices and
other terms of trade are determined by negotiation over the telephone or by wire or satellite. The
foreign exchange market is informal in its operations; there are no special requirements for
market participants, and trading conforms to an unwritten code of rules among active traders.
This section gives us a brief introduction to the foreign exchange markets.
Foreign Exchange Rates
An exchange rate is defined as the amount of one currency that can be exchanged for a unit of
another currency. In fact, the exchange rate is the price of one currency in terms of another
currency. And, depending on circumstances, one could define either currency as the price for the
other. So, exchange rates can be quoted « in either direction ».
Exchange Rate Quotation Conventions
Exchange rate quotations may be either direct or indirect. The difference depends on identifying
one currency as a local currency and the other as a foreign currency. A direct quote is the
number of units of a local currency exchangeable for one unit of a foreign currency. For
example, from Ethiopia point of view Br.9.10 per $ 1 is a direct quote.

13
An indirect quote is the number of units of a foreign currency that can be exchanged for one unit
of a local currency. For example, from U.S. point of view Br.9.10 per $ 1 is an indirect quote.
Interaction of Interest Rates, Inflation, and Exchange Rates
Purchasing power parity
One factor affecting a country’s foreign currency exchange rate with another country is the
relative inflation rate in each country. As relative inflation rates changes, foreign currency
exchange rates should adjust to account for relative differences in the price levels (inflation rates)
between the two countries. One theory that explains how this adjustment takes place is the theory
of purchasing power parity (PPP). According to PPP, foreign currency exchange rates between
two countries adjust to reflect changes in each country’s price levels (or inflation rates) as
consumers and importers switch their demands for goods from relatively high inflation rate
countries to low inflation rate countries.
The relation among the spot exchange rate, inflation rate in two countries and the forward rate is
as follows:


1 I  h
F= s
1  I  f
Where F= forward rate (units of domestic currency per unit of foreign currency)
S = Spot exchange rate (units of domestic currency per units of foreign currency)
Ih =Inflation rate prevailing in the home (domestic) country.
If =Inflation rate prevailing in the foreign country

Example
Assume that the Canadian dollar’s spot rate is $ 0.85 and that Canada experiences 5- percent
inflation, while the United States experiences 3-Percent inflation. According to purchasing
power parity, what will be the new value of the Canadian dollar after it adjusts to the inflationary
changes?
1  I h 
F= S
1 I f 
F= $ 0.85 x
1.03
1.05
F= $ 0.83
Thus, the new value of the Canadian dollar is $ 0.83
Interest Rate Parity
The relation ship that links spot exchange rates, interest rates, and forward exchange rates is
described as the interest rate parity theorem (IRPT). In equilibrium the forward rate differs from
the spot rate by a sufficient amount to off set the interest rate differential between two currencies.
Mathematically, the IRPT can be expressed as:
1  ih 
F=S
1  i f 
14
Where F = Forward rate (units of domestic currency per unit of foreign currency)
S = Spot exchange rate (units of domestic currency per unit of foreign currency)
Ih= Interest rate on an investment in the home (domestic) country
If= Interest rate on an investment in the foreign country.
Example
To illustrate suppose that the interest rate for one year in the United States is 7 percent and in
Germany 9 percent. The spot rate is $0.6234.In order for interest rate parity to prevail, what
should be the forward exchange rate?
1  ih   0.6234 x1.07
F=S
1  i f  1.09
F= $0.6120
Thus, the forward exchange rate is $ 0.6120.
Exchange Rate Systems
Exchange rate systems can be classified according to the degree by which exchange rates are
controlled by the government. Exchange rate systems normally fall in to one of following
categories:
 Fixed
 Freely floating
 Managed float
 Pegged

15
 Chapter five
REGULATION OF FINANCIAL MARKETS AND INSTITUTIONS

5.1. Introduction

Financial regulation is a form of regulation or supervision, which subjects financial

institutions to certain requirements, restrictions and guidelines, aiming to maintain the
integrity of the financial system. This may be handled by either a government or non-
government organization. Financial regulation has also influenced the structure of
banking sectors, by decreasing borrowing costs and increasing the variety of financial
products available. The financial system is among the most heavily regulated sectors of
the economy. The government regulates financial markets for two main reasons: to
increase the information available to investors and to ensure the soundness of the
financial system.

Financial market plays a prominent role in many economies, and governments around
the world have long demand deemed necessary to regulate certain aspects of these
markets. In their regulatory capacities, governments greatly influence the development
and evolution of financial markets and institutions. It is important to realize that
governments, issuers, and investors tend to behave interactively and to affect one
another’s actions in certain ways. Thus, it is not surprising to find that a market’s
reaction to regulations often prompt a new response by the government, which can
cause the institutions of the market to their behavior further, and so on. A sense of how
the government can affect a market and its participants is important to an
understanding of the numerous the markets and securities.

Justification for regulation

The standard explanation or justification for governmental regulation of a market is

that the market, left to itself, will not produce its particular goods or services in an
efficient manner and at the lowest possible cost. Efficiency and low cost production are
hallmarks of a perfectly competitive market. Thus a market unable to produce
efficiently must be one that is not competitive at the time and that will not gain that
status by itself in the foreseeable future. Of course, it is also possible that governments
may regulate markets that are viewed as competitive currently but unable to sustain
completion, and thus low cost production, over the long run. A version of this
justification for regulation is that the governments control a feature of the economy that
the market mechanisms of competition and pricing could not manage without help. A
short hand expression used by economists to describe the reasons for regulation is a
market failure. A market said fail if it cannot, by itself, maintain all the requirements for
competitive situation.

The regulatory structure in the United States is largely the result of financial crisis that
have occurred at various times. Most regulatory mechanisms are the products of the
stock market crash of 1929 and the Great Depression in the 1930s. Some of the
regulations may make little economic sense in the current financial market, but they can
be traced back to some abuse that legislators encountered, or thought they
encountered, at one time. Further, in addition to financial institution regulation, three
other forms of regulation are most often a function of the federal government, with state
governments playing a secondary role. For that reason, the present discussion of
regulation concentrates on the federal government and its agencies.

Forms of federal government regulation of financial markets

Government regulations of financial markets take one of four forms: (1) disclosure
regulation, (2) financial activity regulation, (3) regulation of financial institutions, and
(4) regulation of foreign participants.

Disclosure regulation: Disclosure regulation requires issuers of securities to make

public a large amount of financial information to actual and potential investors. The
standard justification for disclosure rules is that the managers of the issuing firm have
more information about financial health and future of the firm than investors who own
or are considering the purchase of the firm’s securities. The cause of the market failure
here, if indeed it occurs, is commonly described as ‘asymmetric information’, which
means investors and managers are subject to uneven access to or uneven possession of
information. Also, the problem is said to be one of the ‘agency’ in the sense that the
firm’s managers, who act as agents for investors, may act on their own interests to the
disadvantage investors. The advocates of disclosure rules say that, in the absence of the
rules, the investors’ comparatively limited knowledge about the firm would allow the
agents to engage in such practices.

The United States is firmly committed to disclosure regulation. The securities act of
1933 and the securities Exchange act of 1934 led to the creation the Securities and
Exchange Commission (SEC), which is responsible for gathering and publicizing
relevant information and for punishing those issuers who supply fraudulent or
misleading data. None of the SEC’s requirements or actions constitutes a guarantee, a
certification, or an approval of the securities being issued. Moreover, the government’s
rules do not represent an attempt to prevent the issuance of the risky assets. Rather, the
government’s (and the SEC’S) sole motivation in this regard is to supply diligent and
intelligent investors with the information needed for a fair evaluation of the securities.

Financial activity regulation:financial activity regulationconsists of rules about

traders of securities and trading on financial markets. A prime example of this form
regulation is the set of rules against trading by insiders who are corporate officers and
others in a position to know more about a firm’s prospectus than the general investing
public. Insider trading is another problem posed by asymmetric in formation. A second
example of this type of regulation would be the rules regarding the structure and
operations of exchanges where securities are traded. The argument supporting these
rules rests on the possibility that members of the exchanges may be able, under certain
circumstances, to collude and defraud the general investing public.

Like disclosure, financial activity regulation is also widely implemented in the United
States. The SEC has the duty of carefully monitoring the trades that corporate officers,
directors, or major stock holders (insiders) make in the securities of their firms. The
SEC and another government entity, the Commodity Futures Trading Commission
(CFTC) share responsibility for the federal regulation trading in derivative instruments.

Regulation of financial institutions: regulation of financial institution is that form of

government monitoring that restricts these institution activities in the vital areas of
lending, borrowing, and funding. The justification for this form of government
regulation is that these financial firms have a special role to play in modern economy.
Financial institutions help households and firms to save; as depository institutions, they
also facilitate the complex payments among many elements of the economy; and they
serve as conduits for the government’s monetary policy. Thus it is often argued that the
failure of these financial institutions would disturb the economy in sever way.

Historically the U.S. government imposed an extensive array of regulations on financial

institutions. Most of this legislation traces its historical roots to the Great Depression in
the 1930s and deals with restrictions on the activities of financial institutions. In recent
years, expanded regulations restrict how financial institutions manage their assets and
liabilities, typically in the form of minimum capital requirements for certain regulated
institutions. These capital requirements are based on the various types of risk faced by
regulated financial institutions and are popularly referred to as risk based capital
requirements.

Regulation of foreign participants: government regulation of foreign participants

limits the roles foreign firms can play in domestic markets and their ownership or
control of financial institutions. Many countries regulate participation by foreign firms
in domestic financial securities markets. Like most countries, the United States
extensively reviews and changes it policies regarding foreign firm’s activities in the U.S.
financial markets on regular basis.

Restrictions on Interest Rates:Competition has also been inhibited by regulations that impose
restrictions on interest rates that can be paid on deposits. For decades after 1933, banks were
prohibited from paying interest on checking accounts. In addition, until 1986, the Federal Reserve
System had the power under Regulation Q to set maximum interest rates that banks could pay on
savings deposits. These regulations were instituted because of the widespread belief that
unrestricted interest-rate competition helped encourage bank failures during the Great
Depression. Later evidence does not seem to support this view, and restrictions like Regulation Q
have been abolished.
 CHAPTER SIX

OVERVIEW OF ETHIOPIAN FINANCIAL SYSTE

6.1 Financial Markets and Institutions In Ethiopia

The financial sector in Ethiopia consists of formal, semiformal and informal institutions. The formal
financial system is a regulated sector which comprises of financial institutions such as banks,
insurance companies and microfinance institutions. The saving and credit cooperative are considered
as semi-formal financial institutions, which are not regulated and supervised by National Bank of
Ethiopia (NBE). The informal financial sector in the country consists of unregistered traditional
institutions such as Iqub (Rotating Savings and Credit Associations) Idir (Death Benefit Association)
and money lenders. The components of each category are discussed in detail in the following
headings. The financial system is also known with non-existence formal capital market where long-
term Equity and Debt sections are traded. The Treasury-bill market is the main financial market in
Ethiopia in which 28 and 98 days government Treasury-bill are offered for auction to the general
public. However, the participants are mostly existing commercial banks. There is also inter-banks
money market in which the existing commercial banks are taking part and foreign exchange market
also functional in Ethiopia. The commodity market in which few major agricultural products are
formally traded is the phenomenon of the Ethiopian financial system.

6.2 Financial Sector in Ethiopia

6.2.1 The Formal Sector
The major formal financial institutions operating in Ethiopia are banks, insurance companies and
microfinance institutions. In the formal financial sector of Ethiopia, banks take the dominant position
financing the economy.
a. The Banking System
The agreement that was reached in 1905 between Emperor Minilik-II and R.MaGillivray,
representative of the British owned National Bank of Egypt marked the introduction of modern
banking in Ethiopia. Following the agreement, the first bank called Bank of Abyssinia was
inaugurated in Feb. 16, 1906 by the Emperor. The Bank was totally managed by the Egyptian National
Bank. By 1931 Bank of Abyssinia was legally replaced by Bank of Ethiopia shortly after Emperor
Haile Selassie came into power. The National Bank of Ethiopia with more power and duties started its
operation in January 1964. Following the incorporation as a share company on December 16, 1963 per
proclamation No. 207/1955 of October 1963, Commercial Bank of Ethiopia took over the commercial
banking activities of the former State Bank of Ethiopia. It started operation on January 1, 1964 with a
capital of Eth. Birr 20 million. There were two other banks in operation namely Banco di Roma S.C
and Banco di Napoli S.C. that later reapplied for license according to the new proclamation each
having a paid up capital of Eth. Birr 2 million.

Following the declaration of socialism in 1974 the government extended its control over the whole
economy and nationalized all large corporations. Then Addis Bank and Commercial Bank of Ethiopia
S.C were merged by proclamation No. 184 of August 2, 1980 to form the sole commercial bank in the
country till the establishment of private commercial banks in 1994. The Commercial Bank of Ethiopia
commenced its operation with a capital of Birr 65 million. The Savings and Mortgage Corporation S.C
and Imperial Saving and Home Ownership Public Association were also merged to form the Housing

1
and Saving Bank with working capital of Birr 6.0 million and all rights, privileges, assets and
liabilities were transferred by proclamation No. 60, 1975 to the new bank.

Following the change of government in 1991, financial sector reform took place and the subsequent
measures taken to liberalize and reorient the economy towards a system of economy based on
commercial considerations, the financial market was deregulated. A Monetary and Banking
Proclamation number 84/94 was issued out to effect the deregulation and liberalization of the financial
sector, and a number of private banks and insurance companies were established following the
proclamation. The National Bank of Ethiopia as a judicial entity separated from the government and
outlined its main functions. Directives issued in subsequent years further deepen the liberalization
mainly including the gradual liberalizations of the interest rate, foreign exchange determination, and
money market operation. Monetary and Banking proclamation No. 83/1994 and the Licensing and
Supervision of Banking Business No.84/1994 laid down the legal basis for investment in the banking
sector consequently, after the proclamation private banks started operation.

According to NBE (2016), there were 18 banks operating in the country, of which 16 are private banks
while the remaining three are state owned banks, namely Commercial Bank of Ethiopia (CBE) and
Development Bank of Ethiopia (DBE). Construction and Business Bank (CBB), which was one of the
state owned bank, merged in 2016 with Commercial Bank of Ethiopia. The private banks are:
1. Awash International Bank
2. Dashen Bank
3. Wegagen Bank
4. Bank of Abyssinia
5. United Bank
6. Nib International Bank
7. Cooperative Bank of Oromia
8. Lion International Bank
9. Zement Bank
10. Oromia International Bank
11. Bunna International Bank
12. Berhan International Bank
13. Abay Bank S.C
14. Addis International Bank S.C
15. Debub Global Bank S.C
16. Enat Bank S.C
The total number of bank branches in the sector reached 970, with a larger concentration of them(more
than 40%) located in the capital city, Addis Abeba (NBE, 2009). Ethiopia is still one of the most under
banked countries in the world with one bank branch serving over 82,000 people.
Although one can observe a strong growth and revival of the private sector since liberalization in the
1990s; yet, the state-owned banks seem to dominate the industry. As of the year 2009, the state owned
banks account for 67% of total deposits and 55% of outstanding loans and advances and 55 percent of
the capital. More specifically, the state‐owned Commercial Bank of Ethiopia (CBE) - the largest bank
in Ethiopia alone controls about 43% of the branch networks, nearly 40% of the capital , about 46% of
the outstanding loans and advances, and about 58 % of the deposits of the commercial banks. Table
2.4 provides the share of capital and branch network of Ethiopian Banks as of the year 2009.

2
Despite some improvement in the sector in the last couples of years, Ethiopian banking remains in its
low status. For instance, the estimates of Bank‘s recent Financial Sector Diagnost show that less than
10% of households have access to formal credit (African Development Bank, 2011). In general, the
sector is characterized by small banking, limited range of services, absence of capital markets and the
sector largely remains closed to foreign investors.
b. Insurance Companies and Other Financial Institutions
On the other hand, modern forms of insurance service, which were introduced in Ethiopia by
Europeans, trace their origin as far back as 1905 when the Bank of Abyssinia began to transact fire and
marine insurance as an agent of a foreign insurance company.
Before liberalization the command economy including political instability had been the stumbling
block for the growth of the financial sector in Ethiopia. The 1990’s ushered in economic liberalization
that led to the revival of private sector participation in the financial sector. This has led to the
formation of a number of private insurance companies. According to the National Bank of Ethiopia
(2016) there were 17 insurance companies with a total of 221 branches operating in the country. In
terms of ownership, all insurance companies except the Ethiopian Insurance Corporation (EIC), are
privately owned. Private insurance companies accounted for 69.5 percent of the total capital, while the
remaining share was taken up by the single public owned enterprise, the Ethiopian Insurance
Corporation. Of the total insurance branches, 50.7 percent are concentrated in Addis Ababa. Private
insurance companies owned 81.4 percent of the total branches. The private insurance companies were:
1. African Insurance Company S.C
2. Awash Insurance Company S.C
3. Global Insurance Company S.C
4. Lion Insurance Company S.C
5. NIB Insurance Company
6. Nile Insurance Company S.C
7. NyalaInsurance Company S.C
8. The United Insurance S.C
9. AbayInsurance Company
10. Berhan Insurance S.C
11. National Insurance Company of Ethiopia
12. OromiaInsurance Company S.C
13. Ethio-Life and General Insurance S.C
14. TsehayInsurance S.C
15. Lucy Insurance S.C
16. BunnaInsurance S.C
According to Gebreyes (2011) the insurance market is undeveloped, uncompetitive and there exist
paucity of information on the kind of life insurance that is currently present. The current practice of
bulk of insurance coverage and business in Ethiopia is targeting the corporate market and focuses
mainly on general insurance with a very limited coverage in life insurance.
The insurance sector is dependent on the banking sector for much of its new business. Most
Ethiopian insurance companies have sister banks and it's common for these banks to refer their
clients to their sister insurance companies, but this is largely restricted to credit life insurance
products. Moreover, insurance companies tend to derive a large portion of their total income from
investments in banks (Smith and Chamberlain, 2009).

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 c. Microfinance Institution
The emergence of Microfinance institution is a recent phenomenon in Ethiopia compared to other
developing countries. The first microfinance service in Ethiopia was introduced as an experiment in
1994, when the Relief Society of Tigray (REST) attempted to rehabilitate drought and war affected
people through the rural credit scheme. It was inspired by other countries’ experiences and adapted
to the conditions of the Tigrayregion (northern part of Ethiopia). In the second half of the 1990s, as
a result of its success, the microfinance service was gradually replicated in other regions (Berhanu
and Thomas, 2000).
Similar to microfinance approaches in many other parts of the world, MFIs in Ethiopia focus on
group-based lending and promote compulsory and voluntary savings. They use joint liability, social
pressure, and compulsory savings as alternatives to conventional forms of collateral (SIDA, 2003).
These institutions provide financial service, mainly credit and saving and, in some cases, loan
insurance. The objectives of MFIs are quite similar across organizations. Almost all MFIs in the
country have poverty alleviation as an objective. They focus on reducing poverty and vulnerability
of poor households by increasing agricultural productivity and incomes, diversifying off farm
sources of income, and building household assets. They seek to achieve these objectives by
expanding access to financial services through large and sustainable microfinance institutions.
The Ethiopian microfinance industry has undergone tremendous growth and development in a very
short period of time (Micro Ned, 2007, Amaha2009), As of 2009, the 29 MFIs licensed by the
National Bank of Ethiopia succeeded in reaching more than 2.3 million clients and delivered about
7 billion Birr in loans. They also mobilized about 3.8 billion Birr of savings. In the same year, the
sector has a total asset Birr 10.2 billion and total capital of Birr 2.9 billion. Despite the notable
achievements, the operating MFIs reach less than 20% of the total microfinance demand in the
country (AEMFI, 2010). Turning to market concentration, the three largest MFIs, namely Amhara,
Oromia and DedebitCredit and Savings institutions accounted for 67.1 percent of the total capital,
81.4 percent of the savings, 74.0 percent of the credit and 76.2 percent of the total assets of MFIs.

Regulations of Insurance sector in Ethiopia

In 1905, the insurance business like any undertaking was classified as trade and was administered
by the provisions of the commercial code. This was the only legislation in force in respect of
insurance except the maritime code of Ethiopia that was issued to govern the operations of maritime
business and the related marine insurance. The minimum paid-up capital required to establish an
insurance company was as little as 12,500 Ethiopian Birr as stipulated in the commercial code.
There was no restriction on foreign insurers.
The first remarkable event that the Ethiopian insurance market witnessed was the promulgation of
proclamation No. 281/1970. This proclamation was issued to provide for the control & regulation of
insurance business in Ethiopia. It is peculiar in that created an Insurance Council and an Insurance
Controller’s Office.
The law required an insurer to a domestic company whose share capital (fully subscribed) to be not
less than Ethiopian Birr 400,000 for a general insurance business and Ethiopian Birr 600,000 in the

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 case of long-term insurance business and Ethiopian Birr 1,000,000 to do both long-term & general
insurance business. Non-Ethiopian nationals were not barred /excluded from participating in
insurance-business. However, the proclamation defined domestic company as a share company
having its head office in Ethiopia and in the case of a company transacting a general insurance
business at least 51% and in the case of a company transacting life insurance business, at least 30%
of the paid-up capital must be held by Ethiopian nationals or national companies.
Four years after the enactment of the proclamation, the military government that came to power in
1974 put an end to all private entrepreneurship. Then all insurance companies operating were
nationalized and from January 1, 1975 onwards the government took over the ownership and
control of these companies & merged them into a single unit called Ethiopian Insurance
Corporation. In the years following nationalization, Ethiopian Insurance Corporation became the
sole operator.
Following the change in the political environment in 1991, the proclamation for the licensing and
supervision of insurance business heralded the beginning of a new era. Immediately after the
enactment of the proclamation private insurance companies began to flourish.
Current regulations of Insurance sector in Ethiopia
It is of interest to note that the first regulations governing insurance were enacted to protect insurers
against fraudulent action on the part of the insured. It is only because of the appearance of compulsory
insurance and the increasing level of complexity of insurance contracts, that legislators concern
themselves with protecting interests of the insurance consumers.
The contractual relationship between the insured and the insurer reveals a potential imbalance. In other
words the insured pays his consideration (premium payment) at the very beginning of the contract. But
before the insurer is called to perform his part, time may change the security profile of the insurer. In
view of the economic importance of insurance, this has led Government Authorities to enact
regulations that should guarantee the long term viability of insurers.
Regulating the insurance industry does not seem a question of choice for Ethiopia-rather a must to do.
Some individuals who are participating in this industry believe that Ethiopian insurance companies are
working at the capital of other country’s insurance capital which requires legal protection. Besides,
because the attitude, awareness of the public and information flow about insurance activities is at a
lower level there is not any better than developing the trust/confidence of the people on insurance
companies through regulating their activities.
In our country proclamation 86/1994 is proclaimed to provide for the licensing and supervision of
insurance business. For the purpose of this chapter (your instructor) have summarized the basic
regulations in to the following categories:

1. Regulation related to Licensing

Historically, fixed capital requirements have been specified in most countries insurance statues to
ensure that applicants seeking licenses to conduct insurance business have sufficient capital to
support their operational activities. In accordance with Article 4 of proclamation 86/1994 the
minimum paid up capital requirement for non life and life insurance business in Ethiopia is Birr
3,000,000 and Birr 4,000,000 respectively. For composite insurers (undertaking both life and non-
life) the requirement is Birr 7,000,000. In accordance with Article 6, application for the grant of a
license shall be accompanied by Memorandum and Articles of Association, insurance policy

5
 founds and such other particulars as may be prescribed by directive to be issued by the National
Bank.
2. Regulation related to reserves and solvency
Some reserves are specified and compulsory by law: i.e., statutory deposit and various technical
provisions. According to Article 4 of proclamation 86/1994:
a. Every insurer shall, in respect of each main class of insurance business he carries on in
Ethiopia, deposit and keep deposited with the bank, an amount equal to fifteen percent
(15%) his paid up capital in cash or government securities.
b. The deposit specified in sub-article (1) above shall be held to credit of the insurer provided
that the aforesaid deposit or any there of shall not be withdrawn except with the written
permission of the N. Bank: nor shall such deposit be used as a pledge or security against
any loan or overdraft.
The law also requires 10% of annual net profit to be deposited into a legal reserve account.
Insurers can also make additional reserves as prudent underwriting practice dictated them. All
these legally and practically required reserves are aimed at ensuring the financial strength of an
insurer in discharging its financial commitments.
To be solvent an insurance company’s total admitted assets have to exceed its total admitted
liabilities by a certain specified margin in line with the statutory requirement on force. According
to the definition of Article 20 of proclamation No. 86/1994, An insurer carrying on general
insurance business shall be deemed in solved if the value of the insurer’s assets does not exceed
the amount of his liabilities by whichever is the greater of: (a) The amount of the statutory deposit
(i.e. 15% of the paid up capital), or 15% of the net premium written by the insurer in his last
preceding financial year.
c. Disclosure Regulation
As per Article 18 of the proclamation, the balance sheet, profit and loss account and revenue
account of every insurer shall be audited annually by an auditor. A copy of every report of the
auditor shall be sent to the Bank not later than ninety (90) days after the end of its financial year.
In addition according to Directive No SIB/17/98, each insurer shall submit to the supervision
department of the National Bank of Ethiopia separate quarterly reports for general and long-term
insurance business within twenty days after the end of each quarter.
d. Prohibitions or Restrictions
Usually large funds remain under the custody of insurers and invested to produce additional
returns. Under competitive pressure this additional income may enable the insurer to charge lower
rates than would be usual, and make the insurers, products attractive here by improving its overall
profitability. The management of these funds is thus very important both to insurers and insured
and may also play a significant role in the national economy. Appropriate regulations to channel
these funds so as to target developmental areas of the economy may contribute to the overall
economic development of the country. Hence the National Bank of Ethiopia (NBE) Issued
Directive No. SIB25/2004 which Limits on investment of insurance funds as follows:
i. General Insurance Funds
The General Insurance funds of an insurance company can be invested in Treasury Bills
and bank deposits not less than 65% of admitted assets; provided, however, that aggregate
bank deposits (checking, savings and time deposits) held with any one bank shall not
exceed 25% of total admitted assets; In investment in company shares not exceeding 15%

6
 of total admitted assets; In real estate not exceeding 10% of total admitted assets; and 10%
of admitted assets in investments of the insurance company’s choice.
ii. Long-term Insurance Funds
The Long-term Insurance funds of an insurance company can be invested in Treasury
Bills/Bonds and bank deposits not less than, in aggregate, 50% of total admitted assets;
provided, however, that aggregated deposits (checking, savings and time deposits) held
with any one bank shall not exceed 25% of total admitted assets; Investments in company
shares not exceeding 15% of total admitted assets; Investments in real estate not exceeding
25% of total admitted assets; and 10% of total admitted assets in investments of the
insurance company’s choice.
In addition, Article 29 sub article 1 of the proclamation sets Restriction on loans, Advances, etc, by an
insurer. That is Unless provided otherwise by regulations and directives issued hereunder, no insurer
shall grant any loan, advance, financial guarantee or other credit facility either on hypothecation of
property or on personal security or otherwise, except loans on life policies issued by him within their
surrender value, to any shareholder of the insurer or to any director manager, actuary, auditor or
officer working for the insurer or to any insurance auxiliary or to any other person connected with the
said persons.
Other regulations
 Re-Insurance:
In Ethiopia, reinsurance contracts are subject to supervision by NBE. The bank may give
advice and information about re-insurers but the task of monitoring (screening) the security of
re-insurers falls principally upon ceding companies, since it is up to them to choose their re-
insurers.
 Amalgamation:
Article 40 requires that no insurer shall amalgamate with or takeover the insurance business of
another insurer except with the prior approval of the NBE.
Certification of Soundness of Terms of Insurance Business: According to Article 36:
1. The National Bank shall ensure that the terms of insurance policies safeguard the rights of
policy-holders, under the laws of Ethiopia.
2. At any time, the NBE may take any modifications to insure that premium rates, advantages,
terms and conditions offered are workable and sound.
Current regulations of Banking sector in Ethiopia
Banks control the payment system and government monetary policy is implemented through the
banking system. The huge mobilized funds from within and outside the country can be utilized in the
economic development through the banking system. Because of this and other special roles that these
institutions play in the financial system, they are highly regulated in Ethiopia-as it is true in other
countries. The general reasoning behind regulating Banks is almost the same as what we have tried to
discuss for insurance. Below are some of the basic regulations applicable to banks in Ethiopia.
According to proclamation No.84/1994, banking business shall mean any business that consists of:-
 Receiving funds from the public, through accepting deposits of money payable upon demand
or in a fixed period or by notice or any similar operation involving the sale of shares,
certificates, notes, or other securities.

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 Using the funds received in whole or in part, for the account and at the risk of the person
undertaking the banking business and Buying and selling of gold and silver bullion and foreign
exchange.
1. Licensing Banks
 License for doing banking business is issued by the national Bank of Ethiopia if application
is in line with the provision of proclamation 84/1994 Article 3,4 and 5.
 According to Article 4 (sub article 2) the proclamation foreign national shall not undertake
banking business in Ethiopia.
2. Maintenance of Required Capital and Reserve requirement
As per the revised directive of SBB/No. 24/99 the minimum paid-up capital to obtain a
banking business license is birr 75,000,000. Because banks expand their activities every
existing bank shall at all times maintain minimum unimpaired capital of seventy five million
birr to commensurate with the volume of their business to withstand adverse effects, which
shall be fully paid in cash and deposited in bank in the name and to the account of the bank.
According to article 13(1) of the proclamation 84/1994, and directive 27/99, at the end of each
fiscal year, every bank shall maintain a legal reserve of not less than 25% (twenty five percent)
of its net profit.
One of the important monetary policy instruments and prudential regulation tools is reserve
requirement. In this regard, according to article 16 of proclamation 84/1994 and directive No.
SBB/37/2004 banks carrying on business in Ethiopia shall maintain with the NBE a reserve
account 5% (though now it is increased to 15%) of all birr and foreign currency deposit
liabilities held in the form of current, saving and time deposits (this requirement is increased
(changed) to 10% now).
3. Disclosure Requirement (Audit, Information, Inspection and Examination)
Article 18, 19 and 20 with their various directives of Proclamation 84/1994 are proclaimed in
relation to disclosure requirements. Accordingly, every bank shall appoint an independent
auditor to report to the shareholders of the bank upon the annual balance sheet and profit and
loss statement, whether they exhibit a true and fair statement of the Bank’s affair and the copy
of the report shall be sent to the NBE not later than 90 days after the end of financial year.
Each bank shall send to NBE the duly signed Balance Sheet every month within 20 days from
the month from the closing of each financial year. In addition the NBE may periodically or at
any time, without prior notice make or cause an on-site inspection to be made of any bank
whether the inspected or examined bank has failed to comply with applicable laws or
regulations or with the terms and conditions of the license to carry on banking business in
Ethiopia.
4. Limitation of the activities of Banks
The activities of banks are regulated by the government. According to proclamation
No.84/1994, article 27 (1&2) without the prior written approval of the NBE, No person may
acquire either directly or indirectly in a bank a voting right exceeding 20% (Twenty percent) of
the total capital. No bank shall enter into any arrangement or agreement for the sale or disposal
by amalgamation or effect restructuring, dispose of the whole or any part of its property
whether in or out of Ethiopia and other activities not given by the provision of proclamation no
83/1994.

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 The overall open foreign currency position of each bank at the close of business day shall not
exceed 15% (fifteen percent) of its total capital.
To add one more activity limiting regulation of banks directive No. SBB/30/2002 states that
the aggregate sum of loans extended or permitted to be outstanding directly or indirectly to one
related party and related parties at any one time shall not exceed 15% (fifteen percent) and
35% (thirty five percent) respectively of the total capital of the bank. The aggregate loan or
extension of credit by a bank to any one borrower, either a natural person or business
organization at no time shall exceed 25% (twenty five percent) of the total capital of the bank.
Besides, Banks shall not extend loans to related parties on preferential terms with respect to
conditions, interest rates and repayment periods other than the terms and conditions normally
applied to other borrowers.
Penalties for Non-Performance
Because the fundamentals of these proclamations are to safeguard the whole economy and achieve
sustained economic growth through fostering monetary stability and sound financial system, not to
comply with it and/or with the directives would result in a consequence. As it is clearly indicated in
proclamation No. 86/2994, article 41/&7 and directive No. 27/2004, penalties could range from fine in
Birr and imprisonment up to cancellation of licenses.

6.3 The Regulation of Financial Markets & Institutions in Ethiopia

According to a conventional view on the positive role of finance for growth, a good financial system
with a well-functioning competitive market as well as a wee-supporting financial institution is an
essential ingredient for sustainable economic growth.
Developing sound Financial Markets requires the establishment of public confidence in the institutions
that constitute the Finance Sector. Confidence can only be maintained if these institutions deliver
services as promised. Thus one of the duties of Governmental Authorities is to preserve the long term
stability of the financial system and reliability of its components. Governments could do this using
different procedures and regulations.
Regulation of financial markets rests on the tenet that it serves the interest of the public by protecting
investors and guarding against systemic risk. With to investor protection, regulations maintain that
their oversight is justified on the grounds that investors are uninformed and unskilled. The initial
focus, and still the central element, of regulatory system is to solve the problem of the uninformed
investor through company disclosure and transparency of trading markets. Most people agree that
disclosure provides the information needed to make rational decisions. But regulation today goes far
beyond disclosure requirements, because a growing number of stakeholders are presumed to be
unskilled and incapable of making informed decisions.
The other basis for financial regulation is concern about systematic risk. Systemic risk arises if the
failure of one financial institution causes a run on other institutions and precipitates system-wide
failure. Regulation is said to be required because individual institutions do not adequately take account
of the external costs they impose on the financial system when they fail. But almost every aspect of
financial markets, if not daily living itself, involves systemic risk.
One of the most complex issues facing governments is identifying the appropriate level and form of
intervention. Regulatory efficiency is a significant factor in the overall performance of the economy.
Inefficiency ultimately imposes costs on the community through higher taxes and charges, poor

9
service, uncompetitive pricing or slower economic growth. Clearly there must be limits on the
applicability of this rational for regulation.
This chapter considers the purposes and rational behind regulating financial market in general. It looks
in to the major and basic active regulations of Banking and Insurance operations in our country.
Besides, it sets out the different views for determining whether, where and how financial market
regulation should be applied.

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