Financial Markets & Institutions: Chapter 1

Financial Markets &
Institutions: Chapter 1
CHAPTER ONE
FINANCIAL SYSTEM
Tesfaye Nigussie
School of Business and Economics
OROMIA STATE UNIVERSITY
An overview of the Financial System
• The objective of all economic activity is to
promote the well-being and standard of living
of the people, which depends on the income
and distribution of income in terms of real
goods and services in the economy.
• The production of output, which is vital to
the growth process in the economy, is a
function of the many inputs used in the
productive process.
2
• MATERIAL INPUTS HUMAN INPUTS FINANCIAL INPUTS
PRODUCTION OUTPUTS
 The financial inputs emanate from the financial
system, while real goods and services are part of the
real system.
The interaction between the real system (goods and
services) and the financial system (money and capital)
is necessary for the productive process.
3
• Trading in money and monetary assets constitute
the activity in the financial markets and are referred
to as the financial system.
• A financial system is a network of financial
institutions, financial markets, financial
instruments and financial services to
facilitate the transfer of funds. The system
consists of:
 savers, intermediaries,
 instruments and the ultimate user of funds
4
Finance at micro level: Financial System
• At the micro level, Finance is the study of the
financial or monetary aspects of the
production, spending, borrowing, and lending
decisions.
• Finance deals with the raising and using of
money by individuals, firms, governments,
and foreign investors. In this context, finance
deals with how individuals manage money.
5
Finance at macro level: Financial
System
• At the macro level, Finance is concerned with how
the financial system coordinates and channels the
flow of funds from lenders to borrowers and vice
versa, and how new funds may be created by
financial intermediaries during the borrowing
process.
• The production and sale of goods and services within
economic system are intimately related to deposits,
stocks, bonds, and other financial instruments that
are bought & sold in the financial system.
6
What is a Financial System?
• The Financial System is a system which
provides a mechanism whereby an individual
unit (which may be a household or a firm) that
is an SBU may conveniently make funds
available to DBUs who intend to spend more
than their current income.
– SBU: Surplus Budget Unit
– DBU: Deficit Budget Unit
7
Meaning of SBUs and DBUs
• ‘Surplus Budget Units (SBUs) or Surplus Spending
Units’ are those households (and firms) whose
income exceeds their spending. That means, SSUs
spend (towards consuming goods and services) less
than their current income and they have surplus
funds to buy investment goods (which may be real or
financial assets).
• On the other hand, ‘Deficit Budget Units (DBUs) or
Deficit Spending Units’ are those households (and
firms) whose spending exceeds their income.
Obviously, the DSUs have deficit and they need to
find means to finance their deficit.
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Components of a Financial System
Financial
System
Financial Financial Financial

Markets Services Institutions
Financial Other Financial

Money Market Capital Market
Intermediaries Institutions
MM CM Depository Contractual Investment

Instruments Instruments Institutions Institutions Institutions
9
Financial System Components
• A Financial System operates through its
components, viz., Financial Markets, Financial
Services, and Financial Institutions.
• Financial Markets include two major components,
viz., Money and Capital Markets.
• Financial Markets operate through Financial
Instruments, viz., Money Market Instruments, and
Capital Market Instruments.
10
Financial System Components
• Financial Institutions include two
components, viz., Financial Intermediaries
and Other Financial Institutions.
• Financial Intermediaries are classified into
 (i) Depository Institutions,
(ii) Contractual Institutions, and
 (iii) Investment Institutions.
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Financial Markets and Institutions
• Financial Markets (such as Stock Market or
Bond Market) issue claims on individual
borrowers directly to savers.
• Financial Institutions or Intermediaries (such
as Banks, Insurance Companies, and Mutual
Funds) act as go-betweens by holding a
portfolio of assets and issuing claims based on
that portfolio to savers.
12
Financial System: What does it do?
• Financial System provides channels to transfer funds
from individuals and groups who have saved money
to individuals and groups who want to borrow
money.
• Thus, Financial System facilitates smooth transfer of
funds from SAVERS to BORROWERS, wherever they
are.
Financial
Savers Markets & Borrowers
Institutions
13
Savers and Borrowers in Financial
System
• Savers (or lenders) are suppliers of funds,
providing funds to borrowers in return for
promises of repayments of even more funds in
the future.
• Borrowers are demanders of funds for
consumer durables, houses, or business plant
and equipment, promising to repay borrowed
funds based on their expectation of having
higher incomes in the future.
14
Financial Assets & Liabilities
• These promises are FINANCIAL LIABILITIES of

the borrower – that is, both a source of funds
and a claim against borrower’s future
income.
• Conversely, the promises or IOUs, are
FINANCIAL ASSETS for savers – that is, both a
use of funds and a claim on the borrower’s
future income.
15
Financial System
• Thus, Financial System channels funds
from savers to borrowers and channels
returns back to savers, both directly and
indirectly.
• Savers and Borrowers can be
households, businesses, or
governments, both domestic and
foreign.
16
Direct Finance: Meaning
• Financial Markets are the markets in which spending units
trade financial claims (SSUs by lending their surplus funds
and DSUs by borrowing for their deficit). This activity of
SSUs lending their funds directly to DSUs is called ‘Direct
Finance’.
Flow of funds
(loans of spending power for an
agreed-upon period of time)
Borrowers Lenders
(DBUs) (SBUs)
Primary Securities
(stocks, bonds, notes, etc.,
evidencing direct claims against
borrowers)
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Indirect Finance: Meaning
• The Surplus Spending Units park their surplus funds
(in the form of Bank Deposits) out of which the
Financial Intermediaries lend the Deficit Spending
Units to meet their deficit (excess of expenditures
over their income).
• Thus, the Financial Intermediaries serve a connecting
link between SSUs and DSUs. This activity of SSUs
lending their surplus funds through financial
intermediaries to DSUs to meet their deficit is called
‘Indirect Finance’.
18
Diagram showing Indirect Finance
19
Financial Intermediation
• The financial intermediaries obtain the funds
from the SSUs and offer their own securities
(such as Deposit Certificates, Insurance
Contracts, Pension Contracts, which are
commonly known as Secondary Securities) as
financial claims to the SSUs.
20
Financial Intermediation
• They then provide the funds to the DSUs (in
the form of advances) and accept the
securities issued by DSUs (such as Stocks and
Shares, Bonds and Debentures, Treasury Bills,
which are widely known as Primary
Securities) as financial claims on the DSUs.
• Thus they carry out ‘financial intermediation’.
21
Semi-Direct Finance: Meaning
• There are Financial Institutions which do not act
as Financial Intermediaries.
• They are financial institutions which facilitates
funds transfers from SSUs to DSUs without
creating securities on their own.
• They simply act as conduit pipe between the
SSUs and DSUs. This kind of financial transaction
is known as ‘Semi-Direct Finance’, which is
facilitated by ‘Financial Institutions which are not
financial intermediaries’.
22
Diagram showing Semi-Direct Finance
Primary Primary
Securities Securities
(direct claims (direct claims
against against
borrowers) Security borrowers)
brokers,
dealers,
Borrowe & Lenders
rs investme (SBUs)
(DBUs) nt
bankers
Flow of funds Flow of
(loans of funds
spending
(loans of
power ) spending
power)
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Disintermediation of Funds
• Disintermediation refers to the withdrawal of
funds from a financial intermediary by the
ultimate lenders (savers) and the lending of
those funds directly to the ultimate
borrowers.
• Disintermediation involves the shifting of
funds from indirect finance to direct and semi-
direct finance.
24
Disintermediation of Funds
Financial Disintermediation
Primary Securities
Ultimate Financial Ultimate

borrowers intermediaries lenders
(DBUs) (SBUs)
Loanable funds
25
Two Major Categories of Financial
Systems
• Less-developed financial systems are often bank-
dominated financial systems, in which banks and
other similar institutions dominate in supplying
credit and attracting savings.
• The more mature systems today are becoming
security-dominated financial systems, in which
traditional intermediaries play lesser roles and
growing numbers of borrowers sell securities to the
public to raise the funds they need.
• How would you categorize Ethiopian Financial
System?
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Key Services provided by the Financial
System
• In addition to matching individuals who have
excess funds with those who need them, the
Financial System provides three key services
for savers and borrowers, namely:
– Risk-Sharing,
– Liquidity, and
– Information.
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Risk-Sharing Service of FS
• Financial System provides risk-sharing by allowing
savers to hold many assets, the collection of which is
called a portfolio.
• The advantage of a portfolio is though one asset or a
set of assets may perform well and another not so
well, overall the returns tend to average out.
• This splitting of wealth into many assets is known as
DIVERSIFICATION.
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Liquidity Service of FS
• Liquidity refers to the ease with which an asset can
be exchanged for money to purchase other assets or
exchanged for goods and services.
• Financial Assets created by the Financial System are
more liquid than real assets.
• Financial Markets and Intermediaries provide trading
systems for making financial assets more liquid.
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Information Service of FS
• Collection and communication of information
(facts about borrowers and expectations
about returns on financial assets) is the third
service by FS.
• Collection: FS gathers information, which
includes finding out about prospective
borrowers and what they will do with
borrowed funds.
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Information Service of FS
• Communication: FS communicates
information, through various channels, for the
benefits of those who need it.
• Savers and borrowers receive the benefits of
information from the FS by looking at asset
returns.
• This in turn helps them making appropriate
decisions about their financial assets or
liabilities.
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Functions of Financial System # 1
• (1) Savings function:
• The global system of Financial Markets and
Institutions provides a connecting link for the
savings of the public.
• Bonds, stocks and other financial claims sold
in money and capital markets provide a
profitable outlet for the public savings. These
savings flow through the financial markets
into investment so that more goods and
services can be produced.
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• (2) Wealth function:
 The financial instruments sold in the money
and capital markets provide an excellent way
to store wealth (i.e. to preserve the value of
assets held) until they are needed for
spending.
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• Though there is a general preference to store
the value of wealth in the form of real assets
(such as buildings, automobiles), yet they are
subject to depreciation and loss in value.
• Contrarily, the financial instruments do not
have wear and tear, and they have the chance
of generating regular income and appreciate
in value over time.
34
• (3) Liquidity function:
• Financial Markets in the financial system provide a
convenient means of converting the financial
instruments into cash, with ease and without loss of
time.
• Money possessed in the form of bank deposits are
the most liquid form of assets. For other financial
instruments, the financial markets provide a ready
market for those who wish convert them back into
cash.
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• (4) Credit function:
• Financial markets furnish credit to finance
consumption and investment spending.
• Credit consists of a loan of funds in return for a
promise of future payment.
• Consumers need credit to buy home, groceries,
other services, and to pay outstanding debts
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• Business houses need credit to stock the
goods, construct new shops, meet payrolls,
and pay dividend to their stockholders.
• Similarly, governments need credit to
provide public facilities.
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• (5) Payments function:
• The financial system provides a mechanism
for making payments for goods and services.
• Certain financial assets serve as a medium
of exchange in making payments.
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• (6) Risk Protection function:
• By selling insurance policies, the financial
markets offer protection against life, health,
property, and income risks of businesses,
consumers and the governments.
• The money and capital markets are used by
businesses and consumers to “self-insure”
against risk, by building up wealth as
protection against future losses.
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• (7) Policy function:
• In the recent times, the financial markets have been
the principal channel though which government has
carried out its policy of attempting to stabilize the
economy.
• Governments can influence the borrowing and
spending plans of the public, by altering the interest
rates and the availability of credit.
• This in turn influences the growth of jobs,
production, and prices.
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• Financial system is vital to a healthy
economy. That is why the government
regulates and supervises the operations of a
financial system.
• The aim of such regulations is to promote
and ensure a smooth-running, efficient
financial system.
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• By establishing and enforcing operating
regulations for financial markets and
institutions, Government (as a regulator)
tries to promote competition and efficiency
while preserving the safety and soundness of
the system.
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1.3. Financial Assets
• A financial asset is an intangible representation of
the monetary value of a physical item.
• It obtains its monetary value from a contractual
agreement of what it represents.
• While a real asset, such as land, has physical value, a
financial asset is a document that has no
fundamental value in of itself until it is converted to
cash.
• Common types of financial assets include
certificates, bonds, stocks, and bank deposits.
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common types of financial assets
1.A CD is an agreement between an investor and a
bank in which the investor agrees to keep a set
amount of money deposited in the bank in exchange
for a guaranteed interest rate.
 A certificate of deposit is a promissory note issued
by a bank.
 It is a time deposit that restricts holders from
withdrawing funds on demand
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The bank may offer a higher amount of
interest payment since the money is to remain
untouched for a set period of time.
 If the investor withdraws the CD before the
end of the contract terms, he or she will lose
out on the interest payments and be subject to
financial penalties.
CDs issued by banks can be negotiable or non-
negotiable.
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2. Another type of financial asset is a bond.
 Bonds are often sold by corporations or governments
to investors in order to help fund short-term projects.
They are a type of legal document detailing the
amount of money an investor loaned a borrower and
the length of time it needs to be paid.
 A bond represents how much interest is guaranteed
to be returned to the investor along with the original
loan amount.
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3.Stocks are one of the only financial assets that do
not have an agreed upon ending date.
• Investing in stock means the investor has part
ownership of a company and shares in the company’s
profits and losses.
• He or she can keep the stock for any length of time or
decide to sell it to another investor.
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Money that is deposited into a bank account also
counts as a financial asset, rather than a real asset.
When cash is put into a bank account, the proof of
the funds is a bank statement that summarizes the
value of the account.
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• A financial asset is typically given a maturity date in a
contractual claim.
• If it remains untouched and unconverted to cash by
that date, its value will usually increase.
• Cashing out an asset before its maturity date can
ultimately cost a person financial penalties because it
violates the terms of the agreement.
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Financial assets do not provide a continuous
stream of services to the owners i.e. promise
future returns to their owners
• Financial assets serve as a store of value i.e.
purchasing power
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• Financial assets cannot be depreciated physically i.e.
do not wear out
• The physical condition of financial assets is irrelevant
in determining the market value or price
• The cost of transporting and storing financial assets
is low
51
• 1.3.1 Classifications of Financial Assets
• Financial assets include:-
• common stock,
• options and warrants to buy stock at a later date,
• money market certificates,
• savings accounts,
• Treasury bills, commercial paper (unsecured short-term debt),
bonds, preferred stock, and financial futures (contracts to buy
financial instruments at a later date).
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• The Financial assets can be characterized by three
parameters :
1.Liquidity: Liquidity can be defined as the ability to
convert into cash each resource.
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2.Security benefits: it is determined by the
amount of compensation that can generate an
advantage for the investor.
• Ex. investing in shares of various companies is
determined by shareholders dividends in
return.
• Be achieved if the dividend is high, then the
assets (shares) as “the best performing asset”
means.
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3.Risk: It can be defined as the probability or
possibility of loss of investment of economic
resources.
The risk of a financial asset depends on two
factors:
a. The creditworthiness of the issuer and
b. guarantees associated with the financial asset.
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Financial assets can be categorized as given bellow
based different classification bases;
A) Debt Securities and Equity Securities:
i. Debt securities
• Debt securities are securities in which the borrower
agrees to pay periodic interest and principal.
• They may be issued by Corporations, Financial
Institutions, or Governments.
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Debt securities include securities like:
• Bonds, Treasury bill,
• Commercial paper Promissory notes,
• Bankers' acceptances Life insurance policies,
• CD, and Repos
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ii. Equity securities
• Equity securities represent ownership in a business
firm.
• They are claims against the firm's profits and
proceeds from the sale of its assets upon liquidation.
• They usually include common stock and preferred
stock.
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B) Cash instruments and derivative instruments:
i. Cash instruments
• Cash instruments are instruments whose values are
determined by the markets.
• The owner of a primary asset has a direct claim on
the benefits provided by an asset
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They include instruments like:
• Money (coins, currency, and checks),
• Stock (Common & Preferred)
• Bonds, Treasury bill,
• Commercial paper (Promissory notes, Bankers'
acceptances, Life insurance policies)
• Certificate of deposits, and Repurchase agreements
(repos)
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ii. Derivative instruments
• Derivative instruments derive value from some other
instruments.
• They include instruments like options, bond futures,
warranties, swap etc.
• Derivative assets are assets whose values depend on
(or are derived from) some primary assets.
A forward contract obliges its purchaser to buy a
given amount of a specified asset at some stated time
in the future at the forward price.
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Similarly, the seller of the contract is obliged to
deliver the asset at the forward price.
• Forwards are privately negotiated between two
parties and they are not liquid
• simply a forward is a non-standardized contract
between two communities to buy or to sell an asset at
a specified time at a price agreed upon today, making
it a type of derivative instrument.
• They are private agreements with terms that may vary
from contract to contract.
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C) Negotiable and Non-Negotiable Instruments:
i. Negotiable Instruments
 Negotiable instruments are securities that can be
easily transferred from one holder to another.
Their claims are paid to the bearer of the instrument.
 classified in to payable to order, and payable to
bearer.
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• An instrument is said to be payable to order if
it is transferred to another party by
endorsement at the back of the instrument.
• On the other hand, an instrument is said to be
payable to bearer if it is transferred to another
party by delivery.
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• Negotiable instruments include instruments
like:
 Bonds
 Checks
 Stock
 Treasury Bill etc
65
ii. Non-negotiable Instruments
• Non-negotiable instruments are securities that can
not legally be transferred from one party to another
party.
They include instruments like:
Saving accounts,
Bill of lading,
Air waybill
66
Crossed check ( a crossed check can only be
deposited in a bank-account and, unlike a bearer
check, cannot be cashed over a bank’s counter),
When an order check is crossed it generally means
that the written amount is payable only to the
account of the company or person whose name is on
the check, no cash will be issued otherwise.
Warehouse Receipts
Letter of credit, etc
67
1.4 Financial Intermediaries
The term financial intermediary may refer to:
 an institution,
firm or individual who performs
intermediation between two or more parties
in a financial context.
Typically the first party is a provider of a
product or service and the second party is a
consumer or customer.
68
Can be banking and non-banking institutions
which transfer funds from economic agents
(SBU to DBU)
Financial intermediaries can be:
• Banks Building Societies
• Credit Unions Financial adviser or broker
• Insurance Companies Life Insurance Companies
• Mutual Funds Pension Funds
69
• 1.4.1 Classifications of Financial Intermediaries
• As Fee-based and Asset Based Intermediaries
Fee Based/Advisory Financial Intermediaries:
These Financial Intermediaries/Institutions offer
advisory financial services and charge a fee
accordingly for the services rendered.
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Their services include:
• Issue Management
Underwriting
• Portfolio Management
Corporate Counseling
• Stock Broking Syndicated Credit
• Arranging Foreign Collaboration Services
Mergers and Acquisitions
• Debenture Trusteeship
Capital Restructuring
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Asset-based Financial Intermediaries:
These financial Intermediaries/Institutions finance
the specific requirements of their clientele.
The required infra-structure, in the form of required
asset or finance is provided for rent or interest
respectively.
earn their incomes from the interest spread
savers (lenders) give funds to an intermediary
institution (such as a bank), and that institution gives
those funds to spenders (borrowers).
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Deposit-type, Contractual Savings, Investment Funds
and Others
DEPOSIT-TYPE INSTITUTIONS
the most commonly used types of financial
intermediaries
offer different types of checking or savings accounts
and Time Deposits.
use the deposits to make loans such as mortgages,
consumer loans and business loans.
73
• Types of depository institutions
1.Commercial Banks:
 the largest among all financial intermediaries
the most diversified due to the large range of assets
and Liabilities they hold.
Their liabilities are in the form of checking and
savings deposits, and various types of time deposits.
74
 commercial banks hold are securities of various
forms and denominations such as:
 mortgage loans,
 consumer loans,
 business loans and
 loans to state and local governments.
75
2.Thrift Institutions: Savings and loans associations and
mutual savings banks are often called thrift
institutions.
offer checking and savings accounts and other
various types of time-deposits and use these funds to
purchase long-term mortgages.
a. Savings and loans are the largest residential
mortgage lenders.
76
specialize in maturity intermediation since they take
liquid deposits and lend the out in the form of long-
term Collaterised loans.
77
b. Credit Unions:
 are small non-profit depository institutions that are
owned by their members who are also their
customers.
 Members of credit unions all have a common bond
such as military service, occupation etc...
78
 Credit union’s primary liabilities are:
 checking deposits (share drafts) and
 savings accounts (share accounts
 usually make their investments in the form of short-
term installment consumer loans.
79
 The most significant difference between credit

unions and commercial banks are:
 the restrictions that most loans are made to
consumers only,
 the common bond requirement for members,
 the non-profit nature and
 the tax exemptions due to their cooperative nature.
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C. CONTRACTUAL SAVING INSTITUTIONS
obtain their funds through long-term contractual
arrangements and invest these funds on the capital
markets.
Insurance companies and Pension Funds
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Life Insurance Companies:
issues securities which are claims meant to protect
individuals and families from events such as
premature death or early retirement.
• In the event of early death or retirement the
beneficiaries receive benefits that were promised in
the contract.
 Many life insurance companies also offer some
savings to their policy holders.
82
Since their cash-flows are predictable they are able to
invest in long-term securities that provide higher
yields.
 Life Insurance companies are regulated by the states
they operate in unlike depository institution which
are regulated by the federal government.
83
• Casualty Insurance Companies:
• These types of insurance companies sell policies that
protect individuals or businesses against loss of
property from fire, theft, accidents or other causes
that can be predicted through statistical models.
84
Casualty insurance companies' primary source of
funds comes from premiums charged to the
policyholders. Unlike life insurance companies, the
cash outflows of casualty insurance companies are
not as predictable; therefore they invest their funds
in short-term, highly marketable securities.
85
Investment Funds
Mutual Fund:
 A mutual fund is an investment security that
enables investors to pool their money together into
one professionally managed investment.
Mutual funds can invest in stocks, bonds, cash or a
combination of those assets.
Mutual funds pool together funds from investors and
then build a Portfolio consisting of equities and
bonds.
86
The investors own shares which represent a portion
of the mutual fund pie.
The amount of shares an investor owns is dependent
on the amount of money he or she contributed.
The underlying security types, called holdings,
combine to form one mutual fund, also called a
portfolio.
87
Mutual funds are beneficial to small investors
because they offer:
 diversification,
 economies of Scale for transaction costs, and
 professional portfolio management.
 The value of a mutual fund’s share is not fixed;
 it fluctuates with the change in value of the mutual
fund's portfolio
88
Money Market Mutual Funds(MMMF)
 simply a mutual fund that strictly invests its pool of
funds in money market securities which are short-
term securities with low default-risk.
These securities are usually sold in large capital;
therefore most investors don’t have enough money
to purchase them directly.
MMMF’s offer small investors the opportunity to
invest in these short-term securities without taking
on huge financial risks.
89
• MMMF’s generally allow investors to write checks
and make withdraws making them competitive with
checking and savings accounts.
• However, there are usually limits on how many
withdraws can be made and the accounts are not
insured.
90
Pension Funds:
acquire funds from employer and employee
contributions while the employee is still working and
provide the employee with payments during
retirement.
91
Pension funds usually invest funds in corporate bonds
and equities.
Pension funds are beneficial to individuals because
they help employees plan and save for retirement.
• Because of the long-term investment nature, pension
funds generally invest in long-term, higher yield
securities.
92
iii. Other Types of Financial Intermediaries
A. Finance Companies:
obtain most of their money by issuing:
 commercial paper (short-term IOU’s) to investors, &
 sale of Equity capital and long-term debt obligations.
take this money and make loans to consumers
and businesses.
93
There are three basic types of finance companies:

(1) Consumer finance companies which specialize in
loans made to households
(2) Business finance companies which make loans
and leases to businesses
(3) Sales finance companies which finance the items
that are sold by retail stores.
 regulated by the states they operate in, but are also
subject to regulation by the federal government.
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B. Federal Agencies:
The Federal Governments act as a Financial
Intermediary through its agencies which take part in
financial intermediary type transactions.
 The goal: to reduce the costs of borrowing funds
in order to increase the flow of funds in certain
sectors of the economy.
 achieve this by selling Debt securities called agency securities
and then
 lending the funds from the sale to the economic sectors they
serve (housing & agricultural sectors)
95
1.5. Financial Markets
In economics typically, the term market means:
 The aggregate of possible buyers and sellers of a certain
good or service and the transactions between them.
 The term "market" is sometimes used for what are
more strictly exchanges,
 organizations that facilitate the trade in financial
securities, e.g., a stock exchange or commodity
exchange
96
A financial market is a market in which people and
entities can trade:
 financial securities,
 Commodities, and other fungible items of value at
low transaction costs and at prices that reflect supply
and demand Securities include stocks and bonds, and
commodities include precious metals or agricultural
goods.
97
 In finance financial markets are used to describe
firms that engaged in:
– The raising of capital (in the capital markets)
– The transfer of risk (in the derivatives markets)
– Price discovery
– Global transactions with integration of financial markets
– The transfer of liquidity (in the money markets)
– International trade (in the currency markets)
98
1.5.1 Constituents of Financial Markets
Within the financial sector, the term "financial

markets" is often used to refer just to the markets
that are used to raise finance:
1.The Capital markets for long term finance,
2.The Money markets for short term finance.
99
 Another common use of the term is as a catchall for

all the markets in the financial sector
1.Capital markets which consist of:
a. Stock markets which provide financing through the
issuance of shares or common stock, and enable the
subsequent trading thereof.
b. Bond markets which provide financing through the issuance
of bonds and enable the subsequent trading thereof.
2. Commodity markets which facilitate the trading of
commodities.
100
3.Money markets which provide short term debt

financing and investment.
4. Derivatives markets which provide instruments for
the management of financial risk.
5.Futures markets which provide standardized forward
contracts for trading products at some future date;
101
6.Insurance markets which facilitate the redistribution

of various risks.
7.Foreign exchange markets, which facilitate the
trading of foreign exchange
102
 The capital markets may also be divided into

primary markets and secondary markets
1.Primary market:
 is a market for new issues or new financial claims.
 Hence it’s also called new issue market.
 Deals with those securities which are issued to the
public for the first time.
 Newly formed (issued) securities are bought or sold
in primary markets, such as during initial public
offerings
103
2.Secondary market:
 It’s a market for secondary sale of securities.
 securities which have already passed through the
new issue market are traded in this market.
 allow investors to buy and sell existing securities.
 The transactions in primary markets exist between
issuers and investors, while in secondary market
transactions exist among investors.
104
1.5.2 Importance of Financial Markets
some of their main advantages as a glance level of

financial markets as follows:
Saving mobilization:
 Obtaining funds from the savers or surplus units
such as household individuals, business firms, public
sector units, etc
105
Investment:
Financial markets play a crucial role in arranging to
invest funds thus collected in those units which are in
need of the same.
National Growth:
An important role played by financial market is that,
they contributed to a nations growth by ensuring
unfettered flow of surplus funds to deficit units.
106
Entrepreneurship growth: Financial market contribute

to the development of the entrepreneurial claw by
making available the necessary financial resources.
Industrial development:
The different components of financial markets help an
accelerated growth of industrial and economic
development of a country, thus contributing to raising
the standard of living and the society of well-being.
107
Intermediary Functions: The intermediary functions of

a financial markets include the following:
• Transfer of Resources: Financial market facilitate
the transfer of real economic resources from
lenders to ultimate borrowers.
• Enhancing income: Financial markets allow
lenders to earn interest or dividend on their
surplus invisible funds, thus contributing to the
enhancement of the individual and the national
income.
108
• Productive usage: Financial market allow for the

productive use of the funds borrowed. The
enhancing the income and the gross national
production.
• Capital Formation: Financial market provide a
channel through which new savings flow to aid
capital formation of a country.
109
• Price determination: Financial markets allow for

the determination of price of the traded financial
assets through the interaction of buyers and
sellers.
• They provide a sign for the allocation of funds in
the economy based on the demand and supply
through the mechanism called price discovery
process.
110
• Sale Mechanism: Financial markers provide a

mechanism for selling of a financial asset by an
investor so as to offer the benefit of
marketability and liquidity of such assets.
• Information: The activities of the participants in
the financial market result in the generation and
the consequent dissemination of information to
the various segments of the market. So as to
reduce the cost of transaction of financial assets.
111
UNIT TWO: FINANCIAL INSTITUTIONS IN FINANCIAL SYSTEM
2. Concept and Classification of Financial

Institutions.
2.1.1 Concepts of the Financial Institutions:
 Financial Institutions are establishment that focuses
on dealing with financial transactions: such as
investments, loans and deposits
are composed of organizations such as:
 banks,
 trust companies,
 insurance companies and
 investment dealers.
112
2. Concept and Classification of Financial

Institutions.
2.1.1 Concepts of the Financial Institutions:
 Almost everyone has deal with a financial
institution on a regular basis.
FI involves in providing various types of financial
services to their customers.
are controlled and supervised by the rules and
regulations delineated by government authorities.
113
The principal function: to collect funds from the

investors and direct the funds to various financial
services providers in search for those funds.
114
2.1.2 Classification of Financial Institutions
Financial Institutions are classified into:
 Financial Intermediaries, and
 Other Financial Institutions.
Financial Intermediaries are classified into:
Depository Institutions:
1.Commercial Banks
2.Non-Bank Thrift Institutions:
115
Savings and Loan associations
1. Savings Banks
2. Credit Unions
Contractual Institutions:(Non-Depository Inst.)
1.Insurance Companies
2.Pension Funds
Investment Institutions:
1.Investment Companies (Mutual Funds)
2.Real Estate Investment Trusts
116
Other Financial Intermediaries:
Finance Companies
Government Credit Agencies
Mortgage Companies
Other Financial Institutions consist of:
Investment Bankers
Security Brokers
Security Dealers
117
Depository institutions :banks and credit unions which
pay interest on deposits from the interest earned on
the loans and
Non-depository institutions :insurance Companies
and mutual funds (unit trusts) which collect funds by
selling their policies or shares (units) to the public
and provide returns in the form periodic benefits and
profit payouts.
118
The following are the main detail classification of the
financial institutions:
• Commercial banks
• Credit unions
• Stock brokerage firms
• Asset management firms
• Insurance companies
• Finance companies
• Building Societies and
• Retailers
119
 service provided by financial institution depends on
its type.
Typically, these are the key entities that control the
flow of money in the economy.
The services provided by the various types of
financial institutions may vary from one institution to
another
120
2.2.1 Contributions of Financial Institutions for
Economic Growth
economic growth depends on the accumulation of
input factors in the production process and on
technical progress.
Seeing capital and capital accumulation as an
important input factor, financial development is
linked most clearly to this source of growth.
121
More specifically, financial development can affect

growth through three main channels:
(I) It can raise the proportion of savings channeled to
investment, thereby reducing the costs of financial
intermediation;
(ii) It may improve the allocation of resources across
investment projects, thus increasing the social
marginal productivity of capital; and
(iii) It can influence the savings rates of households
122
2.2.2 Important factors for stable financial system
stable financial system can be described as a

financial system that is able to withstand shocks
without giving way to cumulative processes
which could impair the allocation of savings to
investments and the processing of payments in
the economy.
123
A stable financial system is capable of:

 efficiently allocating resources,
assessing and managing financial risks,
 maintaining employment levels close to the
economy’s natural rate, and
eliminating relative price movements of real
or financial assets that will affect monetary
stability or employment levels.
124
1.Financial system architecture should be carefully
planned.
 Different stages of financial development require
adequate institutional processes to be in place.
2.A solid micro supervision of the financial sector and
individual institutions should be in place.
3.Close co-operation and exchange of information between
the central bank and supervisory authorities is
warranted at all times and especially in periods of
financial stress.
4.There are several, complementary public policies that are
typically needed to sustain or build up confidence in
financial institutions.
125
Monetary policy and fiscal policy refer to the two most
widely recognized "tools" used to influence a nation's
economic activity.
Fiscal policy. If fiscal authorities are restricted in their
ability to run deficits or accumulate large debts, an
important source of financial market stress and
financial instability is removed.
Fiscal policy is the collective term for the taxing and
spending actions of governments.
126
 The aim of most government fiscal policies is

to:
 target the total level of spending,
the total composition of spending, or both in
an economy.
 The two most widely used means of affecting
fiscal policy are:
 changes in the role of government spending or
 in tax policy.
127
If a government believes there is not enough

spending and business activity in an economy,
it can increase the amount of money it spends,
often referred to as "stimulus" spending.
If there are not enough tax receipts to pay for
the spending increases, governments borrow
money by issuing debt securities and, in the
process, accumulate debt, or "deficit"
spending.
128
 By increasing taxes, governments pull money

out of the economy and slow business activity.
Governments might instead lower taxes in an
effort to encourage more activity, hoping to
boost economic growth
When a government spends money or changes
tax policy, it must choose where to spend or
what to tax.
129
2.Monetary policy.
monetary authorities should in the first place
try to guarantee price stability
Indirectly, this should also be conducive to
supporting financial stability, as the economy
will have less macro uncertainties to deal with,
when allocating resources.
130
Monetary policy is primarily concerned with

the management of interest rates and the total
supply of money in circulation and is
generally carried out by central banks such as
the Federal Reserve.
Central banks have typically used monetary
policy to either stimulate an economy into
faster growth or slow down growth over fears
of issues like inflation.
131
The Federal Reserve, also known as the "Fed,"

has frequently used three different policy tools
to influence the economy:
1.opening market operations,
2.changing reserve requirements for banks and
3. setting the "discount rate.“
1.Open market operations are carried out on a
daily basis where the Fed buys and sells
government bonds to either inject money into
the economy or pull money out of circulation.
132
2.By setting the reserve ratio or the percentage of

deposits that banks are required to hold and
not lend back out, the Fed directly influences
the amount of money created when banks
make loans.
3.Target changes in the discount rate or the
interest rate charged by the Fed when making
loans to financial institutions which is intended
to impact short-term interest rates across the
entire economy.
a. Financial supervision. An adequate

supervisory framework helps to enhance
financial stability and maintain overall
confidence in the financial system.
Financial supervision:
• ensures the stability of the financial system;
• ensures that the financial markets work efficiently;
• protects consumers against bankruptcies or
unacceptable conduct on the part of financial
institutions.
134
b. A financial safety net.

 A financial safety net is in place in most
countries with a view to protecting small
depositors in case of a bank failure.
This system seems to work relatively well in
maintaining confidence in financial institutions.
135
c. Market discipline.
a stable financial system cannot operate
without market discipline of the financial
sector.
In summary, market discipline refers to the way
in which market participants influence a
financial institution’s behavior through
monitoring its risk profile and financial
position.
136
 In order to avoid costly bank runs and bank

failures, the sector must show some self-
discipline, to meet acceptable standards and
expectations of shareholders.
 Banks should be able to show good
performance, adopt a sound risk management
system and adhere to adequate corporate
governance rules.
137
2.3 Depository Financial Institutions
A depository financial institution is one that
specializes in depository lending
The depository financial institutions are also
known as deposit-taking financial
organizations.
The primary functions of these institutions are
to accept deposits and to use the money
collected for lending purposes.
138
They raise loanable funds by selling deposits to
the public or whose funds come significantly
from customer deposits.
The lending activities of depository financial
institutions basically include channelizing funds
for:
 mortgage loans,
commercial loans and
real estate loans.
139
The major assets of depository institutions are
loans (financial assets) and reported on the left
hand side of the balance sheet.
The major liabilities (sources of funds) of
depository institutions are deposits, presented
on the right hand side of the balance sheet.
140
Depository institutions categorized in to:
commercial banks and
other depository institutions ( saving and loan
institutions, credit unions, and microfinance
institutions).
Depository institutions are popular financial
institutions for the following reasons:
1.They offer deposit accounts that can
accommodate the amount and liquidity
characteristics desired by most surplus units.
2.They repackage funds received from deposits to
provide loans of the size & maturity desired by
deficit units.
3.They accept the risk on loans provided.
4.They have more expertise than individual surplus
units in evaluating the credit worthiness of deficit
units.
5.They diversify their loans among numerous deficit
units and therefore can absorb defaulted loans better
than individual surplus units could.
142
2.They repackage funds received from deposits to
provide loans of the size & maturity desired by
deficit units.
3.They accept the risk on loans provided.
4.They have more expertise than individual surplus
units in evaluating the credit worthiness of deficit
units.
5.They diversify their loans among numerous deficit
units and therefore can absorb defaulted loans better
than individual surplus units could.
143
1. Commercial Banks
 Commercial Banks are institutions that offer:
 deposit and credit services
investment advice,
security underwriting,
selling insurance and financial planning.
manage the customers' current and savings accounts,
 pay out checks that have been drawn on the bank by
account holders
144
Sources of Commercial Bank Funds:

The three major sources of Commercial Banks Funds are:
(i) Checkable Deposits,
(ii) Time and Savings Deposits, and
(iii) Federal Funds.
i. Checkable Deposits:
 Checkable deposits are checking account balances
maintained at commercial banks.
 Commercial Banks and other Depository Institutions
are empowered by law to issue demand deposit
accounts.
145
ii. Time and Savings Deposits:

 Time and savings deposits are interest-bearing liabilities
payable at some future date or after notice.
 Legally banks have a right to claim 30-days notice for
withdrawals of money from time and savings deposits,
but it is invariably waived by them.
 Three types of consumer, time and savings deposits
(though varying with names in different regions):
146
1. Savings deposits, also called passbook savings, fulfill

the short-term savings needs for demand deposit
customers.
2.Time Deposits, also called non-negotiable Certificates of
Deposit (CDs), provide higher rates of interest to
interest-conscious savers.
3.Money-Market Deposit Accounts (MMDAs) and
Super NOW accounts (SNOWs) are savings account
exempt from rate ceilings as a $1,000 minimum or
average balance is maintained
147
iii. Federal Funds:

Commercial banks lend one another funds through
the Federal Reserve or through a correspondent bank
which is a member of the Federal Reserve.
The lending bank notifies the Federal Reserve of the
transaction, and the Federal Reserve simultaneously
debits the lending bank’s account and credits the
borrowing bank’s account.
 The transaction is usually a 1-day loan, involves any
amount specified, and costs very little
148
Investments by Commercial Banks:

Commercial banks put their deposit money to work by
making loans and buying bonds.
The three important investments by commercial banks
are:
(i) Loans,
(ii) State and Local Government Bonds, and
(iii) Money-Market Securities.
149
i. Loans:
Loans are an essential aspect of commercial banking.
1st income from loans contributes to 80 percent of
revenues of the average bank.
2nd lending money to people in a confidential manner is
a valuable service.
3rd lending money stimulates business development and
supports a growing economy.
150
Bank loans can normally be categorized into the

following three types:
(i) Commercial Loans,
(ii) Consumer Loans, and
(iii) Mortgage (Real Estate) Loans.
151
i. Commercial Loans:
 The traditional mainstay of bank lending is the
commercial loan.
 Commercial loans can broadly be grouped thus:
(a) Seasonal loans
(b) Permanent working capital loans, and
(c) Term loans.
152
1.Seasonal Loans:
 Seasonal loans are granted for periods less than one
year, usually for 90 to 180 days.
 Borrowers use seasonal loans to buy inventory and to
finance accounts receivable during their peak sales
season.
 The loan is repaid when inventory and receivables are
converted into cash.
 Seasonal loans are called “self-liquidating loans”, since
repayment follows from the normal liquidation of
inventory and receivables.
153
2.Permanent Working Capital Loans:

Many businesses carry a big stock of merchandise,
carry accounts receivable from past sales, and so are in
need of permanent working capital.
Such loans are usually redeemed out of future profits
and depreciation or from the sale of bonds or common
stock.
154
3. Term Loans:
Term loans are credits extending from 1 to 10 years in
the future.
 Supposing a firm buys a new machine, it requires many
years of operation to earn sufficient profits to repay the
loan.
Typically term loans mature in 3 to 10 years and are
repaid in monthly or quarterly installments.
155
ii. State and Local Government Bonds:

 State and Local Government Bonds are issued by State
and City governments.
 They are also called Municipal Bonds.
 Banks benefit more by investing in these bonds.
156
iii. Money-Market Securities:

 Money-market securities are sources of liquidity, since
they can be sold at nearly full value quickly – usually
within a business day.
• Treasury Bills,
• Federal Funds,
• Repurchase agreements,
• Bankers’ acceptances,
• Commercial Paper, and
• Demand & Call Loans.
157
also perform the collection of checks deposited in their
customers' accounts.
Banks implement a number of other procedures for
payments to customers, such as:
 ATM's (Automated Teller Machines),
 telegraphic transfer, and
EFTPOS (Electronic Funds Transfer at the Point of Sale),
or
Debit Cards.
158
The borrowing process of banks is carried out by:
a. receiving funds in savings accounts and current
accounts and
b. receiving term deposits,
c. through issuance of debt securities, such as bonds and
banknotes.
provide loans to customers that:
 are repayable in installments (promissory Note)
 lending through investments in tradable debt securities
and other types of lending.
159
CBs are business corporations that:
 accept deposits,
 make loans, and
 sell other financial services:
 to business firms, households and
 Governments.
They are the largest and most important depository
institutions
They have the largest and most diverse collection of
assets of all depository institutions.
160
Their main source of funds:
a. demand deposits (i.e., checking account deposits) and
b. various types of savings deposits (including time
deposits and certificates of deposit).
 The major use of funds by commercial banks is
making loans
 These loans could include:
real estate loans and
loans to businesses &
automobile loans.
They are assets of the commercial bank.
161
Others commercial banks' assets include:
• securities (primarily federal government bonds),
• vault cash, (Cash kept on hand in a depository institution's) and
• deposits at the central bank.
Commercial banks also allow for:
 a diversity of deposit accounts, such
 as checking, savings, and time deposit.
 These institutions are run to make a profit and
owned by a group of individuals.
162
Role of Commercial Banks in the Economic Development
1. Banks promote capital formation:
 accept deposits from individuals and businesses,
 made available to the businesses which make
use of them for productive purposes in the
country.
 The banks are not only the store houses of
the country’s wealth, but also provide
financial resources necessary for economic
development.
163
2. Investment in new enterprises:

The commercial banks generally provide short
and medium term loans to entrepreneurs to
invest in new enterprises and adopt new
methods of production.
The provision of timely credit increases the
productive capacity of the economy.
164
3. Promotion of trade and industry:

The use of:
bank draft, check,
bill of exchange,
credit cards and
letters of credit etc has revolutionized both
national and international trade.
165
4. Development of agriculture:
The CBs particularly in developing countries are
now providing credit for development of
agriculture and small scale industries in rural
areas.
 The provision of credit to agriculture sector
has greatly helped in raising agriculture
productivity and income of the farmers.
166
5. Balanced development of different regions:

They help in transferring surplus capital from
developed regions to the less developed regions.
 The traders, industrialist, etc. of less developed
regions are able to get adequate capital for
meeting their business needs.
167
6. Influencing economic activity:

The banks can also influence the economic
activity of the country through its influence on
availability of credit and the rate of interest.
 If the commercial banks are able to increase
the amount of money in circulation through
credit creation or by lowering the rate of interest,
it directly affects economic development.
168
7. Implementation of Monetary policy:
The central bank of the country controls and
regulates volume of credit through the active
cooperation of the banking system in the
country.
It helps in bringing price stability and promotes
economic growth within the shortest possible
period of time.
169
8. Monetization of the economy:

The commercial banks by opening branches in
the rural and backward areas are reducing the
exchange of goods through barter.
 The use of money has greatly increased the
volume of production of goods.
 The non monetized sector (barter economy) is
now being converted into monetized sector with the
help of commercial banks.
170
9. Export promotion cells:
They provide information about general trade
and economic conditions both inside and
outside the country to its customers.
 The banks are therefore, making positive
contribution in the process of economic development.
171
Role of Banks in 21st Century:

The commercial banks are now not confined to
local banking.
They are fast changing into global banking i.e,
using latest information technology, competing
in the open market
The commercial banks are now considered the
nerve system of all economic development in
the country.
172
Virtual Banking:
Providing the banking services through extensive
use of information technology without direct
recourse to the bank by the customer is called
virtual banking.
The principal types of virtual banking services
include:
 automated teller machines (ATM’s),
phone banking and
most recently internet banking.
173
2.3.2 Other Depository Institutions
 The importance of depository institutions for
economic growth coupled with their fragility has led
governments to establish official agencies to regulate
and supervise them.
 The common goals for these agencies are to promote
the development of the modern financial systems
that:
(a) Avoid excessive fragility and
(b)Efficiently intermediate between savers and borrowers.
174
1. Savings and Loans Associations
 known as a thrift,
 specializes in accepting savings deposits and making
mortgage and other loans.
 are often mutually held (often called mutual savings
banks)
Meaning : depositors and borrowers are members
with voting rights and have the ability to direct the
financial and managerial goals of the organization.
 Members of a savings and loan association are
stockholders of the corporation
175
 were as mutual associations, (i.e., owned by
depositors) to convert funds from savings accounts
into mortgage loans.
 predominant home mortgage lender,
 making loans to finance the purchase of housing for
individuals and families.
176
 Today, the distinction between S&Ls and commercial
banks is minimal.
 S &Ls continue to hold a less diversified set of assets
than commercial banks do.
 S and Ls accept deposit and extend loans primarily to
household customers.
177
 S& LAs can be either state or federally chartered and
must fulfill the state requirements to be incorporated.
 Incorporation is based on state law, and the articles of
incorporation must clearly define:
 the organizational structure,
 the rights of members, and
 the r/ship b/n stockholders and the association.
The stockholders of the corporation are the
members of the savings and loan association
who share profits
178
The characteristics of s &Las
 assisting people with home ownership, through
mortgage lending,
 assisting their members with basic saving and investing
 passbook savings accounts and
 term certificates of deposit.
The most important purpose of these institutions is to
make mortgage loans on residential property.
 These organizations, which also are known as:
 savings associations,
 building and loan associations
 cooperative banks and homestead associations, 179
2. Credit Unions
 member-owned financial cooperative,
 controlled by its members
operated for the purpose of:
promoting thrift (saving),
providing credit at competitive rates,
180
 Credit unions are a consumer savings and lending

intermediary that pools savings to make mostly
installment-type loans to its members.
 borrow and lend money to a group of consumers with
a common association.
181
Three ingredients are needed to form a Credit Union:

(1) a group of people with a common bond,
(2) a pool of savings from members, and
(3) a portfolio of loans to members.
 Credit Union members share a ‘common bond’
 borrowing from credit unions after becoming a savings
member.
 Non-Profit-Oriented institutions.
182
Sources of Fund :
 from members’ savings in the form of shares and
deposits.
major source of revenue:
 interest paid on loans.
 Most of the loans by credit unions are the ‘consumer
loans’ to members.
Credit unions are restricted in: (i) the amounts that may
be lent on secured and unsecured loans, (ii) the term of
loans, and (iii) the interest rates that may be charged.
183
Credit unions are restricted in:

(i) the amounts that may be lent on secured and
unsecured loans,
(ii) the term of loans, and
(iii) the interest rates that may be charged.
184
Credit Unions and Banks

CU
owned by the members unlike banks.
 Policies: governed by a volunteer Board of Directors
elected from the membership.
 BD: decides on the interest rates to be charged.
 only the members are eligible to deposit money
borrow money in/from the union.
 profits earned in the forms of dividends.
185
 Due to not-for-profit financial institutions,

credit unions in some countries are exempt from
federal and state income taxes (but, not from
employment or property taxes,).
Additionally, credit union members pay income
taxes on dividends earned through financial
participation in the credit union; this is similar
to the taxation structure enjoyed by many
banks.
186
How are banks and credit unions different?
CREDIT UNIONS BANKS

 depositors are called  Banks are owned by
members. Each member is investors who may or may
an owner of the credit not be depositors
union. (stockholders).
 boards are comprised of
volunteers  board members are paid
 local and are organized to  Banks are open to the
serve the interests of its general public
membership.  Banks are for-profit
 not-for-profit financial corporations
cooperatives
187
How are banks and credit unions different?
CREDIT UNIONS BANKS

 focus on consumer loans  Banks focus on commercial
and member savings loans
188
Micro-Finance Institutions
To provide financial services to micro-entrepreneurs
and small businesses, which lack access to banking
189
The two main mechanisms for the delivery of financial

services to such clients are:
(1)Relationship-based banking for individual
entrepreneurs and small businesses;
(2) Group-based models, where several entrepreneurs
come together to apply for loans and other services as
a group.
Object: many poor and near-poor households as
possible have permanent access to an appropriate
range of high quality financial services,
190
Critics often attack microcredit while referring to it

indiscriminately as either 'microcredit' or
'microfinance'.
 MF-clients are typically self-employed,
entrepreneurs.
 In rural areas, small farmers and others who are
engaged in food processing and petty trade.
 In urban areas, micro-finance activities shopkeepers,
service providers, artisans, street vendors, etc.
191
The Distinguishing characteristics of micro finance

from Conventional Banks
 The most distinguishing characteristics of MFIs from
the conventional banks are: locally provided and easily
and quickly accessible.
192
The traditional lender's requirement for physical

collateral replaced by system of collective guarantee
groups
 Loans are dependent not only on individual's
repayment performance,
Loan amounts especially at the first loan cycle are too
small, much smaller than the traditional banks would
find it viable to provide service.
193
• Borrowers are usually required to be savers.

• MFI's operating costs as well as administrative cost per
loan are higher than the conventional banks.
194
4. Mutual Savings Banks

 Savings banks raise funds with deposits and
 invest primarily in:
 long-term securities,
 bonds,
 residential mortgages,
 consumer loans, and
 commercial loans
195
 Like Savings and Loan Associations, Savings Banks

attract funds from small investors.
 They do not make extensive use of money-market
borrowings for liquidity and have no capital stock.
 owned cooperatively by members with a common
interest, such as company employees, union members,
or congregation members.
196
 exclusive function of these banks is to:

 protect deposits,
 make limited,
 secure investments, and
 provide depositors with interest.
In general, it is a financial institution chartered by state
or federal government to:
(1) Provide a safe place for individuals to save and
(2) Invest those savings in mortgages loans, stocks,
bonds and other securities.
197
5.Money Market Funds

 A money market fund is a mutual fund that invests in
short-term, high-quality fixed income securities.
• pooling deposits of many individuals and investing
those in short-term, high quality, money market
instruments.
• They work like mutual funds and bundle the funds
from a variety of investors to increase the individual
shareholder's buying power.
• The commodity that is being traded is short-term debt.
198
 Additionally, since the minimum purchase

requirements are lower than those of other
investments, more investors have a chance to buy into
these funds.
 If the financial institution that holds them fails, your
money is gone.
199
2.4 Non-depository Institutions
Financial-Brokers
 Security Brokers: act as middlemen providing connecting
link between security buyers and security sellers, for a
commission.
 contribute their expertise and facilities toward helping
individuals, businesses, and Government bring new security
issues to the money and capital market and to exchange
existing securities.
 Many brokers do choose to specialize in one or two areas, it is
possible to find a finance broker that offers a one stop shopping
solution for a variety of business financing needs.
200
Finance Companies:
 are sometimes called department stores of consumer
and business credit.
 They grant credit to businesses and consumers for a
wide variety of purposes acquiring their funds mainly
from debt.
 Like banks, they use people's savings to make loans to
businesses, but instead of holding deposits, they sell
bonds and commercial papers.
201
Types of finance companies:

1.Consumer Finance companies-make personal cash
loans to individuals.
2.Sales Finance Companies- make indirect loans to
consumers by purchasing installment paper from
dealers selling automobiles and other consumer
durables.
3.Commercial Finance Companies- focus primarily on
extending credit to business firms.
202
2.4.2 Other Financial Institutions
Other Financial Institutions:

 Security Dealers are firms that take a position of risk in
government and privately issued securities, purchasing
the instruments from sellers and reselling them to buyers
with the expectation of a profitable spread between
purchases and sales.
203
 Investment Banks are capital market firms that assist

businesses and governments to issue debt and stock in
order to raise new capital.
 Mortgage Banks are intermediaries that work with other
businesses or real estate development projects and sell
the mortgage loan instruments to other investors.
 Venture Capital Firms are institutional investors that
provide long-term capital financing for new businesses
and rapidly emerging companies.
 Real Estate Investment Trusts are specialized lenders
and equity investors that finance commercial and
residential projects. 204
 Leasing Companies are financial firms that purchase

business equipment and other productive assets and
make the purchased items available for use by others in
return for rental fee.
 Investment companies: provide an outlet for the
savings of many individual investors towards bonds,
stocks, and money market securities. Most investment
companies stocks are highly liquid because they
repurchase their outstanding shares at current market
price.
205
 Mutual funds: are especially attractive to small

investor, which purchase shares of these funds and gain
greater diversification, risk sharing, lower transaction
cost, opportunities for capital gains
 They obtain funds through sale of shares and uses
proceeds to acquire bonds and stocks issued by various
business and government units.
206
2.4.3 Pension Funds
2.4.3 Pension Funds

accumulate savings by individuals and inspire people
against the financial misfortune of death.
receive payments (called contributions) from
employees, and/or their employers then invest the
proceeds for the benefit of the employees.
They typically invest in:
 debt securities issued by firms or government agencies
and
 in equity securities issued by firms.
207
2.4.3 Pension Funds
Basic characteristics of Pension Trust Fund

A pension plan is a fund that is established by private
employers, governments, or unions for the payment of
retirement benefits.
Pension plans have grown rapidly largely because of
favorable tax treatment.
Qualified pension funds are exempt from federal income
taxes, as are employer contributions.
208
2.4.3 Pension Funds
The two types of pension funds are;

1.Defined contribution plans and
2.Defined benefit plans.
1. Defined Benefit Plans
 identifies the specific benefit that will be payable to
you at retirement.
 Your basic retirement benefit usually is based on a
formula that takes into account factors like the number
of years a participant works for the employer (years of
service) and the participant's salary (e.g., average of
highest three or five years of earnings).
209
2.4.3 Pension Funds
This stream of periodic payments generally is known as

a pension or sometimes called an annuity.
210
2.4.3 Pension Funds
2.Defined Contribution Plans

specifies how much money will go into a retirement
plan today.
The amount typically is either a percentage of an
employee's salary or a specific dollar amount.
The amount you have at retirement depends on how
much (if anything) your employer contributes to the
plan, how much you as the employee save in the plan,
how long you leave those funds invested, and how well
your investments perform inside the plan.
211
2.4.3 Pension Funds
More and more employers are replacing defined

benefit plans with defined contribution plans,
primarily due to the expense and long-term
obligations associated with running a defined benefit
plan.
 If you have a defined benefit plan through your
employer, be sure to regularly let your employer know
that you really appreciate your retirement plan; it’s a
benefit well worth keeping
212
2.4.3 Pension Funds
The financial condition of a pension plan depends on

a number of factors, including:
 The demographic characteristics. If the plan sponsor
is a new company with relatively young employees, the
eventual pensions are very far in the future.
 The financial state of the company itself.
 The historical investment performance of the fund's
investments results in the amount of assets available at
any point.
213
2.4.4 Insurance Companies

• Insurance companies allow people to choose the
certainty of a slightly reduced current income (reduced
by the premiums they pay) in exchange for avoiding a
catastrophic loss of income (or wealth) if some accident
should occur.
• An insurer, or insurance carrier, is a company selling
the insurance;
• The insured, or policyholder, is the person or entity
buying the insurance policy.
214
The amount to be charged for a certain amount of

insurance coverage is called the premium.
The insured receives a contract, called the insurance
policy, which details the conditions and circumstances
under which the insured will be financially
compensated.
The basic purpose of insurance is to protect against loss.
215
The types of insurance companies include:

1.Captive insurance company, which is a stock
insurance company that is formed to underwrite the
risks of its parent company or in some, cases a
sponsoring group or association.
216
2.Mutual is also is a company in which each policy holder

is an owner, and where earnings are distributed as
dividends. If a net loss results, policyholders may be
subject to extra assessments. In most cases, however,
non-assessable policies are issued.
3.Reciprocal organization is an association of insured
companies that is independently operated by a manager.
Advance deposits are made, against which are charged
the proportionate costs of operations.
217
Another way to categorize insurance companies is by the

type of service offered;
a mono line company provides only one type of insurance
coverage,
a multiple line company provides more than one kind of
insurance.
A financial services company provides not only
insurance but also financial services to customers.
218
2.4.5 Investment Banking Firms

Investment Bankers market new stock and bond
offerings to individual and institutional investors
around the world.
Three major functions of investment bankers are:
 (1) Origination,
(2) Underwriting, and
(3) Distribution.
New securities are created during origination, bought
by investment bankers during underwriting and sold to
investors during the distribution phase.
219
Origination is the important function of providing

issuers investment advice, information and assistance.
Issues frequently depend heavily upon Investment
Bankers who are financial market specialists to create
securities that meet most of the issuer’s needs and are
acceptable for sale to investors.
220
 Investment banking firms often purchase a new issue or

guarantee its sale at a specified price.
 The investment banking firm underwrites the new issue
when it assumes the marketing risk.
221
• A high volume of new issues is the key to investment

banking success, because fees are based on the volume
of securities sold. Ideally, the investment banker can
sell a new issue within a few days after it is
underwritten.
222
There are two main lines of business in investment

banking.
a. Trading securities for cash or for other securities (i.e.,
facilitating transactions, market-making), or
b. The promotion of securities (i.e., underwriting,
research, etc.) is the "sell side",
223
UNIT THREE::FINANCIAL MARKETS IN FINANCIAL SYSTEM
3.1 The Concept and Structure of Markets

A Market is institutional mechanism where
supply and demand meet to exchange goods
and services; or
a place or event at which people gather in order
to buy and sell things in order to trade.
A market is not necessarily a physical and
geographically identifiable place, and goods
traded are not necessarily physical goods.
224
Trading might take place over the telephone,

and goods traded might be knowledge, etc.
There are different markets in a system, such as
the services market
the products market
the financial markets.
225
The different markets in the financial system of a

country are not isolated markets, they interact with
each other.
In Ethiopian context, the money supply is
influenced by the agricultural product price,
because we are a net exporter (seller) of those
products.
226
If the agricultural price increases, the supply

of money in the markets will increase due to
more money flowing into the country.
This could lead to a higher demand for
products in the product markets because of
the availability of money.
227
A higher demand for products could result in

prices of products going up (resulting in inflation),
which would dampen the demand for products
and money.
This interactive circle of changes is an ongoing
process in markets.
228
3.2 Financial Markets and its Formation

FM is a component of the financial system that fulfills
its various roles mainly through markets where
financial claims and financial services are traded
FM is market in which people trade financial securities,
commodities, and other fungible items of value at low
transaction costs and at prices that reflects supply and
demand.
Filled with a desire to lend or to borrow, the end users
of most financial systems are faced with a choice
between three broad approaches:
229
1. They may decide to deal directly with another, which is

costly, risky, inefficient, consequently; and not very likely
2. They may decide to use one or more of many
organized markets.
 In these markets, lenders buy the liabilities issued by
the borrowers.
If the liability is newly issued, then the issuer receives
funds directly from the lender.
Primary
Secondary
230
3. They may decide to deal via intermediaries.

lenders have an asset:
a bank deposit or
contribution to a life insurance or
pension fund
 which cannot be traded but can only be returned to
the intermediary.
 These remain in the intermediaries balance sheets
until they are repaid
231
 Intermediaries themselves will also make use of

markets,
 issuing security to finance some of their activities
and
 buying shares and bonds as part of their asset
portfolio.
One classification differentiates between two types of
markets on the basis when the market participants
are allowed to trade.
232
A call market : is a market in which transactions only take

place at:
specific times or intervals, and
the price of goods is determined by the market,
rather than the activities of buyers and sellers.
This Market is characterized By:
 less volatile than a so-called “auction market” in
which people buy and sell continuously,
 used when trading volume is low and there are very
few players involved.
233
A call market is a marketplace in which trading takes

place at certain points in time (discrete time intervals),
i.e., when the market is called.
In call markets, traders can place both limit and market
orders
234
 In a call market, people put in requests to buy and sell a

commodity, and market analysts look at the requests
to find the optimal market clearing price which will
satisfy the most number of orders.
Once the price has been determined, the transactions
take place all at once.
While the buyers and sellers have some influence over
the market price because they indicate how much they
are willing to pay or accept for a tradable
commodity, they do not have the final say.
235
 Call markets can be used to trade a wide variety of

commodities, and they are utilized all over the world.
 tend to experience less radical swings(fluctuation), and
they can be less stressful to navigate.
• the market clears in a call market at the time that the
orders are filled, which is another contrast with auction
markets
 Over time, interest in buying and selling will appear
again as people's market positions change.
236
Auction Markets
In the auction or conventional market, orders are
filled as needed, with people buying and selling with
the traders who will offer the best prices.
An auction market is some form of centralized facility
(or clearing house) by which buyers and sellers,
through their commissioned agents (brokers), execute
trades in an open and competitive bidding process.
237
 All of the needed information about:

 offers to: buy (bid prices) and
 offers to sell (asked prices) is centralized in one
location which is readily accessible to all would-be
buyers and sellers, e.g., through a computer network.
 The "centralized facility" is not necessarily a place
where buyers and sellers physically meet.
 Rather, it is any institution that provides buyers and
sellers with a centralized access to the bidding
process.
238
 is typically a public market in the sense that it open to

all agents who wish to participate.
 can either be:
 call markets, such as art auctions -- for which bid
and asked prices are all posted at one time, or
continuous markets -- such as stock exchanges and
real estate markets -- for which bid and asked
prices can be posted at any time the market is
open and exchanges take place on a continual basis.
239
 Many auction markets can trade in relatively

homogeneous assets (e.g. treasury bills, notes, and
bonds) to cut down on information costs.
 Alternatively, some auction markets (e.g., in second-
hand jewelry, furniture, paintings etc.)
 allow would-be buyers to inspect the goods to be sold
prior to the opening of the actual bidding process.
240
This inspection in the form of :

 a warehouse tour,
 a catalog issued with pictures and descriptions of
items to be sold, or
 (in televised auctions) a time during which assets are
simply displayed one by one to viewers prior to
bidding.
241
A. Over-the-counter markets:
 An over-the-counter market has no centralized
mechanism or facility for trading.
 the market is a public market consisting of a number
of dealers spread across a region, a country, or indeed
the world, who make the market in some type of
asset.
 Refers to stock traded via a dealer network as opposed
to on a centralized exchange.
 Decentralized market
242
 the dealers themselves post bid and asked prices for

this asset and then stand ready to buy or sell units of
this asset with anyone who chooses to trade at these
posted prices.
 The dealers provide customers more flexibility in
trading than brokers, because dealers can offset
imbalances in the demand and supply of assets by
trading out of their own accounts.
243
B. Organized Exchanges
 The financial markets, such as the New York Stock
Exchange, which combines auction and OTC market
features, are called Organized Exchanges.
 Specifically, organized exchanges permit buyers and
sellers to trade with each other in a centralized
location, like an auction.
244
C. Intermediation Financial Markets:

 An intermediation financial market is a financial market
in which financial intermediaries help transfer funds
from savers to borrowers by issuing certain types of
financial assets to savers and receiving other types of
financial assets from borrowers.
 The financial assets issued to savers are claims against
the financial intermediaries, hence liabilities of the
financial intermediaries,
245
 whereas the financial assets received from borrowers

are claims against the borrowers, hence assets of the
financial intermediaries.
246
3.3 Organization of Financial Markets within the

Financial System
 Markets can be organized in different ways depending
on the characteristic of the market or instrument
used to create categories.
 Depending on the characteristics of financial claims
being traded and the needs of different investors, the
flow of funds through financial markets around the
world may be divided into different segments.
247
These include:
1) The Money Market and Capital Market;
2) Primary and Secondary Markets;
3) Open and Negotiated Markets;
4) Spot; Futures; Forward; and Option Markets.
248
3.3.1 Money Market versus Capital Market

Money Market
 market for short-term financial instruments.
MMI include:-
 Treasury bills,
banker’s acceptances,
 commercial paper,
Federal funds,
municipal notes, and other securities.
249
It actually deals with near substitutes for money or

near money like:
 trade bills,
 promissory notes and
 government papers drawn for a short period not
exceeding one year.
 These short term instruments can be converted into
cash readily without any loss and at low transaction
cost.
250
Near money is an economics term describing non-cash

assets that are highly liquid, such as bank deposits,
certificates of deposit (CDs) and Treasury Bills.
Near money refers to assets that can be quickly
converted into cash. Also called quasi-money.
251
The common characteristic of MMI is that they all

have maturities of one year or less, and often 30 days
or less.
The money market does not have one fixed physical
location.
Takes place in large financial centers, like New York
and London.
investors often use money market securities as
temporary "parking places" for storing cash.
returns on MMIs are relatively low, they are among the
safest of investments.
252
The money market is designed for the making of short-

term loans.
MM enables economic units to manage their liquidity
positions.
commercial banks are the most important institutional
supplier of funds (lender) to both business firms and
Governments
the largest borrower in the money market is the
Treasury Department, which borrows billions of Birr
frequently.
253
Due to the large size and strong financial standing of

these well-known money market borrowers and
lenders, MMIs are considered to be high-quality ,”near
money” IOUs (promises to pay).
254
Features of Money Market

1.It is market purely for short-term funds or financial
assets called near money.
2.It deals with financial assets having a maturity period

up to one year only.
255
3.It deals with only those assets which can be converted

into cash readily without loss and with minimum
transaction cost.
4. There is no formal place like stock exchange as in the
case of a capital market.
256
5.Transactions have to be conducted without the help of

brokers.
6.The components of a money market are:
 the Central Bank,
Commercial Banks,
Non-banking financial companies,
discount houses and acceptance house.
Commercial banks generally play a dominant in this
market.
257
Objectives of Money Market

1.To provide a parking place to employ short-term
surplus funds.
2.To provide room for overcoming short-term deficits.
3.To enable the Central Bank to influence and regulate
liquidity in the economy through its intervention in this
market.
4.To provide a reasonable access to users of Short-term
funds to meet their requirements quickly, adequately and at
reasonable costs.
258
Capital Market
 referred to the market for trading long-term debt
instruments ( mature in more than one year).
the market where capital is raised.
 used in a more general context to refer to the market
for stocks, bonds, derivatives and other investments.
designed to finance long-term investments
259
Capital Market
 the securities traded are informally classified into:
short-term, up to 5yrs CMI
medium-term 5-10yrs
long-term securities more than 10yrs.
The company or other entity issuing the security is
called the issuer
260
Capital Market
 The principal suppliers and demanders of funds in the
CM are more varied than in the MM
The most important borrowers in the capital market
are businesses of all sizes that issue long-term IOUs
to cover the purchase of equipment and the construction
of new facilities.
Many borrowers in the capital market are financial
institutions: insurance companies, mutual funds,
security dealers, and pension funds that supply the
bulk of capital market funds.
261
Capital Market
 The principal suppliers and demanders of funds in the
CM are more varied than in the MM
The most important borrowers in the capital market
are businesses of all sizes that issue long-term IOUs
to cover the purchase of equipment and the construction
of new facilities.
Many borrowers in the capital market are financial
institutions: insurance companies, mutual funds,
security dealers, and pension funds that supply the
bulk of capital market funds.
262
3.3.2. Open versus Negotiated Markets

Financial market can also be divided into open market
and negotiated market
In open markets, financial instruments are sold to the
highest bidder, and they can be traded as often as is
desirable before they mature.
In negotiated markets, the instruments are sold to
one or a few buyers under private contract
263
Open Market
 The open market means an impersonal market.
 good quality securities are bought and sold in large
quantity.
 There may not be contract between buyers and seller.
 In this market the equity securities of big companies
are sold and purchased by big-small investors.
 The bonds of some companies are sold to the highest
bidder through the open market.
264
Such bonds are purchased and sold many times before

maturity.
 Most of the government securities are sold in the open
market.
 It is a market in which buyers enter competitive bids
and sellers enter competitive offers at the same time
 Open-market transactions occur on the open market
where average investors put through their transactions.
 The only difference is that insiders must follow
certain rules and regulations that have been set out by
the policy makers
265
Negotiated Market
 The market in which the lender and the borrower
negotiate the loan and personal basis is called
negotiated market.
 corporate securities are sold by personal negotiation
to one or more than one buyer.
the securities purchased are dept with security until
maturity.
• A bank taking loan from a bank or a businessman
taking loan from credit institution fall under negotiated
is called non-intermediate financial market.
266
An individual who goes to his or her local banker to

secure a loan for a new car enters the negotiated
market for auto loans.
 It is a secondary market in which potential buyers and
sellers negotiate the price of each transaction.
267
Most stock exchanges are negotiated markets: buyers

express interest by posting bid prices and sellers do the
same with ask prices.
A negotiated market operates according to the law of
supply and demand!
Negotiable market is a closed-market transaction
which is the opposite of an open-market transaction.
Any trading that is done in a closed-market
transaction is between the insider and the company;
no other parties are involved.
268
Most often, negotiable-market transactions occur when

the insider is receiving shares as part of a compensation
package or through stock options.
 A negotiated market exists where the buyer puts limits
or what he is willing to pay or the price he is willing to
accept.
An open market is where he will buy or sell at market
whatever that might be.
269
3.3.3 Primary versus Secondary Markets

 In financial market basically there are also two
common:
markets- primary market and
secondary market.
 The primary market is the market for the first issue of
securities.
270
 This issue is normally done by means of a public issue

or by private placement.
 The secondary market is the market for trading
securities once they have been issued.
• The secondary market has a big influence on the issues
in the primary market, as the market rate is
determined in the secondary market.
271
 Issues in the primary market at below market rate,

determined in the secondary market, would be issued at
a discount on the nominal value of the instrument.
If the volumes traded in the secondary market are high
it could be an indicator that an excess of long-term money
is available in the market, and it may thus be an
opportune time to issue new securities into the market
by means of the primary market.
272
Primary Market
 Also called the new issue market, is the market for
issuing new securities.
 PM refers to where shares are created, are sold by the
issuing company to investors, and are listed for the
first time on an exchange.
 is a market for new capitals that will be traded over a
longer period.
273
 In the primary market, securities are issued on an

exchange basis.
The underwriters,:-the investment banks, play an
important role in this market:
they set the initial price range for a particular share
and then supervise the selling of that share.
excludes several other new long-term finance sources,
such as loans from financial institutions.
274
The primary market is synonymous with an

initial public offering (IPO), which occurs when a
private company first sells shares to the general
public and is listed on an exchange.
Many companies have entered the primary market to
earn profit by converting its capital, which is basically a
private capital, into a public one, releasing securities to
the public.
This phenomena is known as "public issue" or "going
public."
275
There are three methods through which securities can

be issued on the primary market.
These are:
a. Rights issue;
b. Initial Public Offer (IPO); and
c. Preferential issue.
 Initial public offering (IPO) is stock issued for the very
first time to the public when a company "goes
public."
276
The holders of these stocks can have the following

rights:
Preemptive rights - on issuance of additional share
allows existing investors to maintain their ownership
position (as a percentage) when new stock is issued.
Without this right investors would have their ownership
interest diluted.
Rights of offering - allow existing stockholders to buy
additional shares in the company at a subscription
price that is generally lower than the market price.
277
Secondary Market
 where existing shares are bought and sold by
investors, traders and speculators alike.
 investors buy and sell among themselves.
 They trade previously issued securities without any
involvement by the issuing companies.
 Its chief function is to provide liquidity to security
investors-that is, provide an avenue for converting
financial instruments into ready cash.
 It is also referred as "after market".
278
 Secondary market is a place where any type of used

goods is available.
 The volume of trading in the secondary market is far
larger than trading in the primary market.
 secondary market does not support new investment
279
Secondary market for equity serves two purposes:

marketability and Share price valuation:
1. Marketability - Allows buyers in the primary market
to subsequently sell shares.
 It would be hard to sell stock in primary market if
there wasn't a secondary market.
2. Share price valuation - Active trading in secondary
markets establishes a true fair market value of stock.
Secondary Markets further classified as:
Dealer Market;
Agency Market;
280
 Fully Automated Trading system; and

 Stock Market Indexes.
A. Dealer Market – OTC (Over the Counter), dealer
network, like NASDAQ, where dealers ("market
makers") specialize in buying/selling certain stocks.
You are buying (selling) the stock from (to) the dealer, not
from (to) another investor, who holds the stock in his/her
account.
That is, Bid (dealer buys) ; Ask (dealer sells) and Spread
is the dealer's commission,
281
• For e.g., $5(bid)-$5.05(ask), 1% spread.

• If the market is very competitive; thus the spreads
could be very lower.
• No limits on the number of dealers/market makers for a
certain stock, and no limit on the number of stocks a
dealer can trade.
B. Agency Market – Agencies are organized as "floor-
broker / specialist-market-maker" centralized trading
systems, where face-to-face trading takes place at a
physical location/trading floor.
282
 The broker takes a buy (sell) order from a

client/investor/trader, and matches it with a sell (buy)
order from another client/trader.
 It is more of an auction market.
C. Fully Automated Trading system
 It serves in the countries where trading is completely
automated.
 That is, quotations and trading takes place directly by
computer.
 Orders are filled faster, and very few people are
needed to operate an exchange.
283
D. Stock Market Indexes

A Stock Market Index is composite value of a group of
stocks traded on secondary markets.
Movements in a stock market index provide investors with
information on movements of a broader range of
secondary market securities.
284
3.3.4 Spot versus Futures/Forward, and Option

Markets
Differences:
In the spot market, assets or financial services are
traded for immediate delivery (usually within two
business days).
Contracts calling for the future delivery of financial
instruments are traded in the futures or forward
market.
Contracts granting the right to buy or sell certain
securities at specified prices within a certain period
are traded in the options market 285
• A spot market is one in which assets or financial

services are traded for immediate delivery (usually
within one or two business days).
 If you pick up the telephone and instruct your broker to
purchase X-Corporation shares at today’s price, this is a
spot market transaction.
 You expect to acquire ownership of X-Corporation
shares within a matter of minutes.
 It is a commodities or securities market in which goods
are sold for cash and delivered immediately.
286
Contracts bought and sold on these markets are

immediately effective.
A futures transaction for which commodities can be
reasonably expected to be delivered in one month or
less.
 The spot market is also called the "cash market" or
"physical market", because prices are settled in cash
on the spot at current market prices, as opposed to
forward prices.
287
A future or forward market, is designed to trade

contracts calling for the future delivery of financial
instruments.
 For example, you may call your broker and ask to
purchase a contract from another investor calling for
delivery to you of Birr 1 million in Government bonds
six months from today.
 The purpose of such a contract would be to reduce risk
by agreeing on a price today rather than waiting six
months, when government bond prices might have
risen.
288
Futures markets, which provide standardized forward

contracts for trading products at some future date.
289
 A currency futures contract consists of a standardized

agreement to make the delivery of one currency and
receive another currency at some fixed upcoming
point in time at a rate determined by the market.
 Put simply, a currency futures contract is a forex
forward contract with a standard delivery date and
standard contract sizes traded on a centralized
exchange.
290
Options markets:
also offer investors in the money and capital markets an
opportunity to reduce risk.
These markets make possible the trading of
options on selected stocks and bonds, which are
agreements (contracts) that given an investor the
right to either buy from or sell designated
securities to the writer of the option at a
guaranteed price at any time during the life of the
contract.
291
 With spot transactions, there is an agreement

between two parties regarding a rate of exchange, and
the currencies are traded at that rate, occurs in one
month or less.
In a forward transaction, money does not change
hands until a future date.
 The buyer and seller agree on an exchange rate and
the future date when the transaction will occur,
regardless of what the market exchange rate is on that
date.
 The future exchange can be a matter of days, months
or years. 292
An option is more flexible than a forward

transaction.
It allows the option owner the right to buy or
sell a specific amount of foreign currency at a
certain price before the chosen expiration date.
 Depending on the market, the option owner
may exercise his option or allow the option to
lapse and buy at the less expensive current
market rate.
293
3.3.5 Debt versus Equity Markets:

These markets are also known as securities
exchanges.
• Debt Markets- The debt market is the market
where debt instruments are traded.
Debt instruments are assets that require a fixed
payment to the holder, usually with interest.
294
a debt instrument is a contract in which:

 one party -- the borrower -- agrees to repay
 another party – the lender -- at a specified future date,
known as the maturity date.
 Short-term debt securities are instruments that a
borrower must repay within a year.
 Long-term instruments have a maturity exceeding 12
months.
295
 Debt instrument holders, also known as bondholders,

receive periodic interest payments during the loan
term and the principal amount when the loan matures.
296
Equity Markets- The equity market (often referred to as

the stock market) is the market for trading equity
instruments.
 Stocks are securities that are a claim on the earnings
and assets of a corporation.
 Equity securities are portions of a company's
ownership capital.
 buyers of equity instruments -- known as shareholders
or stockholders -- own the company.
297
 Shareholders receive periodic dividend payments and

make profits when share prices increase.
Stockholders also participate in annual meetings and
vote on important corporate affairs, including the
appointment and compensation of senior
management and directors.
298
Similarities and Difference between Debt and Equity

Markets/Instruments
 The price of shares determines the amount of funds
that a firm can raise by selling newly issued stock.
 will determine the amount of capital goods this firm
can acquire and, ultimately, the volume of the firm’s
production.
 Poor performance of equity and debt markets reduces
wealth of households who hold stocks and bonds.
 This, in turn, reduces their spending (via the wealth
effect), slowing down the economy.
299
• Both instruments often interrelate in the financial

marketplace.
• In fact, investors who are interested in debt-equity
products can purchase hybrid instruments, such as
convertible bonds and preferred shares.
• These instruments allow an investor to benefit from
positive market developments in equity or debt sectors.
For example, convertible bondholders can exchange
their debt assets with equity products if stock market
profits are expected to be higher than what bonds offer.
300
On the other hand, the debt or bond market and the
equity or stock markets are the two most important
pieces of the capital market.
 While the equity or stock market is mostly known as a
barometer about where the economy may be headed,
the debt or bond market is highly regarded as an
indicator about how the economy is doing now.
The stock market as an equity market focuses primarily
on predicting future earnings of corporations and the
bond market as a debt market cares more about
current interest rates that are the concerns of many
market participants beyond corporations. 301
Companies issue more debt than equity on a continuing

basis. The underwriting process for debt issuance is
simpler than for equity issuance. Issuing debt concerns
mostly a company's ability to pay interest and repay
principal at maturity, and thus involves basically credit
analysis of certain debt-related financial ratios.
Issuing equity requires the complete evaluation of a
company's net worth so that new shares of equity can
be appropriately priced. The higher demand by
companies on debt than equity results in the larger size
for the bond market than the stock market.
302
 While only corporations can issue stocks, governments

and any organizations and agencies, along with
corporations, may all issue bonds.
303
• Not all companies are publicly traded; many companies

are privately held, and their equity is not counted as
part of the stock market. On the other hand, almost all
entities borrow in the debt market. Some borrowings
may be done on a rolling basis through refinancing,
effectively maintaining an entity's relative borrowing
size, whereas in the stock market, companies
implement share buybacks from time to time, reducing
their market size.
304
• The debt or bond market is a massive, decentralized

network of market participants, while the equity or
stock market is a highly centralized marketplace
consisting of only a few exchanges and a limited
number of tightly controlled over-the-counter markets.
The differences in market structure provide different
incentives for bond issuers and stock issuers.
• Bonds often are referred to as fixed-income securities
that pay an agreed-upon, periodic interest and return
investment principal at maturity, presenting relatively
low risk to investors. On the contrary, stocks provide
potentially the most returns but also with higher risks.
305

Financial Markets & Institutions: Chapter 1

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Financial Markets & Institutions: Chapter 1

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Financial Markets &

Financial Financial Financial

Financial Other Financial

MM CM Depository Contractual Investment

• These promises are FINANCIAL LIABILITIES of

Ultimate Financial Ultimate

 The most significant difference between credit

There are three basic types of finance companies:

Within the financial sector, the term "financial

 Another common use of the term is as a catchall for

3.Money markets which provide short term debt

6.Insurance markets which facilitate the redistribution

 The capital markets may also be divided into

some of their main advantages as a glance level of

Entrepreneurship growth: Financial market contribute

Intermediary Functions: The intermediary functions of

• Productive usage: Financial market allow for the

• Price determination: Financial markets allow for

• Sale Mechanism: Financial markers provide a

2. Concept and Classification of Financial

2. Concept and Classification of Financial

The principal function: to collect funds from the

More specifically, financial development can affect

stable financial system can be described as a

A stable financial system is capable of:

 The aim of most government fiscal policies is

If a government believes there is not enough

 By increasing taxes, governments pull money

Monetary policy is primarily concerned with

The Federal Reserve, also known as the "Fed,"

2.By setting the reserve ratio or the percentage of

a. Financial supervision. An adequate

b. A financial safety net.

 In order to avoid costly bank runs and bank

Sources of Commercial Bank Funds:

ii. Time and Savings Deposits:

1. Savings deposits, also called passbook savings, fulfill

iii. Federal Funds:

Investments by Commercial Banks:

Bank loans can normally be categorized into the

2.Permanent Working Capital Loans:

ii. State and Local Government Bonds:

iii. Money-Market Securities:

2. Investment in new enterprises:

3. Promotion of trade and industry:

5. Balanced development of different regions:

6. Influencing economic activity:

8. Monetization of the economy:

Role of Banks in 21st Century:

 Credit unions are a consumer savings and lending

Three ingredients are needed to form a Credit Union:

Credit unions are restricted in:

Credit Unions and Banks

 Due to not-for-profit financial institutions,

CREDIT UNIONS BANKS

CREDIT UNIONS BANKS

The two main mechanisms for the delivery of financial

Critics often attack microcredit while referring to it

The Distinguishing characteristics of micro finance

The traditional lender's requirement for physical

• Borrowers are usually required to be savers.

4. Mutual Savings Banks

 Like Savings and Loan Associations, Savings Banks