SAINT MARY’S

UNIVERSITY

Faculty of Accounting and finance

Financial market and institution

assignment one

NAME: mhiret zerihun

ID: RAD/0517/2011
SECTION: I
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1. Direct finance

With the direct financing technique borrower and lender meet each other and exchange funds in

return for financial asset without the help of a third party to bring them together.

You engage indirect finance when you borrow money from a friend and give him or her your

IOU or when you purchase stocks or bonds directly from the company issuing them

Direct finance is the simplest method of carrying out financial transaction ns and probably the

most efficient if conditions are right.

2. Semi direct finance

Early in the history of most financial systems, anew form of financial transaction called semi

direct finance appears. Some individuals and business firms become securities brokers and

dealers whose essential functions is to bring surplus-budget ( SBU) and deficit budget ( DBU)

units together, there by reducing information cost.

We must distinguish here between a broker and a dealer in securities. A broker is merely an

individual or financial institution who provides in formation concerning possible purchases and

sales of securities.

Either a buyer or a seller of securities may contact a broker, whose job is simply to bring buyers

and sellers together. A dealer also serves as a service channel between buyers and sellers, but the

dealer actually at a favorable price.

Semi direct finance may have some advantages over direct finance if conditions are right. It

lowers the search (information) costs for participants in financial markets. Frequently, a dealer

will split up a large issue of primary securities in to smaller units affordable by even buyers of

modes means and there by , expand the flow of savings into investment, In addition, brokers and

dealers facilitate the development of secondary markets in which securities can be offered for

resale.
3. Indirect finance and financial intermediation

The limitations of direct and semi direct finance under certain condition stimulated the

development of indirect finance carried out with the help of financial intermediaries. Financial

intermediaries include commercial banks, insurance companies, credit union finance companies,

savings and loan associations, Savings banks, pension fund, mutual funds and similarly

organization.

Their fundamental role in the financial system is to serve both ultimate lenders and borrowers

but in a different way than brokers and dealers do financial in term diaries issue. Securities of

their own-often called secondary securities to ultimate lenders and at the same time accept IOUS from
ultimate borrower’s primary securities.

The Secondary securities issued by financial intermediaries include such familiar instruments as

checking and saving accounts, life insurance policies, annuities and shares in a mutual fund.

They are generally low risk default, can be acquired in small denomination.

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Financial Assets Vs Physical Assets

1. Physical assets

Physical assets have a physical characteristics or location such as buildings, equipment, inventories etc.
Physical assets provide continuous stream of services. Physical assets wear out or subject to
depreciation. Their physical condition is relevant for the determination of market value.

2. Financial assets

Financial assets represent a financial claim with a right to some cash. They represent a claim against the
income or wealth of business, household, or unit of Government. They are usually created by or related
to the lending of money (credit transactions).

The financial assets are the financial instruments that are traded in the financial markets such as money
market and capital market.

These financial assets constitute the documentary evidence through the funds raise secure money from
the investors and savers who have surplus to part with for the use of corporate entities and
government.
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Characteristics of Financial Assets

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

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

Divisibility & denomination-denominated in smaller sizes

Reversibility-ability to be converted back to cash at a lower cost (low round trip cost)

Term to maturity-length of time between when the instrument is issued and its liquidation.

Some instruments are liquidated upon demand by the creditor

Instruments may be issued with the term of a few days to so many years. E.g. T-bill Vs Bonds

Liquidity-can be resold without substantial loss of value.

Convertibility-ability to be converted into other financial assets

Cash flow and return predictability- return on a financial asset depends on the cash flow expected to be
received

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The Role/Functions of the Financial System in an Economy

Saving Role/Function

The system of financial markets and institutions provides a conduit for the public’s savings. Bonds,
stocks, deposits, and other financial claims sold in the money and capital markets provide a profitable,
relatively low-risk outlet for the public’s savings. Those savings flow through financial markets into
investments so that more goods and services can be produced in the future which increases society’s
standard of living. When savings flow decline, however, the growth of investment and living standards
tends to elevate.

The savings function of any financial system supplies the vital raw material of funds to invest so that
economic growth and living standards can flourish.
Liquidity Role/ Function

It is a means of raising funds by converting securities and other financial assets into cash balances.
The financial system provides liquidity for savers holding financial instruments but who are in need of
money. In modern society, money consists of mainly deposits held in banks and is the only financial
instrument possessing of perfect liquidity. Money can be spent as it is without the necessity of
converting it into some other form.

iii. Wealth Role/Function

It is a means to store purchasing power until needed at a future date for spending on goods and
services. Shifting power from high earning periods to warnings periods of life. For the business and
individuals choosing to save, the financial instruments sold in the money and capital markets provide an
excellent way to store wealth (to preserve value or hold purchasing power) until funds are needed for
spending in the future periods.

While we might choose to store our wealth in things” (e.g. automobiles and clothes), such items are
subject to depreciation and often carry great risk of loss.

Credit Role/Function

The role of credit is to provide a continuous supply of credit for the business, consumers and
governments; to support both the consumption and investment spending in the economy. Example,
Governments borrow funds to construct public facilities and to cover daily expenses until tax revenues
flow in.

Payments Role/ Function:

It provides a mechanism for making payments to purchase goods and services; certain financial assets,
mainly checking accounts and negotiable order of withdrawal accounts, serve as a medium of exchange
in the making of payments. Example: Credit cards (plastic credit cards) give the customer instant access
to short-term credit but also is widely accepted as a convenient means of payment. Debit card (plastic
credit cards) - is used today to charge a buyer’s deposit account for purchasing of goods and services
and transfer the proceeds instantly by wire to the seller’s account.
Risk Role/Function:

The financial markets offer business, consumers and Governments protection against life, health,
property and income risks. It provides a means to protect business, consumers, and Governments
against risk to people, property and income.

Example: life insurance policy

Thus, capital markets allow the risk that is inherent to all investments to be borne by investors most
willing to bear that risk. This allocation of risk also benefits the firms that need to wise capital to finance
their investments. When investors can self-select into security types with risk-return characteristics, that
best suits their preferences, each security can be sold for the best possible price. This facilitates the
process of building the economy’s stuck of real assets.

Example: More optimistic or risk-tolerant investors buy shares of stock.

The more conservative individuals buy bonds.

Policy Role/Function:

In recent decades, the financial market has been the principal channel through which the Federal
Government has carried out its policy of attempting to stabilize the economy and avoid excessive
inflation.

By manipulating the interest rate

By manipulating the availability of credit

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Negotiable Bank Certificates of Deposit (CD): - A certificate of deposit (CD) is a debt instrument sold by a
bank to depositors that pays annual interest of a given amount and at maturity pays back the original
purchase price. Before 1961 CD', were non-negotiable; that is, they could not be sold to someone else
and could not be redeemed from the bank before maturity without paying a substantial penalty. Now
CD are on negotiable term, that is, the can be sold to other person and can be redeemed from the bank
even before maturity date.

The negotiable certificate of deposit (NCD) is issued by large commercial banks and other depository
institutions as a short-term source of funds. Its minimum denomination is $100,000, although a $1
million denomination is more common. Non-financial corporation’s often purchase NCDs. Although NCD
denominations are typically too large for individual investors, they are sometimes purchased by money
market foists that have pooled individual investors’ funds. Thus, the existence of money market funds
allows individuals to be indirect investors in NCDs, making a more active NCD market.

Maturities of NCDS normally range from two weeks to one year. A secondary market for NCDS exists
providing investors with some liquidity. However, institution prefers not to have their newly issued
NCDs compete with their previously issued NCDS that are being resold in the secondary market. The
over-supply of NCDs for sale can force them to sell their newly issued NCDs at a lower price.

Measurement of the Premium. NCDs must offer a premium above the Treasury bill yield to compensate
for less liquidity and safety. The premiums are generally higher during recessionary periods. The
premiums also reflect the market’s perception about the safety of the financial system.

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Repurchase Agreement (RPs): - These are effectively short-term loans (usually with a maturity of less
than two weeks) in which T-bills serve as collateral, an asset that the lender receives if the borrower
does not pay back the loan. Repurchased agreement is made in such a way that a large company say BGI
Ethiopia, may have some idle funds in its bank account say 1 million, which the company would like to
lend overnight. The company uses this excess 1 million to buy T-bill from a bank; the bank agrees to
repurchase them the next morning at a price slightly above the company purchase price. Repurchase
Agreement is a fairly recent (1989) innovation in financial market. Repurchase agreements are now
important sources of funds to banks, and the most important lenders in these markets are large
corporations.

A repurchase agreement (or repo) represents the sale of securities by one party to another with an
agreement to repurchase the securities at a specified date and price; In essence, the repo transaction
represents a loan backed by the securities. If the borrower defaults on the loan, the lender has claim to
the securities. Most repo transactions use government securities, although some involve other securities
such as commercial paper or NCDs. A reverse repo refers to the purchase of securities by one party from
another with an agreement to sell them. Thus, a repo and reverse repo can represent the same
transaction but from different perspectives. These two terms are sometimes used interchangeably, so a
description of a repo transaction may actually reflect a reverse repo.

Repo transactions are negotiated through a telecommunications network. Dealers and repo brokers act
as financial intermediaries to create repo for firms with deficient and excess funds, receiving a
commission for their services.

When the borrowing firm can find a counter party to the repo transaction, it avoids the transaction fee
involved in having a government securities dealer find the counter party. Some companies that
commonly engage in repo transactions have an in-house department for finding counter parties and
executing the transactions. These same companies that borrow through repos may, from time to time,
serve as the lender. That is, they purchase the government securities and agree to sell them back in the
near future.

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Treasury Bills (T- bills): - These are short-term debt of government. They are issued in three, six and
twelve-month’s maturities. Treasury bills pay a set amount at maturity and have no interest payments,
but they effectively pay interest by initially selling at a discount. That is, a price lowers than the set
amount paid at maturity and the difference between these prices represents return to the owner of the
instrument. For example: You might buy a one-year T-bill in September for 9,000 birr that can be
redeemed for 10,000-birr September of the coming year. The difference between the initial price of the
T-bill and the price at maturity represents return from investment in T-bill.

Many country government issue T-bill and the United State government is the most liquid of the entire
money market instrument, because they are the most actively traded. They are also considered as risk
free instrument because there is no possibility of default. The government of Ethiopia frequently issues
T-but they are not accessible to small investors or households. Income earned from T-bills is free from
tax.

T-bills do not offer coupon payments but are sold at discount from par value. Their yield is influenced by
the difference between the selling price and purchase price. If an investor purchases a newly issued T-
bill and holds it until its maturity, the return is based on the differences between the par value and the
purchase price. If the T-bill is sold prior to maturity, the return is based on the difference between the
price for which the bill was sold in the secondary market and the purchase price.

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Bankers’ Acceptance: -: These money market instruments are created in the course of international
trade. Bankers' Acceptance are a bank draft (a promise of payment similar to a check) issued by a firm,
payable at some future date, and guaranteed for payment by the bank who stamps it as accepted. The
firm issuing the instrument is required to deposit the required funds into its account to cover the draft.
If the firm fails to pay the amount to the holder of the draft, the bank's guarantee means that the bank
that puts its stamp is obligated to make payment on the draft.

The advantage of the firm issuing the draft is that the draft is more likely to be accepted when
purchasing goods abroad because the foreign exporter knows that even if the company purchasing the
goods goes bankrupt, the bank draft will still be paid off.

A banks acceptance represents a bank accepting responsibility for a future payment. It is commonly
used for international trade transaction. Exporters often prefer that banks act as guarantor before
sending goods to importers whose credit rating is not known. The bank therefore facilities international
trade by stamping ACCEPTED on a draft which obligates payment at a specified point in time in turn the
important will pay the bank what is owed to the exporter along with a fee to the bank for guaranteeing
the payment.
Exporters can hold the banker’s acceptance until the date at which payment is to be made, yet they
frequently sell the acceptance before then at a discount to obtain cash immediately. The investor who
purchases the acceptance then receives the, payment guaranteed by the bank in the future. The
investor’s return on a banker's acceptance like that of commercial paper, is derived from the discounted
price paid for the acceptance and the amount to be received in the future. Maturities on banker’s
acceptances often range from 30 to 270 days. Because there is a possibility of banks’ defaulting on
payment, investors are exposed to slight degree of default risk. Thus, they deserve a return above the T-
bill yield as compensation.

Because acceptances are often discounted and sold by the exporting firm prior to maturity an active
secondary market exists Deals match up companies that wish to sell acceptances with other companies
that wish to purchase them. The bid price of dealers is less than their ask price, which creates their
spread, or their reward for doing business. The spread is normally between one-eighth and seven-
eighths of one percent.

9/ positive effect

- Reduction in poverty
- Improved technology and infrastructure negative
- Creative destruction
- Health challenges
- Increase in income inequality
- Increase pollution

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TYPES OF FINANCIAL INSTRUMENTS

There are mainly two types of financial instruments: Derivative Instruments and Cash Instruments.

DERIVATIVE INSTRUMENTS

We derive the value of such instruments from the value and characteristics of the asset they represent.
Or in simple words, these instruments are securities that we link to other securities. Such instruments
can represent assets like interest rates, indexes, shares and more. Examples of such instruments are
futures and options contract. Derivative instruments can either be exchange-traded or over-the-counter
(OTC) derivatives.

CASH INSTRUMENTS

Cash instruments are the instruments whose market value is available directly. Market forces directly
determine and influence the value of such instruments. Such securities are readily transferable as well.
Shares, bonds, cheques are some examples of these instruments. Deposits and loans are also cash
instruments if lender and borrower agree over its transferability.