CHAPTER ONE

1.1OVERVIEW OF FINANCIAL SYSTEM

A financial system no matter how rudimentary is a complex system. It is complex in its operation neither
the system itself nor its operation can be measured accurately. Because of its complexity a simple
definition cannot adequately capture what a financial system is.
A financial system comprises financial institutions, financial markets, financial instruments, rules,
conventions, and norms that facilitate the flow of funds and other financial services within and
outside the national economy.
A financial system is defined as
 a financial system is a set of institutions, such as banks, insurance companies, and stock
exchanges, that permit the exchange of funds.
 A 'financial system' is a system that allows the exchange of funds between lenders,
investors, and borrowers. Financial systems operate at national and global levels. ... Money,
credit, and finance are used as medium of exchange in financial systems.
 the collection of markets, individuals, laws, polices, systems, conventions, techniques and
institutions through which bonds, stocks, and other securities are
Traded, interest rates are determined and financial services are provided and delivered.
A financial system consists of institutional units and markets that interact, typically in a complex
manner, for the purpose of mobilizing funds for investment and providing facilities including payment
Systems for the financing of commercial activity.
The financial system of an economy consists of the following four main components:
1) Financial assets (A financial asset is a liquid asset that gets its value from a contractual right or ownership
claim. Cash, stocks, bonds, mutual funds, and bank deposits are all are examples of financial assets. )
2) Financial markets (Some examples of financial markets and their roles include the stock market, the
bond market, and the real estate market. Financial markets can also be broken down into capital markets,
money markets, primary markets, and secondary markets.)
3) Financial intermediaries (Some examples of financial intermediaries are banks, insurance companies,
pension funds, investment banks and more.)
4) Financial regulators (For example, in the USA banking is regulated by a lot of regulators, such as the
Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the
Currency, the National Credit Union Administration, the Office of Thrift Supervision, as well as regulators at the
state level.)
Each of the components plays a specific role in the economy.
1. Financial instruments: monetary claims like stocks, and bonds.
2. Financial markets facilitate the flow of funds in order to finance investments by corporations,
governments and individuals.
3. A financial institution within the system is primarily to intermediate between those that provide
funds and those that need funds, and typically involves transforming and managing risk.
4. The financial regulators perform the role of monitoring and regulating the participants in the
financial system.
The Role/Functions of the Financial System in an Economy

The financial system plays a vital role in the economic development of a country. It encourages both

savings and investment and also creates links between savers and investors and also facilitates the
expansion of financial markets and aids in financial deepening and broadening.

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The financial system of a country performs certain valuable functions for the economic growth of that
country. The main functions of a financial system may be briefly discussed as below:
1. Saving function:
An important function of a financial system is to mobilize savings and channelize them into productive
activities. It is through financial system the savings are transformed into investments.
2. Liquidity function:
The most important function of a financial system is to provide money and monetary assets for the
production of goods and services. Monetary assets are those assets which can be converted into cash or
money easily without loss of value. All activities in a financial system are related to liquidity-either
provision of liquidity or trading in liquidity.
3. Payment function:
It provides a mechanism for making payments to purchase goods and services; certain financial assets,
mainly checking accounts and now 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.

 Debit cards and other electronic means of payment, including computer terminals at homes,
offices, and stores are likely to displace checks and other pieces of paper as the principal
means of payment.
4. Risk function:
Risk can be decreased through diversification (The holding of many (rather than a few) assets and asset
formation. The financial markets provide protection against life, health and income risks. These
guarantees are accomplished through the sale of life, health insurance and property insurance policies.
5. Information function: A financial system makes available price-related information. This is a
valuable help to those who need to take economic and financial decisions. Financial markets
disseminate information for enabling participants to develop an informed opinion about investment,
disinvestment, reinvestment or holding a particular asset.
6. Transfer function: A financial system provides a mechanism for the transfer of the resources across
geographic boundaries.
7. 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.
However, bonds, stocks, deposits and other financial instruments, do not wear out overtime, usually
generate income, and normally, their risk of loss is less as compared to many other forms of stored
wealth.

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8. Other functions: It assists in the selection of projects to be financed and also reviews performance of
such projects periodically. It also promotes the process of capital formation by bringing together the
supply of savings and the demand for investible funds.
1.2 FINANCIAL ASSET
An asset is any resource that is expected to provide future benefits, and thus possesses
Economic value.
Assets are divided into two categories: physical assets and intangible assets.
 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
 Financial assets
Financial asset are an intangible asset represents a legal claim to some future economic benefits. The
value of an intangible asset bears no relation to the form, physical or otherwise, in which the claims are
recorded.

Financial assets also referred to as financial instruments, securities or financial claims. They are often
used to finance the ownership of tangible assets as equipments and real estate.
Any transaction related to financial instrument includes at least two parties:
1) The party that has agreed to make future cash payments to the legal owner of the financial claim is
called the issuer, who is the party that has Deficit of funds.
2) The party that owns the financial instrument, and therefore the right to receive the Payments made by
the issuer, is called the investor.This is the party that have Surplus of fund.
Consider the following examples of financial securities:
1. A Birr 100,000 loan by Commercial Ethiopia of Bank to Mr. Abel. The issuer in this case is Mr. Abel
and the owner of the financial asset (security) is Commercial Bank of Ethiopia. Mr. Abel agrees to pay
Commercial Bank of Ethiopia a specified amount of interest and principal repayments over an agreed
time horizon.
 Financial assets can also be classified as 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. Debt securities include
securities like:
 bonds  bankers' acceptances
 treasury bill  life insurance policies
 commercial paper  certificate of deposits
 promissory notes  repurchase agreements (Repos)

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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  Business ventures need capital or resources for their successful operation and
maintenance. Equity financing and debt financing are the normal two options
available for this purpose. Capital is important for business. However no less
important is the means for raising it. This is because capital raised through different
means entails imposition of different conditions on the operation of the business. It is
up to the management to decide which course of action would be followed after
conducting a well researched cost benefit analysis. It is a mixed bag. One needs to
take ones pick depending on one’s requirements.

1.2.1 ROLE OF FINANCIAL ASSETS

Financial assets serve different economic functions:
i) Transfer funds from those who have surplus funds to invest to those who need a source of financing
tangible assets.
ii) Redistribute the risk associated to the investment in tangible assets between different counter parties
according to their preferences and risk aversion.
iii) Determine price or required rate of return of asset
iv) Provide liquidity
v) Reduce transactions costs, which consists of search costs and information costs
1.2.2 PROPERTIES OF FINANCIAL ASSETS
♦Moneyness: Financial assets can be used as a medium of exchange or can be converted into money at
little cost or risk. This attractive property for investors is called moneyness.
♦ Divisibility and Denomination refers to the minimum amount or size in which assets can be traded.
For instance, US bonds are generally sold in $ 1,000 denominations, commercial paper in $25,000 units
and deposits are infinitely divisible.
♦ The Cash Flow is the return associated to the investment on financial assets corresponded in different
forms according to the type of financial asset as dividends and options of stocks or coupon payments on
bonds.
♦ Term to maturity is the length of the period until the final repayment date or the date at which the
owner can demand the asset liquidation. In different cases the financial assets may terminate before the
stated maturity (in presence of call provisions, bankruptcy of the issuer...) or can be also increased or
extended on demand of both counterparties.
♦ Convertibility relates to the possibility to convert the financial assets into another type of asset. This is
the case of convertible bonds and preferred stocks.
♦ Liquidity: It refers to the speed (and price impact) with which the asset can be soldThe degree of
liquidity of an instrument can be determined either in the financial market or it can be determined by
means of contractual obligations. An example of agreement that can determine the degree of liquidity of
an instrument is the claim of a private pension fund. In this case, the asset is clearly considered illiquid
in that the claim can be satisfied not before the retirement date. Another basic property is the
Risk/Return predictability, for which the riskiness associated to an asset depends on the uncertainty
about future interest rates and future cash flow (nominal expected returns). In case the future cash flow
is known in advance, as contractually determined, the uncertainty may regard only the solvency of the
debtor
♦Complexity a financial asset can be also regarded as a combination of two or more simpler financial
instruments whose value is the sum of the price of its component parts. For instance, the price of a

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callable bond corresponds to the price of a similar non-callable bond less the value of the option that
allows the issuer to redeem the bond early. This property is called Complexity.
♦Tax status: the last property is the so-called Tax status which depends on the governmental regulations
applying to the asset. The tax treatment generally varies according to the issuer and owner nature, the
asset maturity, the country’s or different territorial unit's legislation, and so on.
These properties are important to determine the pricing of the financial asset. Basically, the true or
correct price of a financial instrument is equal to the present value of its expected cash flow. However,
there are several theories on the pricing of financial assets directly related to the notion of expected
1.2.3 Valuation of Financial Assets
The value of financial asset is the present value of the future cash flows expected, regardless of the type
of financial asset.
Valuation is the process of determining the fair value or price of a financial asset. It is also referred to as
“pricing” a financial instrument. Once this process is complete, we can compare a financial instrument’s
computed fair value as determined by the valuation process to the price at which it is trading for in
the market (i.e., the market price). Based on this Comparison, an investor will be able to assess the
investment worth of a financial instrument.
♦If Market price equal to fair value , financial instrument is fairly priced
♦If Market price is less than fair value, financial instrument is undervalued
♦If Market price is greater than fair value, financial instrument is overvalued
A financial instrument that is undervalued is said to be “trading cheap” and is a candidate for purchase.
If a financial instrument is overvalued, it is said to be “trading rich.” In this case, an investor should sell
the financial instrument if he or she already owns it
1.3 Financial markets
A financial market can be defined as a market in which entities can trade financial claims undersome
established rules of conduct. It can also be defined as A financial market is a market where financial
instruments are exchanged or traded.
Role of financial markets
Financial markets serve the following basic functions. These functions are briefly listed below:
 Borrowing and lending: Financial markets permit the transfer of funds from one agent to another
for either investment or consumption purposes.
 Price discovery: Financial markets provide vehicles by which prices are set both for newly issued
financial assets and for the existing stock of financial assets. Transactions between buyers and
sellers of financial instruments in a financial market determine the price of the traded asset. At the
same time the required return from the investment of funds is determined by the
participants in a financial market. The motivation for those seeking funds (deficit units)
depends on the required return that investors demand. It is these functions of financial
markets that signal how the funds available from those who want to lend or invest funds will be
allocated among those needing funds and raise those funds by issuing financial instruments.
 reduction of transaction costs: The function of reduction of transaction costs is performed,
when financial market participants are charged and/or bear the costs of trading a financial
instrument. In market economies the economic rationale for the existence of institutions and
instruments is related to transaction costs, thus the surviving institutions and instruments are
those that have the lowest transaction costs.
 Risk sharing: Financial markets allow a transfer of risk from those who undertake investments to
those who provide funds for those investments.
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  Liquidity: Financial markets provide the holders of financial assets with a chance to resell or
liquidate these assets. Liquidity referred to as a measure of the ability to sell an asset at its fair
market value at any time. Without liquidity, an investor would be forced to hold a financial
instrument until conditions arise to sell it or the issuer is contractually obligated to pay it off.
Debt instrument is liquidated when it matures, and equity instrument is until the company is
either voluntarily or involuntarily liquidated. All financial markets provide some form of liquidity.
However, different financial markets are characterized by the degree of liquidity.
TYPES OF RISK FOUND IN FINANCIAL MARKETS
The following is a list of some of the types of risk which financial institutions and investors have to
worry about in financial markets.
 Credit risk: this is the risk we take when lending money, namely the possibility that the borrower
may be unable or unwilling to pay back his loan, causing us a loss.
 Liquidity risk: this is the risk we take when holding a less liquid investment, in that we may be
forced to accept a loss because we are forced to sell the investment in a hurry.
 foreign exchange (fx) risk: this is the risk we take that we may suffer a loss from changes in the
exchange rates between currencies, because we have entered into an arrangement where we are
required to deliver, or are due to receive, a sum in a foreign currency at some later date.
 Interest rate risk: this is the risk that the value of our assets (investments) will change because the
market interest rate did.