Bac 305 Financial Mkts Lecture Notes

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BAC 305- Financial MKTS Lecture Notes
Financial Institutions And Markets (Moi University)
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KENYATTA UNIVERSITY
SCHOOL OF BUSINESS
ACCOUNTING AND FINANCE DEPARTMENT
FINANCIAL MARKETS AND INSTITUTIONS MODULE
BAC 305
Contents
LESSON ONE : INTRODUCTION TO FINANCIAL MARKETS AND
INSTITUTIONS 2
1.0. Nature of Financial system...................................................................................2
1.1. Financial instruments and services.......................................................................6
1.2. Importance of a Well Functioning Financial System............................................6
1.3 The Negative Impact of Small Financial Systems in Africa.....................................7
1.4. Financial System and Economic Development........................................................9
1.5. Growth of Financial markets : Financial Repression and financial Deepening.....10
Key terms in financial markets :....................................................................................12
LESSION TWO : FINANCIAL MARKETS 13
2.0 Financial Market Defined :....................................................................................13
2.1. Functions of financial markets................................................................................15
2.2. Effects of an efficient financial market on the economy........................................17
2.3. Broad Classification of Financial Markets.............................................................17
2.4. Structure of Kenya’s Financial Market...................................................................20
2.5. Forms of Exchange in Financial Markets..............................................................25
2.5. The need for financial intermediation (intermediation theory).............................27
LESSON THREEE : FINANCIAL INSTITUTIONS 29
3.0 Functions of Financial institutions...........................................................................29
LESSON FOUR: REGULATION OF FINANCIAL MARKETS 32
3.1. The need for financial regulation............................................................................32
3.2. Financial regulation in Kenya................................................................................36
LESSON FIVE: KEY FINANCIAL INSTITUTIONS 38
5.1 Commercial Banks in Kenya...................................................................................38
5.2. Factors That Have Led To Rapid Development of Commercial Banks In Kenya..40

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5.3. General Principles of Bank Management...............................................................40

5.3 Performance Evaluation of Commercial Banks......................................................45
5.3.1. Camel System..................................................................................................46
5.3.2. Stress Tests.......................................................................................................54
5.4. Pension Funds.........................................................................................................56
5.4.1 Types of Retirement Plans................................................................................57
5.4.2. Pension Schemes in Kenya..............................................................................60
5.4.3. Growth in Pensions in Kenya..........................................................................62
5.4.4. Regulation of pension funds............................................................................65
5.4.5. The Role of Trustees in Pension Schemes.......................................................66
5.4.6. Key challenges of pension funds in Kenya......................................................67
LESSON SIX : MONEY MARKETS AND INSTRUMENTS 68
6.1. Treasury Bills..........................................................................................................69
6.2. Uses of repurchase agreements...............................................................................73
6.3. Commercial papers.................................................................................................75
6.4. Negotiable certificate of deposit.............................................................................76
6.5.Bankers Acceptance.................................................................................................77
International money markets.........................................................................................78
6.6. Euro commercial paper (or euro notes):.................................................................78
LESSON SEVEN : CAPITAL MARKETS 80
7.1. The Role of Capital Markets In An Economy........................................................80
7.2 The role of Capital Markets Authority ( CMA)......................................................82
7.3. Participants in capital markets in Kenya................................................................83
7.3. Securities Market....................................................................................................87
7.4. Equities or Stock Market........................................................................................87
7.4.1. Capital Market Terminologies........................................................................87
7.4.2. Securities issued in equity market...................................................................90
7.4.3.The equities market may be divided into two :.................................................90
7.4.4. Organised Exchange........................................................................................95
LESSON EIGHT : THE BOND MARKET 102
LESSON NINE : INTEREST RATES IN KENYA 118
9.1. Interest Rates.........................................................................................................118
9.2. Determination of interest rate : theory of interest determination..........................119
9.3. Term structure of Interest Rates............................................................................121
9.4. Term structure theories.........................................................................................123
9.4.1. Expectation theory.........................................................................................123
9.4.2. Liquidity preference (or liquidity premium) theory.......................................124
9.4.3. Market Segmentation theory..........................................................................125
LESSON TEN : DERIVATIVES MARKET AND INSTRUMENTS 127
10.0. Introduction and Definition...................................Error! Bookmark not defined.
10.1. Need to Develop a Derivative Market in Kenya...Error! Bookmark not defined.
10.2. Elements of the Microstructure of a Derivatives Exchange.......Error! Bookmark
not defined.
10.3. Derivative Market Instruments...........................................................................127
10.3.1.Forward Contracts:.......................................................................................129
10.3.2. Futures Contracts.........................................................................................131

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10.3.3 Options.........................................................................................................135
10.3.4 Swaps............................................................................................................138
LESSON 11 : INTERNATIONAL FINANCIAL INSTITUTIONS 142
11.1. Establishment of IMF.........................................................................................142
11.1.1. Requirements of I.M.F.................................................................................143
11.1.2. The major objectives of the IMF set by charter are:-...................................144
11.2 World Bank..........................................................................................................145
11.3. World Trade Organization (WTO)......................................................................146
11.4. International Finance Corporation (IFC)............................................................146
LESSON ONE : INTRODUCTION TO FINANCIAL MARKETS AND

INSTITUTIONS
Objectives
By the end of this lesson, you should be able to: Understand the nature of
financial systems Describe the usefulness of a financial system, the nature of
financial systems in Africa
1.0. Nature of Financial system.
The financial system can also be defined as the collection of markets, institutions, laws,
regulations, and techniques through which financial instruments (bonds, stocks, and other
securities) are traded, interest rates are determined, and financial services are produced
and delivered around the world.
The financial system or the financial sector of any country (Bhole and Mahakund (2009)
consist of :
 Specialized and non-specialized financial institution (banking institutions-
deposit taking,loans and investmnts)
 Organized and unorganized financial markets (market where people trade
financial securities and derivatives(a financial instrument whose value
depends upon the value of another asset) at a low transaction cost.)

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Organized financial mkt: incorporated with the appropriate authority of gvt

and follows the rules and regulations.
Securities includes stock,bonds and other precious metals)
o Stocks; company is selling a piece of itself in exchange of cash
o Bonds; company is debt with the agreement to pay interest for the use
of the money
Examples of derivatives:
a) Swap:exchange of financial instruments/future cash flows for another between
parties concerned i.e interest rates swap
b) Futures: standardized contract between between 2 parties to buy or sell a specified
assets of standardized quantity and quality for a price agreed upon today with
delivery and payments occurring at a specified future date
c) Forwards: Forward contracts is an agreement in which one party commits to buy a
currency,obtain a loan or purchase a commodity in future at a price determined
today.
d) Options: financial instrument whose value is derived from another entity which is
also known as the the underlier. The underlier can range from assets i.e
commodities, stocks and real estate.
 Financial instruments (a document i.e check, draft, bond, share, bill of

exchange, futures or options contracts, that has a monetary value or represents
a legally enforceable agreements between two or more parties regarding a
right to payment of money.) and services which facilitate transfer of funds.
 Procedures and practices adopted in the markets, and financial
interrelationship are also part of the system.
The structure of a financial system can as below :
FINANCIAL SYSTEM
ewe

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FINANCIAL FINANCIAL FINANCIAL FINANCIAL

INSTITUTIONS MARKETS INSTRUMENT SERVICE
Primary Secondary
Regulatory Intermediary Non-
intermediary
Short-term medium long-term
Organised Unorganised
d
Primary Secondary
Capital Market Money Market
Debt Market Equity Market Derivative Market
Capital market: long term securities

Bond market: mid
Money market: short term lending and borrowing

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Debt market: bonds are bought and sold

Equity market: stocks are traded; ownership of a company
Derivative market: market for derivatives
According to the structural approach, the financial system of an economy consists of

main components:
1) Financial markets; facilitate the flow of funds in order to finance investments by
corporations, governments and individuals
2) Financial intermediaries (institutions); are the key players in the financial markets as
they perform the function of intermediation and thus determine the flow of funds.
3) Financial regulators. Perform the role of monitoring and regulating the participants.
4) Financial infrastructure is the set of institutions that enables effective operation of
financial intermediaries and financial markets, including such elements as payment
systems, credit information bureaus, and collateral registries.
5) Financial services
6) Financial instruments
Functions of a Financial System
Broad function of financial system can be put in three sets: (1) monetary function, (2)
capital allocation function and (3) controlling function. These functions can be expanded
into :
The following are the functions of a Financial System:
(i) Mobilise and allocate savings – linking the savers and investors to mobilise
and allocate the savings efficiently and effectively. [capital allocation
function]
(ii) Monitor corporate performance – apart from selection of projects to be

funded, through an efficient financial system, the operators are motivated to
monitor the performance of the investment. [controlling function]

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(iii) Provide payment and settlement systems – for exchange of gods and services
and transfer of economic resources through time and across geographic
regions and industries. The clearing and settlement mechanism of the stock
markets is done through depositories and clearing operations. [monetary
function]
(iv) Optimum allocation and reduction of risk - by framing rules to reduce risk by
laying down the rules governing the operation of the system. This is also
achieved through holding of diversified portfolios.
(v) Disseminate price-related information – which acts as an important tool for

taking economic and financial decisions and take an informed opinion about
investment, disinvestment, reinvestment or holding of any particular asset.
(vi) Offer portfolio adjustment facility – which includes services of providing
quick, cheap and reliable way of buying and selling a wide variety of financial
assets.
(vii) Lower the cost of transactions – when operations are through and within the
financial structure.
(viii) Promote the process of financial deepening and broadening – through a well-
functional financial system. Financial deepening refers to an increase of
financial assets as a percentage of GDP. Financial depth is an important
measure of financial system development as it measures the size of the
financial intermediary sector. Financial broadening refers to building an
increasing number of varieties of participants and instruments.
Key elements of a well-functioning Financial System
The basic elements of a well-functional financial system are:

i. a strong legal and regulatory environment;

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ii. stable money;

iii. sound public finances and public debt management;
iv. a central bank;
v. a sound banking system;
vi. an information system; and
vii. Well functioning securities market.
1.1. Financial instruments and services

Financial system deal in financial services and claims or financial assets or securities
or financial instruments. Financial securities are classified as primary (direct) and
secondary (indirect). The primary securities are issued by the ultimate investors
directly to the ultimate savers such as shares and debentures, while the secondary
securities are issued by the financial intermediaries to the ultimate savers such as
bank deposits, insurance, unit trust shares. The investment characteristics of financial
assets and financial products are the following :
 Liquidity
 Volatility
 Marketability
 Reversibility
 Transferability
 Lower transaction costs
There are two Financial Systems prevalent in the world today:
(a) Bank Dominated Financial System – Stage I – In undeveloped countries
(b) Market Dominated Financial System – Stage III – In developed countries.
In between the two, there is a second stage which is a transitory stage between Stage I
and III. This stage is often found in developing countries like ours who are in the process
of transition from Bank Dominated to Market Dominated Financial System.
When the equity market is fully evolved, industrialists raise finance from the market.
However, in case the market is not fully developed, govt facilitates easy finance for
industrial development through banks.

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Market Dominated Financial System is prevalent in US and UK. Such system is possible
only in countries where Debt and Equity market has fully evolved. Therefore, Financial
System in countries like Germany and Japan, which otherwise are well developed, have
still got Bank Dominated System.
1.2. Importance of a Well Functioning Financial System
In a well-functioning financial system, financial contracts, markets and intermediaries act

to reduce the costs of acquiring information, enforcing contracts, and making
transactions. Financial instruments and institutions, in turn, influence the allocation of
financial resources within an economy in favor of the more efficient use of capital. Thus,
a developed financial system is better equipped than an underdeveloped one to perform
the following functions:
• Producing information and allocating capital. Financial intermediaries can

reduce the costs associated with acquiring information, which leads to more
efficient capital allocation;
• Monitoring firms and exerting corporate governance. The extent to which

capital providers can monitor capital users has implications in terms of the use of
resources. For example, if capital providers can monitor firms effectively and
ensure that management is committed to maximizing firm value, firms will make
better use of their resources;
• Trading, diversification, and risk mitigation. Financial institutions and

instruments can diversify, mitigate and distribute agents’ risks over time. The
financial system facilitates separating, distributing, trading, hedging, diversifying,
pooling and reducing risks.
• Mobilizing and pooling savings. Mobilizing and allocating capital is a costly

process due to (i) transaction costs related to collecting savings from many
individuals and (ii) mitigating informational asymmetries between savers and
those seeking capital; and,

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• Easing exchange of goods and services. Financial systems that reduce transaction
costs can lead to greater specialization, technological innovation, access to
finance, and growth.
1.3 The Negative Impact of Small Financial Systems in Africa

As well as being associated with lower economic growth, small size is also an obstacle to
the development of financial systems. Financial services in small systems tend to be more
limited in scope, more expensive, and of poorer quality than services in larger systems. In
Sub-Saharan Africa, many countries’ financial systems and financial institutions are
amongst the smallest in the world. Only South Africa and Nigeria have financial systems
with total assets of more than US$10 billion . Only ten countries’ financial systems have
assets of between US$2 and US$10 billion, and the remaining countries’ systems have
assets of less than US$2 billion, which is the equivalent of a moderately sized bank
branch in many developed countries. The impact of small size on financial markets
can be summarized as:
• Fewer participants and are consequently less competitive. Small financial
systems tend to have fewer participants and are consequently less competitive.
This leads to higher financial product pricing, less access to finance, and lower
levels of innovation than in larger financial systems;
• Inefficiency. Small financial systems are less efficient because economies of scale
are often absent. Research has found scale economies for banking, securities
markets and payment systems. For instance, modern banks, insurance companies,
pension funds, payments systems, and securities markets all use computer-based
technology that is scale dependent for cost-effective operation. Even in their
smallest configurations, the capacity of these technologies often far exceeds the
processing needs of institutions in small financial systems;
• Inadequate services. Small financial systems are more likely to be incomplete.

Since minimum scale economies may preclude the provision of some financial

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services, customers may be unable to purchase some of the products and services
they need e.g development of the derivative market;
• Small financial systems are less able to diversify their investment and
operational risks. The smaller range of products, clients and geography in small
markets make financial services firms inherently less stable than firms in larger
markets;
• The regulatory infrastructure of small financial systems tends to be of higher

cost and lower quality than in large systems. Financial supervision and
regulation is prone to high set-up costs and faces human capital constraints; and,
• Auxiliary components of financial infrastructure are often absent from small

systems. For example, credit information services may not exist in small markets
because they are unable to secure the economies of scale required for cost
effective operation and the legal infrastructure may lack the skills and capacity to
meet the needs of modern financial services.
1.4. Financial System and Economic Development
The role of financial system in an economic development can be illustrated using the
flow indicated below :
Economic Development
Savings and investment or

capital formation
Surplus spending economic

Deficit spending economic
units
units
Income minus (consumption

+own investment) 10

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Income minus (consumption

+own investment
Surplus or Savings
Deficit or Negative Saving
Financial system
The economic development greatly depends on the rate of capital formation. Capital
formation depends on whether finance is made available in time, in adequate quantities
and on favourable terms i.e a good financial system. The importance of finance and
finance system in economic development can be understood by discussing the theories of
the impact of financial development on saving and investment . These are :
1.5. Growth of Financial systems: Financial Repression and financial Deepening
Financial repression may be defined as a state where, due to either formal (Government)
or informal controls, there exist barriers to the development of free securities markets in
the economic sense. Following Goldsmith (1969), Shaw (1973), Fry (1982) and Fischer
(1989) one may conclude that the key characteristics of financial repression include:
- Existence of controls on interest rates (normally maintained at fixed statutory levels
by the Government) which may result in negative real interest rates in the economy.
- Government and other institutional barriers to the entry and development of
financial institutions and instruments. This is evidenced by very strict rules for joining
stock exchanges or registering financial institutions. These maintain such institutions at
the bare minimum and give the existing ones no incentive to innovate new financial
instruments
- Formally targeting savings and investments into specified areas of the economy
thereby stifling capital available to other high growth innovative projects. In developing
countries this is observed by requiring specific deposit/liquidity ratios, investment in
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treasury bills and demanding fixed percentage investment in certain sectors e.g.
agriculture [Fry (1982)]. This has the effect of directing investment funds to inefficient
investments.
The consequence is to slow down the rate of economic growth and bring down the rate of
innovation in the securities market.
- The existence of parallel informal markets of money lenders who can advance funds
on a short term basis at very high-levels of interest rates. These markets will not be able
to satisfy the demand for funds since they are, by their risky nature, unable to attract any
significant deposits from savers.
Solutions of Financial repression

Financial repression can be dealt with by systematic change of policies to move towards
financial deepening. Financial deepening means the accumulation of financial assets at a
pace, faster than accumulation of non-financial wealth [Shaw (1973, p.vii)]. The policies
adopted which encourage the growth of financial institutions and instruments are:
- Removing the institutionalised barriers of entry into the financial markets. This,
for example, calls for more liberal policies on entry into organised markets and the
floating of financial institutions. The removal of barriers may call for initial statutory
legislation and the synchronising of monetary and fiscal policies [IFC
(1984), Fischer (1989)].
- Action on existing interest rate policies. The presumption in financial repression that
fixed interest rates may be desirable to move the economy towards higher levels of
investment is not well founded [Kitchen (1986,
p.80-83)]. This is due to the banking sector sometimes being the only organised financial
market. The Government in such a case has no other access to ready borrowing other than
the banking system thereby stifling funds available to other borrowers. Financial
deepening calls for the liberalization of interest rates so that an equilibrium can be
reached between savings and investment.
It is not clear how the market may react to liberal policies on interest rates. It is
nevertheless expected that the rates of interest will adjust themselves to match yield on
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other financial assets such as shares and also match expected returns on retained earnings.
The economic power of financial intermediation will be in full play.
Removing institutional targeting of savings and investments. This means that markets
would be free to exercise discretion on where to seek savings and where to direct
investments. One hypothesised effect of such a policy change is that it will be possible
for markets to make funds available for highly innovative projects which will play a
major role in economic development.
Key terms in financial markets :
Diversification : diversification means the existence or the development of a very wide

variety of financial institutions, markets, instruments, services and practices in the
financial system. It refers to the opportunities for investors to purchase a large mix or
portfolio of varieties of financial system.
Disintermediation : it refers to the phenomenon of a decline in the share of financial

intermediaries in the economy because of investors seek direct finance in the open
market.
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.
Securitization: is used in financial literature in two senses
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First, it means faster growth of direct (primary) financial markets and financial
instruments. In other words, it refers to the growing ability and practices of firms to tap
into the bond, commercial paper and equity market directly. Secondly it refers to the
process through which the existing assets of the lending institutions are sold or removed
from the balance sheet through their funding by other investors.
LESSON TWO : FINANCIAL MARKETS

Objectives
2.0 Financial Market Defined :
At any point in time in an economy, there are individuals or organizations with excess
amounts of funds, and others with a lack of funds they need for example to consume or
to invest.
 Exchange between these two groups of agents is settled in financial markets
 The first group is commonly referred to as lenders, the second group is

commonly referred to as the borrowers of funds.
A financial market is a market in which financial assets are traded. In addition to

enabling exchange of previously issued financial assets, financial markets facilitate
borrowing and lending by facilitating the sale by newly issued financial assets .Financial
markets refers to an elaborate system of the financial institution and intermediaries
and arrangement put in place and developed to facilitate the transfer of funds from
surplus economic units (savers) to deficit economic units (investors).
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• Financial market is a market in which financial assets (securities) such as stocks

and bonds can be purchased or sold
• Financial markets are critical for producing an efficient allocation of capital,
which contributes to higher production and efficiency for the overall economy, as
well as economic security for the citizenry as a whole
• Financial markets also improve the lot of individual participants by providing
investment returns to lender-savers and profit and/or use opportunities to
borrower-spenders.
Characteristics of a Good Financial Market
• To determine the appropriate price, participants must have timely and accurate
information on the volume and prices of past transactions and on all currently
outstanding bids and offers. Therefore, one attribute of a good market is timely
and accurate information.
• Another prime requirement is liquidity, the ability to buy or sell an asset

quickly and at a known price—that is, a price not substantially different
from the prices for prior transactions, assuming no new information is
available. An asset’s likelihood of being sold quickly, sometimes referred to as its
marketability, is a necessary, but not a sufficient, condition for liquidity. The
expected price should also be fairly certain, based on the recent history of
transaction prices and current bid-ask quotes.
•
• Price continuity means that prices do not change much from one transaction to
the next unless substantial new information becomes available. A continuous
market without large price changes between trades is a characteristic of a liquid
market.
•
• A market with price continuity requires depth, which means that numerous
potential buyers and sellers must be willing to trade at prices above and below the
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current market price. These buyers and sellers enter the market in response to
changes in supply and demand or both and thereby prevent drastic price changes.
In summary, liquidity requires marketability and price continuity, which, in turn,
requires depth.
•
• Another factor contributing to a good market is the transaction cost. Lower costs
(as a percent of the value of the trade) make for a more efficient market. an
efficient market as one in which the cost of the transaction is minimal. This
attribute is referred to as internal efficiency.
•
• Finally, a buyer or seller wants the prevailing market price to adequately reflect
all the information available regarding supply and demand factors in the market.
If such conditions change as a result of new information, the price should change
accordingly. Therefore, participants want prices to adjust quickly to new
information regarding supply or demand, which means that prices reflect all
available information about the asset. This attribute is referred to as external
efficiency or informational efficiency.
2.1. Functions of Financial Markets

Financial markets attract and allocate savings (1) investment and (2) financing function, (3)
pricing function), (4) payment function and (5) risk management (6) Asymmetric
information problem resolution.
 Intermediary Functions: The intermediary functions of a financial markets
include the following:
o Transfer of Resources: Financial markets facilitate the transfer of real
economic resources from lenders to ultimate borrowers. Financial markets
channel funds from households, firms, governments and foreigners that
have saved surplus funds to those who encounter a shortage of funds (for
purposes of consumption and investment). They allow funds to move from
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people who lack productive investment opportunities to people who have

such opportunities.
o 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.
o Risk Sharing and Distribution Risk sharing : financial markets allow
transfer of risk from those undertaking investments to those who provide
funds for those investments
o Productive usage: Financial markets allow for the productive use of the
funds borrowed. The enhancing the income and the gross national
production.
o Capital Formation: Financial markets provide a channel through which
new savings flow to aid capital formation of a country.
o 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.
o Sale Mechanism: Financial markets 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.
o 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.
o Financial Efficiency Financial markets reduce information asymmetry
and transaction costs. The facilitation of financial transactions through
financial markets lead to a decrease in informational cost and transaction
costs, which from an economic point of view leads to an increase in
efficiency.
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 Financial Functions

o Providing the borrower with funds so as to enable them to carry out their
investment plans.
o liquidity : The existence of financial markets enables the owners of
financial assets to buy and resell these assets. Generally this leads to an
increase in the liquidity of these financial instruments.
o
o Providing the lenders with earning assets so as to enable them to earn

wealth by deploying the assets in production debentures.
o Providing liquidity in the market so as to facilitate trading of funds.
o it provides liquidity to commercial bank
o it facilitate credit creation
o it promotes savings
o it promotes investment
o it facilitates balance economic growth
o it improves trading floors
2.2. Effects of an efficient financial market on the economy
 Provide opportunity to increase future consumption

 It encourages thrift by allowing individuals to defer current consumption and
build wealth in the future.
 Investors benefit from excess to real resources that efficient market permits.
 Expansion of profit opportunities.
 Better standards of living to people.
 High consumption made possible by greater capital intensity and greater output.
 Provide economic growth to country.
 Very specialized projects financed through financial institutions.
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2.3. Broad Classification of Financial Markets
Financial markets can be classified on the following basis :
According to type of assets: debt market vs. equity market
A Firm or an individual can obtain funds in a financial markets in two ways. The
most common method is to issue a debt instrument. Debt instruments are particular
types of securities that require the issuer (the borrower) to pay the holder (the lender)
certain fixed shilling amounts at regularly scheduled intervals until a specified time (the
maturity date) is reached, regardless of the success or failure of any investment projects
for which the borrowed funds are used. A debt instrument holder only participates in the
management of the debt instrument issuer if the issuer goes bankrupt. The maturity of a
debt instrument is the number of years or terms until the instrument’s expiration date. A
debt instrument is short-term if it is less than one year, long term if it is maturity is ten
years or longer. Between one year to ten years is intermediate term.
In contrast, an equity is a security that confers on the holder an ownership interest in the
issuer. The main disadvantage of owning a corporation’s equities rather than debt is that
an equity holder is a residual claimant. Corporation must pay all other debt holders before
it pays its equity holders.
Some financial instruments due to their characteristics can be viewed as a mix of debt
and equity. For example Preferred stock is a financial instrument, which has the attribute
of a debt because typically the investor is only entitled to receive a fixed contractual
amount. However, it is similar to an equity instrument because the payment is only made
after payments to the investors in the firm’s debt instruments are satisfied.
Another “combination” instrument is a convertible bond, which allows the investor to

convert debt into equity under certain circumstances. Because preferred stockholders
typically are entitled to a fixed contractual amount, preferred stock is referred to as a
fixed income instrument.
According to maturity of assets :Money versus Capital Markets:
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Money market is the sector of the financial market that includes financial instruments
that have a maturity or redemption date that is one year or less at the time of issuance.
These are mainly wholesale markets. Examples: Treasury bills; negotiable bank
certificates of deposit (CDs); commercial paper; Eurodollars/Eurocurrency market
The capital market is the sector of the financial market where long-term financial
instruments issued by corporations and governments trade. Here “long-term” refers to a
financial instrument with an original maturity greater than one year and perpetual
securities (those with no maturity). There are two types of capital market securities: those
that represent shares of ownership interest, also called equity, issued by corporations, and
those that represent indebtedness, or debt issued by corporations and by the state and
county governments. This includes corporate bonds, debentures and equity, treasury
bonds and Eurobond.
Delivery of assets: spot market and Forward Market
This classification applies to the foreign exchange market. cash/spot market: asset
exchange immediately after trade (2 days) and derivative market: asset exchange occurs
on future date after trade . The cash market, also referred to as the spot market, is the
market for the immediate purchase and sale of a financial instrument.
In contrast, some financial instruments are contracts that specify that the contract holder
has either the obligation or the choice to buy or sell another something at or by some
future date. The “something” that is the subject of the contract is called the underlying
(asset). The underlying asset is a stock, a bond, a financial index, an interest rate, a
currency, or a commodity. Because the price of such contracts derive their value from the
vazzlue of the underlying assets, these contracts are called derivative instruments and
the market where they are traded is called the derivatives market.
Primary versus Secondary Markets:
Primary markets are securities markets in which newly issued securities such as bonds or
shares are offered for sale to buyers. The new issues of financial instruments can be
through private placement, initial public offers, book building and seasoned public offers.
Primary markets are meant to raise capital for corporations and government. The initial
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issuer raises funds only through the primary market. An important institution that assists
in the primary market is the investment banks. It does this by underwriting the initial
public offer.
Secondary markets are securities markets in which existing securities that have
previously been issued are resold. Secondary markets are important for two reasons: first
they make it easier for investors to buy or sell financial securities to raise cash, that they
make the financial security more liquid. Secondly they assist in price determination of the
financial securities. (price discovery).
Structure of market : Organised exchange , over the counter market
secondary markets can be organized in two ways:
Organized exchange: buyers and sellers meet in physical location to trade . Specifically,
organized exchanges permit buyers and sellers to trade with each other in a centralized
location, like an auction. However, securities are traded on the floor of the exchange with
the help of specialist traders who combine broker and dealer functions. The specialists
broker trades but also stand ready to buy and sell stocks from personal inventories if buy
and sell orders do not match up. For example Nairobi stock exchange, New York stock
exchange, Johannesburg stock exchange. The trading can be done through the traditional
system (open outcry system) or modern system (automated trading system).
Over-the-counter (OTC) market: An over-the-counter market has no centralized

mechanism or facility for trading. Instead, 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. That is, 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. Over the Counter Market (OTC) Provides an
opportunity for unlisted/unquoted firms to sell their security . Otc is usually organized by
the dealers or stock brokers who buy securities themselves and then sell them. They
maintain a reasonable balance between demand and supply and observe price movements
to determine profit margins on sale. Trading may be done through telephones, computer
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networks, fax etc. The dealers/participants set the treading rules. OTC specialize in
securities such as corporate bonds, equity securities, Treasury bonds etc. OTC is
underdeveloped in Kenya
According to trade intermediation : order driven, quote-driven and brokered

market.
On the basis of how the trade intermediation occurs, a distinction between quote-driven
dealer markets, order-driven markets and brokered markets can be made.
• Quote-driven market structure is the one, in which market makers or dealers quote
the prices at which the public market participants are trading. Market makers provide a
bid quote (to buy) and an ask quote (to sell). Market makers or dealers earn profit from
the spread between the two quotes and the turnover of the shares. which dealers (market
makers) adjust their quotes continuously to reflect supply and demand. This is a dealer
market. Also called price-driven market.
Order-driven market structure allows buyers and seller orders submit their orders
through their broker. The latter sends these orders to a centralized location, where orders
are matched and the transaction is executed.•
In brokered markets, brokers perform an active search role to match buyers and sellers.
They do not provide liquidity but they find liquidity. They hold no inventory as they do
not participate in the trade themselves. The most important brokered securities markets
are those
Internal and External Markets

The internal market, also called the national market, consists of two parts: the
domestic market and the foreign market. The domestic market is where issuers
domiciled in the country issue securities and where those securities are subsequently
traded. The foreign market is where securities are sold and traded outside the country of
issuers. External market is the market where securities with the following two
distinguishing features are trading: 1) at issuance they are offered simultaneously to
investors in a number of countries; and 2) they are issued outside the jurisdiction of any
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single country. The external market is also referred to as the international market,
offshore market, and the Euromarket (despite the fact that this market is not limited to
Europe).
Call and continuous Markets

In call markets, trading for individual stocks takes place at specified times. The intent is
to gather all the buy (bid prices) and offers to sell (asked prices) for the stock and attempt
to arrive at a single price where the quantity demanded is as close as possible to the
quantity supplied. Call markets are generally used during the early stages of development
of an exchange when there are few stocks listed or a small number of active
investors/traders.
.
In a continuous market, trades occur at any time the market is open. Stocks in this
continuous market are priced either by auction or by dealers. If it is a dealer market,
dealers are willing to make a market in the stock, which means that they are willing to
buy or sell for their own account at a specified bid and ask price. If it is an auction
market, enough buyers and sellers are trading to allow the market to be continuous; that
is, when you come to buy stock, there is another investor available and willing to sell
stock. A compromise between a pure dealer market and a pure auction market is a
combination structure wherein the market is basically an auction market, but there exists
an intermediary who is willing to act as a dealer if the pure auction market does not have
enough activity. These intermediaries who act as brokers and dealers provide temporary
liquidity to ensure that the market will be liquid as well as continuous.
Private vs. Public markets. Private markets, where transactions are worked out directly
between two parties, are differentiated from public markets, where standardized contracts
are traded on organized exchanges. Bank loans and private placements of debt with
insurance companies are examples of private market transactions. Since these
transactions are private, they may be structured in any manner that appeals to the two
parties. By contrast, securities that are issued in public markets (for example, common
stock and corporate bonds) are ultimately held by a large number of individuals. Public
securities must have fairly standardized contractual features, both to appeal to a broad
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range of investors and also because public investors cannot afford the time to study
unique, no standardized contracts. Their diverse ownership also ensures that public
securities are relatively liquid. Private market securities are, therefore, more tailor-made
but less liquid, whereas public market securities are more liquid but subject to greater
standardization
Structure of Kenya’s Financial Market
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FINANCIAL MARKET IN KENYA AND

MAJOR PLAYERS
MONEY MARKET CAPITAL MARKET
INSTRUMENT SECURITY
S NON-SECURITY
SEGMENT SEGMENT
CURRENCY INSTRUMENTS
INSTRUMENTS
COMMERCIAL STOCKS
PAPER
TREASURY TERM LOANS
DEBENTURE
BILLS
CERTIFICATE OF LEASE BONDS
DEPOSITS
REPURCHASE CONVERTIBLE
AGREEMENTS BONDS
WARRANTS
FOREIGN
INSTITUTION BONDS
S INSTITUTIONS
INSTITUTIONS
CENTRAL
BANK
SAVINGS BANK PRIMARY
COMMERCIAL MARKET
BANKS
DEALERS DEVELOPMENT INVESTMENT
BANKS BANKS
MONEY MARKET VENTURE
INSURANCE CAPITAL
FUNDS COMPANIES DEALERS/BROK
CREDIT REFERENCE ERS
BUREAUS LEASING SECONDARY
COMPANIES MARKET
MICRO-FINANCE
INSTITUTIONS STOCK
EXCHANGE
OVER-THE-
COUNTER
25 BROKERS/DEAL
ERS
MUTUAL
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2.5. Forms of Exchange in Financial Markets
Financial markets perform the essential function of channeling funds from

households, firms, government that have surplus funds to those who have a deficit of
funds. For consumption and investment. The most important savers (lenders) are
households, business firms, governments and foreigners. Important borrowers are
households, business enterprises and government. The They allow funds to move
from people who lack productive investment opportunities to people who have such
opportunities. Financial markets are crucial for producing an efficient allocation of
capital. Which contribute to higher production and efficiency for the overall economy.
Financial markets operating efficiently improve the economic welfare of all members
of the society. Funds flow through the financial market through two channels, as
illustrated in figure :
1. Direct Finance
• Borrowers borrow directly from lenders in financial markets by
selling financial instruments which are claims on the borrower’s
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future income or assets. The financial security or instruments are

assets to the savers (lenders) but a liability to the individual and
firms who sell or issue them.
•
2. Indirect Finance
• Borrowers borrow indirectly from lenders via financial intermediaries
(established to source both loanable funds and loan opportunities) by
issuing financial instruments which are claims on the borrower’s future
F in a n c ia l I n t e r m e d ia t io n : T h e F lo w o f F u n d s a n d P r im a r y S e c u r it ie s
income or assets
F u n d s S u r p l u s U n it s B ro k e rs F u n d s D e f ic it U n it s
F u n d s S u r p l u s U n it s D e a le rs F u n d s D e f ic it U n it s
F u n d s S u r p l u s U n it s U n d e r w r it e r s F u n d s D e f ic it U n it s
In v e s t m e n t B a n k s
F u n d s S u r p l u s U n it s M u tu a l F u n d s F u n d s D e f ic it U n it s
27
F u n d s S u r p l u s U n it s Banks F u n d s D e f ic it U n it s
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(Adopted from
The process of indirect finance is known as financial intermediation. It involves the use
of financial intermediaries. Financial intermediaries are important because they match
sellers and buyers indirectly through the process of financial asset transformation.
Financial intermediation is the primary route for moving funds from borrowers to
lenders.
2.5. The need for financial intermediation (intermediation theory)
The Perfect ( arrow-debreu) Model

Three pillars are at the basis of the modern theory of finance: optimality, arbitrage, and
equilibrium. Optimality refers to the notion that rational investors aim at optimal returns.
Arbitrage implies that the same asset has the same price in each single period in the
absence of restrictions. Equilibrium means that markets are cleared by price adjustment
– through arbitrage – at each moment in time. In the neoclassical model of a perfect
market, e.g. the perfect market for capital, or the Arrow-Debreu world, the following
criteria usually must be met:
– No individual party on the market can influence prices;
– Conditions for borrowing/lending are equal for all parties under equal circumstances;
– There are no discriminatory taxes;
– Absence of scale and scope economies;
– All financial titles are homogeneous, divisible and tradable;
– There are no information costs, no transaction costs and no insolvency costs;
– All market parties have immediate and full information on all factors and events
relevant for the (future) value of the traded financial instruments.
The Arrow-Debreu world is based on the paradigm of complete markets. In the case of
complete markets, present value prices of investment projects are well defined. Savers
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and investors find each other because they have perfect information on each others
preferences at no cost in order to exchange savings against readily available financial
instruments. These instruments are constructed and traded costless and they fully and
simultaneously meet the needs of both savers and investors. Thus, each possible future
state of the world is fully covered by a so-called Arrow-Debreu security (state contingent
claim). Also important is that the supply of capital instruments is sufficiently diversified
as to provide the possibility of full risk diversification and, thanks to complete
information, market parties have homogenous expectations and act rationally. In so far as
this does not occur naturally, intermediaries are useful to bring savers and investors
together and to create instruments that meet their needs. They do so with reimbursement
of costs, but costs are by definition an element – or, rather, characteristic – of market
imperfection.
In the traditional Arrow-Debreu model of resource allocation, firms and households
interact through markets and financial intermediaries play no role. When markets are
perfect and complete, the allocation of resources is Pareto efficient and there is no scope
for intermediaries to improve welfare. Moreover, the Modigliani-Miller theorem applied
in this context asserts that financial structure does not matter: households can construct
portfolios which offset any position taken by an intermediary and intermediation cannot
create value. See Fama (1980).
Therefore, intermediaries are at best tolerated and would be eliminated in a move towards
market perfection, with all intermediaries becoming redundant: the perfect state of
disintermediation. This model is the starting point in the present theory of financial
intermediation. All deviations from this model which exist in the real world and which
cause intermediation by the specialized financial intermediaries, are seen as market
imperfections(frictions). These imperfections (frictions) include different taxes,
information asymmetry, transation costs, hence the need for financial intermediaries
(financial institutions)
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LESSON THREEE : FINANCIAL INSTITUTIONS
3.0 Functions of Financial institutions
The process of indirect finance using financial intermediaries is known as financial

intermediation. It is the primary route of moving funds from lenders to borrowers.
Financial intermediaries match sellers and buyers indirectly through the process of
financial asset transformation.
Financial institutions are important in a financial system because of the following

reasons :
1. Solving Asymmetric information problem:( Adverse Selection and Moral
Hazard)
Asymmetric information is lack of complete information in financial markets to make
accurate decisions.
Financial intermediaries also use their expertise to screen out bad credit risks and monitor
borrowers. They thereby help solve two problems related to imperfect information in
financial markets. Adverse Selection refers to the problem that arises before a loan is
made because borrowers who are bad credit risks tend to be those who most actively seek
out loans. Financial intermediaries can help solve this problem by gathering information
through credit reference bureaus and sharing information on delinquent accounts (non-
performing loans) about potential borrowers and screening out bad credit risks.
Moral Hazard refers to the problem that arises after a loan is made because borrowers
may use their funds irresponsibly.
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Financial intermediaries such as credit reference bureau can help solve this problem by
monitoring borrowers’ activities by providing sufficient financial information
2. Reduction of transaction cost :

Transaction costs involves the time and money spent in carrying out financial
transactions.
Financial intermediaries can reduce substantially transaction cost because they have
developed expertise in lowering them and also because of economies of scale advantages
i.e the reduction of transaction cost per shilling as the size of transaction increases.
Example: a bank can use the same loan contract again and again, thereby reducing the
costs of making each individual loan agreement.
Because financial intermediaries are able to reduce transaction costs substantially, they
make it possible for suppliers of funds to indirectly invest in productive investment
opportunities.
3.Risk Sharing and Diversification

Risk is uncertainty about the returns investors will receive on any particular asset. By
purchasing a large number of different assets issued by a wide range of borrowers,
financial intermediaries use diversification to help with risk sharing.
Example: by lending to a large number of different businesses, a bank might see a few of
its loans go bad; but most of the loans will be repaid, making the overall return less risky.
Here, again, the bank is taking advantage of economies of scale, since it would be
difficult for a smaller investor to make a large number of loans.
The process of risk sharing is further enhanced through diversification of assets
(portfolio-choice), which involves spreading out funds over a portfolio of assets with
different types of risk.
4. Reduction of Monitoring Costs

Suppliers of funds who directly invest in a fund user financial claim face a high cost of
monitoring the fund users actions in an accurate and timely manner. Financial institutions
such as mutual funds and collective investment schemes enable suppliers of funds to pool
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their resources and invest through skilled financial analysts who have superior skills in
monitoring and collecting information. In this case fund suppliers have appointed
financial institutions as a delegated monitor to act on their behalf.
5.Maturity Intermediation
Greater ability to bear risk of mismatching maturities of assets and liabilities Most
borrowers wish to borrow in the long term while most savers/investors are unwilling to
lock up their money for the long term. Financial intermediaries by developing a large
pool of deposits, they are able to satisfy the needs of both the lenders and borrowers.
6.Denomination Intermediation
Some financial institutions, especially mutual funds perform a unique service because
they provide services relating to denomination intermediation. This is because many
assets sold in larges denomination which are out of reach of individual small savers, may
be acceseed through buying shares in mutual funds. Financial institutions Allow small
investors to overcome constraints imposed to buying assets imposed by large minimum
denomination size
7.Money Supply Transmission
Depository institutions are the conduit through which monetary policy actions impact the
economy in general and the rest of the financial system
8.Credit Allocation often viewed as the major source of financing for a particular sector
of the economy (e.g. farming and real estate)
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LESSON FOUR: REGULATION OF FINANCIAL MARKETS AND

INSTITUTIONS
Financial markets are among the most regulated markets in modern economies.
The main objectives of Regulation of Financial Markets include:
Customer Protection to ensure:

 Market failures are corrected
 Information asymmetry between suppliers of financial products and consumers is
redressed
 Transparency – ensure full, plain, adequate and comparable information about
prices, terms and conditions of financial products
 Choice – ensure fair, non-coercive practices in selling financial products and
services and collection of payments
 Redress – inexpensive and speedy mechanisms to address complaints and resolve
disputes
Maintaining financial stability because financial sector:

 affects long-term economic growth through its effect on the efficiency of
intermediation
 allows for monitoring of the users of external funds, affecting thereby the
productivity of capital employed
 impacts the volume of saving, which influences the future income-generating
capacity of the economy
 affects the stability of the whole economy
3.1. The need for financial regulation
Why regulate financial markets?
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Financial markets are among the most regulated markets in modern economies.
The Three Main Reasons for Regulation are :
 The first reason for this extensive regulation is to increase the information
available to investors (and, thus, to protect them).
 The second reason is to ensure the soundness of the financial system.
 Improve Monetary Control
1.Increase Investor Information

• Asymmetric information in financial markets means that investors may be subject
to adverse selection and moral hazard problems that may hinder the efficient
operation of financial markets and may also keep investors away from financial
markets
• The Capital Market Authority (CMA) requires corporations issuing securities to
disclose certain information about their sales, assets, and earnings to the public
and restricts trading by the largest stockholders (known as insiders) in the
corporation
• Such government regulation can reduce adverse selection and moral hazard
problems in financial markets and increase their efficiency by increasing the
amount of information available to investors
Ensure Soundness of Financial Intermediaries

• Because providers of funds to financial intermediaries may not be able to assess
whether the institutions holding their funds are sound or not, if they have doubts
about the overall health of financial intermediaries, they may want to pull their
funds out of both sound and unsound institutions, with the possible outcome of a
financial panic that produces large losses for the public and causes serious
damage to the economy
• To protect the public and the economy from financial panics, the government has
implemented six types of regulations:
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• Restrictions on Entry
• Disclosure
• Restrictions on Assets and Activities
• Deposit Insurance
• Limits on Competition
• Restrictions on Interest Rates
• Restrictions on Entry
• Regulators have created very tight regulations as to who is allowed to set

up a financial intermediary
• Individuals or groups that want to establish a
financial intermediary, such as a bank or an insurance company, must
obtain a license from the government, they must also adhere to specific
sectorial regulatory frameworks such as Banking act cap 489, central bank
act cap 491, insurance act of 2006, company act cap 486, capital market
authority act cap 485 and other relevant regulatory acts.
• The capital requirement to operate a financial intermediary has been raised
for example minimum capital requirement for operating a Commrcial
Bank is Ksh 250 Million but by 2012 should be Sh 1 Billion. Insurance
Companies is 250million while investment Banks has been raised from
Shs 250 Million.
• Only if they are upstanding citizens with impeccable credentials and a
large amount of initial funds will they be given a charter.
Disclosure Requirements
• There are stringent reporting requirements for financial intermediaries

• Their bookkeeping must follow certain strict principles,
• Their books are subject to periodic inspection,
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• They must make certain information available to

the public.
• There are restrictions on what financial intermediaries are allowed to do and what
assets they can hold
• Before you put your funds into a bank or some other such institution, you would
want to know that your funds are safe and that the bank or other financial
intermediary will be able to meet its obligations to you
• One way of doing this is to restrict the financial intermediary from
engaging in certain risky activities
• Another way is to restrict financial intermediaries from holding certain
risky assets, or at least from holding a greater quantity of these risky assets
than is prudent
Regulation: Deposit Insurance

• The government can insure people providing funds to a financial intermediary to
cushion depositors and investors from any financial loss if the financial
intermediary should fail
• The central bank of kenya, insures each depositor at a commercial bank up to a
loss of Ksh100,000 per account through the depositor protection fund. The
Capital Market authority investor protection fund pays Sh 50,000 per account.
Restrictions on Interest Rates

• Competition has also been inhibited by regulations that impose restrictions on
interest rates that can be paid on deposits.
•
• These regulations were instituted because of the widespread belief that
unrestricted interest-rate competition helped encourage bank failures during the
Great Depression
Later evidence does not seem to support this view, and restrictions on interest rates have
been abolished
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In duplum rule on interest rates introduced by the central bank of Kenya under section 44
of the Banking act aimed at curbing high interest rates in Kenya.
Improve Monetary Control

• Because banks play a very important role in determining the supply of money
(which in turn affects many aspects of the economy), much regulation of these
financial intermediaries is intended to improve control over the money supply
• One such regulation is reserve requirements, which make it obligatory for all
depository institutions to keep a certain fraction of their deposits in accounts
with , the central bank in the central bank.
• Reserve requirements help the central bank exercise more precise control over the
money supply
3.2. Financial regulation in Kenya
The structure of regulation in Kenya include the following :
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LESSON FIVE: KEY FINANCIAL INSTITUTIONS
5.1 Commercial Banks in Kenya
The banking sector comprised the Central Bank of Kenya, as the regulatory authority,
Commercial Banks, Non-Bank Financial Institutions, Forex Bureaus and Deposit Taking
Microfinance Institutions as the regulated entities. Commercial banks are the major
players in banking sector
CENTRAL BANK OF KENYA
Public Financial Private financial Foreign exchange Deposit-taking

Institution institution Bureau (130) Financial
1 Consolidated Bank of Institution
Kenya Ltd
2 Development Bank of
Kenya Ltd
3 National Bank of
Kenya Ltd
Local : Foreign (over 50%)

Commercial Banks 28 Commercial Banks
Mortgage Finance Institutions 2 13
Structure of commercial banks (2009)
Commercial banks and mortgage financial institutions are licensed and regulated under
the banking act. Currently there are 44 licensed commercial banks and 2 mortgage
finance companies.
Out of the 46 institutions, 33 are locally owned and 13 foreign owned. The commercial
banks are further divided into three classes:
Banks incorporated in Kenya
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Branches of overseases banks

This include banks such as bank of india, bank of baroda, habib bank A.G Zurich.
The two classes of banks undertake retail banking and offer a wide range of bith financial
and non-financial services vital for the economy
Banks with represenatative offices in Kenya. These include :
Bank of Tokyo, deutsche bank, chase manhattan bank. These banks do not accept
deposits from the public and as such do not create loans but rather represent their home
trading interest in Kenya.
Challenges and policy direction for the central bank of Kenya concerning
commercial Banks.
The banking sector being the largest segment of the money market players requires
attention. The central bank has faced several challenges which have necessitated change
in policy for the banking sector in Kenya. These challenges include,
 Lack of credit information sharing which has contributed to high levels of non-
performing loans in the banking sector. Further more banks have tended to rely
on physical rather personal collateral in their lending decisions. Following the
enactment of the finance act 2006, sharing information on non-performing loans
has become compulsory. This has set the stage for the licensing and oversight of
credit reference bureaus by the central bank. The absence of reliable information
on potential borrowers increases adverse selection risks for banks resulting in
high credit risk and loan loss provision which in turn raises interest rates.
 Lack of a sound legal framework for money laundering: sound legal and
regulatory framework for money laundering prevention and control is critical to
safeguarding the integrity of the Kenyan financial system. Money laundering
 Access to financial services: survey indicates that 38 % of Kenyans lack access to
financial services due to costs and barriers to entry. There is a need to
operationalise micro finance act 2006 and agency banking. This will provide the
central bank with a platform to license and oversee micro-finance institutions.
This means more players and more flexibility and competitiveness within the
financial sector.
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 Enhance banking supervision: to ensure compliance with the banking rules and
regulations. Most banks fail to categorize loans properly which lead under-
provisioning making some banks appear more healthy by declaring high profits
and hence dividends than actually justified. Re-categorization required by the
central bank supervision has led to the need for additional provisioning to meet
statutory requirements and increased transparency and accountability.
 Disposal of collateral: another challenge facing commercial banks has been
disposal of collateral used to secure non-performing loans. Central bank has
issued guidelines aimed at gradual elimination of institutions overreliance on
collateral based lending. These changes have the benefit of improving credit
allocation in favour of credit worthy customers, maintaining financial discipline
among borrowers and early recognition of bad debts
5.2. Factors That Have Led To Rapid Development of Commercial Banks In Kenya
 Stable macro-environment conducive for the development of a stable financial
market.
 Increased awareness as regards to saving habits among Kenyans.
 Increased income per capita i.e growth of agriculture, tourism, remittances from
abroad e.t.c.
 Government policies that favour the development of a robust private sector.
 High credit rating amongst foreign lenders i.e standard and poors high rating that
has led to capital inflows and investment.
 Development of the co-operative movement In Kenya . this movement has been
responsible for the fast growth of financial institutions i.e SACCO, micro-finance
institutions and commercial banks.
5.3. General Principles of Bank Management
Bank management is the mechanisms through a commercial bank manages assets (loans)
and liabilities (deposits) to maximize profits. There are four concerns , these are :
1. Liquidity Management - maintaining enough liquid assets to meet obligations to

depositors (for cash withdrawals) and to central bank of Kenya.
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2. Asset Management - managing assets (loan portfolio) to achieve diversification and

minimize default risk/credit risk and interest rate risk.
3. Liability Management - acquire/attract funds (deposits) at lowest possible cost.
4. Capital Adequacy Management - maintaining the appropriate net worth to meet central
bank of Kenya regulations and prevent bank failure.
By looking at a bank’s balance sheet, one can see how banks are involved in the process
of asset transformation: they sell liabilities with one set of characteristics and use the
proceeds to acquire assets with a different set of characteristics.
By engaging in asset transformation, the bank hopes to profit by charging a higher
interest rate on its assets than it must pay on its liabilities. Thus, a bank manager must be
concerned with both asset management (acquiring assets with the highest return and the
lowest risk) and liability management (acquiring funds at the lowest cost).
1. LIQUIDITY MANAGEMENT- it involves management of bank reserves. There are

Two concerns: 1) excess reserves and 2) insufficient reserves.
If a commercial Bank holds non interest-bearing assets as reserves they earn zero
interest. Investing in Loans through lending generate interest income for the commercial
bank. The Opportunity cost of excess reserves is the lost/foregone interest income.
Banks therefore want to minimize holding excess reserves. However, if a bank has
deficient in reserves, there could possibly be a costly readjustment process. Banks
therefore seek to hold the optimal amount of reserves, but the optimal amount is NOT
zero.
Basic Example: . Assume reserve requirement is 10%, banks are required to hold
minimum reserves equal to 10% of deposits.
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Scenario #1: Bank initially has excess reserves. Required reserves: Ksh 10million.
Actual reserves: Ksh 20million . Excess reserves in this case is Ksh 10 million.
Assume a deposit outflow of Ksh 10million . People move to Florida for the winter and
withdraw $10m from Bank One. Or Stock market boom and people transfer money from
checking to mutual funds. Or there is a large deposit outflow. Bank can handle the
Ksh10million deposit outflow and still meet the 10% reserve requirement without having
to make any other changes in its balance sheet.
Scenario #2: Bank has no excess reserves, Deposit outflow of Ksh10million. The bank
now has NO reserves and required reserves are Ksh 9 million.
Four options for bank to meet reserve requirement, :
1. Borrow Ksh nine million from other banks in the at the existing inter bank market
rates
2. Sell Ksh nine million of securities – for example Treasury bills.
Disadvantages: a) transactions costs and b) converting interest-bearing assets to non

interest-bearing assets.
3. Borrow Ksh nine million from central bank in the discount market .
4. Reduce loans by Ksh nine million : a) calling them in - actually not renewing them.
Example: many commercial loans are short term, renewable at short intervals. Customers
will be upset, and will go to other banks or b) selling factoring the loans to other banks.
Point: Optimal amount of excess reserves is not zero. Banks hold excess reserves to
provide insurance, a cushion against unexpected deposit outflows. The cost of excess
reserves is the opportunity cost of interest on loans.
ASSET MANAGEMENT
The bank must hold a mix of assets that provides the highest return with the lowest risk.
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Thus, asset management involves four basic principles:
1. Assess creditworthiness of loan customers, avoid costly defaults. Banks are usually
conservative - defaults are less than 1% of bank loans. Optimal number of loan defaults
is not zero. Why?
2. Finding securities with high returns and low risk. This involves Purchasing securities,
subject to central bank regulations. Commercial banks investment is usually restricted to
treasury securities such as treasury bonds and bills.
3. Diversifying the bank’s asset holdings to minimize risk: holding many types of
securities and making many types of loans offers protection when there are losses in one
type of security or one type of loan. For example the diversification can be on the basis of
Short and long term securities. Diversity loan portfolio - commercial, asset financing,
student, mortgage, credit card, etc. Undiversified loan portfolios are exposed to risk.
Example: too many real estate or farm loans in one area is risky.
4. Manage assets to ensure liquidity, holding sufficient liquid assets like Treasury-Bills in
case of large deposit outflows, loss of reserves. Treasury-Bills are so safe and liquid that
they are considered "secondary reserves." Bank has to balance liquidity (holding
reserves and Treasury -Bills) against increased earnings from less liquid assets (holding
loans).
Capital adequacy Management

Banks have to make decisions about the amount of capital they need to hold for three
reasons,
 Bank helps prevent bank failure, a situation in which the bank cannot satisfy its
obligation to pay its depositors and other creditors and so goes out of business.
 The amount of capital affects returns for the owners ( equity holders) of the bank.
 A minimum amount of bank capital ( bank capital requirements) is required by
regulatory authorities.
How Bank capital helps prevent bank failure
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Consider two banks with the following balance sheets
Bank A BANK B
ASSETS LIABILITIES ASSETS LIABILITIES

Reserve 10,000,00 deposit 90,000,00 Reserv 10,000,00 deposit 96,000,00
s 0 s 0 es 0 s 0
loans 90,000,00 bank 10,000,00 Loans 90,000,00 bank 4,000,000
0 capital 0 0 capital
Ratio of capital to assets 10% ratio of capital to assets 4%
Suppose both banks have non-performing loans of Ksh 5 Million that cannot be
recovered. The total value of the assets will decline by the same amount. The balance
sheet will appear as follows :
Bank A Bank B
ASSETS LIABILITIES ASSETS LIABILITIES

Reserve 10,000,00 deposit 90,000,00 Reserv 10,000,00 deposit 96,000,00
s 0 s 0 es 0 s 0
loans 85,000,00 bank 5,000,000 Loans 85,000,00 bank -
0 capital 0 capital 1,000,000
Bank B has become insolvent. It does not have sufficient funds to pay off all holders of
its liabilities. When the bank becomes insolvent the regulators can put it under statutory
management.
Amount of capital affects returns to equity holders, the key measures include :
return on assets= net provides information how efficiently the bank is run or
profit after tax/assets managed
return on equity= there is a direct relationship between how efficiently a bank is
net profit after tax/equity run and the measures on how well the owners are doing on
capital their investment
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Equity Given the return on assets, the lower the bank capital, the
Multiplier=assets/equity higher the returns for the owners of capital.
capital
LIABILITY MANAGEMENT
Banks used to rely on demand deposits (no interest) for their main source of funds - 60%,
in 1960s. Before 1980, banks were not allowed to pay interest on checking, so there was
no competition for demand deposits. Also, the inter bank market was not developed, so
inter-bank borrowing was rare, to meet reserve requirements. Therefore, banks used to
focus on asset management (optimal loan portfolio), because liabilities (demand deposits)
were stable and non-competitive.
Currently, interbank market developed, so banks had access to a new source of funds:
other banks. Also, banks began to issue negotiable CDs, right issues, corporate bonds
which allowed banks access to another source of funds besides deposits. Banks now
placed greater emphasis on liability management, due to increased flexibility for
attracting sources of funds. They no longer needed to rely exclusively on checking
deposits. They now set goals for asset (growth) and then acquired funds (issuing
liabilities) as they needed for new loans.
5.3 Performance Evaluation of Commercial Banks
Majorly there are two performance evaluation techniques used commercial banks. These
techniques are used by regulators such as central bank of Kenya as early warning system.
These techniques include :
 Camel
 Stress testing
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5.3.1. Camel System
CAMELS system acronym indicating the six categories evaluated to assess a bank’s
overall financial condition: C (capital adequacy), A (asset quality), M (management), E
(earnings), L (liquidity), and S (sensitivity to risk).
Capital Adequacy
A financial institution is expected to maintain capital commensurate with the nature and
extent of risks to the institution and the ability of management to identify, measure,
monitor, and control these risks. The effect of credit, market, and other risks on the
institution's financial condition should be considered when evaluating the adequacy of
capital.
Capital adequacy in Kenyan banking industry is measured in terms of :

 Absolute minimum core capital.
 Core capital exposure limits as prescribed by the Banking Act and prudential
regulations.
 Capital adequacy ratios.
Core capital exposure limits set include:

 Credit Exposure Limits-Single Borrowings should not exceed 25% of core
capital. In case of insiders this limit is set at 20% of core capital and aggregate
insider borrowing is limited to 100% of core capital.
 Foreign Exchange Exposure Limit-Should not exceed 20% of an institution’s
core capital.
 Investment Exposure limit-Investment in non-core business should not exceed
20% of core capital.
 Fixed Assets Exposure Limit-Fixed assets should not exceed 20% of core capital.
CAPITAL ADEQUACY RATIOS (CARS)
 Core Capital/Deposits (Gearing Ratio)- Minimum 8%.
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 Core Capital/Total Risk Weighted Assets (TRWA)-Minimum 8%.

 Total Capital/TRWA-Minimum 12%.
 For rating purposes the ratio of total capital to TRWA is used
Rating/Performance Category Total Capital/TRWA (%)

Total Capital/TRWA >=19.5 strong capital level relative to the
(%) institution's risk profile.
2-Satisfactory <19.5 and =15.5
3-Fair <15 and =12 The rating indicates a need

for improvement, even if the institution's
capital level exceeds minimum regulatory
and statutory requirements.
4-Marginal <12 and =8.3
Assistance from shareholders or other

external sources of financial support may
be required.
5-Unsatisfactory <8.3 Immediate assistance from

shareholders or other external sources of
financial support is required.
All institutions with problems with any of the indicators of capital adequacy are flagged
and necessary corrective action is recommended.
Institutions that meet all the capital adequacy ratios but whose minimum core capital is
below the prescribed core capital are automatically rated fair at best.
Asset Quality
The asset quality rating reflects the quantity of existing and potential credit risk
associated with the loan and investment portfolios, other real estate owned, and other
assets, as well as off-balance sheet transactions. The ability of management to identify,
measure, monitor, and control credit risk is also reflected here. The evaluation of asset
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quality should consider the adequacy of the allowance for loan and lease losses and
weigh the exposure to counterparty, issuer, or borrower default under actual or implied
contractual agreements. All other risks that may affect the value or marketability of an
institution's assets, including, but not limited to, operating, market, reputation, strategic,
or compliance risks, should also be considered.
Kenya’s perspective
Asset Quality is measured in terms of non-performing loans less provisions as a
percentage of gross loans. Non-performing loans are those facilities whose performance
does not conform with the terms and conditions in the letter of offer (agreement). These
are facilities classified as substandard, doubtful and loss in accordance with the
prudential regulation on loan classification and provisioning.
Rating/Performance Net NPLs/Gross

Category Advances (%)
1-Strong <=5
2-Satisfactory >5 and = 10
3-Fair > 10 and = 15
4-Marginal > 15 and = 20
5-Unsatisfactory > 20
An increase in the percentage of non-performing loans to gross advances is an indicator
of declining asset quality .This quality requires remedial action, which includes requiring
an institutions’ management to enhance recovery efforts on non-performing loans and
enhancing credit appraisal and administration procedures.
Asset Quality - Ratings

1. A rating of 1 indicates strong asset quality and credit administration practices. Risk
exposure is modest in relation to capital protection and management's abilities. Asset
quality in such institutions is of minimal supervisory concern.
2. A rating of 2 indicates satisfactory asset quality and credit administration practices.
Risk exposure is commensurate with capital protection and management's abilities.
3. A rating of 3 is assigned when asset quality or credit administration practices are less
than satisfactory. Trends may be stable or indicate deterioration in asset quality or an
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increase in risk exposure. There is generally a need to improve credit administration and
risk management practices.
4. A rating of 4 is assigned to financial institutions with deficient asset quality or credit
administration practices.
5. A rating of 5 represents critically deficient asset quality or credit administration
practices that present an imminent threat to the institution's viability.
Management
The capability of the board of directors and management, in their respective roles, to
identify, measure, monitor, and control the risks of an institution's activities and to ensure
a financial institution's safe, sound, and efficient operation in compliance with applicable
laws and regulations is reflected in this rating.
Depending on the nature and scope of an institution's activities, management practices
may need to address some or all of the following risks: credit, market, operating or
transaction, reputation, strategic, compliance, legal, liquidity, and other risks. Sound
management practices are demonstrated by: active oversight by the board of directors and
management; competent personnel; adequate policies, processes, and controls taking into
consideration the size and sophistication of the institution; maintenance of an appropriate
audit program and internal control environment; and effective risk monitoring and
management information systems.
1. A rating of 1 indicates strong performance by management and the board of directors

and strong risk management practices relative to the institution's size, complexity, and
risk profile. All significant risks are consistently and effectively identified, measured,
monitored, and controlled.
2. A rating of 2 indicates satisfactory management and board performance and risk
management practices relative to the institution's size, complexity, and risk profile.
.
3. A rating of 3 indicates management and board performance that need improvement or
risk management practices that are less than satisfactory given the nature of the
institution's activities. The capabilities of management or the board of directors may be
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insufficient for the type, size, or condition of the institution. Problems and significant
risks may be inadequately identified, measured, monitored, or controlled.
4. A rating of 4 indicates deficient management and board performance or risk
management practices that are inadequate considering the nature of an institution's
activities. The level of problems and risk exposure is excessive. Replacing or
strengthening management or the board may be necessary.
5. A rating of 5 indicates critically deficient management and board performance or risk
management practices. Replacing or strengthening management or the board of directors
is necessary.
Earnings
This rating reflects not only the quantity and trend of earnings, but also factors that may
affect the sustainability or quality of earnings. The quantity as well as the quality of
earnings can be affected by excessive or inadequately managed credit risk that may result
in loan losses and require additions to the allowance for loan and lease losses, or by high
levels of market risk that may unduly expose an institution's earnings to volatility in
interest rates.
KENYA PERSPECTIVE
Earnings/profitability is measured in terms of return on assets (ROA) expressed as profit
before tax as a percentage of gross assets including off-balance sheet assets.
Other profitability ratios used include :-
• Net Interest Income/Average Earning Assets.
• Non-Interest Expenses/Operating Income.
• Total Expenses/Total Income.
Institutions with declining or negative ROA’s are flagged and appropriate remedial action
is recommended.
EARNINGS RATING BANDS
Rating/Performance Category Liquidity Ratio
1-Strong >=3
2- Satisfactory <3 and = 2
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3- Fair < 2 and = 1

4-marginal <1 and = 0
5- Unsatisfactory <0
Earnings - Ratings
1. A rating of 1 indicates earnings that are strong. Earnings are more than sufficient to
support operations and maintain adequate capital and allowance levels after consideration
is given to asset quality, growth, and other factors affecting the quality, quantity, and
trend of earnings.
2. A rating of 2 indicates earnings that are satisfactory. Earnings are sufficient to support
operations and maintain adequate capital and allowance levels after consideration is
given to asset quality, growth, and other factors affecting the quality, quantity, and trend
of earnings.
3. A rating of 3 indicates earnings that need to be improved. Earnings may not fully
support operations and provide for the accretion of capital and allowance levels in
relation to the institution's overall condition, growth, and other factors affecting the
quality, quantity, and trend of earnings.
4. A rating of 4 indicates earnings that are deficient. Earnings are insufficient to support
operations and maintain appropriate capital and allowance levels. Institutions so rated
may be characterized by erratic fluctuations in net income or net interest margin, the
development of significant negative trends, nominal or unsustainable earnings,
intermittent losses, or a substantive drop in earnings from the previous years.
5 A rating of 5 indicates earnings that are critically deficient. A financial institution with
earnings rated 5 is experiencing losses that represent a distinct threat to its viability
through the erosion of capital.
Liquidity
In evaluating the adequacy of a financial institution's liquidity position, consideration
should be given to the current level and prospective sources of liquidity compared to
funding needs, as well as to the adequacy of funds management practices relative to the
institution's size, complexity, and risk profile. In general, funds management practices
should ensure that an institution is able to maintain a level of liquidity sufficient to meet
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its financial obligations in a timely manner and to fulfill the legitimate banking needs of
its community. funds management practices should ensure that liquidity is not
maintained at a high cost, or through undue reliance on funding sources that may not be
available in times of financial stress or adverse changes in market conditions.
KENYAS PERSPECTIVE
Liquidity refers to the ability of a financial institution to meet its’ maturing obligations.
Liquidity is measured in terms of net liquid assets as a percentage of net deposit
liabilities. The minimum statutory liquidity is 20%. Institutions whose liquidity ratio falls
below 20% are flagged for remedial action. The liquidity ratio is supplemented by gap
analysis of maturity mismatches between assets and liabilities within specified maturity
LIQUIDITY RATING BANDS
Rating/Performance Liquidity Ratio
Category
1-Strong >=34
2- Satisfactory <34 and = 25
3- Fair < 25 and = 20
4-marginal -Marginal < 20 and = 15
5- Unsatisfactory < 15
Liquidity - Ratings
1. A rating of 1 indicates strong liquidity levels and well-developed funds management
practices. The institution has reliable access to sufficient sources of funds on favorable
terms to meet present and anticipated liquidity needs.
2. A rating of 2 indicates satisfactory liquidity levels and funds management practices.
The institution has access to sufficient sources of funds on acceptable terms to meet
present and anticipated liquidity needs. Modest weaknesses may be evident in funds
management practices.
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3. A rating of 3 indicates liquidity levels or funds management practices in need of

improvement. Institutions rated 3 may lack ready access to funds on reasonable terms or
may evidence significant weaknesses in funds management practices.
4. A rating of 4 indicates deficient liquidity levels or inadequate funds management
practices. Institutions rated 4 may not have or be able to obtain a sufficient volume of
funds on reasonable terms to meet liquidity needs.
5. A rating of 5 indicates liquidity levels or funds management practices so critically
deficient that the continued viability of the institution is threaten
5.3.2. Stress Tests

Stress testing is used to identify events or influences that could greatly impact on the
bank’s performance or bank’s capital, by anticipating the potential impact of specified
events on selected indicators of bank performance
Scenario analysis which seeks to assess the resilience of financial institutions/sector to
unexpected but plausible economic scenarios, e.g. changes in interest rates
Tests of the sensitivity of the financial sector to extreme events, extreme scenarios and
contagion among financial institutions have become an integral part of the regular
financial reports published by many central banks and regulators. Stress tests are
designed to explore vulnerabilities to events which have a low probability of occurrence,
but which, should they occur, could prove extremely costly.
They are also helpful for contingencies whose probability of occurrence is difficult to
estimate. They complement analyses which deal with vulnerabilities which are highly
probable and for which expected losses are small, unless the financial system is on the
brink of a crisis." Most common are tests of sensitivity to individual risk factors, such as
a sharp rise in interest rates, a rapid depreciation of the exchange rate or a collapse of
asset prices. Sensitivity tests are often combined with exercises to adjust the balance
sheets of financial institutions to reflect perceived weaknesses such as overvaluation of
assets. Evaluation of the financial system's resilience to scenarios that combine several
shocks is also' quite common. Stress tests usually focus on the adequacy of the capital
base of the financial system, were it to be faced with a shock, with a few tests also
considering the implications for profitability and liquidity of the financial system.
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By anticipating the potential impact of specified events on selected indicators, stress

testing help focus on financial system vulnerabilities arising from particular banking
system and macroeconomic shocks
The key indicators used in stress testing include :
indicator key ratios red flag (point of concern)

capital leverage ratio Capital red flags
tier one capital
capital adequacy ratio
Equity growth versus asset
growth
• Performance ratios that are

significantly different
from peer ratios
• Dividend payout is
significantly higher than
peer
ratios
• Significant growth in
balance sheet activities
Asset quality non-performing loans/Total Asset quality red flags
Loans
• Loan growth
• Loans to equity ratios
• Loans to assets
• NPLs (net
provisions)/capital
Earnings: focus on the  Return on Assets Earnings red flags
quantity, trend, quality  Return on Equity
• Significant increase in
and sustainability of non-interest income
earnings
Significant variance in ROE
and ROA with prior periods
and compared with peer
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group averages
Significant variance from

budgeted amounts on
income and expenses and
balance sheet accounts
liquidity  Loans to deposit Liquidity red flags

ratios
• High Loans to deposit ratio
• Net short-term liabilities
• Funding concentration
from a single source or
multiple sources with

common credit or rate
sensitivity
• Declining levels of core

deposits
5.4. Pension Funds
A Pension Scheme is an investment vehicle whose aim is to provide an individual with a

sufficient and consistent source of income after retirement.
Definition: pensions are asset tools that accumulates over an individual’s working life and
is paid out during non-working years.
 Pension funds are defined by their tax treatment and function.
o They exist for the eventual payment of retirement benefits
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o Qualified plans have tax exempt contributions and earnings

 Pension plan sponsors can be private companies, government employers, unions
or individuals
o They are administered by employers, insurance companies or investment
companies and typically involve the assets of insurance or investment
companies.
5.4.1 Types of Retirement Plans
Retirement plans may be classified as defined benefit or defined contribution. This

classification is according to how the members’ benefits are determined.
Defined Benefit Pension Plans: Defined Benefit Plans are designed to guarantee an
individual a specified amount of benefit after retirement. These benefits undergo actuarial
valuations based on a formula.
1/Pension Factor X Years of Service X Salary
The defined benefit depends on certain factors such as years of service and member’s
earnings. Members of this type of plan are advised on a specific amount that they are to
contribute to the scheme. Employer promises a specified payments monthly during
retirement. The employee may or may not have to contribute to this plan. To receive
benefits an employee must be vested; vesting refers to the minimum years of service
necessary to receive any benefits. The advantages of this type of plan from the employee
perspective include a limited investment risk for the employee, no risk of outliving assets.
the disadvantages of this type of plan include a lack of portability from job to job and a
lack of control over how pension contributions are invested, or even if the employer is
contributing enough to meet the promised obligations
 Salary most often than not has been final salary.
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 In recent times, salary has been calculated as average of last three years to reduce
cost.
 Pension Factor reflects the amount of income replacement a sponsor is willing to

provide for employees in retirement and advised by actuary
The defined benefit schemes may be three categories :
Fully funded : when sufficient funds are set aside by the employer to meet promised
payments.
Under-funded Pension Plan
Future pension obligations of a defined-benefit plan are uncertain because obligations are
fixed payments to retirees and payments depend on salary level, retirement ages and life
expectancies
 Over-optimistic projections (estimated rates of return) can mean
inadequate cash to cover obligations
 High risk investments might be used to generate higher returns with varied
results
 Many companies are under funded for they were “pay-as-you-go” for
many years before funding began
Over-funded Pension Plan
When investment returns for defined-benefit plans perform better than expected, there are
funds in excess of the amount needed to meet obligations
 A portion of the surplus can be credited to the income statement of a corporation
 Encourages exchange of defined benefit for insured pension purchase (liquidation
of plan)
Drivers for reform in defined benefits

 Cost Saving measures. Employer reducing open ended liabilities
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 Non contributory schemes . Employers who have been making

contributions alone are feeling the burden and see the need to involve
employees
 Low funding levels . less than the statutory required 80% caused by:
Failure of schemes to carry out actuarial reviews – formula were not
revised leading to unaffordable generous pensions .Where actuarial
valuations were conducted, schemes failed to implement actuarial
recommendations.
 Failure by employers to remit contributions of both members and

employers which worsened the liability position
 Failure to separate scheme assets and employer assets fund. Scheme funds
constituted part of employer balance sheet.
 _ High Mobility of employees. employees agitate for DC schemes where

transferability of funds is easy and simple
Defined Contribution Pension Plans: In a defined contribution plan, a member’s

contribution together with any funds from the employer are deducted and remitted to a
registered pension scheme for investment. The amount that the member receives at
retirement is dependant on the total amount of money contributed and the investment
performance over the period of time. Individual pension schemes and occupational
schemes can be found under this category.
Another method of saving for retirement is through a Provident Fund. This fund pays
retirement benefits as a lump-sum on exit. Under this scheme, a stipulated sum is
deducted from the salary of the employee as her contribution towards the fund. The
accumulated contribution along with the interest (which is calculated as a percentage of
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one’s salary) is paid to the employee at the time of retirement. The main difference
between a provident fund and a pension plan is the payment of the funds' benefits. Upon
retirement, a provident fund's benefit is available in full to the member. In contrast, a
member of a pension fund is restricted to a lump sum proportion with the remaining
benefit commuted on a regular basis.
Conclusion
It is important to note that a pension member can choose to boost their retirement benefits
by making additional payments into another pension scheme. For example, a member of
an occupational scheme can make additional contributions to an individual scheme. This
is referred to as Additional Voluntary Contributions (AVCs). AVCs also apply to
situations where one contributes over and above the limit on which tax benefits apply.
At the end of the day, the most important factors to consider when joining a pension
scheme are the security of the funds, members’ interests and the transparency of
operations the safety of a Pension Scheme is enhanced by its structure.
The RBA requires all pension schemes to have a Trustees to safeguard the interests of the
pension members. A Custodian to look after the pension assets such as cash and other
investments and a Fund Manager to invest the scheme funds. This separation of roles in
the structure ensures good governance, transparency and accountability for the decisions
made on behalf of the members. In addition, members should be able to access their
statements on an annual basis or at the Pension Plan’s stipulated frequency.
5.4.2. Pension Schemes in Kenya
There are four main types of pension schemes in Kenya,

they include:
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a) The Civil Service Pension Scheme: This type of pension scheme caters
specifically to employees of the Government. Its operations are legislated in
Parliament.
b) National Social Security Fund (NSSF): This is a fund to which both the
employer and employee make statutory contributions. The statutory contribution
amount is Kshs.400, with the employee contributing Kshs.200 and the employer
adding the remaining Kshs.200.
c) Private Occupational Schemes: This is a scheme that is set up by the employer
and caters to the employees of the company only. Most employers who operate
occupational pension schemes make contributions to the scheme as an addition to
the amounts paid by the member. A major feature of an occupational scheme is
that if an employee resigns from employment, she can access her part of the
contributions. However, the employer’s contributions remain with the employer
until the employee reaches retirement age. Although an employee cannot access
the employer’s contribution if she leaves employment, she is able to transfer these
contributions to another pension scheme of her choice.
d) Individual Retirement Benefits Schemes: This type of scheme is suitable to

individuals who are self employed or those who are employed but are not
members of an occupational scheme. In an Individual Pension Plan, both the
contribution of the employer and the employee are consolidated and can only be
accessed upon retirement, severe ill health and permanent emigration to another
country.
Civil service N.S.S.F Occupational Individual

Scheme scheme
Legal Acts of Acts of Trust deed Trust deed
structure parliament parliament
Membership All civil Formal sectors Formal sector Individual
servants workers with employees with formal and non-
companies for companies formal,
at least five having their voluntary
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years own scheme

Funding Non funded Funded Funded Funded
Regulation Exempt from Under the RBA Under the RBA Under the RBA
RBA
Graphical illustration of pension schemes is as follows:
5.4.3. Growth in Pensions in Kenya

Growth of the industry has been influenced by:
 Increasing awareness of the need to save for retirement and of rights of scheme
members;
 Trustees’ awareness of their roles and responsibilities;
 Research and best international practice based pension reforms geared at
development of the industry;
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 Professional management of assets;

 Independence of service providers, which increases accountability;
INVESTMENT OBJECTIVES OF PENSION FUNDS IN KENYA

• To preserve and enhance the purchasing power of members’ savings.
• Long term return above the rate of Inflation.
• Long term return in excess of actuarial assumption.
• To achieve a return that is above benchmark.
• Maximum long term return within acceptable risk parameters.
• Manage volatility particularly as retirement approaches
• Comprehensive risk management
• Performance must always be measured against the long term objectives of the
fund and appropriate levels of risk
The investment framework as indicated by retirement benefit authority
Asset Class Strategic Benchmark Tactical Actual RBA Limits

Allocation Allocation Allocation Allocation
Cash &0%-5% 1% 0% 1% 5%
Deposits
Term 30%
Deposits
Corporate 30%
Notes & CP
35% -65% 44% -5% 44%
Government 70%
Paper
Domestic 20% -40% 30% +7% 37% 70%
Equities
Unquoted 0% - 5% 0% 0% 0% 5%
Equity
Offshore 5% - 15% 10% -3% 7% 15%
Property 0% - 30% 15% -4% 11% 30%
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ROLE & OBJECTIVES OF RETIREMENT BENEFIT AUTHORITY

 To regulate and supervise the establishment and management of retirement
benefits schemes.
 To protect the interest of members and sponsors of retirement benefits
schemes.
 To promote the development of the retirement benefits industry.
 To advise the Minister for Finance on the national policy to be followed
with regard to the retirement benefits industry.
 To implement all government policies relating thereto
THE RBA KEY REQUIREMENTS ON PENSION SCHEMES IN KENYA

summarized
 Schemes must be funded

 Scheme must be established under irrevocable trust unless established under written
law
 1/3 Member nominated trustees on the Board of Trustees
 Schemes must Appoint separate Managers and Custodians
 Defined Benefits Schemes must avail actuarial valuations every three years
 Schemes must ensure availability of annual Audited Accounts
 Schemes must ensure submission of quarterly contribution and investment reports.
 There should be no assignments/attachment of members benefits for debt /loan,
judgment or for any other form of impropriety
 Scheme rules should provide for immediate vesting of members’ contributions and
vesting of employer’s contribution within a maximum of five years
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 Schemes must ensure compliance with RBA Investment. Each scheme should submit
an investment policy that has been prepared by Trustees with assistance of an
investment advisor. The policy should:
 Adhere to RBA investment guidelines;
 Give the scheme’s investment objectives for the relevant
 period;
 Consider the scheme’s age profile;
 Specify the fund manager’s discretionary limits; and,
 Be revised every 3 years
5.4.4. Regulation of pension funds
Funding : sometimes pension funds may operate such that the employees annual
contribution are insufficient to meet annual pension obligation. The retirement benefit
authority establishes guidelines for funding and sets penalties for deficiencies.
Contributions to the pension fund must be sufficient to meet all annual costs and
expenses.
Vesting benefits: frequently, while employers start contributing to an employees pension

fund as soon as the employees is eligible to participate, benefits may not be paid to the
employee until he or she has worked for the employer for a stated period of time (or until
the employee is vested).
Fiduciary responsibilities. : a pension plan is a fiduciary is trustee or investment adviser

charged with the management of the pension fund. The RBA requires that the pension
fund contributions be invested with diligence, skill and care . the fund assets are supposed
to be managed with the sole objectives of providing benefits to participants. To ensure
that a fund operates in this manner, RBA, requires pension fund to report on the current
(i.e market value of assets held, income and expenses of the fund) of the pension fund.
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Transferablity : RBA allows employees to transfer pension credit from one employee’s
fund to another.
Investment policy : retirement benefit authority has set an investment policy to be

followed by pension funds.
KEY PLAYERS IN THE PENSION INDUSTRY

The government through retirement benefit authority requires that
All retirement benefits schemes in Kenya must:
 Be registered with RBA;
 Appoint a fund manager;
 Appoint a custodian (segregated funds); and,
 Appoint a Board of Trustees to manage scheme affairs.
In order to eliminate conflict of interest, these institutions must be independent
companies. This separation of roles in the structure ensures good governance,
transparency and accountability for the decisions made on behalf of the members.
The role of each player is as discussed :
5.4.5. The Role of Trustees in Pension Schemes
The RBA requires all pension schemes to have a Trustees to safeguard the interests of the
pension members. Their role include :
 Appoint, appraise and as required remove, Fund Managers (whether internal or

external).
 - Appoint, appraise and as required remove, other service providers such as asset
consultants and custodians
 -Monitor and review all investment arrangements
 Regularly review and revise this Statement of Investment Principles (3 years)
 Specify the risk tolerance, investment policy, objectives and principles of the
Fund.
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 Develop and implement an appropriate investment strategy to meet the objectives.

 Determine the permissible assets to be invested in (subject to any statutory
limitation).
 Determine the Strategic asset allocation strategy
 Ensure compliance with all relevant legislation and regulations, and to act in
accordance with the Trust Deed
The Role of the Fund Manager
Advise the Trustees on investments…

• Set investment policy in consultation with Trustees & Actuary.
• Identify & Analyse securities
• Construct investment portfolio.
• Constantly review portfolio.
• Evaluate & Report Performance.
5.4.6. Key challenges of pension funds in Kenya
Non-funded or Under-funded schemes, especially in the public sector.

*Poor investments of Scheme funds leading to poor returns
*Misappropriation of scheme funds and denials of benefits to pensioners as a result of
member’s ignorance
*Poor administration and record keeping by pensions leading to long delays in payment
of benefits to members
*Poor coverage; In Kenya only about 15% of Kenyans are in any form of pension
arrangement
Aging population; the percentage of population aged over 65 in less developed countries
is forecast to rise from around 5 per cent today to nearly 15 per cent by the year 2050
*Resignation of individuals from the family unit occasioning breakdown of family-based
provisions as a result of urbanization and social changes
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*Dependency ratios could be nearly 1:1 within 30 years for some countries
*Low saving rates, low income and wealth, alternative development priorities
LESSON SIX : MONEY MARKETS AND INSTRUMENTS
A variety of money market securities are issued by corporations and government units to
obtain short-term funds. These include treasury bills, repurchase agrremeents,
commericial papers, negotiable certificate of deposits and bankers acceptance. Money
market exists to transfer funds from individuals, corporations and government units with
short term excess funds (suppliers of funds) to economic agents with short term needs for
funds (users of funds). Specifically in money market short term debt instruments (with
original maturity of less than one year are issued by economic agents with short term
fund requirement and purchased by the economic agents that require short term funds.
Need for money markets.

The need for money market is based on two perspectives :
Corporations, individuals and government have immediate cash needs that do not
necessarily coincide with their receipt of cash. On the other hand holding cash by those
who have excess involves an opportunity cost, hence those economic unit with excess
cash usually keep such balances at minimum. Hence the holders of cash invest excess
cash balances in financial securities that can be quickly converted into cash when needed
with little loss of value over short term horizon. Money markets are efficient in
performing
Money market have a low default risk i.e the risk of non-payment compared to the
capital market instruments.
The instruments in this market include :
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 Treasury Bills
 Commercial paper
 Repurchase agreements
 Certificates of deposit
6.1. Treasury Bills
These are are shot-term obligations issued to cover current shortfalls and refinance
maturing government debts. They are also used by the central bank as a tool in
conducting monetary policy through open market operations. The treasury bills generally
are 91-day, 182-day and 364-day in terms of maturity. The minimum allowable
denomination is Ksh 50,000 from a previous minimum of Ksh 100,000.
Characteristics of Treasury Bills

Default Risk Treasury bills are generally considered to be free of default risk because
they are obligations of the government of kenya. In contrast, even the highest grade of
other money market instruments, such as commercial paper or certificates of deposit
(CDs), is perceived to have some degree of default risk. Concern over the default risk of
securities other than Treasury securities typically increases in times of weak economic
conditions, and this tends to raise the differential between the rates on these securities and
the rates on Treasury bills of comparable maturity .
Because Treasury bills are free of default risk, various regulations and institutional
practices permit them to be used for purposes that often cannot be served by other money
market instruments. For example, banks use bills to make repurchase agreements free of
reserve requirements with businesses and state and local governments, and banks use
bills to satisfy pledging requirements on state and local
deposits. Treasury bills are widely accepted as collateral for selling short various
financial securities and can be used instead of cash to satisfy initial margin requirements
against futures market positions. And Treasury bills are always a permissible investment
for state and local governments, while many other types of money market instruments
frequently are not.
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Liquidity A second characteristic of treasury bills is their high degree of liquidity, which
refers to the ability of investors to convert them into cash quickly at a low transactions
cost. Investors in Treasury bills have this ability because bills are a homogeneous
instrument and the bill market is highly organized and efficient. A measure of the
liquidity of a financial asset is the spread between the price at which securities dealers
buy it (the bid price) and the price at which they sell it (the asked price). In recent years
the bid-asked spread on actively traded bills has been 2 basis points or less, which is
lower than for any other money market instrument.
Minimum Denomination A third investment characteristic of Treasury bills is their

relatively low minimum denomination. In 1990s the minimum denomination was Ksh
100,000. The Treasury made this change in order to discourage noncompetitive bids by
small investors, reduce the costs of processing many small subscriptions yielding only a
small volume of funds, and discourage the exodus of funds from financial intermediaries
and the mortgage market. Despite the increase in the minimum denomination of bills,
investors continued to shift substantial amounts of funds out of deposit institutions into
the bill market in periods of high interest rates such as 1973 and 1974. Currently the
minimum denomination of Treasury bills is ksh50,000 which is far below the minimum
denomination required to purchase other short-term securities, with the exception of
some government-sponsored enterprise and municipal securities. Typically, it takes at
least Ksh 100,000 to purchase money market instruments such as CDs or commercial
paper.
Investors in Treasury Bills

Because of their unique investment characteristics Treasury bills are held by a wide
variety of investors.
Available information suggests that individuals, commercial banks, money market mutual
funds, and foreigners are among the largest investors in bills. Other investors in Treasury
bills are nonbank financial institutions, nonfinancial corporations, and state and local
governments.
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Because Treasury bills have a relatively low minimum denomination and can be
purchased at central Bank and branches without any service charge, the direct investment
by individuals in bills has been greater than in any other money market instrument.
Commercial banks' holding of Treasury bills tends to vary inversely with the demand for
business loans.
When loan demand is slack, banks increase their holdings of bills and other Treasury
securities. Conversely, when loan demand is increasing, banks reduce their holdings of
Treasury securities in order to expand loans. Of course, banks finance increases in
business loans not only through the sale of securities but also
through the issuance of liabilities such as CDs. Further, as noted above, banks also use
Treasury bills to satisfy various collateral requirements and to make repurchase
agreements with businesses and state and local governments.
Determining the return on treasury bills
Treasury bills are sold at discounted price (a price less than par price of Ksh 100) and
therefore the discount is the only return an investor earns on Treasury bills. The price is
computed per Kshs 100 depending on the interest rate/yield quoted by investor using the
following formula:
 
 
1
P= 100   r d 


 1  x  
  100 365  
Where,
P = Price per Ksh 100 which investor will pay
r = Interest Rate or yield per annum quoted by the investor
d = Days to maturity of Tenor (91, 182 and 364 days)
Illustration
An investor intents to place Ksh 12,000,000 in the 91 days Treasury bill at a quoted
rate/yield of 7.65% p.a. What is his/her return, if s/he is withholding tax-payer or non-
withholding taxpayer?
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Solution :
(a) For Non-Withholding Tax payer at 15%;
 
 1 
P 100    Kshs 98.128
 7.65 91 
 1  100 X 365 
 
This implies for every Ksh 100 investor wishes to lend to the Government, s/he will pay
Ksh 98.128 on the value date (the day the government borrows) and receive Ksh 100 on
maturity date (the 91st day). This translates to a net return of Ksh 1.872 per Ksh 100.
Therefore for Ksh 12,000,000, the investor will pay the Government a total of
 12,000,000 
  x98.128  Kshs11,775,360
 100 
Implying investor’s total return/interest amount is Ksh (12,000,000 – 11,775,360) = Ksh

224,640 in 3-months period.
(b) For Withholding Tax payer at 15%, the investor’s total return/interest amount will
be Ksh (12,000,000 – 11,775,360) = Ksh 224,640 in 3-months period.
 12,000,000 
  x98.128  Ksh11,775,360
 100 
But 15% withholding tax =
 15 
12,000,000  11,775,360 x   Ksh33,696
 100 
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Then investor pays 11,775,360  33,696  Ksh11,809,056
Implying, the investor’s return is Ksh 190,944 for 3-months investment of Ksh 12
million. (Source Central Bank 2008)
Repurchase agreements
Is an agreement involving the sale of securities by one party to another with a promise to
repurchase the securities at a specified price and a specified date in future. The
repurchase agreements are essentially collateralized central bank loans, with the collateral
being in form of treasury bills. For example a firm can sell treasury securities in a
repurchase agreement whereby the firm agrees to buy back the securities at a specified
future date.
A reverse repurchase agreements (reverse REPO) is an agreement involving the

purchase of securities by one party with a promise to sell them back at a given date in
future. Most repos have a short term maturity (between 0ne to fourteen days) but there is
growing demand for longer term (one to thirty days).
6.2. Uses of repurchase agreements.
Government securities dealers frequently engage in repos. The dealers may sell the
securities to a bank with a promise to buy them back the next day. This makes repos
short-term collaterised loans. Securities dealers use repos to manage their liquidity and
take advantage of anticipated changes in interest rates.
The government also uses repurchase agreements in conducting monetary policies. The
central bank may buy or sell treasury securities in the repos market. The maturiries of the
central bank repos does not exceed 15 days.
Many commercial firms with idle cash balances at bank uses repos as a way of earning a
return on these funds.
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Interest on repos are usually low because repos are usually collaterised low risk
investment.
Repurchase agreement yields

Because treasury securities (treasury bills) back repurchase agreement, they have low
credit risk investments and low interest rates. The yield on repurchase agreement is
calculated as follows :
PF  P0 360
i RA  X
P0 h
Where :
PF =Repurchase price of securites (selling price plus interest paid on the repos)
PO= Selling price of the repos
H=the number of days until the repos matures
Suppose a bank enters into a reverese repurchase agreement in which it agrees to buy
treasury bills from another bank at a price of $10,000,000 with a promise to sell the
securities back at $10,002,986 after five days. Determine the yield on repos
$10,002,986  $10,000,000 360

x 2.95%
$10,000,000 5
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6.3. Commercial papers.

Is an unsecured short-term promissory note issued by a corporation to raise short-term
cash often to finance working capital requirements. Commercial papers is the largest
money market instruments used by corporations. It is used by firms with strong credit
ratings to borrow ar a lower interest rates from banks directly.
Commercial papers are usually sold in denominations of mostly Ksh 100,000
The maturity period generally range from from one day to 270 days.
Market for commercial papers.
Commercial papers can be sold directly by a corporation to the buyers mostly large
institutional investors such as mutual funds and pension funds. This process is known as
direct placement. The issuer by-passes dealers and sells directly to the investors. It saves
on commission.
Most issuer of commercial papers back their papers with a line of credit at a commercial
bank, in the event that the issuer cannot pay off the maturing paper, the bank will lend
funds for this purpose.
Commercial papers are generally held to maturity by investors because they have no
active secondary market.
The investors in commercial papers are generally commercial papers, insurance
companies , mutual funds, pension funds and non-financial business.
Note: commercial papers is not actively traded and it is unsecured debt. Therefore credit
rating of the issuing firm is therefore very important in determining the marketability of a
commercial paper issue. Credit rating provides potential investors with information
regarding the ability of the issuing firm to repay the borrowed funds. General credit
rating firms standard and poors, fintch and Moodys’.
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Commercial papers can also be sold indirectly through brokers and dealers. Commercial
papers underwritten by dealers and brokers is quite expensive to the issuer, because of the
underwriting cost.
Commercial paper like treasury bills are quoted on a discount basis
PF  P0 360
icp  X
PF h
Suppose an investor purchased 95-day commercial paper with a par value of $1,000,000
for a price of $994,854, the discount yield is as follows :
$10,000,000  $994,854 360

icp  x 1.95%
$10,000,000 95
6.4. Negotiable certificate of deposit

A negotiable certificate of deposit is a bank issued security that documents a time deposit
and specifies the interest rate and maturity date. It is also negotiable in the secondary
market. Because maturity date is unspecified , a certificate of deposit is a term security.
Term security have a specified maturity date. A negotiable CD is a bearer instrument, this
means whoever holds the security at maturity receives the principal and interest. The CD
can be bought and sold until maturity
Terms of negotiable CD
Negotiable CDs have denomination ranging from $10,000 to $ 1,000,000. the large
denomination makes negotiable CDs are too large for individuals to buy. They are
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mostly purchased by money market funds. Negotiable CDs have a maturities from two
weeks to one year, with most having a maturity of one month to four months.
6.5.Bankers Acceptance
Is an order to pay a specified amount of money to the bearer on a given date. They are
used to finance goods that have not yet been transferred from the seller to the buyer. A
bankers acceptance is a time draft. Time draft issued by banks are orders for the bank to
pay a specified amount to the bearer of the time draft at a given time. For example a
Kenyan construcution firm wants to buy a bull dozer from komatsu in japan. Komatsu
does not want to ship the bulldozer without cash because Komatsu has never heard of the
Kenyan company. Similarly the Kenyan firm is reluctant to send money to japan before
the arrival of the equipment. A bank can intervene through a bankers acceptance.
Advantages
 Bankers acceptance are important to international trade without then most
international transactions will not occur.
 Because the default risk is low (backed by a commercial bank gurantee) , interest
rates on bankers acceptance are low.
 The exporter does not have to asses the creditworthiness of the importer because
bankers acceptance guarantees payment.
 The exporter is protected from foreign exchange risk because the local bank pays
in domestic currency.
Because bankers acceptance are payable to the bearer at maturity, they can be traded in a
secondary market. Maturity range between 30 to 270 days. Denominations are
determined by the size of the original transaction (between domestic importer and the
foreign exporter).
International money markets
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Money markets have expanded internationally and have grown in size and importance
because of :
 Money market securities bought and sold by foreign investors, firms and
governments.
 Accessibility to foreign money Markey securities.
 There are several money Market instruments used internationally :
 Euro commercial paper
 Euro dollar certificate of deposit
6.6. Euro commercial paper (or euro notes):

This is a short-term financial instrument:
i. Issued in the form of unsecured promissory notes with a fixed maturity of

up to one year
ii. Issued in bearer form
iii. Issued on a discount basis (so the rate of interest) on the commercial
paper is implicit in its sales value)
The eurocommercial paper is denominated in any currency - usually a hand

currency.
INTRUMENT PRINCIPAL PRINICIPAL USUAL

ISSUER INVESTOR MATURITY
Treasury Bills Government commercial banks 91-day
money market 182-day
mutual funds 364-day
brokers and
dealers
pension funds,
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insurance
corporations
repurchase Central Bank central bank of 1-15 days
Agreement commercial Banks Kenya
money market
mutual funds
brokers and
dealers
corporations
commercial papers commercial papers brokers and 1 to 270 days
corporations dealers
pension funds
commercial banks
negotiable commercial banks brokers 14-120 days
certificate of
deposits
bankers commercial banks businesses, 30-180 days
acceptance commercial banks
LESSON SEVEN : CAPITAL MARKETS
These are markets for long term funds, for at least more than one year. This market has
two main categories :
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Securities market : this is the market for long-term securities such as shares, bonds and
government treasury bonds
Non-securities market (long term loan market) : is the market for such finances as
leasing, mortgage financing, long term loans.
7.1. The Role of Capital Markets In An Economy
 Provides an important alternative source of long-term finance for long-term

productive investments. This helps in reducing stress on the banking system by
matching long-term investments with long-term capital.
 Provides equity capital and infrastructure development capital that has

strong socio-economic benefits - roads, water and sewer systems, housing,
energy, telecommunications, public transport, etc. - ideal for financing through
capital markets via long dated bonds and asset backed securities.
 Provides avenues for investment opportunities that encourage a thrift culture

critical in increasing domestic savings and investment ratios that are essential
for rapid industrialization. The Savings and investment ratios are too low, below
10% of GDP in kenya.
 Encourages broader ownership of productive assets by small savers to enable

them benefit from Kenya’s economic growth and wealth distribution.
Equitable distribution of wealth is a key indicator of poverty reduction.
 Promotes public-private sector partnerships to encourage participation of

private sector in productive investments. Pursuit of economic efficiency
shifting driving force of economic development from public to private sector to
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enhance economic productivity has become inevitable as resources continue to

diminish.
 Assists the Government to close resource gap, and complement its effort in
financing essential socio-economic development, through raising long-term
project based capital.
 Improves the efficiency of capital allocation through competitive pricing

mechanism for better utilization of scarce resources for increased economic
growth.
 Provides a gateway to Kenya for global and foreign portfolio investors, which is
critical in supplementing the low domestic saving ratio
 Attraction of international capital flows to supplement a country’s savings to

finance investment needs
 Transmission of liquidity to the economy for investments in productive sectors
 Corporate Governance, a market for corporate control and market based
benchmarks for corporate performance
 Capital markets provide diversification within market dominated by banking
systems
 EA source for long-term finance – capital markets are seen as an alternative to
bank finance as a means of addressing the shortage of long-term finance
 Improve management of financial risk – securities markets
 enable firms to improve their gearing ratios
 Improve capital allocation – capital is allocated to the most efficient use through
the process of risk return identification
 Savings mobilization – provide more opportunities for investorsco
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7.2 The role of Capital Markets Authority ( CMA)
It was established in 1990 by an act of parliament to assist in creation of a conducive

environment for growth and development of capital markets in Kenya.
THE ROLE OF CMA
 To remove bottlenecks and create awareness for investment in long term securities
 To serve as an efficient bridge between public and private investors
 Create an environment which will encourage local companies go public ( be
quoted or listed in the stock market)
 To operate a compensation fund to protect investors from financial losses should
brokers fail to meet contractual obligations.
 Act as a watchdog for the entire capital market
 To establish rules and regulations on placement of securities.
 To implement government programs with regard to the capital markets.
 Guard against manipulation of share prices and insider trading. (provides
adequate information to guard against insider trading.)
7.3. Participants in capital markets in Kenya
The main market players in the Kenyan capital markets include: the Nairobi stock
exchange, the Central Depository and Settlement Corporation Ltd, Stockbrokers, Stock
Dealers, Investment Advisers, Fund Managers, Authorized Securities Dealers, Credit
Rating Agencies, Collective Investment Schemes, Custodians and Venture Capital Funds.
The roles for each of the market intermediaries are as briefly outlined below:
Stockbroker
A stockbroker is a market professional who buys and sells securities on behalf of clients
at a Stock Exchange in return for a brokerage commission.
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Stock Dealer
A stock dealer is a person who carries on the business of buying, selling, dealing, trading,
underwriting or retailing securities as a principal (i.e. on his own behalf).
Investment Advisers / Fund Managers
An investment adviser and/or a fund manager are market professionals who promulgate
analysis and research on capital markets securities, and advise investors on such
securities at a commission. They also manage portfolios of securities on behalf of clients
pursuant to a contract.
Authorized Securities Dealers
This is a bank licensed under the Banking Act or a financial institution approved by the
Authority to deal in fixed-income securities listed on the Fixed Income Securities Market
Segment at a stock exchange. Authorized Securities Dealers are also required to act as
market makers and dealers in this market segment; facilitate deepening of the fixed
income securities market; enhance trading and liquidity in the fixed income securities
market; and minimize counter party risk.
Investment Banks
These are non-deposit taking institutions that advise on offers of securities to the public
or a section of the public, corporate financial restructuring, takeovers, mergers,
privatization of companies, underwriting of securities, etc. They can also engage in the
business of a stockbroker, a dealer, and fund manager of collective investment schemes
and provider of contractual portfolio management services.
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Credit Rating Agencies
A Credit Rating Agent is a professional whose role is to give an objective and

independent opinion on the general creditworthiness of an issuer of a debt instrument,
and its ability to meet its obligations in a timely manner over the life of the financial
instrument based on relevant risk factors including the ability of the issuer to generate
cash in the future.
Collective Investment Schemes
These are specialized market players licensed to mobilize savings in financial assets and
to enhance access to capital markets by small investors. They include Mutual Funds, Unit
Trusts, Investment Trusts and other forms of Specialized Collective Investment Schemes.
Collective Investment Schemes offer a unique opportunity to investors in terms of
professional management, economies of scale and diversification of portfolio and risk.
The following are companies licensed as Unit Trust Companies.
Approved Unit Trust:
1. Africa Alliance Kenya Unit Trust Scheme:
1)African Alliance Kenya Shilling Fund.
2)African Alliance Fixed Income Fund
3)African Alliance Kenya Managed Fund.
4)Africa Alliance Kenya Equity Fund
2. Old Mutual Trust scheme:

1)Old Mutual Equity Fund.
2)Old Mutual Money Market Fund
3)Old Mutual Balanced Fund
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3. British American Unit Trust Scheme.

1)British American Money Market Fund
2)British American Income Fund
3)British American Balanced Fund.
4)British American Management Retirement Fund.
5)British American Equity Fund.
4. Stanbic Unit Trust Scheme:

1)Stanbic Money Market Fund.
2)Stanbic Flexible Income Fund.
3)Stanbic Management prudential Fund.
5. Commercial Bank of Africa Unit Trust Scheme:

1)Commercial Bank of Africa Money Market Fund
2)Commercial Bank of Africa Equity Fund.
6. Zimele Unit Trust Scheme:

1)Zimele Balanced Fund
2)Zimele Money Market Fund.
7. Suntra Unit Trust Scheme:

1)Suntra Balanced Fund
2)Suntra Money Market Fund
3)Suntra Equity Fund
8. ICEA Unit Trust Scheme

1)ICEA Equity Fund
2)ICEA Money Market Fund
3)ICEA Growth Fund.
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Custodians
this is a bank licensed under the Banking Act or a financial institution approved by the
Authority to hold in custody funds, securities, financial instruments or documents of title
to assets registered in the name of local investors, East African investors, or foreign
investors or of an investment portfolio. Every investment adviser and fund manager that
manages discretionary funds shall appoint a custodian for the assets of the fund.
Name
Barclays Bank of Kenya Limited
National Bank of Kenya Limited
Stanbic Bank Limited
Kenya Commercial Bank Limited
National Industrial Credit Bank Limited
Co-operative Bank of Kenya Limited
Investment and Mortgages Bank Limited
CFC Bank Limited
Equity Bank Limited
Venture Capital Funds:
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These are companies incorporated for purposes of providing risk capital to small and
medium sized business which are new and have a high growth potential, whereby not less
than 80% of the funds so invested consist of equity or quasi equity investment in eligible
enterprises.
7.3. Securities Market
This is the main category in the capital market. It is divided into two :
 Equities or stock market
 Bond market
7.4. Equities or Stock Market

Stock markets allow suppliers of funds to efficiently and cheaply get equity funds to
public corporations. In exchange the fund users (corporations) give the fund suppliers
right to the firm cashflows in form of dividends.
7.4.1. Capital Market Terminologies
Bonds and Shares : Shares are financial instrument where one acquires ownership
stakes of a company rather than an IOU. Returns are neither fixed nor guaranteed one
acquires voting rights and benefits from exceptional performance. Bonds on the other
hand are financial instruments that serve as an IOU; an investor loans an issuer, and
returns are fixed and guaranteed, no voting rights and no benefits from exceptional
performance by a company.
Quotation : the process by which a company’s shares are allowed to be bought and sold
at the Nairobi stock exchange. This quotation is important to make the shares available to
wide market as possible.
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Underwriting : this is the process by which a company wishing to issue new shares to
the public enters into agreement with another institution such insurance company,
investment bankers under which this institution agrees at a fee to acquire a stated
proportions of any shares left unsold after the public issue. Underwriting is a
requirement for companies going public in Kenya.
The arrangement may be necessary because the shares may not be fully subscribed
because of the following :
 The issuing firm is not well known to the public.
 The shares may be overpriced and as such unaffordable
 The economy may be experiencing high inflation and such investment in shares
not viable.
The underwriter may purchase the shares not bought at a discount i.e a price lower than
what the public paid.
The underwriter has two options :
 He may take up the unsubscribed shares as a shareholder and earn a dividend
 He can keep them for some time and sell them later to earn a capital gain.
Call-over : bargaing and closing deals in stock or shares in a stock exchange without a
formal floor and position dealings. Each security to be bought or sold is dealt with at a
time.
Carry-over : when a deal has been arranged but, for some valid reason, either the buyer
caanot pay in time or the broker may not deliver the shares in time. In this case a third
party can be introduced to solve the problem
Backwardation: where shares cannot be delivered on settlement date although they have
been paid for , a third party is found who owns and will lend similar stocks. When the
original shares are finally available, the lender will be given back his shares and will
refund monies paid to him less backwardation i.e the commission for the loan
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Contango : it is the interest paid by a client by his broker to cover the cost of borrowing
money on his behalf. This happens when a client ordered his broker to purchase securities
but for some reason the client cannot pay in time.
Bulls market : it is a market where share prices are expected to rise. A bull is a
speculator who buys shares or stocks with an expectation of the prices to rise. They buy
shares at a low price in secondary market and expect the prices to rise in future hence
make a profit. The profit made under such circumstance is known as bull.(difference
between the bull’s purchase price and selling price).
Bears market. It is market where share prices are expected to fall. In this case the
speculators will sell shares or stock in anticipation of a fall in price. They dispose the
shares with the hope of acquiring them at a low price in future. However in some
circumstances this speculation may not work , the share prices may rise instead hence
resulting to a loss for the bear.
Parri-pasu: the new shares issued by a company have the same right like the existing
shares. these rights include rights to dividend, voting and bonus issues.
8. Stocks splits
Division of shares into shares of smaller amount of nominal value. It is Increasing
the
number of shares in a company without raising new funds because the individual
holdings
does not change. It increases the number of shares certificates ownership.
Reasons for stock splits
(i) To create cheaper shares with increased marketability (increases the

value at the investors’ holdings)
(ii) Dividend adjustment – greater dividend paid than before.
(iii) Suggests high earnings are expected to continue in future.
(iv) To encourage more dealings at a lower market value.
10 Right issue - Offers the first priority of any sale of shares to the existing shareholders.
- Shareholders are given the right to be allotted a certain number of shares.
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Shares given = Existing ownership X new shares to be sold

Total No. of Co, shares
In right issue share holders maintains their existing ownership and control of the
company although the price at which shares are issued to the members may not reflect the
market price.
7.4.2. Securities issued in equity market
Two of securities exist :

Ordinary shares (common stock) : is the fundamental ownership claim in a public
corporation. They have the following characteristics :
 residual claim : ordinary shares have the lowest claim on corporate assets in the
event of bankruptcy.-they have residual claim. Only after senior claims are paid
i.e payment ot creditors, bondholders , government taxes and preferred
shareholders are common stock holders entitled to the assets.
 Limited liability : the shareholder losses are limited to the amount of investment
in terms of shareholding in the company.
 Voting rights: they have voting rights in any given corporation. It can be one vote
per share holder or dual class- according to the number of shares.
Preferred stock : is a hybrid security that has the characteristics of both a bond and
ordinary share. Preferred stock or share represents an ownership interest in the firm
hence similar to ordinary shares. they are similar to bond because there returns are fixed.
They have no voting power.
7.4.3.The equities market may be divided into two :
Primary market and secondary market
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7.4.3.1. Primary market

Primary markets are markets through which corporations raise fund through new issue of
shares. The new stock securities are sold initially to investors. This is the market new
shares
A primary market sale may be a first time issue by a private firm or government
parastatal going public (i.e allowing its equity that were privately held to be publicly
traded for the first time). These first time issues are referred to as initial public offers.
Alternatively, a primary market issue may be a seasoned offering, in which the firm
already has shares trading in the secondary market.
Primary market issues may include the following mechanisms
7.4.3.2. Private placement

This is a method of raising capital through the sale of shares by private firms. This is
done by issuing shares to individuals and institutional investors privately. This method is
ideal for small companies whose issue of shares is equally small. However for a company
to use this method it must approach an investment banker or broker. The brokers and
investment banks will act as middlemen and hence act as guarantors to this private
company.
Advantages of private placement
 It takes a relatively short time to raise capital as there will be no need to go

through the stock exchange where formalities will delay availability of share
capital.
 The company will maintain its control because directors will select the would be
shareholders from close associates, hence retaining control over the form.
 It is ideal for small issues, hence adequate for small companies which want to
raise finance in form of share capital.
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 Since most of the shares are bought in large blocks of shares by institutional
investors, this may lower the cost of issuing such shares. And hence reduce the
cost of paying dividends.
 The company’s secrets are reserved as this method does not call for advertising
and publication of prospectus and public disclosure of information
 The company by selling such share, will obtain permanent finance particularly if
these are ordinary shares and this finance can be used for future planning of the
firm
Disadvantages of using private placing to the company

 It is an expensive method of issuing shares
 This method will only allow the company to raise limited finance
7.4.3.3. Public sale

For a company to sell shares under this method such a company will first of all have to go
public. i.e get the permission from the capital market authority, treasury and stock
exchange to sell shares to the public. The company will have to advertise in order to
encourage the public to subscribe to the shares. For this reason investment bankers are
used to underwrite the public issue and stock brokers used to market the shares to the
public.
The CMA and stock exchange will have to asses the company’s financial performance
before allowing its shares to be quoted in the stock market. The company must produce a
prospectus indicating its performance for the last five years. In Kenya a company that
intends to sell its shares in public must produce a prospectus and be registered as a
limited under company act cap 486.
This method is ideal for large issues.
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Advantages
 The company obtains permanent capital if it sells ordinary shares
 It can benefit from share premium which will increase its capital reserve because
it will manage to sell the shares at a premium above the par value.
 Shares are transferable and this may boost the company’s goodwill especially if
the shares command a high price in the market.
 Shares quoted in the stock market have a “signaling effect” in terms of the
company’s performance.
Disadvantages
 Dilution of control because new shareholders may change the existing policies in
the company.
 The company’s secret will be lost to outsiders as these shareholders will have a
right to inspect the corporate books. Proprietary information may be lost out to
competitors.
 The method is quite lengthy in terms of procedures.
 It is an expensive method of issuing shares because it entails a high floatation cost
which will reduce the capital available.
NB: Floatation costs include the following :

 Underwriting commission paid to those financial
institutions ready to buy unsubscribed shares
 Audit / account fees
 Brokerage commission paid to brokers or investment
bankers sponsoring the issue.
 Cost of printing the prospectus
 Legal costs
 Fees paid for each class of shares issued.
 Fees paid to the stock exchange council to allow the
company to change its capital structure
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 Advertising expenses.
Offer for sale: in this method shares are offered to a single investor who in most cases is
an institutional investor who is in the business of investing in shares of other companies.
This issue may be advertised by a broker or investment banker and is used when the firm
seeking capital is not well known to the public.
Offer for sale by tender :

This a method of a company in need of capital will advertise to potential investors to
submit their application. The applicants are supposed to state the number of shares they
need to purchase and at what price.
Methods of issuing new shares to existing share holders.
Right issues : this method is ideal for companies which have been making profits for
sometime in which case the share prices will be high. If the firm needs additional capital
it will issue shares limited to the existing shareholders. The shareholders will purchase
the shares at a price lower than the market value but higher than the par value. The issue
is known as a right issue because it is restricted to the shareholders of the company.
they are usually issued parri-passu.
Shares are issued at a discount to help ensure a successful share issue. There is a risk that
the market price of the company's shares will fall between the date of the rights
announcement and the date when the rights shares are issued. Where the market price
falls below the rights issue price, shareholders have no incentive to take up the rights
issue: shares in the company can be acquired more cheaply through the stock market. By
issuing rights shares at a discount, the risk of this occurring is reduced and the greater the
discount, the greater the fall in share price needed to make the share issue unattractive.
Discounting the shares provides an incentive to shareholders to either take up the shares
allocated or to sell their rights.
Whichever of these options is chosen, the wealth of the shareholder will be unaffected.
However, doing nothing can lead to a loss in shareholder wealth as the rights offer, which
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has value, will lapse. Thus, a shareholder should acquire the rights shares allocated or sell
the rights rather than allow the rights to lapse. (In practice, however, doing nothing may
not be penalised as the company may sell the rights on behalf of the shareholder and then
pass on the proceeds.)
Bonus or scrip issue : this is an issue of extra shares to the company’s existing
shareholders by which additional shares are credited to their accounts from the
company’s reserves. It is given proportion to the existing shareholding and it does not
involve any monetary payment on the part of the shareholder. This issue constitutes a
capitalization of reserves, hence retained earnings become permanent finance for the
company.the capitalization involves taking retained earnings instead of paying dividends.
Secondary market
Secondary market are the markets in which stocks are traded once they have been issued-
that is , bought and sold by investors. The secondary market facilitates the flow of
information, liquidity, stock ownership and funds, a critical feature of a well-developed
and efficient market.
The secondary market may be :

 Organized exchange
 or over the counter market
7.4.4. Organised Exchange
The traditional definition of an organized exchange is that there is a specified location

where buyers and sellers meet on a regular basis to trade securities. This can be through
modern method, electronic trading (central depository system) or traditional method,
(open-outcry auction model).
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There many stock exchanges in the world. The most active in the world include Nikkei in
Japan, London stock exchange, new york stock exchange, the Dax in Germany and the
Toronto stock exchange in Canada. In Africa the most active stock exchanges include :
 Johannesburg stock exchange in South Africa

 Lagos stock exchange in Nigeria
 Stock exchange in Zimbabwe
 Nairobi stock exchange in Kenya
Nairobi Stock Exchange

A stock exchange is, in essence, a market place that is designed to bring together
providers of capital and companies seeking to raise capital. It acts as both a primary
market and a secondary market for securities. The purpose of each of these markets
is as follows:
(i) Primary market :In this role, a stock exchange facilitates the issue of new shares and
debentures by public companies.
These companies would find it more difficult to raise finance without an organised and
regulated market in which issues of securities can take place.
(ii) Secondary market: In this role, a stock exchange facilitates the purchase and sale of
‘second-hand’ securities. Investors are more likely to purchase shares and debentures in
companies if they are confident that these securities can be sold when required. A stock
exchange enables investors to transfer their investments easily and quickly.
As a capital market institution, the Stock Exchange plays an important role in the process
of economic development:
 It helps mobilize domestic savings thereby bringing about reallocation
of financial resources from dormant to active agents.
 Long-term investments are made liquid, as the transfer of securities
(shares and bonds) among the participating public is facilitated.
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 The Exchange has also enabled companies to engage local

participation in their shares ownership, thereby giving Kenyans a
chance to own shares of reputable firms.
 Companies can also raise extra finance essential for expansion and
development. To raise funds, a company (issuer) issues extra
shares; an issuer publishes a prospectus, which gives all pertinent
details about the operations and future prospects of a company,
while at the same time stating the price per share of the Issue.
 A stock market also enhances the inflow of international capital.
 Stock markets also facilitate government’s privatization
programmes.
You have been appointed as the chief financial officer of a multimedia company which is
financed by private equity.
There is considerable public interest in the company and it continues a very rapid rate of
growth under the leadership of its dynamic founder and chief executive officer, Martin
Pickle. Martin Pickle owns over 30 per cent of the company’s equity and has also loaned
the business substantial sums to sustain its overseas development. The balance of the
other investors consist of some small shareholdings held by current and past employees
and the remainder is in the hands of a private equity company which is represented by
two directors on the board.
You enjoy a substantial salary and package of other benefits. Your role description gives
you overall responsibility to the board for the financial direction of the company, the
management of its financial resources, direction and oversight of its internal control
systems and responsibility for its risk management. After two months in the job you are
called to a meeting with Martin Pickle and the company’s non-executive chairman. In
that time you have made significant
progress in improving the financial controls of the business and the current year end,
which is three weeks away, looks very promising. The company’s underlying earnings
growth promises to be in excess of 20 per cent and its cash generation is strong. The CEO
tells you that he would like you to put together a plan to take the company to full listing
as a first step to him undertaking a substantial reduction in his financial stake in the
business. He tells you that this discussion must be confidential, as he expects that the
market would react adversely to the news. However, he would like to see what could be
done to make sure that the year end figures are as strong as possible. Given your
performance, he also tell you that they would like to offer you a substantial incentive in
the form of share options.
Required:
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(a) Prepare a board paper, describing the procedure for obtaining a listing on an
international stock exchange such as the London or New York Stock Exchange. (6
marks)
(b) Prepare a briefing note, itemising the advantages and disadvantages of such a
step for a medium-sized company. (6 marks)
(Including 2 professional marks)
(c) Discuss any ethical considerations or concerns you may have concerning this
proposed course of action.
(8 marks)
(20 marks)
Market orders in organized exchange

The vast majority of orders sent to the organized exchange are of three types
 Market order : it is an order for the broker to transact at the best price available
in the market when the order is made. Generally :
 buy/sell order to be executed at the best price
 orders of this type are given priority on the trading floor of
exchanges
 no guarantee of execution price; i.e. adverse price movements
could take place between the time an order is placed to the time the
trade actually occurs
 Limited order : it is an order to transact at a specified price (limited price). When

the broker receives a limited order , he or she will stand by the trading floor until
the current price of share ordererd are near the limit price. The specialist who is
at the trading floor all the time the market is open, will monitor the current price
of the stock and conduct trade when and if it equals the limit price. Some limit
orders are submitted with time limits. If the order is not fulfilled within a given
period of time it is deleted from the market maker’s books.
 A stop order is an order, which can save an investor from extreme loss. In a stop
order, an investor tells the broker to sell his/her securities if the price drops below
a certain specified level.
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 market if touched order

 turns into market order if designated price is reached.
 example: buy if prices falls to $55; sell if price rises to $62
 allows investor to get into a position at an acceptable price without
constantly watching the market
Benefits of listing on the Nairobi Stock Exchange.

 Raising long-term funds in large amounts at fairly competitive costs
 Lower corporation tax rate for newly listed companies from the standard rate of
30%, as well as other tax incentives and exemptions
 Reliable basis of valuation of the company’s worth, arising from the demand and
supply forces in the secondary market activity
 Enhanced corporate governance, which is a prerequisite for listed companies
likely to translate to improved corporate earnings; Enhanced publicity, through
print and electronic reporting of the trading in the secondary market
 Potentially enhanced market scope for their products and services through cross
border
 listings;
 Facilitates the separation of the company between owners and managers;
 Restructuring options wide- allows mergers, takeovers and buy-out plans;
 Provides exit mechanisms for both founder members and other shareholders.
 Capital structure optimisation
The advantages of a company obtaining a stock exchange listing are as follows:

Share transferability As mentioned above, shares that are listed on a stock exchange can
be transferred with ease and this, in turn should encourage investment.
Cost of capital Shares in listed companies are perceived by investors as being less risky
than shares in equivalent unlisted companies because of their marketability. As the risks
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associated with listed shares are lower, the returns required by investors will also be
lower. Hence, the cost of capital for listed companies will be lower.
Share price Shares that are traded on a stock exchange are closely scrutinised by
investors, who will take account of all available information when assessing their worth.
This results in shares that are efficiently priced, which should give investors confidence
when buying or selling shares.
Company profile Companies listed on a stock exchange have a higher profile among
investors and the wider business community than unlisted companies. This higher profile
may help in establishing new contacts or in developing business opportunities.
Credit rating A listed company may be viewed by the business community as being
more substantial and, therefore, more creditworthy than an equivalent unlisted company.
This may help in obtaining loans and credit facilities.
Business combinations A stock exchange listing can facilitate takeovers and mergers. A
listed company can use its shares as a form of bid consideration when proposing a
takeover of another company. Shareholders in a target company will usually be more
prepared to accept a share-for-share exchange when the shares offered are marketable and
have been efficiently priced.
Furthermore, when two companies propose to combine, the shareholders of each
company can assess the attractiveness of the proposal more easily if the shares are listed.
The disadvantages of obtaining a stock exchange listing are as follows:
Flotation costs The costs of floating a company on a stock exchange can be high. The
fees paid to professional advisors, such as lawyers and accountants, as well as
underwriting fees often account for a large part of the total cost incurred.
Regulatory costs Once the company is floated, the cost of maintaining a stock exchange
listing can be high. An important reason for this is the cost of additional regulatory
requirements surrounding listed companies. The regulations of modern stock exchanges
require greater transparency between management and owners and this causes some of
the additional costs.
Control A company seeking a stock exchange listing must normally ensure that a
substantial quantity of its total issued share capital is available to new investors. This
means that the existing shareholders may suffer loss of control.
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Investors expectations There is a widely-held view that investor expectations often put
the directors of companies under pressure to produce gains over the short term. To do
this, the directors may take decisions that have an adverse effect on the long-term
profitability of the business. However, the evidence to support this view is flimsy.
Public scrutiny Listed companies attract much attention from investors, the financial
press and the broadcasting media. Being in the public spotlight makes it difficult for a
company to engage in controversial activities or to conduct sensitive negotiations.
It also makes it difficult for directors to hide poor decisions.
Takeover target The existence of a ready market for shares in a listed company means
that a listed company is much more vulnerable to a takeover than an unlisted company. A
listed company may be particularly vulnerable when there is a fall in its share price,
perhaps caused by disillusionment with the level of returns that are being provided.
Over the counter market
The over the counter market is not organized in the sense of having a physical trading
place but rather trading occurs through sophisticated telecommunication networks.
Dealers make the market in these market by buying stock when investors want to sell and
selling stock of shares when investors want to buy.
Organized exchange and over-the counter market

There is a significant difference between how organized exchange and over the counter
market operate.
Organized exchange are characterized as auction markets and trading floor traders who
specialists in particular stocks. These specialists oversee and facilitate the trading in
shares. Floor traders, representing various brokerage firms, with buying and selling
orders, meet at the trading floor on the exchange to trade. The specialists match the
buyers and sellers.
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On the other hand over the counter markets have the market makers. Rather trade in an
auction format they trade through electronic networks where bid (buying) and ask prices
(selling prices) are set by the market makers. Market makers are important in the OTC
market as they ensure that there is continuous liquidity for every share. They earn a
spread, the difference between the bid price (the price at which they buy the shares) and
ask price (the price they sell the shares for).
LESSON EIGHT : THE BOND MARKET
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The bond is a Debt (or fixed income) instrument is obligation of borrower of funds to
make specified interest and principal payments to lender of funds. It is a security that
obligates the issuer to make specified interest and principal payments to the holder on
specified dates.
Coupon rate
Face value (or par)
Maturity (or term)
Bonds are sometimes called fixed income securities.
A Bond market has the following characteristics :
 Longer-term market for borrowing and lending funds

 Securities with original maturities of more than 1 year
 Issuer usually makes fixed periodic interest payments based on coupon rate
(coupon securities)
 Issuer pays par/principal/face value at maturity
 Borrowers secure long-term access to funds at known rate to finance long-term
projects
 Credit and interest rate risk can be large
 Liquid secondary market
 Mostly wholesale, over-the-counter market
The bond markets therefore are markets where bonds are issued and traded. They are
channels through which money from those with surplus of funds to those with productive
investment opportunities
Bond Terminology
Principal: The amount of money on which interest is paid. Also known as the par value
or face value. This is typically $1000 for each bond.
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Coupon: A fixed amount of interest that a bond promises to pay investors. Typically paid
semi-annually.
Maturity Date: The date at which the bond’s life ends and the final coupon payment and
par value are paid.
Indenture: A legal document stating the terms under which the bond has been issued
Coupon Rate: The rate derived by dividing the bond’s annual coupon payment by its par
value.
Coupon Yield: The amount obtained by dividing the bond’s coupon by its current market
price.
Example: A firm issues a bond with a $1000 par value and promises semiannual coupon
payments of $45. The current market price of the bond is $975. What is the coupon rate?
Redemption value is the final value paid at maturity to the bondholder. Usually,
redemption is at par, i.e. redemption value = face value.
BOND COVENANT
Bond covenants might include:
(i) An asset covenant. This would govern the company’s acquisition, use and disposal of
assets. This could be for specified types of assets, or assets in general.
(ii) Financing covenant. This covenant often defines the type and amount of additional
debt that the company can issue, and its ranking and potential claim on assets in case of
future default.
(iii) Dividend covenant. A dividend covenant restricts the amount of dividend that the
company is able to pay. Such covenants might also be extended to share repurchases.
(iv) Financial ratio covenants, fixing the limit of key ratios such as the gearing level,
interest cover, net working capital, or a minimum ratio of tangible assets to total debt.
(v) Merger covenant, restricting future merger activity of the company.
(vi) Investment covenant, concerned with the company’s future investment policy.
(vii) Sinking fund covenant whereby the company makes payments, typically to the
bond trustees, who might gradually repurchase bonds in the open market, or build up a
fund to redeem bonds.
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There will often also be a ‘bonding covenant’ that describes the mechanisms by which the
above covenants are to be monitored and enforced. This often includes an independent
audit and the appointment of a trustee representing the interests of the bondholders
From the company’s perspective the major disadvantage of covenants is that they restrict
the freedom of action of the managers, and could prevent viable investments, or mergers
from occurring. They also necessitate monitoring and other costs.
However, covenants are also of value to companies. Without covenants the company
might not be able to raise as much funds in the form of debt, as lenders would not be
prepared to take the risk. Even if lenders were to take the risk they would require a higher
default premium (higher interest rates) in order to compensate for the risk. The existence
of covenants therefore reduces the cost of borrowing for a company.
International bonds markets (Euro Markets)
They are those markets that trade bonds that are underwritten by an international
syndicate of international investment banks, offered to investors in different countries.
There has been a rapid growth in the international bond market, as companies and
government seek large size capital. International financial markets are generally known
as euro market
Advantages of the Euromarkets include:
(i) They are more flexible than many domestic markets and not subject to the same
degree of control.
(ii) The cost of borrowing in the Euromarkets is often slightly less than for the same
currency in relevant domestic capital markets.
(iii) Interest is normally payable gross, which is attractive to some investors.
(iv)Very large sums can be quickly raised, without the queuing process that exists in
many domestic capital markets.
(v) Issue costs are relatively low.
(vi) There is an active secondary market in many types of Euromarket security.
(vii) Eurobonds, in particular, offer the opportunity to swap interest payments into a more
convenient form (e.g. fixed to floating rate), often at lower costs than borrowing directly.
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Potential problems include:

(i) The company borrowing would either need to be rated highly by one of the
international rating agencies in order to be able to access the markets, or it would
probably be necessary for the company to offer a guarantee from its government in
association with any issue.
(ii) Any Euromarket borrowing is likely to be in dollars or another hard currency. The
company will need to convince the market that it has access to sufficient hard currency to
fully service the interest and principal payments.
International bonds can be classified into three main groups:
Euro bonds : euro bonds are long term bonds issued and sold outside the country of the
currency in which they are denominated. For example a dollar denominated bonds issued
to Europe, Asia and Africa but not in united states. The term euro means the bond is
issued outside the country in whose currency it is denominated. Hence Eurobonds are
bonds issued in countries outside Europe and in other currencies apart from the euro.
They are usually issued to avoid taxes and regulation by hosting countries and capital
market regulators. They grew from the point that most U.S corporations were limited by
the amount of capital they could borrow domestically. The firms created Eurobond that
were not subject to U.S regulation. Companies accessed capital at a low cost and hence
reduced the cost of capital.
They are issued in denominations of $10,000 and pay interest semi-annually. They
depend on good credit rating of the firm and hence they are rated by Moody’s and
Standard and Poors.
Euro bonds are placed in the primary market by investment banks, i.e a syndicate of
investment banks work together to place the bond world wide. The Eurobond issuer
selects the currency in which the bond will be denominated. The choice of currency and
interest rate changes affect the overall cost of the bond to the issuer.
Foreign bonds
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Foreign bonds are long term bonds issued by firms and government in a foreign capital
market and usually denominated in the currency of the country in which they are issued
rather than the domestic currency. For example a Kenyan company issues a bond in
Ugandan shillings in Ugandan capital market. Foreign bonds were issued long before the
Eurobonds. Countries sometimes name their foreign bonds indicate the country of origin.
For example bonds issued by American companies are known as Yankees.Foreign bonds
issued in Japan are called samurai. And foreign bonds issued in United Kingdom are
known as bulldogs
Brady and sovereign bonds

Brady bonds were created through international monetary fund where banks in the U.S
exchanged their loans for bonds issued by developing countries. The bonds had a loner
maturity period compared to the loans. Once banks and other financial institution swap
loans for bonds, they can sell the bonds in the secondary market.
DOMESTIC BOND MARKET
It majorly has two instruments

 Treasury bonds
 Corporate bonds
TREASURY BONDS
What is a Treasury bond?

Treasury Bonds are medium to long term debt instrument issued by the government to
raise money in local currency for a period of more than one year. So far, Treasury Bonds
that have been issued are of maturities range of 1 year to 20 years. Minimum face value
of Ksh 50, 000, additional values MUST be in multiples of Ksh. 50,000 except for
Infrastructure bonds whose minimum investible amount is Ksh 100,000.
What types of Treasury bonds issued by Government of Kenya?
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The types of Treasury bond may be defined by the purpose, interest rate structure,
maturity structure, and even by issuer. So far, the Government has issued Fixed
Coupon/Rate Bonds, Zero Coupon, Floating Rate, Infrastructure (project specific),
Restructuring/Special bonds and Amortized bonds. Most commonly issued bonds are
zero coupon and fixed coupon bonds which have huge investor demand. Treasury bonds
are issued monthly.
Fixed coupon Treasury bonds – Bear predetermined fixed coupon (interest) which is
semiannually based on the face value held during the life of the bond. When bought at a
discount, investor benefits from discount (capital gain) which is critical for secondary
market trading and regular interest payment.
Infrastructure bonds – Proceeds are used to fund specific infrastructure/projects specified

in the prospectus.
Floating Rate Bonds – Pay semiannual interest based on a benchmark rate, for example
average rate of 91-days or 182-days Treasury bill plus some margin. They are on high
demand in high inflationary environment. They are no longer issued by the Government
since 2001, most corporate bodies issue them.
Zero Coupon Bonds – Do not have fixed interest and investor’s return is only the discount
amount equivalent to the yield quoted. Mostly short term and most taken up by
commercial banks. Pricing is similar to the Treasury bill.
Corporate bonds
Corporate bonds are long term bonds issued by corporations. The bond indenture is the
legal document that specifies the right and obligations of the bond issuer and bond holder.
The indenture has covenants that indicate the rules and restrictions placed on the two
parties. Corporate bonds can have so many variations as indicated below :
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Bearer bond and registered bond : The bearer bonds, coupon are attached to the bonds
and the holder (bearer) of the bond gets paid. Registered bonds it is only the person
whose name is provided in the bond register get paid
Term bond and serial bonds : most corporate bonds are term bonds meaning that the
entire issue matures on a single date. Some corporate bonds can be serial bonds with
different maturity periods. The issue has so many maturity dates. For economic reasons
some firms may want to avoid paying a large sum of money once. This especially when
the earnings of the firm are unstable.
Mortgage bonds : corporations issue bonds to finance specific projects that are pledged as
collateral for the bond issues. Hence mortgage bonds are secured debt issues. bond
holders may take the title the asset if the issuer defaults. They are less risky compared to
unsecured bonds.
Debentures and surbodinated debentures :bonds that are unsecured, only backed by
the creditworthiness of the issuing firm are known as debentures. Debenture holders are
only paid after the mortgage bond holders have been paid. Surbodinated bonds are also
unsecured and are junior to debentures. They are the riskiest bonds and generally have a
higher yield than compared to the other bonds. They usually have a low credit rating.
Convertible bonds are bonds that may be exchanged for another security i.e equity in the
issuing firm. Convertible bonds are hybrid securities, with both elements of debt and
equity. The yield on this bonds is quite low compared to non-convertible bonds.
Conversion value = current market price* conversion rate stock received on conversion
Example Kenya corporation has a convertible bond issue outstanding. Each bond has a
face value of ksh 1,000 and could be converted into 285.71 shares per ksh 1,000 face
value bond. The firms shares are currently trading at ksh 9.375 per share. On the other
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hand the convertible bond was trading at 267.875% of the face value. Determine whether
or not iti is profitable to convert
If the bond were to be converted into shares each bond worth ksh 2678.75 wouold be
exchanged for 285.71 shares . the conversion value if the bond is :
Ksh 9.375* 285.71 shares = ks 2,678.53
Hence no difference.
Callable bonds : many corporate bonds include a call provision which allows the issuer
to require the bond holder to sell back the bond- usually at a premium. The difference
between the call price the the face value of the bond is the call premium. Bonds are
recalled when the interest rates fall (bond prices rise) so that the issuer can issue lower
coupon rate bonds.
Puttable bond : is the bond with put provisions that give the bondholder the option to
return the bond to the issuer before maturity and receive the par value.
• The put option in a puttable bond can be exercised only after the elapse of a specified
initial period. The puttable bond gives the right (option) of early redemption to the
bondholder. This is a valuable option, since, for example, if the coupon rate is less than
the current market yield, the bondholder of a puttable bond will return the bond earlier
than the redemption time.
• The reclaimed principal can then be reinvested at the higher market rate
Bond Trading process
The trading process : bonds trading may be through two means i.e primary and
secondary issue.
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Primary issue is also known as initial public offer. primary issue of the bonds may occur
through private placement or a public issue. The primary issue price may be determined
through :
Valuation by investment bankers and dealers : this is where the intrinsic value of the bond
is determined.
Book building: this is market force determined price. The bond prices are determined
through demand and supply by allowing institutional investors to quote prices at which
they are willing to acquire the bonds.
Green shoe option : A provision contained in an underwriting agreement that gives the
underwriter the right to sell investors more shares or bonds than originally
planned by the issuer. This would normally be done if the demand for a security issue
proves higher than expected. Legally referred to as an over-allotment option.
A greenshoe option can provide additional price stability to a security issue because the
underwriter has the ability to increase supply and smooth out price fluctuations if demand
surges. Greenshoe options typically allow underwriters to sell up to 15% more shares or
bonds than the original number set by the issuer, if demand conditions warrant such
action. However, some issuers prefer not to include greenshoe options in their
underwriting agreements under certain circumstances, such as if the issuer wants to fund
a specific project with a fixed amount of cost and does not want more capital than it
originally sought.
The secondary Market

The bonds may be sold in the secondary market through the exchange or the over-the-
counter market.
Bond Credit Rating
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Bond ratings are simply judgments about the future risk potential of the bond in question.
Bond ratings are extremely important in that a firm’s bond rating tells much about the
cost of funds and the firm’s access to the debt market.
The factors that are likely lead to a company to default depend on :

The magnitude and strength of the company’s cashflow
The size of the debt relative to the asset value of the firm
The length of time the debt has to run
Three primary rating agencies exist—Moody’s, Standard & Poor’s, and Fitch Investor
Services in the world. Bonds can also be classified by their default risk or the issuer’s
credit risk.
– Government bonds are considered as default free.
– Company bonds have a varying level of risk depending on the financial condition of the
company.
• This risk is quantifiably represented by the company’s credit rating.
• The lower the credit rating of a company is, the higher will be the default risk and the
risk premium.
• The highest credit ratings AAA or Aaa have minimal credit risk.
• The credit ratings below BB or Ba high risk and called noninvestment grade bonds or
high-yield bonds or junk bonds.
– The two main providers of credit ratings are the international rating agencies Standard
and Poor’s and Moody’s
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Fitch/ S& P GRADE RISK OF DEFAULT

AAA INVESTMENT HIGH QUALITY- ZERO
RISK
AA INVESTMENT HIGH QUALITY: VERY
LITTLE RISK
A INVESTMENT STRONG-MINIMAL RISK
BBB INVESTMENT MEDIUM-LOW BUT
CLEAR RISK
BB JUNK SPECULATIVE-
MARGINAL
B JUNK SIGNIFICANT RISK
EXPOSURE
CCC JUNK CONSIDERABLE RISK
EXPOSURE
CC JUNK HIGHLY SPECULATIVE-
HIGH RISK
C JUNK IN DEFAULT
.Table of credit spreads for industrial company bonds

rating 1 year 2 year 3 year 5 year 7 year 10 year 30 year
AAA 5 10 15 22 27 30 55
AA 15 25 30 37 44 50 65
A 40 50 57 65 71 75 90
BBB 65 80 88 95 126 149 175
BB 210 235 240 250 265 275 290
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BB+ 375 402 415 425 425 440 450
CORPORATE BOND PRICING AND VALUATION
Bond pricing and Valuation is a function of the following elements:

 The amount and timing of the asset's expected cash flow
 The riskiness of these cash flows
 The investors' required rate of return for undertaking the investment
 Term to Maturity :It is the time remaining in the life of the bond.
 It represents the length of time for which interest has to be paid as promised.
 It also represents the length of time after which the face value will be repaid.
 Interest rates: bond prices and interest rates move in opposite directions.
 Changes in interest rates have larger impact on long-term bonds than on short-
term bonds.
Bond Pricing : the bond prices are determined using the following formula
P0=INT (PVAF)k,n+ P (PVF) k,n
Price of a bond = f(Coupon, YTM, T)
The formula for the price of a bond shows that the bond's price is a function of the
maturity of the coupon rate and of the YTM. Other factors being constant, the higher the
coupon rate, the higher the value of the bond. Other factors being constant, the higher the
YTM, the lower the price of the bond. ¨
Yield to Maturity (YTM)
The bondholder's expected rate of return is the rate the investor will earn if the bond is
held to maturity, provided, of course, that the company issuing the bond does not default
on the payments.
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Yield to maturity is the rate of return that an investor will get if he buys the bond at the
prevailing market price and holds it till maturity.
In order to get the YTM, two conditions must be satisfied.

The bond must be held till maturity.
All coupon payments received before maturity must be reinvested at the YTM.
Note: The investor uses the bond's computed YTM by comparing it to his/her required
rate of return on the bond after considering all risk factors.
1) If the investor's required return is greater than the YTM, the investor should not buy
the bond
2) If the investor's required return is less than the YTM, the investor should buy the bond
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• Since the bond's coupon rate, kc, is fixed for the life of bond, the following \
YTM/bond price relationship is created:
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Discuss why conflicts of interest might exist between shareholders and bondholders.
(8 marks)
(b) Provide examples of covenants that might be attached to bonds, and briefly
discuss the advantages and
disadvantages to companies of covenants. (7 marks)
LESSON NINE : INTEREST RATES IN KENYA
Interests rates can be defined as the price of funds. Interest rates in Kenya are based on
the treasury bill as the benchmark rate. This is because it is considered risk-free. The
commercial bank consider the prevailing risk in the financial environment. i.e risk
premium. Therefore the base lending rates of commercial banks are based on treasury
bills and prevailing interest rates.
Interest rates can be further be defined by the prevailing inflation rates. This provides the
nominal interest rates and real interest rates. The nominal interest rate are the rates
published. The real interest rates are obtained by (Nominal interest rates-inflation
expectation).
The issue in financial markets is whether the lenders and borrowers prefer short or long
term interest rates. this relationship is explained by the term structure of interest rates.
9.1. Interest Rates
The required rate of return (Ri) is the minimum rate of return that a project must generate
if it has to receive funds. It’s therefore the opportunity cost of capital or returns expected
from the second best alternative. In general,
Required Rate of Return = Risk-free rate + Risk premium
Risk free rate is compensation for time and is made up of the real rate of return (R r) and the
inflation premium (IRp). The risk premium is compensation for risk of financial actions
reflecting:
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- The riskiness of the securities caused by term to maturity

- The security marketability or liquidity
- The effect of exchange rate fluctuations on the security, etc.
The required rate of return can therefore be expressed as follows:
Rj = Rr +IRp +DRp +MRp + LRp + ERp + SRp + ORp.
Where:
 Rr is the real rate of return that compensate investors for giving up the use of their
funds in an inflation free and risk free market.
 IRp is the Inflation Risk Premium which compensates the investor for the decrease in
purchasing power of money caused by inflation.
 DRp is the Default Risk Premium which compensates the investor for the possibility
that users of funds would be unable to repay the debts.
 MRp is the Maturity Risk Premium which compensates for the term to maturity.
 LRp is the Liquidity Risk Premium which compensates the investor for the possibility
that the securities given are not easily marketable (or convertible to cash).
 ERp is the Exchange Risk Premium which compensates the investors for the
fluctuation in exchange rate. This is mainly important if the funds are denominated in
foreign currencies.
 SRp is the Sovereign Risk Premium which compensates the investors for the
possibility of political instability in the country in which the funds have been
provided.
 ORp is the Other Risk Premium e.g. the type of product, the type of market, etc.
9.2. Determination of interest rate : theory of interest determination
Loanable model
In this framework – interest is the price paid for the right to borrow and utilize loanable
funds.
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An increase in money supply is a source of funds to the market which a decrease in the
money market induces demand for loanable funds. Likewise a reduction in the demand
to hold money provides a source of loanable funds, but an increase in money demand
creates a demand for loanable funds.
The supply of loanable funds comes from three sources
(a) Personal savings

(b) Banking systems
(c) Public sources
Interest rate S
i ----------------------- Interest rate
Q Loanable funds
Traditionally, economists regard the interest rate as a measure of the incentive to refrain
from current consumption i.e. to save. In making decision to save, individuals:-
(a) Substitute future consumption for current consumption.
NB/ The higher the interest rate, the greater is the amount for future consumption.
Hence Demand to hold money balances decreases as interest rates rises.
The Demand for loanable funds is negatively related to the level of interests. i.e. the
lower the interest, the higher the demand for loanable funds. Interest rate moves to the
level which equates quantity of loanable funds supplied to quantity of demand of
loanable funds. The point of intersection is the equilibrium.
There are factors that can produce a change to equilibrium position:-

 Change in supply of money / monetary policies.
 Change in demand of money / Automated overdrafts.
 Decline in consumer confidence resulting to reduce business investment.
 Change in price level resulting to inflation.
 Change in consumer behavior resulting to thrift
NB/ An increase in interest rate must be produced by either an increase in demand or

reduction in the supply of loanable funds.
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Ii -------------------------
Ii
Io -------------------
Di Io
Do
Qo Qi
Qi Qo
Increase in demand Decrease in supply
 An increase in personal savings resulting from a shift in attitude concerning thrift

would raise the supply of loanable funds and brings down the interest rates. So
would increase in business savings owing to an increase in business profit.
 An increase in government budget surplus due to a cut back in government

expenditure would result to lowering the interest rate.
 Monetary policies which increase the supply of money would reduce interest rate.
 A decrease in Dd for money originating from automated overdrafts would lower

interest rates.
 Income tax hikes has a negative effect to interest rates.
 Decline in business and consumer confidence results to increase in interest rates.
9.3. Term structure of Interest Rates
The term structure of interest rates describes between long-term and short-term interest
rates. The relationship between the yield to maturity of a bond and its term to maturity is
known as the terms structure of interest rates, and it is represented graphically by the
yield curve.
It explains whether short-term bonds will attract higher interest rates compared to long
term interest and vice versa. This relationship is depicted by a yield curve which shows
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the interest rate and maturity. The yield curve could either be upward sloping, downward
sloping or constant.
Financial theory states that any long-term interest is the expected value of short-term
interest rates. An investor makes a choice between short-term and long-term instruments.
The yield curve can be of any of the following four shapes:
1. Normal yield curve (upward sloping): The short- YTM
term yield is lower than the long-term yield. In

other words, it is cheaper to borrow short-term
than it is to borrow long-term.
Time to maturity
2. Inverted yield curve (downward sloping): The YTM
short-term yield is higher than the long-term

yield. In other words, it is more expensive to
borrow short-term than it is to borrow long-term.
Time to maturity
3. Flat yield curve: The short-term yield is the same YTM
as the long-term yield. In other words, the short-

term cost of borrowing is the same as the long-
term cost of borrowing.
Time to maturity
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4. Humped yield curve: The intermediate yield is YTM
higher than both the short-term and long-term

yields. In other words, it is cheaper to borrow
short-term or long-term than it is to borrow
intermediate-term.
Time to maturity
Three theories have been put forward to explain the term structure of interest rates, that is
the relationship among interest rates on bonds of different maturity.
9.4. Term structure theories
Several theories have been used to explain the shape of yield curve. Three major ones
include :
 Market segmentation theory

 Liquidity preference theory
 Expectation theory
9.4.1. Expectation theory
This theory states that the yield curve depends on expectation about factors affecting
expected returns on similar assets. Example of such factors include economic conditions
such as inflation, recession, boom and political conditions. For example inflation, if
annual inflation is expected to decline the yield curve will be downward sloping whereas
it will be upward sloping if inflation is expected to increase. Other factors influencing
interest rates are :
 Central bank monetary policy
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 Government fiscal policy

 The level of business activities
The expectation theory attempts to explain why the yield curve is upward sloping,
downward sloping or flat by explaining the expectation implicit in yield curves with
different shapes.
According to expectation hypothesis an upward sloping yield curve indicates that
investors expect interest to rise. A downward sloping yield curve indicates that investors
expect rates to fall. A flat yield curve implies that investors expect the rate to remain the
same.
 The entire term structure at a given time reflects the market’s current expectations
of future short-term rates
 An upward sloping term structure must indicate that the market expects short-
term rates to rise throughout the relevant future
 A flat term structure reflects an expectation that future short-term rates will be
mostly constant
 A downward sloping term structure must reflect an expectation that future short-
term rates will decline steadily
9.4.2. Liquidity preference (or liquidity premium) theory.
The liquidity preference theory is very similar to the pure expectation theory, with one
modification. This theory claims that long-term interest rate should be higher than short-
term interest rate for the following reasons:
1. Savers have to be compensated for giving up cash (i.e. liquidity). And the longer the
period of time they have to give up, the more they need to be compensated.
2. Long-term bonds are more sensitive to interest rate changes than short-term bonds.
Hence, the return for a longer-term bond needs to be higher than a shorter-term bond.
In other words, returns of long-term bonds need to include a liquidity premium to
induce investors to buy them.
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3. Uncertainty and volatility causes investors to favour short term investment to long
term investments. Short term investments are less volatile.
As a result, investors (or savers) need a positive liquidity (or term) premium to induce
them to give up their money for a period of time. The longer the period of time they have
to give up their money, the larger the term premium.
This theory states that investors will hold longer-term maturities if they are offered a
long-term rate higher than the average of expected future rates by a risk premium that is
positively related to the term to maturity
Put differently, the forward rates should reflect both interest rate expectations and a
liquidity premium (which is really a risk premium), and the premium should be higher for
longer maturities
The implied forward rates will not be an unbiased estimate of the market’s expectations
of future interest rates because they include a liquidity premium
Thus, an upward-sloping yield curve may reflect expectations that future interest rates
either will rise or will be flat (or even fall), but with a liquidity premium increasing fast
enough with maturity so as to produce an upward-sloping yield curve
9.4.3. Market Segmentation theory.
It is also known as institutional or hedging theory. This theory states that each lender and
borrower has a preferred maturity. For example a company borrowing to buy long long
term assets like plant and machinery equipment would want to borrow in the long term
market. However a retailer borrowing to increase the level of stock will borrow in the
short term market.
Similar differences exist among the lenders , for example long term savers and short term
savers who lend in the long and short term respectively.
The market segmentation theory states that their exist two separate market long term
market and short term market . the slope of the yield cirve depends on the demand and
supply in the two markets.
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An upward sloping demand curve will occur if there is a large supply of funds relative to
demand in the short term market but relative shortage of funds in the long term market.
Similarly downward sloping curve will indicate a strong demand in the short term market
compared to long term market. While a flat yield indicates balanced demand in the two
markets.
According to segmentated market theory, the maturity preferences of investors and

borrowers are so strong that investors never change and hence the two markets are
segmentated.
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LESSON TEN : DERIVATIVES MARKET AND INSTRUMENTS
Definition of the term Derivatives :

The term ‘derivatives, refers to a broad class of financial instruments which mainly
include and These instruments derive their value from the price and other related
variables of the underlying asset. They do not have worth of their own and derive their
value from the claim they give to their owners to own some other financial assets or
security. The asset underlying a derivative may be commodity or a financial asset.
Derivatives are those financial instruments that derive their value from the other assets.
For example, the price of gold to be delivered after two months will depend, among so
many things, on the present and expected price of this commodity
Underlying Asset in a Derivatives Contract

As defined above, the value of a derivative instrument depends upon the underlying asset.
The underlying asset may assume many forms:
i. Commodities including grain, coffee beans, Wheat;
ii. Precious metals like gold and silver;
iii. Foreign exchange rates or currencies;
iv. Bonds of different types, including medium to long term negotiable debt securities
issued by governments, companies, etc.
v. Shares and share warrants of companies traded on recognized stock exchanges and
Stock Index
vi. Short term securities such as T-bills; and
vii. Over- the Counter (OTC) money market products such as loans or deposits.
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Participants in Derivatives Market

1. Hedgers: They use derivatives markets to reduce or eliminate the risk associated with
price of an asset. Majority of the participants in derivatives market belongs to this
category.
2. Speculators: They transact futures and options contracts to get extra leverage in betting
on future movements in the price of an asset. They can increase both the potential gains
and potential losses by usage of derivatives in a speculative venture.
3. Arbitrageurs: Their behaviour is guided by the desire to take advantage of a
discrepancy between prices of more or less the same assets or competing assets in
different markets. If, for example, they see the futures price of an asset getting out of line
with the cash price, they will take offsetting positions in the two markets to lock in a
profit.
Applications of Financial Derivatives
Some of the applications of financial derivatives can be enumerated as follows:
1. Management of risk: This is most important function of derivatives. Risk management
is not about the elimination of risk rather it is about the management of risk. Financial
derivatives provide a powerful tool for limiting risks that individuals and organizations
face in the ordinary conduct of their businesses. It requires a thorough understanding of
the basic principles that regulate the pricing of financial derivatives. Effective use of
derivatives can save cost, and it can increase returns for the organisations.
2. Efficiency in trading: Financial derivatives allow for free trading of risk components
and that leads to improving market efficiency. Traders can use a position in one or more
financial derivatives as a substitute for a position in the underlying instruments. In many
instances, traders find financial derivatives to be a more attractive instrument than the
underlying security. This is mainly because of the greater amount of liquidity in the
market offered by derivatives as well as the lower transaction costs associated with
trading a financial derivative as compared to the costs of trading the underlying
instrument in cash market.
3. Speculation: This is not the only use, and probably not the most important use, of
financial derivatives. Financial derivatives are considered to be risky. If not used
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properly, these can leads to financial destruction in an organisation like what happened in
Barings Plc in united kingdom. However, these instruments act as a powerful instrument
for knowledgeable traders to expose themselves to calculated and well understood risks
in search of a reward, that is, profit.
4. Price discover: Another important application of derivatives is the price discovery
which means revealing information about future cash market prices through the futures
market. Derivatives markets provide a mechanism by which diverse and scattered
opinions of future are collected into one readily discernible number which provides a
consensus of knowledgeable thinking.
5. Price stabilization function: Derivative market helps to keep a stabilising influence on
spot prices by reducing the short-term fluctuations. In other words, derivative reduces
both peak and depths and leads to price stabilisation effect in the cash market for
underlying asset.
Classification of derivative Market :

There are two bases :
based on trading location
exchange-traded derivatives (ETD) are Over-the-counter (OTC)-traded derivatives
standardized products traded on the floor of are privately negotiated, bilateral
organized exchanges agreements transacted off organized
exchanges.
based on instruments
commodity financial
 Futures  forwards
 options  futures
 forwards  options
 swaps
10.3. Derivative Market Instruments
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10.3.1.Forward Contracts:
A forward contract is an agreement between two parties to buy or sell an asset at a
specified point of time in the future. They are tailored to the needs of the customer, which
means that the contract value, the currency and the time period of the contract are the
subject of negotiation. Forward contracts eliminate uncertainty by locking into a fixed
exchange rate immediately. This avoids the risk of future losses, but also denies the
company the opportunity of benefiting from any favourable future currency movements.
Forward contracts are binding agreements that must be executed irrespective of whether
the currency receipts or payments, for which the contract was designed to hedge, actually
occur
Buyer and seller agree on Price and Quantity today, for delivery sometime in the future
(one month, one year, ten years). Forward contracts are private contracts, and are
therefore not marketable securities, there is no secondary market, e.g. like the difference
between a bank loan (not marketable) and a bond (marketable).
Example: Jolly Green Giant Co., or Pepsi Cola, enters into a forward contract in May to
purchase tea at harvest time in October, at a guaranteed price, from various farmers for
their entire crop. Advantage: buyer (company) and the seller (farmer) have a guaranteed
price. They are now protected from price swings in tea, they have eliminated price risk
completely by hedging their position, locking in a price with a forward contract.
Example two : For instance, consider a US based company buying textile from an
exporter from England worth £ 1 million payment due in 90 days. The Importer is short
of Pounds- it owes pounds for future delivery. Suppose the spot (cash market) price of
pound is US $ 1.71 and importer fears that in next 90 days, pounds might rise against the
dollar, thereby raising the dollar cost of the textiles. The importer can guard against this
risk by immediately negotiating a 90 days forward contract with City Bank at a forward
rate of say, £ 1= $1.72. According to the forward contract, in 90 days the City Bank will
give the US
Importer £ I million (which it will use to pay for textile order), and importer will give the
bank $ 1.72 million (1million ×$1.72) which is the dollar cost of £ I million at the
forward rate of $ 1.72.
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Advantage of Forward Contracts:

1) they are very flexible can be customized to the needs of the parties.
2) Forward contracts are negotiated between a bank and its customer and can be
tailored to the requirements of the customer. Thus the contract value, the currency
and the time period forward are a matter of agreement between the two parties.
Where the customer has market power, it may be possible to negotiate a
favourable forward market rate.
3) Forward contracts eliminate the risk of adverse currency movements because the
shilling value of the order is established immediately. By locking into a fixed
exchange rate, losses can be avoided, but this also means that the company will be
unable to benefit from any favourable currency movements during the period.
Disadvantages of Forward Contracts:
1) There is not a liquid market for forward contracts, no secondary market. Might be hard
to match up the two parties to the transaction.
2) High default risk. No outside party guaranteeing the transaction, like there is in the
futures market.
3) Requires actual delivery to complete the contract. Once a forward contract has been
agreed, it is binding. Thus, if the customer does not pay the amount owing, the firm that
entered into the forward contract will still be obliged to sell the shillings at the forward
rate in six months’ time. This will be done at the spot rate and even if is lower than the
current forward rate , the company will incur a loss.
10.3.2. Futures Contracts
Futures is a standardized forward contact to buy (long) or sell (short) the underlying asset
at a specified price at a specified future date through a specified exchange. Futures
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contracts are traded on exchanges that work as a buyer or seller for the counterparty.
Exchange sets the standardized terms in term of Quality, quantity, Price quotation, Date
and Delivery place (in case of commodity).
Advantages of futures contracts over forward contracts:

1. Liquid market, lots of buyers and sellers at organized exchanges all over the world
2. Active secondary market. Contracts may trade hands many times before expiration.
3. Minimal risk - the futures exchange requires an initial margin requirement to open a
position and they enforce daily settlement of all gains and losses to avoid default. There
is a maximum price movement, called the daily limit, to minimize large losses. Example:
daily price limit for wheat futures contracts is 20 cents per bushel, trading stops for the
day.
4. Cash settlement for most futures contracts, instead of settlement in the actual
commodity.
5. You can close out your account any time by taking an offsetting position. If your
original position is to buy (go long) a futures contract, you can subsequently sell (go
short) to close out your position, and vice versa. You are basically agreeing to sell the
contract to yourself, so you can cash out without having to make or receive delivery.
Disadvantages of futures contracts over forward contract:
1. Less flexible, since futures contracts are for fixed, standard amounts, e.g. wheat futures
contracts are for 5,000 kilogram per contract.
2. Expiration dates are fixed, e.g. Jan, March, May, July, September, and December for
futures contracts, so there are only six delivery days per year.
futures contracts Forward contract
Trading location Traded competitively on Traded by bank dealers via
organized exchange. a network of telephones and
computerized dealing
systems (over-the-counter
transactions)
Contractual size Standardized amount of the Tailor –made to the needs of
underlying asset the participants
Settlement Daily settlement, of Settlement is at maturity
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marking to markets done

Expiration date Standardized delivery dates Tailor made delivery date to
i.e delivery date is fixed. meet the needs of the
investor
Delivery Delivery of the underlying Delivery of the underlying
asset is not made asset is made
Trading costs Bid-ask spread plus Bid-ask spread plus banks
broker’s commission indirect charges
Counter party (third party) Clearing house serves as a Banks serve as a third party
third party in all
transactions
Secondary market Active secondary market No active secondary Market
Types of Futures Contract

FINANCIAL FUTURES: interest rate contracts (T-bonds, Eurodollar, etc.) to manage
interest rate risk, stock index contracts (S P500 Index, ) to hedge stock price declines
(portfolio insurance), currency contracts (Euro, Yen, SF, etc.) to hedge exchange rate
risk.
To give an example of a futures contract, suppose on November 2007 Ramesh holds 1000
shares of ABC Ltd. Current (spot) price of ABC Ltd shares is Rs 115 at National Stock
Exchange (NSE). Ramesh entertains the fear that the share price of ABC Ltd may fall in
next two months resulting in a substantial loss to him. Ramesh decides to enter into
futures market to protect his position at Rs 115 per share for delivery in January 2008.
Each contract in futures market is of 100 Shares. This is an example of equity future in
which Ramesh takes short position on ABC Ltd. Shares by selling 1000 shares at Rs 115
and locks into future price.
2. COMMODITY FUTURES: grains (corn, oats, soybeans, wheat, barley), metals
(copper, gold, silver, platinum), livestock (hogs, cattle, pork bellies), foods and fibers
(sugar, coffee, cotton, orange juice, rice), petroleum (crude oil, natural gas, heating oil,
gasoline, propane), miscellaneous (lumber, seafood, electricity). These contracts allow
participants to hedge against commodity price risk.
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FUTURES TERMS: BUY = GO LONG and SELL = GO SHORT. Example: Sept 2004
wheat futures are trading at 320 cents per bushel, or $3.20/bushel. You can buy wheat or
sell wheat at that price for delivery in Sept 2004, in units of 5,000 bushel per futures
contract. If you buy a Sept 2004 wheat futures contract, you are "going long" on wheat.
If you sell a Sept 2004 wheat futures contract, you are "going short" on wheat.
PROFTIT/LOSS FROM FUTURES CONTRACT:

1. For the person SELLING wheat @ $3.20/kg (short position), they will make a PROFIT
when the spot/cash price of wheat GOES BELOW $3.20/kg and they will suffer a LOSS
when the cash price GOES ABOVE $3.20/kg.
Reason: They have a contract to sell wheat at $3.20/kg to the futures contract buyer (long
position), and if wheat goes to $3 in the cash market, they could theoretically buy low at
the spot price ($3) and sell high at the contract price of $3.20 and make money ($.20/kg).
If wheat goes to $3.50 wheat in the cash market, they would now have to buy high at
$3.50/kg and sell low at $3.20, for a loss $0.30/kg.
2. For the person BUYING wheat @ $3.20/kg (long position), they will make a PROFIT
when the spot/cash price of wheat GOES ABOVE $3.20/kg and they will suffer a LOSS
when the cash price GOES BELOW $3.20kg.
Reason: They have a contract to buy wheat at $3.20/kg from the futures contract seller
(short position), and if the spot/cash price goes to $3.50, they can buy low at $3.20 from
the seller, and then sell high at $3.50 in the cash market and make money ($0.30/bu).
However, if the cash/spot price goes to $3/kg, they now have to buy high at $3.20 and
sell low at $3.00, for a loss of $0.20/kg.
POINT: Futures markets are ZERO SUM trades, meaning that for every contract there is
a winner and a loser and the winner wins the same amount as the loser loses, NET
OUTCOME = 0 (+$1 winner, -$1 loser, ZERO SUM OUTCOME). For example, if spot
prices for corn go up to $3.50/kg , the long position makes $.30 profit and the short
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position loses $.30. If the cash price falls to $3, the short position makes $.20 profit per
bushel and the long position has a loss of $.20 per kg.
10.3.3 Options
By paying a premium, the option gives you the right but not the obligation to buy or sell
currencies at a predetermined date and rate. The option (used for hedging and not
speculative purposes) acts as a form of insurance policy, allowing you to make a profit
when exchange rates shift in your favour and protect you when the opposite occurs.
There are two main types of options

(Call option)
A currency call option is a contract that gives the holder the right to buy a stated number
of units of foreign currency at a given price (which is called the exercise price or strike
price) from the counterparty (called the writer of the option).
– For “European” option, this right can be exercised on a given maturity date T.
– For “American” option it can be exercised at any time until its expiration date T.
(Put option)
A currency put option is a contract that gives the holder the right to sell a stated number
of units of foreign currency at a given price (which is called the exercise price or strike
price) to the counterparty (called the writer of the option).
– For “European” option, this right can be exercised on a given maturity date T.
– For “American” option it can be exercised at anytime until its expiration date T.
NB: Options can be either American or European. American Options are options that can
be exercised at any time up to the expiration date, whereas European options are options
that can only be exercised on the expiration date.
Comparing options with forwards and futures
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Options have the following features that makes them more attractive than forwards and
futures contracts:
1. Options are more liquid than forwards;
2. Options can hedge non-linear payoffs;
3. Options are more suited to hedging cashflows with uncertain timing;
4. Options are better suited to hedging cashflows contingent on some event;
5. Options are more suited to hedging (accounting) exposure that depends on the average
exchange rate; and
6. Options are more suited to speculating on the direction and volatilityof exchange rates.
Specification of Options
Strike Price : Price at which a holder may buy (call) or sell (put) the underlying currency
Premium: Cost of purchasing the option contract, generally expressed as a percentage of
the nominal price of the option .
Expiry: Final maturity past which your option can no longer be exercised.
Options Market Organization

Whereas Futures contracts are traded only on organized exchanges and Forward
contracts only over the counter, Options are available both in over the counter markets
and on organized exchanges.
• Traded options
An organized option exchange, like a futures market, has an organized secondary market,
with a clearing house as a guarantor party. Contracts on option exchanges, just like
futures contracts, are standardized. For instance trading in one of the united states
exchange on the Philadelphia exchange:
– Expiration dates: all options expire on the third Wednesday of March, June, September,
or December, and only the three nearest expiration dates are traded. Early exercise is
possible until the last Saturday of the option’s life.
– Contract sizes: one dem option contract gives the right to buyo r sell dem 62,500.
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– Exercise prices: the strike prices must be multiples of one usd cent (for dem, chf, or cad
options), of 5 cents for GBP options, and multiples of .01 cent for JPY options.
– The exchanges ensure that there are always contracts available with strike prices around
the prevailing spot rate.
Over-the-counter markets
– Over-the-counter (OTC) options are written by financial institutions.
– These OTC options are more liquid than forward contracts: at any moment, the holder
can sell them back to the original writer, who quotes two-way prices.
– Like forward contracts, OTC options are tailor made: in the over the counter market
you can pick your customized expiration date, contract size, and strike price.
– Consequently, the bid-ask spread in the OTC market is higher than in the traded options
market.
– In OTC markets, most of the options are written at a strike price equal to the spot price
of that moment (“at the money option”).
Underlying Assets for options

Stock Options: the underlying asset is shares
Foreign Currency Options: exchange for foreign currency options trading, underlying
asset being the currency.
Index Options: Settlement is in cash rather than by delivering the portfolio underlying
the index.
Futures Options - When the holder of a call option exercises, he or she acquires from the
writer a long position in the underlying futures contract plus a cash amount equal to the
excess of the futures price over the strike price.
Currency options are useful to companies in the following situations.
When there is uncertainty about foreign currency receipt or payment either in timing or
amount. If the foreign exchange transaction does not materialise then the currency option
can be sold in the market (if it has any value) or it can be exercised if it will make a
profit
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- It can be used to support a tender for an overseas contract priced in foreign currency.
- It can be used to allow publication of price-lists for goods in foreign currency.
- It can be used to protect the imports or exports of price sensitive goods.
Currency options have the following limitations:
- The cost of the option is very high, approximately 5% of the total value
- Options must be paid for as soon as they are bought.
- Traded options are not available in every currency. They are only available in
standard currency.
10.3.4 Swaps
Swaps are agreements between between two parties to exchange assets or sets of
financial obligations or a series of a casflow for a specified period of time at a
predertimined interval.
Types of swaps
The financial market has developed a variety of swaps
10.3.4.1. Interest rate swaps
An interest rate swap is a transaction between two parties involving an exchange of one
stream of interest obligations (payment) for another for specified maturity.
An interest swap is an agreement whereby the parties agree to swap a floating stream of
interest payments for a fixed stream of interest payments. There is no exchange of the
principal amount.
The companies involved are termed as counter-parties. Swaps can run for upto 30 years.
Swaps can be used to hedge against an adverse movement in interest rates. for example a
company having Ksh 400 million floating interest loan and it is expected that the interest
rates are going to rise over the next five years. The firm can enter into swap with a
counter party for a fixed rate of interest for the next five years.
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A swap can be used to obtain cheap finance. A swap should result in a company being
able to borrow what they want at a better rate under swap arrangement.
There are many different types of interest rate swaps.
Bond swap : is the simultaneous purchase and sale of two or more bonds with similar
characteristics in order to earn a yield differential. Differences among bonds in coupons,
default risk, marketability, maturity, tax treatment e.t.c , determine the potential
profitability of the bond swaps.
Features of interest rate swaps
The principal features of interest rate swaps
 They effectively translate floating rate into a fixed borrowing and vice versa.
 They are structured as separate contract distinct from underlying loan agreements.
 They are treated as off-balance sheet transactions.
 Interest rate swaps have the following advantages:
– Transaction costs : Transaction costs tend to be fairly low as a result of competition
between swap banks. These costs will include the fees of swap banks and any legal fees.
– Flexibility Swaps can be arranged in a way to suit the particular needs of the customer.
Thus they can be arranged for different time periods, different amounts and so on.
– Set up arrangements: Swaps can often be arranged easily through a swap bank. The
swap bank will normally undertake to find a suitable counterparty to the swap agreement
(although the bank may be willing to act as a counterparty, thereby making this
unnecessary). It is possible to reverse a swap agreement before the maturity date by re-
swapping with other counterparties. However, this will usually result in additional costs
being incurred.
The main disadvantage of a swap agreement is counterparty risk, that is, the risk that the
counterparty to the agreement will default on its commitments. This risk may be managed
by paying a fee to the swap bank to act as guarantor. Where a swap bank agrees to act as
the counterparty, this problem is not really an issue.
10.3.4.2. Currency swaps
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A currency swap allows two counterparties to swap interest rates commitment on

borrowings in different currencies. In effect a currency swap has two elements :
An exchange of principal amount in different currencies which are swapped back at the
original spot rate.
An exchange of interest rates-the timing of these depends on the individual contract.
Currency swaps can help manage both interest rate and exchange rate risk. A major
difference between the interest swap and currency swap is that in currency swap there the
exchange of the principle amounts at maturity at a predetermined exchange rate.
Advantages of currency swaps include:

(i) They allow companies to undertake foreign currency hedging, often for longer periods
than is possible with forwards.
(ii) They are usually cheaper than long term forwards, where such products exist.
(iii) Finance may be obtained at a cheaper rate than would be possible by borrowing
directly in the relevant market. This occurs by taking advantage of arbitrage if a company
has a relative funding advantage in one country.
(iv) They may provide access to finance in currencies that could not be borrowed directly,
e.g. due to government restrictions, or lack of a credit rating in the overseas market.
(v) Currency swaps offer the opportunity to restructure the company’s debt profile
without physically redeeming debt or issuing new debt.
(vi) Currency swaps might be used to avoid a country’s exchange control restrictions.
Potential problems include:

(i) If the swap is directly with a corporate counterparty the potential default risk of the
counterparty must be considered.
Swaps arranged with a bank as the direct counterparty tend to be much less risky.
(ii) Political or sovereign risk, the possibility that a government will introduce restrictions
that interfere with the performance of the swap.
(iii) Basis risk. With a floating to floating swap basis risk might exist if the two floating
rates are not pegged to the same index.
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(iv)Exchange rate risk. The swap may result in a worse outcome than would have
occurred if no swap had been arranged.
10.3.4.3. Debt-equity Swap
In a debt-equity swap , investors (corporate) purchase the external debt of less developed
countries on the secondary loan market at a discount to swap it into equity or domestic
currency in those same countries. For several years commercial banks in the united states
and Europe have been selling troubled least developing countries loans in secondary
market at heavy discounts.
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LESSON 11 : INTERNATIONAL FINANCIAL INSTITUTIONS
11.0 Introduction
After the First World War there was complete lack of monetary co-operation among the
countries of the world. The gold coin standard used before World War I, was
abandoned during the war. As a result of the breakdown in gold standard, the World
lost the most efficient automatic standard upon which nations had for a long time a
vehicle for restoring equilibrium in their balance of payments whenever it was
disturbed.
It was therefore necessary that a concerted effort be made on international level to

create some effective international arrangement whereby exchange stability could
be guaranteed. A common plan evolved at United Nations Monetary and Fiscal
Conference of 44 world nations held at Bretton Woods, New Hampshire in July
1944. Out of the deliberation of this conference sprang up the Brettonwoods twins
- the International Monetary Funds (IMF) and the International Bank for
Reconstruction and Development (IBRD).
11.1. Establishment of IMF
Beginning from 1914, when the First World War, most countries suspended the
convertibility of their currencies to gold. They financed their war operations by printing
more money. This led to transactional accumulations of currencies during the four years
of war (1914 – 1918)
As a result the gold standard system declined by a half. The value of the paper money
issued by the central banks depreciated as prices continued to increase.
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Exchange rates and interest rates experienced wide fluctuations. The German mark (DU)
fell to its record low as German lost the war. Even the winners in the war experienced
great problems. The old gold standard was re- established in the early 1920s but it failed
leading to the financial crash during the great depression.
During 1920 – 1935, production levels were very low and the levels of unemployment
were very high. Most countries resulted to protection tactics, by selling high tariffs,
establishing Quotas and banning certain imports. The situation led to the establishment
of the gold exchange standard system, where currencies were not directly convertible to
gold but only their par value were based on the value of gold.
A new system was established and the amount of gold in each central bank had to be
fixed as a fixed fraction or percentage of the total money supply in circulation.
In 1944, after the gold exchange standards had failed completely, the U.K. and U.S.A.
laid down the basis for an international monetary system at Breton woods, New
Hampshire, U.S.A. This was designed to prevent a recurrence of the hectic inter – war
conditions in international trade and Finance. It called for establishment of the
international monetary fund (IMF) to see to it that the nations kept the generally accepted
code of rules in their conduct of international trade and finance. IMF was expected to set
up borrowing facilities for nations having deficits.
11.1.1. Requirements of I.M.F

1) Each member state, upon entering the IMF, was to fix the value of its Currency in
terms of gold or dollars and then keep its exchange rate within One % of this par value.
2) The par value could be changed only within the permission of the IMF, except
where the member state changed the value of its currency by less than 10%.
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3) Temporary deficit were to be financed out of the nation’s reserves with IMF and firm
direct borrowing from the IMF. The World Bank was created to provide from long term
development.
4) A Quota was assigned to each nation in the IMF. The size of the quota was based on
the nation’s economic importance it determined the nation’s voting power in the
organization and its ability to borrow from the fund.
NB/ Each nation was required to deposit 25% of its quota in gold and 75% in its own
currency with the IMF. The Breton woods system worked well until the period after
1950 when huge and persistent deficit in the USA’s balance of trade caused it to collapse.
11.1.2. The major objectives of the IMF set by charter are:-
1. To promote cooperation among countries on international monetary Issues
2. Promote stability in exchange rates.
3. Provide temporary funds to member countries attempting to correct imbalances of

international payments.
4. To promote free trades. It’s clear from these objectives that the IMF goals
encourage increased internationalization of business.
Each member of IMF is assigned a quota based on a variety of factors reflecting the
country status and each country that a country can borrow from IMF is dependent on its
particular assigned quota.
The financing by IMF is measured in special drawing rights (SDRS). This is a unit of
account, an international reserve asset created by IMF and allocated to the member
countries to supplement currency reserves. SDR’s value fluctuates in accordance with
the value of five major currencies i.e. US Dollar, German Mark, French Franc, Japanese
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Yen and British Pound. Each currency was assigned weight in accordance with their
international importance to determine the SDR value. U.S. dollar received 42% weight,
German mark received 19% weight, the following other currencies received 13% weight
each.
11.2 World Bank
The international Bank for Reconstruction and Development (IBRD), also referred to as
World Bank was established in 1944. The primary objective of the World Bank is to
make loans to countries in order to enhance economic development. E.g. World Bank
recently extended a loan to Mexico about $4 billion over ten year period over
environmental projects to facilitate industrial development near U.S. border.
The philosophy behind the World Bank’s objective is profit- oriented. Therefore, loans
are not subsidized but are extended at market rates to government (and their agencies)
that are likely to make repayment.
One of the World Bank’s facilities is the structural adjustment loan (SAL) facility
established in 1980. The SAL is intended to enhance a country’s long- term economic
growth. Example SALS have been provided to Turkey and to some other LDCs that are
attempting to improve their Balance of trade (B.O.T). Because the World Bank provides
only a small portion of the financing needed by developing countries, it attempts to
spread its funds by a entering into co-financing agreements. Such as:-
(a) Official Aid agencies

-Development agencies may join World Bank by financing development projects
in low income countries.
(b) Export credit Agencies

- World bank co-finances some capital intensive projects that are also financed
through export credit agencies.
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(c) Commercial Banks

-World bank has joined with commercial banks to provide financing for private
sector development. In recent years 350 commercial banks have participated in
financing with the world bank.
11.3. World Trade Organization (WTO)
The world trade organization was created as result of the Uruguay Round of trade
negotiations that led to the GATT (General Agreement of Trade & tariffs) accord in 1993.
This organization was established to provide a form for multilateral trade negotiations
and to settle trade disputes related to the GATT accord. It begun its operations in 1995
with a membership of 81 countries, and more countries are joining. Member countries
are given voting rights that are used to make judgments about trade disputes and other
issues.
11.4. International Finance Corporation (IFC)
Established in 1956 to promote private enterprise initiative within countries like IMF, it is
composed of a collection of nations as members. While it aims to enhance economic
development, it uses the private rather than government sector to achieve its objectives.
It is not only providing loans to corporations but also purchase stock, thereby becoming a
part owner in some cases rather than a creditor. The IFC typically provides 10 to 15% of
the necessary funds in the private enterprise projects in which it invests, and the
remainder of the projects must be financed through other sources.
In this, the IFC act as a catalyst, as opposed to a sole supporter, for private enterprise
development projects. It traditionally has obtained financing from the World Bank but
can borrow within the international financial markets.
Questions
Qn/ How can government restrictions affect international payments among countries.
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Qn/ What are the major objectives of:-
(a) The IMF

(b) The world bank
Qn/ Explain how the existence of the Euro could affect U.S. international trade.
Services provided by the international Banks

 Risk sharing service
 Liquidity services
 Information services
The rise of Euromarkets

Before World War II, London was the leading global financial and commercial centre
British pond largely served as an international transaction currency. After World War II
the United States become the dominant financial and industrial nation. Thus, the US
Dollar became the international transaction currency, even in exchange in which neither
the buyer nor the seller was a U.S. firm. In certain markets, such as world oil market,
trades are still made in dollars. During the following World War II, the former Soviet
Union and Eastern block countries accumulated dollars reserves for international trade.
For political reasons, they did not want to keep these reserves in banks inside the United
States. They had lost confidence with U.S. Currency as a result of persistent deficit and
balance of trade in U.S.A. Instead they deposited their US Dollars reserves in European
banks rather than converting them into European currencies, they kept them dominated in
dollars. These Accounts became known as Eurodollars.
Since 1960s the Euro market has grown from negligible size to a very big size. Much of
current international banking system is conducted in a relatively unregulated banking
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center known as Euromarkets. Euro markets are markets for Euro currency deposits or
time deposits dominated in a currency rather than that of the issuing domestic financial
center e.g. Dollar deposits at a French bank.
Euro loans, Eurobonds or Euro commercial papers are bonds, loans and commercial
papers dominated in a currency other than that of the issuing financial centre.
Most of Euro currency deposits are negotiable certificates of deposits with maturities of
at least 30 days.
FACTORS TO CONSIDER WHEN CHOOSING BETWEEN EUROMARKETS OR

DOMESTIC MARKETS
(a) The currency that the borrower wants to obtain

Multinational companies usually want to borrow in foreign currency to reduce
their foreign exchange exposure and therefore borrow in euromarkets rather
than the domestic market.
(b) The cost
There is often a small difference in interest rate between eurocurrency and
domestic markets. On large borrowings, however, even a small difference in
interest rate result in a large difference in the total interest charged on the loan.
(c) Timing and speed
It may be possible to raise money on the euromarket more quickly than in the
domestic markets.
(d) Security
Euromarket loans are usually unsecured. Whereas domestic market loans are
more commonly secured. Large borrowers may therefore prefer euromarkets.
(e) The size of the loans
It is often easier for a large multinational to raise very large sums on the
euromarkets than in a domestic financial market.
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Qn/ what is Euro market, how did it start?
Qn who are the customers of Euro market
Qn/ what is currency swap
LECTURE 9
Contemporary issues and innovation in financial sector
The financial sector is experiencing an era of rapid innovations. These changes are
fueled by rapid improvement in two technologies.
(a) Data processing Heart of financial services

(b) Telecommunication
Financial sector is one of the heavily regulated sectors in Kenya.

Though technological improvements and innovations are almost always healthy and
beneficial for an economy, they can place serious strains on the incumbents in a particular
industry or sector on which they are focused. They create challenges:-
Challenges in the financial sector

- Printing of fake currency as a result of advanced technology and innovations.
- Frauds and forgery as a result of advanced technology
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- Rapid/Rivalry competitions among institutions
- Threats of new entrants.
- The bargaining power of the savers resulting to decline of minimum amounts

to open accounts.
- Threats of substitute products and services from other institutions.
Banks / Financial institutions must make innovations to transform resources into proper
services that people want. Just in Time (JIT) can be applied in order to be competitive.
This is a system where the required resources / service are introduced in the market to
avoid wastage of scarce resources and utilize resources that require small proportions to
begin with. Eg. During this time, 2008, April safaricom shares are on sales. Banks
should come up with JIT to make sure that they benefit from this sale. Money should set
aside to buy shares on behalf and rent out to those who need these shares.
Intelligence of competition is required. You must know whom you’re up against in order
to win in a business.
Competition intelligence
1. Avoid surprises from existing competitors’ new strategies and tactics.
2. Identify potential new competitor’s
3. Improve reaction to competitors’ action.
4. Anticipate rivals next strategic moves.
Contribution of financial sector to the economy
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a. Improving the economic, social and cultural situation of persons of limited

financial resources and encourage their spirit of initiative.
b. Increase personal National capital resources by encouraging thrift and sound us of

credits by eliminating usury.
c. Contribution to the economy an increased measures of democratic control of

economic activity and equitable distribution of surplus resources.
d. Increased National income, export revenues and employment by proper utilization

of revenues.
e. Helping to raise the level of general and technical knowledge for the customers
through seminars and workshops and advertisement through brochures.
NB/ A lot of regulations can be a hindrance to innovations and sometimes may spur to
innovations.
Financial innovations
Innovations includes of firm’s developing new products / services and or new production
process, sometimes new organizations. In essence, innovation involves new ways of
doing things.
Conditions that Encourages / Limit innovations

o Nature of technology and rate of change of that technology.
o Structure of the financial institution and competitiveness of the entire industry.
o The economic environment of the industry in question.
o The regulatory environment to the industry
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Innovation in the financial sector
Firms in various sub - sectors of finance and Banking, securities and insurance have long
history of developing new instruments and services and developing improved back office
processes to reduce costs of existing services and to support the offering of new ones.
Even with the recent electronic based technological innovations, that have attracted much
attention, are not new to the financial sector.
The development of telegraph in 1840’s soon lent to its use for wire transfer of funds for
dissemination of price information. Quotas, with respect to gold and securities were
traded on various exchanges, nationally and internationally (Gabede, 1978). The
innovation of telephone in 1876 was followed by next year by first commercial
installation of telephones by two bankers. Large branch – office Brokerage firms
extensively used the telegraph and the telephone and soon earned them a descriptive term
wire house. The electronic fund transfer (EFT) system of the Freeware was developed
shortly after the establishment of the Federal Reserve in 1913. The pace of innovation has
quickened dramatically since late 1960’s.
Common Regulations available

1. -Economic regulations – Direct control of prices, profit and taxation.
2. Health and Environment regulations – Restriction on production process and

product types and qualities to ensure safety.
3. Information Regulations - Involves specifying of types of information to be attached

or dispatched eg. Labeling products’ requirements and problem (Labeling cigarettes as a
hazard to smokers).
151

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BAC 305- Financial MKTS Lecture Notes

Financial Institutions And Markets (Moi University)

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ACCOUNTING AND FINANCE DEPARTMENT

FINANCIAL MARKETS AND INSTITUTIONS MODULE

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5.3. General Principles of Bank Management...............................................................40

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LESSON ONE : INTRODUCTION TO FINANCIAL MARKETS AND

1.0. Nature of Financial system.

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Organized financial mkt: incorporated with the appropriate authority of gvt

 Financial instruments (a document i.e check, draft, bond, share, bill of

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FINANCIAL FINANCIAL FINANCIAL FINANCIAL

Short-term medium long-term

Capital Market Money Market

Debt Market Equity Market Derivative Market

Capital market: long term securities

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Debt market: bonds are bought and sold

According to the structural approach, the financial system of an economy consists of

Functions of a Financial System

The following are the functions of a Financial System:

(ii) Monitor corporate performance – apart from selection of projects to be

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(v) Disseminate price-related information – which acts as an important tool for

Key elements of a well-functioning Financial System

The basic elements of a well-functional financial system are:

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ii. stable money;

1.1. Financial instruments and services

There are two Financial Systems prevalent in the world today:

(a) Bank Dominated Financial System – Stage I – In undeveloped countries

(b) Market Dominated Financial System – Stage III – In developed countries.

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1.2. Importance of a Well Functioning Financial System

In a well-functioning financial system, financial contracts, markets and intermediaries act

• Producing information and allocating capital. Financial intermediaries can

• Monitoring firms and exerting corporate governance. The extent to which

• Trading, diversification, and risk mitigation. Financial institutions and

• Mobilizing and pooling savings. Mobilizing and allocating capital is a costly

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1.3 The Negative Impact of Small Financial Systems in Africa

• Inadequate services. Small financial systems are more likely to be incomplete.

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• The regulatory infrastructure of small financial systems tends to be of higher

• Auxiliary components of financial infrastructure are often absent from small

1.4. Financial System and Economic Development

Savings and investment or

Surplus spending economic

Income minus (consumption

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Income minus (consumption

1.5. Growth of Financial systems: Financial Repression and financial Deepening

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Solutions of Financial repression

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Key terms in financial markets :

Diversification : diversification means the existence or the development of a very wide

Disintermediation : it refers to the phenomenon of a decline in the share of financial

Disintermediation refers to the withdrawal of funds from a financial intermediary by

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