CHAPTER FOUR

THE FINANCIAL MARKETS

4.1 Introduction
A Market is an institutional mechanism where supply and demand will meet to exchange goods
and services; or a place or event at which people gather in order to buy and sell things in order to
trade. In modern economies, households provide labor, management skills, and natural resources
to business firms and governments in return for income in the form of wages, rents and
dividends. Consequently, one can see that markets are used to carry out the task of allocating
resources which are scarce relative to the demand of the society. Along with many different
functions, the financial system fulfills its various roles mainly through markets where financial
claims and financial services are traded (though in some least-developed economies Government
dictation and even barter are used). These markets may be viewed as channels which move a vast
flow of loan able funds that are continually being drawn upon by demanders of funds and
continually being replenished by suppliers of funds.
4.2 The Organization and Structure of Markets
Broadly speaking, markets can be classified in to Factor markets, Product market and financial
markets.

a) Factor markets: - are markets where consuming units sell their labor, management skill, and
other resources to those producing units offering the highest prices, i.e. this market allocates
factors of production (Land, labor and capital – and distribute incomes in the form of wages,
rental income and so on to the owners of productive resources.

b) Product market: - are markets where consuming units use most of their income from the
factor markets to purchase goods and services i.e. this market includes the trading of all
goods and services that the economy produces at a particular point in time.

c) A financial market is a market where funds are transferred from people who have an
excess of available funds to people who have a shortage. Financial markets such as the
bond and stock markets are important in channeling funds from people who do not have
a productive use for them to those who do.
4.3 Structure of Financial Markets
The various structures of financial markets are discussed below.

4.3.1 Exchanges and Over- the – Counter Markets

Organized Exchanges (Auction) Markets
An auction market is some form of centralized facility (or clearing house) by which buyers and
sellers, through their commissioned agents (brokers), execute trades in an open and competitive
bidding process. The "centralized facility" is not necessarily a place where buyers and sellers

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physically meet. Rather, it is any institution that provides buyers and sellers with a centralized
access to the bidding process. All of the needed information about offers to buy (bid prices) and
offers to sell (asked prices) is centralized in one location which is readily accessible to all would-
be buyers and sellers, e.g., through a computer network. An auction market is typically a public
market in the sense that it open to all agents who wish to participate.

Over-the-counter (OTC) markets

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. The dealers provide customers more
flexibility in trading than brokers, because dealers can offset imbalances in the demand and
supply of assets by trading out of their own accounts. Many well-known common stocks are
traded over-the-counter through NASDAQ (National Association of Securities Dealers'
Automated Quotation System).

4.3.2 Primary and Secondary Markets

Primary Market
It is a financial market in which new issues of a security such as a bond or stock are sold to
initial buyers by the corporation or government agency borrowing the funds

The primary markets for securities are not well known to the public because the selling of
securities to the initial buyers takes place behind closed doors. An important financial institution
that assists in the initial sale of securities in the primary market is the investment bank. It does
this by under writing securities: It guarantees a price for a corporation’s securities and then sells
them to the public.
Secondary Market
It is a financial market in which securities that have been previously issued (and are thus second
handed) can be resold.
When an individual buys a security in the secondary market, the person who has sold the security
receives money in exchange for the security, but the corporation that issued the security doesn’t
acquire new funds.

A Corporation acquires new funds only when its securities are first sold in the primary market.
Nonetheless, secondary market serves two important functions:

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4.3.3 Debt and Equity Market
Debt Market
This is a financial market where debt instruments such as bonds or mortgages, which are
contractual agreements by the borrower to pay the holder of the instruments fixed dollar amounts
at regular intervals ( interest and principal payments) until a specified date (the maturity date),
when a final payment is made. The maturity of a debt instrument is the time (term to the
instrument’s expiration date). A debt instrument is short- term if its maturity is less than a year
and long term if its maturity is ten years of longer. Debt instruments with a maturity between one
and ten years are said to be intermediate term.
Equity Market
It is a financial market where equity securities, such as common stock, which are claims to share
in the net income (income after expenses and taxes) and the assets of a business, are traded.
Equities usually make payments (dividends) to their holders and are considered long- term
securities because they have no maturity date.
The main disadvantage of owning a corporation’s equities rather than its debt is that an equity
holder is a residual claimant; i.e. the corporation must pay all its debt holders before it pays its
equity holders. The advantage of holding equities is that equity holders benefit directly from any
increases in the corporation’s profitability or asset value because equities confer ownership rights
on the equity holders. Debt holders do not share in the benefit because their dollar payments are
fixed.

4.3.4 Money and Capital Markets

The Money Market
The money market is a financial market in which only short-term debt instruments (maturity of
less than one year) are traded. Money market securities, which are discussed in detail latter, have
the following characteristics.
 They are usually sold in large denominations
 They have low default risk
 They have smaller fluctuation in prices than long- term securities, making them safer
investments
 Widely traded than long- term securities and so more liquid.

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Money market transactions do not take place in any one particular location or building. Instead,
traders usually arrange purchases and sales between participants over the phone and complete
them electronically. Because of this characteristic, money market securities usually have an
active secondary market. This means that after the security has been sold initially, it is relatively
easy to find buyers who will purchase it in the future. An active secondary market makes the
money market securities very flexible instruments to use to fill short term financial needs.

Another characteristic of the money markets is that they are whole- markets. This means that
most transactions are very large. The size of this transaction prevents most individual investors
from participating directly in the money markets. Instead, dealers and brokers, operating in the
trading rooms of large banks and brokerage houses, bring customers together.

Money Market Instruments

A variety of money market instruments are available to meet the diverse needs of market
participants. One security will be perfect for one investor; a different security may be best for
another. Because of their short- terms to maturity the debt instruments traded in the money
market undergo the least price fluctuations and so are the least risky investments.
The principal money market instruments are:
a) Treasury Bills
These are short- term debt instruments, usually issued for 3, 6, and 12- month maturities, to
finance the deficits of the federal government.

Treasury Bills are the most liquid of all the money market instruments because they are the most
actively traded.

Treasury bills have zero default risk because it is assumed that the federal government is always
able to meet its debt obligations because it can raise taxes or issue currency (paper money or
coins) to pay off its debts. The risk of unexpected changes in inflation is also low because of the
short term to maturity.

Treasury bills are held by banks, although small amount are held by households, corporations,
and other financial intermediaries.

The government does not actually pay interest on T- bills. Instead they are issued at a discount
from par (their value at maturity). The investor’s yield comes from the increase in the value of
the security between the time it was purchased and the time it matures. For instance you might
buy in May 2003 for $9,000 a one- year Treasury bill that can be redeemed in May 2004 for
$10,000.

The yield on an investment is found by computing the increase in value in the security during its
holding period and dividing by the amount paid for the security. This yield is converted in loan
annual yield by multiplying 365 divided by the number of days until maturity. This gives the
following equation.
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 𝐹−𝑃 365
i= 𝑃 × 𝑛

Where: i = annual yield on the investment

F= face value
P= purchase price
n = number of days until maturity
Example 1: You decide to purchase a 91-day T-bill for birr 9850. When it matures the bill
will be worth birr 10,000. What is the T-bill’s annual yield?

Solution
𝐹−𝑃 365
i= 𝑃 × 𝑛
10,00−9850 365
i= × = 0.0611 = 6.11%
9850 91

Example 2: Now suppose that you decide to sell the Treasury bill 31 days before it matures. By
selling before it matures, you will receive birr 9948. What is the bill’s annual yield?

Solution

Given: Face value (F) = birr 9948

Purchase price (P) = 9850
Number of days security held (n) = 91 – 31 = 60

𝐹−𝑃 365
i= 𝑃 × 𝑛
9948−9850 365
i= × = 0.0605 = 6.05%
9850 60

b) Repurchase Agreements (Repos)

Repurchase agreements (repos) are effectively short- term loans (usually with a maturity of less
than two weeks) in which Treasury bills used as collateral; an asset that the lender receives if the
borrower does not pay back the loan. Reposes are made as follows; a large corporation, such as
general motors, may have some idle funds in its bank account, say, $ 1 million, which it would
like to lend for a week. GM uses this excess $ 1 million to buy Treasury bills from a bank, which
agrees to repurchase them the next week at a price slightly above GM’s purchase price. The
effect of these agreements is that GM makes a loan of $ 1 million to the bank and holds $1
million of the bank’s Treasury bills until the bank repurchases the bills to pay the loan. It is
recent innovation and the most important lenders in this market are large corporations.
Because repos are collateralized with Treasury securities, they are usually low-risk investments
and therefore have low interest rates.

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 c) Negotiable Certificates of Deposits (CDs)
A certificate of deposit (CD) is debt instrument sold by a bank to depositors that pay annual
interest of a given amount and at maturity pays back the original purchase price. Before 1961,
CDs were non-negotiable; that is they could not be sold to someone else and could not be
redeemed from the bank before maturity without paying a substantial penalty. But later on, to
make CDs more liquid and more attractive to investors, certificates of deposits become
negotiable that could be resold in a secondary market. CDs are extremely important sources of
funds for commercial banks.

The interest rates paid on CDs are negotiated between the bank and the customer. They are
similar to the rate paid on other money market instruments because the level of risk is relatively
low.

d) Commercial Paper
Commercial paper securities are unsecured promissory notes, issued by large banks and well-
known corporations that mature in no more than 270 days. Because these securities are
unsecured, only the largest and most credit worthy corporations’ issue commercial paper. The
interest rates the corporation is charged reflects the firm’s level of risk.

Commercial banks were the original purchasers of commercial papers. Today the market has
greatly expanded to include large insurance companies, non-financial businesses, and
government pension funds. These firms are attracted by the relatively low default risk, short
maturity and high yields these securities offer.
e) Banker’s Acceptance
These money market instruments are created in the course of carrying out international trade. A
banker’s acceptance is a bank draft (a promise of payment similar to a check) issued by a firm,
payable at future date, and guaranteed for a fee by the bank that stamps it “accepted.” The firm
issuing the instrument is required to deposit the required funds into its account to cover the draft.
If the firm fails to do so, the bank’s guarantee means that it is obliged to make good on the draft.
The advantage to the firm is that the draft is more likely to be accepted when purchasing goods
abroad because the foreign exporter knows that even if the company purchasing the goods goes
bankrupt, the bank draft will still be paid off. These “accepted” drafts are often resold in a
secondary market at a discount and so are similar in function to treasury bills.

Summary of the steps for using banker’s acceptance

1. The importer requests its bank to send letter of credit to the exporter
2. The exporter receives the letter, ships the goods, and is paid by presenting to its bank the
letter along proof that the merchandize was shipped.
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 3. The exporter’s bank creates a time draft based on the letter of credit and sends it along
with proof of shipment to the importer’s bank

4. The importer’s bank stamps the time draft “accepted “and sends the banker’s acceptance
back to the exporter’s bank so that the exporter’s bank can sell it on the secondary market
to collect payment.

Advantages of Banker’s Acceptance

 Banker’s acceptances are crucial for international trade. Without them, many transactions
simply would not occur as the parties would not feel properly protected from losses
 The exporter is paid immediately. This is important when delivery times are long after
shipment
 The exporter is shielded from foreign exchange risk since the local bank pays in domestic
currencies
 The exporter does not have to assess the creditworthiness of the importer since the
importer’s bank guarantees payment.
2. The Capital Market
Capital market is a financial market for debt and equity instruments with maturities of greater
than one year. They have far wider price fluctuations than money market instruments and are
considered to be fairly risky investments.

Firms that issue capital securities and the investors who buy them have very different
motivations than those who operate in the money markets. Firms and individuals use the money
markets primarily to warehouse funds for short period of time until a more important need or a
more productive use for the funds arises. To the contrary, firms and individuals use the capital
markets for long term investments.
Capital Market Trading
Capital market trading occurs in either the primary market or the secondary market. The primary
market is where new issues of stocks and bonds are exchanged. Investment funds, corporations,
and individual investors can all purchase securities offered in the primary market. A primary
market transaction is the one where the issuer of securities actually receives the proceeds of the
sale. When firms sell securities for the very first time, the issue is called Initial Public Offering
(IPO). Subsequent sales of a firm’s new stocks or bonds to the public are simply primary market
transactions.

The capital markets have well-developed secondary markets. A secondary market is where the
sale of previously issued securities takes place, and it is important because most investors plan to
sell long term bonds and stocks before maturity. Secondary market for capital market
instruments may take place either in an organized exchanges market or in an over the counter
market.

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Capital Markets can be classified in to two broad categories; the bond market and the equity
(stock) markets.

a) The Bond Market

The bond market is composed of longer-term borrowing debt instruments than those that trade in
the money market. These instruments are some times said to comprise the fixed income capital
market, because most of them promise either a fixed stream of income or stream of income that
is determined according to a specified formula. In practice, these formulas result in a flow of
income that far from fixed. Therefore the term “fixed income” is probably not fully appropriate.
It is simpler and more straightforward to call these securities either long term debt instruments or
bonds.

A bond is a security that is issued in connection with a borrowing arrangement. The borrower
issues (sells) a bond to the lender for some amount of cash; the bond is in essence the “IOU” of
the borrower. The arrangement obligates the issuer to make specified payments to the bond
holder on specified dates. A typical bond obligates the issuer to make semiannual payment of
interest called, coupon payments, to the bond holder for the life of the bond. These are called
coupon payments because, in pre computer days, most bonds had coupons that investors would
clip off and present to the issuer of the bond to claim the interest payment. When the bond
matures, the issuer repays the debt by paying the bond’s par value (or its face value). The
coupon rate of the bond determines the interest payment: The annual payment equals the coupon
rate times the bond’s par value. The coupon rate, maturity date, and par value of the bond are
part of the bond indenture, which is the contract between the issuer and the bond holder.
b) The Stock Market/ Equities Market
Equities represent ownership shares in a corporation. Each share of common stock entitles its
owners to one vote on any matters of corporate governance put in to a vote at the corporation’s
annual meetings and to a share in the financial benefits of ownership.

Types of Stock/Equity
There are two most important forms of equity investments; these are the common stock /ordinary
shares (in America) and preferred stock/ preference shares (in British terminologies).
4.4 The Derivatives Market
Firms are exposed to several risks in the ordinary course of operations and when borrowing
funds. For some risks, management can obtain protection from an insurance company. For
example, management can insure a factory against destruction by fire by obtaining a fire
insurance policy from a property and casualty insurance company. There are capital market
products available to management to protect against certain risks that are not insurable by an
insurance company. Such risks include risks associated with a rise in the price of commodity
purchased as an input, a decline in a commodity price of a product the firm sells, a rise in the
cost of borrowing funds, and an adverse exchange rate movement. The instruments that can be
used to provide such protection are called derivative instruments. The term derivatives refers to
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a large number of financial instruments, the value of which is based on, or derived from, the
prices of securities, commodities, money or other external variables. These instruments include
futures contracts, forward contracts, option contracts, and swap agreements.

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