Part-II

Financial Assets, Financial Transaction And

Financial Intermediation
 The creation of financial assets
• Asset: - Any possession that has value in an
exchange.
• Anything of value that is owned or controlled
by a business/ individual.
• Asset can be
A.Physical Assets
B.Financial Assets/Instruments
 Cont...
A. Physical assets-assets have a physical characteristics
or location such as buildings, equipment, inventories etc.
 provide continuous stream of services
 subject to depreciation
 physical condition is relevant for the determination
of market value
B. Financial assets- liquid asset that gets its value from a
contractual claim
Cash, stocks, bonds, bank deposits and the like are
examples of financial assets.
do not necessarily have inherent physical worth
They are usually created by or related to the lending of
money (credit transactions)
 Characteristics of financial assets
A. do not provide a continuous stream of services
to the owners i.e. promise future returns to their
owners
B. serve as a store of value i.e. purchasing power
C. cannot be depreciated physically i.e. do not wear
out
D. physical condition of financial assets is irrelevant
in determining the market value or price
E. The cost of transporting and storing financial
assets is low
 Kinds of financial assets
• Financial assets can be classified in to two
categories:
A.cash instruments and
B.derivative instruments:
C. cash instruments: are instruments whose values are
determined by the markets. They include:
1. Treasury-Bills (T-Bills)
2. Commercial paper
3. Certificate of deposit
4. Repurchase agreement
5. Bankers Acceptance
 Cont….
1. Treasury-Bills (T-Bills)
• Treasury bills (or T-bills) mature in one year or less
• They are debt securities
• They do not pay interest prior to maturity
• they are sold at a discount of the par value to create a
positive yield to maturity
• the least risky investment available to investors
• Regular weekly T-Bills are commonly issued with maturity
dates of 28 days (or 4 weeks, about a month), 91 days (or
13 weeks, about 3 months), and 182 days (or 26 weeks,
about 6 months).
• Treasury Bills are sold by single price auctions held weekly.
• Banks and financial institutions, especially primary dealers,
are the largest purchasers of T-Bills.
 Cont….
2. Commercial paper
 market security issued by large banks and corporations
 is typically issued for the financing of payroll, accounts
payable, inventories, and meeting other short-term liabilities.
 not used to finance long-term investments but rather to
purchase inventory or to manage working capital
 the issuing amounts are often too high for individual
investors
 Generally regarded as a very safe investment.
 As a relatively low-risk investment, and returns are not large
 Cont...
3. Certificate of deposit
 is a time deposit, a financial product commonly
offered to consumers by banks, thrift institutions,
and credit unions.
 similar to savings accounts in that they are insured
and thus virtually risk-free; they are "money in the
bank”
 different from savings accounts in that the CD has a
specific, fixed term (often three months, six months,
or one to five years), and, usually, a fixed interest
rate
 Cont...
• It is intended that the CD be held until
maturity, at which time the money may be
withdrawn together with the accrued
interest.
• grant higher interest rates
• Fixed rates are common, but some
institutions offer CDs with various forms of
variable rates.
 cont...
• A few general rules of thumb for interest rates are:
1. A larger principal should receive a higher interest
rate, but may not.
2. A longer term may or may not receive a higher
interest rate, depending on the current yield curve.
3. Smaller institutions tend to offer higher interest
rates than larger ones.
4. Personal CD accounts generally receive higher
interest rates than business CD accounts.
 Cont...
• Key terms and conditions of a certificate of deposit
include:
• The CD may be "callable“: The terms may state that the
bank or credit union can close the CD before the term ends.
• Payment of interest : Interest may be paid out as it is
accrued or it may accumulate in the CD
• Interest calculation : The CD may start earning interest from
the date of deposit or from the start of the next month or
quarter.
• Right to delay withdrawals. Institutions generally have the
right to delay withdrawals for a specified period to stop a
bank run.
• Withdrawal of principal: May be at the discretion of
the financial institution.
 Cont….
• Withdrawal of principal below a certain minimum—or any
withdrawal of principal at all—may require closure of the
entire CD
• Withdrawal of interest. May be limited to the most recent
interest payment or allow for withdrawal of accumulated total
interest since the CD was opened
• Penalty for early withdrawal: May be measured in months of
interest, may be calculated to be equal to the institution's
current cost of replacing the money
• Fees. A fee may be specified for withdrawal or closure or for
providing a certified check
• Automatic renewal. The institution may or may not commit to
send a notice before automatic rollover at CD maturity.
– The institution may specify a grace period before automatically rolling over
the CD to a new CD at maturity.
 Cont…
4. Repurchase agreement
 Repurchase agreements (RPs or repos) are
financial instruments used in the money markets
and capital markets.
• A more accurate and descriptive term is Sale and
Repurchase Agreement, since what occurs is that the cash
receiver (borrower/seller) sells securities to the cash
provider (lender/buyer) now in return for cash, and agrees
to repurchase those securities from the buyer for a greater
sum of cash at some later date, that greater sum being all
of the cash lent and some extra cash (constituting interest,
known as the repo rate).
• A reverse repo is simply the same repurchase agreement
as described from the buyer's viewpoint, not the seller's.
 Cont....
5. Bankers Acceptance
 Banker's acceptance, or BA, is a time draft drawn on and
accepted by a bank
Before acceptance, the draft is not an obligation of the
bank; it is merely an order by the drawer to the bank to
pay a specified sum of money on a specified date to a
named person or to the bearer of the draft.
Upon acceptance, which occurs when an authorized bank
accepts and signs it, the draft becomes a primary and
unconditional liability of the bank.
A banker's acceptance is also a money market instrument –
a short-term discount instrument that usually arises in the
course of international trade.
 B. Derivative instruments
• Derivative instruments derive value from some other
instruments.
• They include instruments like options, bond futures,
warranties, swaps etc.
• An Option contract is a type of derivative instrument, which
gives holder the right to buy an asset but not the obligation to
purchase at a fixed price (strike price) for a specific timeframe
• A Bond Future is a contractual obligation for the contract
holder to buy or sell a Bond on a specified date at a
predetermined price.
• There is a financial instrument known as a warrant giving the
owner the right but not the obligation to buy or sell a security
• A financial swap is a derivative contract where one party
exchanges or "swaps" the cash flows or value of one asset
for another.
Financial assets can also be classified as debt securities
and equity securities.
1.Debt securities Debt securities are securities in which
the borrower agrees to pay periodic interest and principal.
• They may be issued by Corporations, Financial Institutions,
or Governments. Debt securities include securities like:
1. bonds
2. treasury bill
3. commercial paper
4. promissory notes
5. bankers' acceptances
6. life insurance policies
7. certificate of deposits
8. repurchase agreements (Repos
 Cont...
2. Equity securities Equity securities represent
ownership in a business firm.
• They are claims against the firm's profits and
proceeds from the sale of its assets upon
liquidation. They usually include
A.Common stock and
B.Preferred stock.
 Financial assets can be further classified as
negotiable and non-negotiable instruments.
1. Negotiable Instruments: Negotiable instruments are
securities that can be easily transferred from one holder to
another.
• Their claims are paid to the bearer of the instrument. They
may be classified in to payable to order, and payable to
bearer
• payable to order if it is transferred to another party by
endorsement at the back of the
• instrument.
• payable to bearer if it is transferred to another party by
delivery
• Negotiable instruments include instruments like bonds,
checks, stock, treasury bill, etc
 Cont...
2.Non-negotiable Instruments
• Non-negotiable instruments are securities that cannot legally
be transferred from one party to another party.
• They include instruments like:
1. saving accounts
2. bill of lading
3. Airway bill
4. crossed check ( a crossed check can only be deposited in a
bank-account and, unlike a bearer check,cannot be cashed
over a bank’s counter)
5. warehouse receipts
6. letter of credit, etc
 Types of financial transactions
• transfer of funds from savers to borrowers can be
accomplished in at least three different ways. These
are:-Direct finance, Semi-direct finance, and
Indirect finance.
1) Direct Finance Borrower and lender meet each other and
exchange funds in return for financial assets.
• It is the simplest method of carrying financial transactions.
• when you purchase stocks or bonds directly from the
company issuing them.
 Cont…
2) Semi direct Finance: financial institutions which facilitates
funds transfers from SSUs to DSUs without creating
securities on their own. They simply act
• As conduit pipe between the SSUs and DSUs.
• Financial Institutions which do not act as Financial
Intermediaries
• Broker
– An individual or institution that provides information
concerning possible purchases and sales of securities
– Either a buyer or a seller of securities may contact a
broker, whose job is simply to bring buyers and sellers
together.
 Cont...
• Dealer
– Also serves as a middle man between buyers and
sellers, but the dealer actually acquires the seller’s
securities in the hope of marketing them at a more
favorable price.
– Dealers take a position of risk because by purchasing
securities outright for their own portfolios, they are
subject to risk of loss if those securities decline in value.
 Cont...
3. Indirect Finance/Financial Intermediation
• The financial intermediaries obtain the funds from the SSUs
and offer their own securities (such as Deposit Certificates,
Insurance Contracts, and Pension Contracts, which are
commonly known as Secondary Securities) as financial
claims to the SSUs.
• They then provide the funds to the DSUs (in the form of
advances) and accept the securities issued by DSUs (such
as Stocks and Shares, Bonds and Debentures, Treasury
Bills, which are widely known as Primary Securities) as
financial claims on the DSUs.
Cont….
• Major groups of Financial Intermediaries are:
 Depository Institutions:
– Commercial banks
– Non-bank thrifts:
• S and L associations
• Savings banks
• Credit unions
• Money market fund
Cont...
 Contractual institutions:
– Life insurance Company's
– Property – causality insurers
– Pension funds
 Investment Institutions:
Investment Company's (mutual funds)
Real-estate investment trusts.
 Other Financial Intermediaries:
– Financial companies
– Government credit units
End of part-II
 Part-III
FINANCIAL INSTITUTIONS IN THE
FINANCIAL SYSTEM
 Classification of Financial Institutions
• Financial institutions may be grouped in a
variety of ways.
• One of the most important distinctions is
between
1.depository institutions and
2. non-depository institutions.
 1. Depository Institutions
• Include commercial banks and non-bank
thrift institutions (like savings & loan
associations, savings banks, credit unions,
and money market mutual funds).
• It derive the bulk of their loan able funds
from deposit accounts sold to the public.
 Cont…
Characteristics of Depository Institution:
• Deposit taking institutions that accept and
manage deposits and make loans.
• Those deposits represent the liabilities (debts) of
the deposit accepting institutions
• With the funds rose through deposits and other
funding sources, depository institutions makes
direct loans to various entities and invest in
securities.
• their income is derived from interest on loans, interest and
dividend on securities, and fees income
• They are highly regulated institutions
 A. Commercial Banks and Money Creation

Commercial Banks: General

• This institution offers the public both deposit and
credit services
• Fewer & more innovative services provided also
include
• Investment advice & execution
• Tax and travel planning
• The name commercial implies that the banks devote a
substantial portion of their resources to meeting the
financial needs of business firms.
• In recent years, the services are expanded to consumers
and units of government
 Importance of Commercial Banks
• They are principal means of making payments
• Are able to create money from excess reserves made
available from the public’s deposits
• Receive (deposit) excess cash of savers and provide
loans and make investments
• Most important source of consumer credit
• One of the major sources of loans to small and medium
sized businesses
• Principal purchasers of debt securities issued by state,
local, and federal government
• Major buyers of government treasury bills
• Play a dominant role in the money and capital markets
 Portfolio Characteristics
• The assets of Commercial Banks generally
comprise
1. primary reserves,
2. secondary reserves,
3. security holdings, and
4. various kinds of loans; while deposits, non-
deposit sources (borrowings), and
5. equity comprise the financial claims of
Commercial Banks.
 1. Primary Reserves
• All commercial banks hold a substantial part of
their assets in primary reserves, consisting of
cash and deposits due from other banks.
• Deposits held with other banks are also
considered primary reserves.
– Such deposits are a means of “paying” for
correspondent banking service
– Primary reserves also include reserves held behind
deposits as required by Federal Reserve System
(“National Bank”, in case of Ethiopia).
 Cont…
• These reserves are the bank’s first line of
defense against:
– Withdrawal by depositors
– Customer demand for loans
– Immediate cash needs to cover expenses
 II. Security Holdings and Secondary Reserves
• These reserves are often held in the form of
assets that can be quickly and easily converted to
cash and are used to meet unanticipated
obligations.
• Hold securities acquired in the open market as a
long-term investment and as a secondary reserve
to help meet short run cash needs.
• Bonds and notes issued by state, city, and local
governments are largest portion of their security
investments.
 Cont…
• Such securities provide tax-exempt interest income
• Banks favor treasury bills & short term treasury notes
and bonds.
– Such securities are readily marketable
– Such securities are freed from default risk
• Commercial banks also hold small amounts of corporate
bonds and notes, though they generally prefer to make
direct loans to business as opposed to purchasing their
securities in the open market.
• Commercial banks are forbidden to purchase corporate
stock
• However, banks do hold small amounts of corporate
stock as collateral for loans.
 III. Loans
• The principal business of commercial
banks is to make loans to qualified
borrowers.
• Loans are among the highest yielding assets a
bank can hold in its portfolio
• Provide the largest portion of their operating
revenue
• Make loans of reserves to other banks through the
federal funds market and to securities dealers
through repurchase agreements.
 Cont…
• Direct loans to business & individual constitute
the largest portion of bank loans
– Arise from negotiation
– Result in written agreement for adequate security &
income
• Historically, commercial banks have preferred to make
short term loans to business, principally to
– support purchases of inventory.
– Recently, commercial banks extended to provide term loans to
finance purchase of buildings, machinery, etc.
– The long term loans carry greater risk
• Bank holding companies are those invested in or
acquired shares of banks.
 IV. Deposits
• The bulk of commercial bank funds come from
deposits.
• Types of deposits:
1. Demand Deposits
– Demand deposits are checking accounts
– They are also called transaction accounts
– Significant portion of bank funds are generated
through demand deposits
– Demand deposits are principal means of making
payments
– Demand deposits are safer than cash & widely
accepted
 Cont…
B. Savings Deposits
– Small in birr amount
– Bear relatively low-interest rate
– Withdrawn with little or no notice
C. Time Deposits
– Carry a fixed maturity
– Offer the highest interest rates a bank can
pay
– Can be divided into:
 Cont…
A) Non-negotiable CDs
– Are contracts negotiated between two parties
and hence, the liability
– cannot be transferred to a third party
– Usually are small in amount
– Consumer type accounts
B) Negotiable CDs
– May be traded in the open market
– Purchased mainly by corporations
 V. Non-Deposit sources of Funds
• Borrowed funds to meet bank cash needs
(when competition for deposits increased)
– Purchases of reserves (federal funds from
other banks)
– Security repurchase agreement (where
securities are sold temporarily by a bank and
then bought back later)
– Capital notes counted under regulations as
equity capital
 VI. Equity Capital
• Net worth supplied by a banks shareholders
– The most important functions of equity capital is
to keep a bank open even in the face of
operating losses until management can correct
its problems
 VII. Revenues and Expenses
• Revenues
– Interest and fees on loans
– Interest and dividends on securities held (for instance,
interests on bonds held and dividends on stocks held
as a collateral)
– Earnings from trust (fiduciary) activities
– Service charges on checking accounts
• Expenses
– Interest on deposits
– Salaries and wages
– Interest cost on non-deposit sources of funds
 Reserve requirement and excess reserve
• A banks legal reserve may be divided in to
two:
1.Required Reserves – are equal to the
legal reserve requirement ratio times the
volume of deposits subject to reserve
requirements; and
2.Excess Reserves – are equal to the
difference between the total legal reserves
actually held by a bank and the amount of
its required reserves.
 Cont…
• Example 1
• Assume that a given commercial bank holds birr
20,000,000 in transaction accounts and birr
30,000,000 in non-personal time deposits. If the
law requires commercial banks to hold 3% of both
deposits in legal reserves, how much would be
the level of the required reserve on the above
deposits. In this case, the required reserve for this
bank is determined as follows:
• Required Reserve = 0.03 x 50,000,000= 1,500,000
 B. Non-Bank Thrift Institutions
• The non-bank thrift institutions are depository
institutions that accept deposits from the public
as commercial banks do.
• The rapid growth of selected non-bank financial
intermediaries in recent years.
• The increasing penetration of traditional financial
service markets by non-bank institutions
• Governments started to authorize savings and
loan associations to provide services provided
by commercial banks
 Types of Non-Bank Thrift Institutions
• The well-known non-bank thrift institutions
are four. This are:
1.Credit Unions
2.Savings & Loan Associations (S & Ls),
3.Savings Banks,
4.Money Market Mutual Funds
 A. Credit Unions
• Credit unions
– Are institutions, exclusively household oriented
intermediaries
– Offer deposit plans & credit resources only to individual
& families.
– provide low loan rates and high deposit interest rates
to individual and families compared to other institutions
– They are really cooperatives, self-help associations of
individuals, rather than profit motivated financial
institutions.
 Cont…
• Areas of Organization
– Occupation related credit unions
– Around a non-profit association (Labor union,
church, fraternal, or social organization)
– Common areas of residence – such as
Kebele, towns, etc.
 B. Savings and Loan Associations
• They are major sources of mortgage loans
to finance purchase of homes by
households
• The first S & Ls were started early in the
19th C as building and loan associations.
• Currently, S & Ls receive their charters
from the states (regions) or from the
federal government.
 Cont…
• F. S & Ls – Ethiopian Perspective
• The initial objective of S & Ls in Ethiopia is to reach the
poor
• The poor can’t get loan from banks due to collateral
requirement.
– Bank require investment proposal & see business
standing of borrowers
• Thus, S & Ls in Ethiopia are ultimately aimed at
providing loans in small denominations to the low income
groups in the society.
• The risk of default is much higher on the loans provided.
– Due to such risks, their smaller size, and high operating costs,
the S & Ls in Ethiopia are providing the highest costing loans
reaching about 18 % to the users of such funds.
 C. Savings Banks
• Initially started to meet the financial needs of
small savers.
• Plays active role in the residential mortgage
market as do S &Ls but are more diversified in
their investments.
– Purchase corporate bonds and common stock
– Make consumer loans
– Invest in commercial mortgage
– Designated their financial services to appeal to
individual and families. The saving banks
investment is limited (as required by law)
 Cont…
• Technically saving banks are owned by their
depositors.
• The principal sources of funds for saving banks
are deposits.
• All net earnings available after funds are set
aside to provide adequate reserves must be
paid to the depositors as owner’s dividends.
• Regulations exercised primarily by the states are
designed to ensure maximum safety of deposits.
 D. Money Market Mutual Funds
• A money market fund is a kind of mutual
fund that invests in highly liquid, near-
term instruments
• Money market funds are intended to offer
investors high liquidity with a very low level
of risk.
• Money market funds are also called
money market mutual funds.
 2. Non-Depository Institutions
• These Non-depository institutions are
financial institutions that do not mobilize
deposits: These include (among others):
1.Insurance companies
2.Pension funds
3.Mutual funds
4.Investment Banking
1. Insurance companies
• The primary function of insurance companies is
to compensate individuals and corporations
(policyholders)
• Insurance companies provide (sell and service)
insurance policies, which are legally binding
contracts.
• Insurance companies promise to pay specified
sum contingent on the occurrence of future
events, such as death or an automobile accident
• Insurance companies are risk bearer.
 Cont…
• Insurance industry is classified in to
1. Life insurance and
2. General or Property-causality insurance.
1.Life insurance
 deals with death, illness disablement and
retirement policies
 The primary income source of life insurance
companies is premium receipts from sale of
various kinds of insurance policies.
 Cont…
• Three basic factors influence premium
determinations in life insurance.
a) Expected mortality rate
b) Investment income earned by insurers on
premium income
c) Expenses to be incurred in running the
business.
 Cont…
2. General (property-casualty) insurance
• deals with theft, property, house, car and general
accident insurance.
• P&C insurance companies provide broad range of
insurance protections against;
A. Losses, damages or destruction of property
B. Losses or impairment of income –producing capacity
C. Claims for damages by third party because of negligence
D. Loss resulting from injury, or death due to occupational
accidents.
 Cont…
• P&C insurance is normally divided into
two: personal line and commercial line
Insurance Companies.
– Personal line includes automobile insurance
and home owner insurance and
– commercial line insurance includes product
liability insurance commercial property
insurance.
 Source of funds for P&C insurance companies

• P&C Company generates revenues from

two sources:
1.Initially underwriting income ( insurance
premium)
2. Investment income that occur over time.
 2. Pension Fund
• Pension plan is a fund that established for the
payment of retirement benefits.
• The entities that establish pension plans are called
plan sponsors.
• Pension plan sponsors can be private businesses
acting for their employees or public organizations
• Pension funds are financed by contributions by
employers and employees.
• Pension plan assets are legally illiquid, It cannot
be used before retirement even as collateral.
 Cont…
• The pension fund company comprises two
distinct sectors.
1. Private pension funds:-are those funds
administered by private corporations (insurance
companies, mutual funds etc).
2. Public pension funds:-are those funds
administered by federal, state, or local
government (social security).
 3. Mutual Funds
• A mutual fund (in US) or unit trust (in UK and
India) raise funds from the pubic and invests the
funds in a variety financial asset, mostly equity
both domestic and overseas and in liquid money
and capital market.
• Mutual funds are investment companies that
pool money from investors at large and offer to
sell and buy back its shares on a continuous
basis and use the capital thus raised to invest in
securities of different companies
 Cont…
• The stocks these mutual funds are very fluid
• Mutual funds posses shares of several
companies and receive dividends in lieu of them
and the earnings are distributed among the
share holders
• Mutual funds sell shares (units) to investors and
redeem outstanding shares on demand at their
fair market value
• Mutual funds are also able to enjoy economies
of scale by incurring lower transaction costs and
commission.
 Cont…
• Advantage of Mutual Funds
1.Mobilizing small saving
2.Professional management
3.Diversified investment/ reduced risks
4.Better liquidity
5.Investment protection
6.Low transaction cost (economy of scale)
7.Economic Development
 Cont…
• Return to Investors in the Mutual Fund
 Investors in the mutual fund have the potential to
gain:
 They are entitled to a share in the capital
appreciation of the underlying values of existing
assets, adds to the value of MF assets.
 They have a claim on the income generated by
the underlying assets of the fund i.e. dividend
 Capital gain when MF sells an asset at a price
higher than the purchase price of the asset.
 4. Investment Banking
• Investment banking involves the raising of debt
and equity securities for corporations or
governments.
• Investment banking also includes corporate
finance activities such as advertising on mergers
and acquisitions (Ms &As) as well as advertising
on the restructuring of existing corporations.
• Investment banking firms generate revenue from
commissions, fee income, and spread income
from principal activities.
 Cont…
• The principal activities that generate
revenues include the following:
1. Public offering (underwriting) of securities.
2. Private placement of securities
3. Securitization
4. Trading of securities
5. Mergers & acquisitions
6. Trading &creation of risk control instruments
7. Money management.
 Cont…
• Underwriting of securities: the underwriting
process involves three functions.
1. Advising the issuer on the terms and timing
of the offering.
2. Buying the securities from the issuer
3. Distributing new issues of debt & equity
securities.
• Investment banking advices the investment bankers to
design security structures:
• More palatable
• Low cost of borrowing for their clients
• More attractive to investors
 Cont…
• When the investment banking agrees to buy
the securities from the issuer at a set price,
the underwriting arrangement is referred to
as a firm commitment.
• The fee earned from underwriting a security
is the difference between the price paid to
the issuer and the price at which the
investment banker offers the security to the
public. This difference is called gross spread
or the underwriter discount.
 Nature of Liabilities of Financial Institutions
• Based on the amount and timing of cash
outlays, any financial institutions’ liability
can be classified under the following
groups.
1. Type –I Liabilities: both the amount and
timing of liabilities are known with
certainty.
• Banks and thrifts have type –I liabilities
 Cont…
2. Type-II liabilities: The amount of cash outlay is
known but the timing of cash outlay is uncertain.

 The most obvious example of type- II liability is life

insurance policy which agrees to make a specific
dollar amount to policy beneficiaries up on the
death of the insured.
3. Type-III liability: the timing of cash outlay is
known but the amount of cash outlay is uncertain
 Example, Floating rate guaranteed investment contract
(GIC) falls into the type-III liability category.
 Cont…
4. Type-IV liabilities: there are numerous
insurance products and pension obligation
where there is uncertainty to both the
amount and timing of the cash outlays.
• Most of the property-casualty insurance
companies have such type of liabilities.
End of part-III