PPT For CH 1 2 3

Financial Institutions and Markets
Main objective of the course:

To make students understand the
essence of financial markets,
Financial Assets, and institutions and
able to identify their services .
To explain the nature and services
of financial markets, Financial
assets, and institutions in Ethiopia
Course contents
Chapter 1: the Financial system

Chapter 2: The Financial Institutions
Chapter 3: Interest Rates
Chapter 4: Regulation of the Financial system
Chapter 5: Financial Markets and Institutions in
Ethiopia (assignment for term paper and presentation)
Minimum contents of the assignment
The financial system in Ethiopia (players, types of

service, and regulation)
 What are the existing financial markets and future
prospect? (the primary, the secondary, money market,
capital market etc.)
What are the existing financial institutions and future
prospect? (banks, MFIs, S & C associations, Financial
brokers, Financial dealers etc. )
Conclusion
Recommendation
Submission one week before the class end
Chapter One
Financial System
What is Financial System?
A collection of:
 Financial assets
 Institutions
 Individuals
 Financial markets
 The complex laws &regulation and
 Interaction among the above
 Is a system of controlling money circulation in the
economy (instrument of monetary policy-economy)
Channels money from excess(savers) to
deficit(borrowers).
?Determines both the cost of financing and the amount
of fund-economy)
Provide either debt or equity?
Goals of financial system
Facilitate the flow of funds: in direct
financing(with out intermediaries like issuing
securities to market or borrowing from a friend)
and also the common indirect financing (through
intermediaries).
 Helps Risk diversification or sharing of risks e.g
insurance companies, LCs, using credit
enhancement techniques.
?Helps to generate liquidity: both market
liquidity(ease transfer) and funding
liquidity( getting funds as needed).
 Liquid assets are: standardized, value known by all,
have many buyers/sellers. Risk and liquidity are
related so are co-managed.
Functions/Roles of FS in an Economy
Saving role: you can save at bank.
Liquidity role: Banks and Money markets give you
immediate liquidity.
Wealth role: You can invest on shares, bonds, bank
fixed/time deposit (storage device)
Credit role: you can borrow from bank, through LC,
through bond issuance.
Risk shield/diversification: you can get insurance
against property, the financial markets help you
diversify your investments
Policy role: your banks, insurance companies, bank of
banks can be used as policy instruments.
Payment Role: Fs Provides you means of payment
(credit cards, checks, mobile systems, internet
banking)
Financial System mainly has:
Financial assets.
Financial Institutions/Intermediaries.
Financial market.
What are Financial assets?
Differ from real assets(tangible and some are intangible).
Are intangible assets.
Are legal contracts providing the holder right to claim on real asset
and property of issuer.
Characteristics of FAs:
 Serve as the store of value. (A store of value is an asset, currency, or
commodity that maintains its value over a long period. An item would be considered a store
of value if its value is either stable or increases over time but doesn't depreciate.)
 Don't physically deteriorate/depreciate

 Market value is not related to their physical nature.
 Cost of storing/transporting is low
 They are promises for future return than continuous
service
Financial System Could be:
1. Financial contracts Vs Securities
 Financial contracts/not-securitized/
 Bank deposits and borrowings
 Insurance policies
 Securities:
 are securitized
 Are usually negotiable.
a.Equity vs debt securities
 Equity( C/S (Conditional Sale agreement) Select a term and make regular monthly repayments to repay the balance, it's that simple. As
your interest rate is fixed, you have a guaranteed monthly payment, allowing you to budget with confidence. Once all the monthly repayments have been
made, you will own the car., P/S (price-to-sales) ratio shows how much investors are willing to pay per dollar of sales for a stock. The P/S ratio is
calculated by dividing the stock price by the underlying company's sales per share. , private equity investment which
include venture capital firm- mostly investment on start ups on seed

money and usually hold non-majority, private equity firm/fund-
investments by financial sponsors on mature companies by holding
majority share to restructure and sell it, leveraged buyout- where the
investment by private equity firm involves borrowing)
 Debt[bond, CPs (Cash per share) measures how much cash a company has on hand on a per-share basis. , CDs (credit
default swap) is a contract between two parties in which one party purchases protection from another party against losses from the default of
., repos (repurchase agreement) , Bas (business activity statement) (is a
a borrower for a defined period of time
letter of credit Accepted by bank so negotiable; is like post dated check),

TBs (twin banking sheet problem) ,]
Debt versus equity
Debt Equity
Characteristic
Borrower-lender relation,
fixed maturities Ownership, no time limit
Advantages:
 for the firm

Predictability, independence
from shareholders’ influence Flexibility, low cost of
finance, reputation
 for the investor
Low risk High expected

return
Disadvantages:
 for the firm

Debt servicing obligation Shareholder dependence,
short-
sightedness, volatility
influencing management
decisions
  for the investor
Low returns High risk
Securities…
b. Long-term vs short term securities
 ST securities/Money market instruments( CDs, CPs, Repos, BAs, T-bills,
Eurodollar deposits) . Most of the instruments are used for inter-bank
lending. Money mkt securities are liquid, less risky, and low return
 LT Securities/capital market Instruments( long term Bonds, stocks etc).
Bonds Include:
 Government /Treasury notes( < 10 years) and Bonds(10-20 yrs)
 Municipal bond: issued by local governments
 Eurodollar bonds Vs Foreign/bulldog/ bond
 Mortgage bond – backed by securityvmmnjmb
 Also bonds with several features
 Bearer vs registered bonds
 Perpetual(consols) vs fixed maturity bonds
 Floating rate bonds ( linked to LIBOR or US T-bill rate Vs Index-linked
bonds( coupons and principal grow with inflation)
 Zero coupon Vs Coupon bonds
 Convertible Vs non-convertible
 Callable vs puttable
 Serial(series of maturities) vs term bond
 Subordinated bond: inferior
 Debenture: unsecured bond
Securities…
Money market instruments
Certificate of deposit – Time deposit, commonly offered to consumers by banks, thrift institutions, and
credit unions.
Repurchase agreements – Short-term loans—normally for less than one week and frequently for one
day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed
price on a fixed date.
Commercial paper – Short term instruments promissory notes issued by company at discount to face
value and redeemed at face value. May range to 6 months
Eurodollar deposit – Deposits made in U.S. dollars at a bank or bank branch located outside the United
States.
Federal agency short-term securities – In the U.S., short-term securities issued by
government sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and
the Federal National Mortgage Association. Money markets is heavily used function.
Federal funds – In the U.S., interest-bearing deposits held by banks and other depository institutions at
the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on
an overnight basis. They are lent for the federal funds rate.
Municipal notes – In the U.S., short-term notes issued by municipalities in anticipation of tax receipts
or other revenues
Treasury bills – Short-term debt obligations of a national government that are issued to mature in three
to twelve months
Money funds – Pooled short-maturity, high-quality investments that buy money market securities on
behalf of retail or institutional investors. Shares of such funds are regarded money mkt instruments.
Foreign exchange swaps – Exchanging a set of currencies in spot date and the reversal of the exchange
of currencies at a predetermined time in the future
Short-lived mortgage- and asset-backed securities
The core of the money market consists of interbank lending—banks borrowing and lending to each
other using commercial paper, repurchase agreements and similar instruments. These instruments are
often benchmarked to (i.e., priced by reference to) the London Interbank Offered Rate (LIBOR) for the
II. Cash instruments Vs Derivative instruments
Cash Instruments:
 Value determined by the market directly
 Settled in few days of the transaction( may be 3 days)
 Are spot transaction instruments
 Include:
 Money(anything accepted in payment for g/s─ coins,
currency, check, debit/credit cards). What is money & cash?
What are forms (commodity money, metallic money, paper
money); types of money (commodity money, representative
money, credit money, Fiat money); what are functions of
money [medium of exchange, unit of account (divisible,
fungible,specific weight/size) store of value, standard of
deferred payment]
Stocks
Bonds
TBs, CPs, PNs(promissory Notes), BAs, Life insurance
policies, CDs, repos/RPs
Derivative/forward Instruments
Transactions settled on a predetermined day.
Value of the instrument is derived from the underlying asset:
The underlying asset could be commodity ( commodity derivatives) or security, interest rate,
stock market index, forex etc. (Financial Derivatives)
Underlying assets usually not delivered.
Traded in derivatives market but the underlying assets are traded in the cash market.
Derivatives are mostly secondary market instruments and have little usefulness in mobilizing
fresh capital by the corporate world, however, warrants and convertibles are exception in this
respect.
 Options ( usually short term) Specifically, options are contracts that grant the right, but not the obligation to
buy or sell an underlying asset at a set price on or before a certain date
 Call options (right to issuer to call the security before maturity)
 Put options ( right to the holder to redeem the sec. bfr maturity)
 Conversion options ( right to convert the security to a diff. secu.)
 Forward contracts( futures, forwards ,Swaps)
 Swaptions: options to buy or sell a swap that will become operative at the expiry of the
options. Thus a swaption is an option on a forward swap. Rather than have calls and
puts, the swaptions market has receiver swaptions and payer swaptions. A receiver
swaption is an option to receive fixed and pay floating. A payer swaption is an option to
pay fixed and receive floating.
 Warrants: while options are short term and issued by exchanges, warrants are long-term
options to buy shares at a stated price & are usually traded on primary OTC mkts by
issuer company itself.
 Contracts for difference(CFDs): CFD trading enables you to speculate on the rising or
falling prices of fast-moving global financial markets (or instruments) such as shares,
indices, commodities, currencies and treasuries.
Derivatives…
Forward contract - a Customized contract to buy (sell) an
asset at a specified date and a specified price (forward price).
No payment takes place until maturity.
Futures contracts - a standardized contract to buy (sell)
an asset at a specified date and a specified price (futures
price). The contract is traded on an organized exchange, and
the potential gain/ loss is realized each day (marking to
market). Futures contracts are forward contracts traded on
organized exchanges. So are more liquid.
Both take place on
 Currencies;
 Commodities;
 Interest rate futures;
 Short-term deposits;
 Bonds;
 Stock futures;
 Stock index futures;
Derivatives…
A swap is an agreement whereby two parties (called

counterparties) agree to exchange periodic payments. The cash
amount of the payments exchanged is based on some predetermined
principal amount, which is called the notional principal amount or
simply notional amount. The cash amount each counterparty pays to
the other is the agreed-upon periodic rate times the notional amount.
The only cash that is exchanged between the parties are the agreed-
upon payments, not the notional amount.
For example, an interest-rate swap is a derivative in which one party
exchanges a stream of interest payments for another party’s stream of
cash flows(Like For example, one of the counterparties can pay a fixed
interest rate and the other party a floating interest rate. The floating interest
rate is commonly referred to as the reference rate.)
 interest rate swaps,
 currency swaps,
 commodity swaps, and
 Credit default swaps
Derivatives…
Example: SWAPS
Company XYZ issues a $10 million in 15-years corporate
bonds with a variable interest rate of LIBOR + 150 basis
points. LIBOR is currently 3%, so company XYZ pays
bondholders 4.5%.
After selling the bonds, an analyst at XYZ decides there is a
reason to believe LIBOR will increase in the near term.
Company XYZ doesn't want to be exposed to an in increase in
LIBOR, so it enters in to a swap agreement with investor ABC.
Company XYZ agrees to pay investor ABC 4.58% on $10
million each year for 15 years. Investor ABC agrees to pay
company XYZ LIBOR + 1.5% on $10 million per year for 15
years.
Note:
Investor ABC thinks that Interest rates are going to go down so
he is willing to accept fixed interest from XYZ. So investor is
expecting a gain from his fixed interest cost (i.e. Arbitrage)
III. Negotiable Vs Non-negotiable Instruments
Negotiable:
 easily transferrable from one person to the other.
 Could be payable to order(could be endorsed) or payable to
bearer(payable to holder)
Non-negotiable:
 Cannot legally transferred
 Include( saving accounts, Bill of lading (B/L)─ from carrier to
shipper as proof of receipt of cargo for shipment, Crossed check,
LCs if not BA, Warehouse receipts ─ proof of property at store
(but mostly negotiable).
Note:
• However, some times transferability and negotiability are used differently. Unlike
transferable documents, negotiable instruments can give to the transferee rights
that are better or greater than the right of the transferor, provided that
consideration is paid for the transfer. But transferable documents are just passing
the rights of the original holder to the transferee but no more.
• B/L and Warehouse receipts are some times used as collateral for borrowing and
also in some countries are negotiable.
Financial institutions/Intermediaries?
Financial Institutions: link fund seekers and fund providers.
 Depository Institutions(DIs)
 Commercial Banks (CBs): offer deposit, unsecured loans and also secured loans,
and different IT-based services
 Saving & Loan Associations (S &Ls): also called thrift banks: offer previously
saving but later moved to checking and mortgage loan, emphasize on residential
mortgage, more local oriented, less unsecured loans like credit cards, competitive
interest on saving)
 Credit Unions (Cus): (non profit only to meet members loan need, more interest
and lesser fee)
 Contractual saving Institutions
 Insurance companies ( P/C and Life insurances)
 Pension funds ( defined benefit plan and defined cont. plan)
 Investment Intermediaries
 Mutual funds and Money Market Mutual funds? (sell shares and buy diversified
portfolios)
 Investment banks( assist in selling of new issues)
 Security firms (assist in trading of existing securities can be brokers or
dealers/market makers)
 Investment banks and Security firms are rather called Financial facilitators
than financial intermediaries.
 Finance companies( sell CPs and issue stocks and bonds and lend the money to
fur, auto etc buyers). Unlike CBs they do not take deposit.
Financial institutions/Intermediaries…
What are functions of Financial Intermediaries?
Asset transformation Theory
Transaction Cost Reduction Theory
Liquidity Insurance Theory
Delegated Monitoring Theory( to avoid or
reduce Adverse Selection and Moral Hazard
that results from asymmetric information in
Financial market).
 Asset Transformation Theory
 Maturity transformation: e.g borrow short
and lending long
 Size transformation: e.g small lenders to
large borrowers
 Liquidity transformation: e.g
deposits(superior liquidity) to acquiring
bond.
 Risk transformation: accept the [riskless]
deposits to change it in to risky loans. Form
and sell assets of comfortable risk to buyers
and use the money to buy high risk assets.
 To manage risk banks do:
 Proper screening of applicants, diversifying risk by
business area, pooling of risks
 Transaction cost reduction Theory
 Because are specialists they complete
financial transactions in limited transaction
costs( search and information costs,
contracting and monitoring costs, and costs
of incentive problems)
 Use economies of scale( standard loan
contract for a wide range of loans) and
economies of scope(producing more than
one product jointly- e.g mobilize deposit
provides source of lending and satisfy
request of payment instruments)
 Liquidity Insurance theory
 Are ‘pools of liquidity’ providing households
insurance against idiosyncratic shocks affecting
consumption needs.
 Are consumption smoothers
 Delegated Monitoring Theory( to avoid or reduce
Adverse Selection and Moral Hazard that results from
asymmetric information in Financial market). Moral
hazard in large corporations may result from agency
problem.
what is Adverse selection? What is moral hazard?
Adverse selection is the problem created by asymmetric
information before the transaction occurs.
Moral hazard is the problem created by asymmetric
information after the transaction occurs.
Financial Markets?
Financial markets are markets where the fund seekers and
fund providers interact.
May not be physical markets.
They have functions to do: pricing, liquidity provision,
information dissemination, money circulation etc.
Are different in type:
 Based on Nature of securities traded: Primary(IPO and
SEO/SPO) Vs Secondary( sell indirect securities; affect liquidity,
tradability, rate of Primary securities/market); cash/spot mkts Vs
derivative mkts(mainly sold in OTC); debt mkts( the market has
large nominal value than equity mkts) vs equity mkts.
 Based on Organization: Organized exchange markets working
with a specialist[equity or debt) Vs OTC( is less transparent,
trades securities not in organized exchange, it can be Organized-
(dealers/market makers as main actors like NASDAQ*) or
Unorganized]
 Based on who participates: Interbank market vs the
Fx/Forex/currency mkt( largest and most liquid, OTC mkt)
Financial Markets?...
Are different in type…
 Based on Maturity of Security: Capital market(debt or
equity) Vs Money Market (Short term and liquid)
 Forms of trade intermediation: Quote-driven dealer
markets( are led by dealers/market makers/a specialist; are
non-auction exchange markets) Vs Order-driven markets
(are Auction exchange markets) Vs Brokered
markets( buyers and sellers meet through brokers).
Actually Exchange markets are hybrid of the three.
 Third mkt vs Fourth market: Are trades on OTC but using
exchange-listed stocks; Third market is b/n non-
exchange(auction) member dealer/brokers and inst. Investors
but Fourth is b/n institutional Investors themselves i.e in an
Unorganized private computer networked OTC markets. Unlike
3rd , 4th markets may not deal with publicly offered securities.
 Based on Country of Origin: Internal/National
markets( Domestic and Foreign) Vs
External/international/offshore Markets.
30
Financial Markets ...
Quote-driven market – a market in which
dealers (market makers) adjust their quotes
continuously to reflect supply and demand. It
is a dealer market. Also called price-driven
market.
Order - driven market – a market
without active market makers, in which buy
and sell orders directly confront each other.
An auction market.
Brokered markets( buyers and sellers meet
through brokers: brokers receive orders and
send to clearing process to match sellers)
Financial market classification
From the perspective of country origin, its financial market can be
broken down into an internal market and an external market. 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(e.g Ethn market
which sells only Ethn. companies’ shares). The foreign market is
where securities are sold and traded outside the country of issuers
(e.g Ethn market which sells only other country companies’ shares).
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 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). ( e.g if a south African market sells
Coca Cola shares issued from both USA and South Africa and
available to all investors world wide simultaneously at issuance)
32
Criterion Features Examples
Products
Tradability, transferability,
ownership, maturity, denomination, substance
Equity, debt instruments,

derivatives
Services Technical, advisory,

information and knowledge-based,
administrative.
IT support, research
and analysis, custody
Ways of trading
Physical, electronic, virtual
Over the counter,
exchange,
internet
33
Participants
Professionals,
nonprofessionals,
Institutions, officials
Banks, central banks,
non-bank financial companies,
institutional investors,
business firms, households
Origin
Domestic, cross-border,
regional, international
National markets,
regionally integrated mkts,
Euromarkets,
domestic/foreign currency mkts,
34 onshore/offshore markets
Chapter Two
MORE on FIs
2.1 Depository Institutions
 include commercial banks, savings and loan

associations, and credit unions
 income derived from interest on loans, interest
and dividend on securities, and fees income
 are highly regulated because
(1) they mobilize a significant amount
of household and business deposits
(2) they are used as vehicles for executing
monetary policy
36 Financial markets and Institutions

Asset/Liability Problem of DIs

DIs are exposed to
 Credit risk- default by borrower or by issuer
of security
 Regulatory risk-adverse impact of regulations
on earnings
 Funding (interest rate) risk-caused by interest
rate changes when DIs borrow long(short)
and lend short(long)

Liquidity concerns
 arises due to short-term maturity nature of
deposits
 DIs should always be ready to satisfy
withdrawals and meet loan demand
 Sources of funds include
 attract additional deposit
 borrow using securities as a collateral
 sell securities it owns
 raise short-term funds in the money market
(e. CPs, BAs)
COMMERCIAL BANKS
 Services include
 Individual banking( households Saving)
 Institutional banking(checking/demand
deposit)
 Global banking( Involving foreign
exchange import/export, money
transfer/remittence)

Sources of funds
 Deposits-non-transactional
deposits(savings and time) and
transactional deposits (demand/checking
deposits).
 Reserve requirement-portion of deposit kept
as a caution against possible bank illiquidity
 Non-deposit borrowings
 Common stock and Retained earnings

Regulation
 is by the central bank (bank of banks)
 areas of regulation include,
1. Liquidity requirment
2. Ceilings on deposit interest. How you see this in Ethiopia?
3. Permissible activities and assets for CBs- For
instance the Glass-Steagall Act of 1933, which is inacted
following the great depression, separeted commercial
banking from securities industry ( as this is believed to be
the cause for the 1929 stock market crash) and prohibited
merging of different financial industries. Good part of the act
is the fact that it also established FDIC. This act is repealed
and relaxed by the Grahm Blealy act of1999 which
deregulated the finacial sector to the extent of making banks
to be owned by holding companies.
4. Capital requirements:
 aimed at preventing insolvency
 banks normally have high debt to equity ratio
 Risk-based capital requirements(Basel I);
 Basel I has two components(note that there are three Basel
accords and threshholds and capital components of each tier are
improved accordingly. For example Basel III has 10.5% Tier I
capital ratio, 2% Tier II capital ratio, and 12.5% Total capital
ratio):
(1) Classifying bank capital into Tier 1 and
Tier 2 capital
(2) Establishing credit risk wieght for bank
assets
Classes of capital
(a) Tier 1 (core) capital includes Common
Stockholders‘ equity, certain types of
preferred stock, minority interest in
consolidated subsidiaries
(b) Tier 2 (supplementary) capital includes
loan-loss reserves, perpetual debt, certain
types of preferred stock, revaluation
surplus,and subordinated debt

How about in Ethiopia?
Capital adequecy requirment:

Ethn govmt has a 10% capital adequecy ratio on its risk-
weighted assets. NBE defines capital as paid up capital,
retained earnings, donated capital, legal reserves, and
permanent free reserves (General reserve).
Any bank in Ethiopia shall keep 5% (25% by proc. Of 1995)
of its annual net profit as legal reserve.
Also as liquidity requirement:

Any bank operating in Ethiopia shall at all times maintain in
its Reserve Account 15% (fifteen percent) of all Birr and
foreign currency deposit liabilities held in the form of
demand (current) deposits, saving deposits and time deposits.
(2) Credit weights of assets
Risk Examples of Assets included
Weights
0% - Treasury securities
- Mortgage backed securities issued by government
mortgage institutions
20% - Municipal general obligation bonds

- Mortgage backed securities issued by government
sponsored mortgage institutions
50% - Municipal revenue bonds

- Residential mortgages
100% - Commercial loans and commercial mortgages
- Corporate bonds

2.1 Risk weight of Assets: NBE

 In Basel I,the minimum Tier 1 capital requirement was 4%
risk weighted book value of assets, and minimum total
capital is 8% of the risk-weighted assets.
 But now in accordance with BASEl III ,the minimum Tier 1

capital requirement is 10.5% of risk weighted book value
of assets, and minimum total capital is 12.5% of the risk-
weighted assets.
 Note that Tier 2 capital is supplementary capital because it

is less relieble than tier 1 capital
 tier 1 capital, can absorb losses without a bank being

required to cease trading, and tier 2 capital, can absorb
losses in the event of a winding-up and so provides a lesser
degree of protection to depositors.
Example: Consider the following assets of

Adis Bank
Asset BV in millions
FGE treasury bill Br 240
Bonds issued by AACA(General Obl) 120
Residential mortgages 450
Commercial loans 780
Total book value Br 1,590
Determine total risk weighted assets, tier 1 &
total required capital according to Basel I
 A combination of Tier 1 ratio and tier II ratio is
the Total Capital Adequacy Ratio (CAR). CAR is
a measure of a bank's available capital expressed
as a percentage of a bank's risk-weighted credit
exposures., as we calculated earlier The Capital
Adequacy Ratio, also known as capital-to-risk
weighted assets ratio (CRAR), is used to protect
depositors and promote the stability and
efficiency of financial systems around the world.
 CAR= (Tier 1 capital + Tier 2 capital)/ Risk
weighted assets

Savings and Loan associations(S&Ls)

 established to provide finance for acquisitions
of homes
 can be mutually owned(by depositors) or have
corporate stock ownerships
 ASSETS include
 mortgages,
investments on: mortgage-backed securities,
government securities, and municipal
securities
 consumer loans, non-consumer loans and
FUNDING
 Saving and time deposits
 NOW (Negotiable Order of Withdrawal)
–demand checkable deposit that pays
interest and is negotiable
 Borrow from the federal home loan banks

2.2 Non-depository Institutions
 Are contractual saving inst.= Insurance companies and
Pension funds
 Less affected by liquidity risk than DIs b/s they can predict
their CFs easily that is why they unrestrictedly make
investment.
INSURANCE COMPANIES
 make payments, for a price, when a certain event
occurs
 Life and non-life insurance companies
Characteristics
 Have Insurance policy and receive premium
 Have Surplus (A-L) and statutory reserves (for potential
claim losses) requirments
 Underwriting income and investment income are their income
componenets
52
 Face competition from banks (as they are allowed to offer life
Life insurance companies
 Insurance against death or retirement.
 Liabilities and liability risk: a liability risk
arises when an insured desires to let the
policy lapse due to policy rate
(compensation) falling below market rate
( causes illiquidity to the insurer).
 Insurance companies make Investments in
equity and debt securities.

Types of life insurance policies
 Temporary life insurance (term life Insurance being the
common one):Is protection against risk of death in a stated
period; no cash value, paid only if policy is active and person
dies in the stated time period. There are different types of term
insurance.
 Permanent Life insurance: unlike term insurance has no fixed
expiration period and has cash value. It has an
investment/saving component and can be different in type (like
whole life policy, Universal life policy, variable life policy etc).
It has strong guarantee of cash values and may be participating
in the sence that dividends may be paid against the policy, can
pay premium from cash value,Can borrow against it, or else
withdraw the cash value and cancel the policy.
 Annuity Life Insurance: contribute a certain amount to a
certain set age and get a stream of cashflows then after to
54 death. It is an invstment Vehicle and an insurance against risk
Non-life insurance companies
 a.k.a property and casuality insurance
 they provide protection against
 loss,damage, theft, or distruction of property
almost for any reason covered.
 loss or impairment of income producing ability
 claims for damages by third parties
 loss from injury or death due to occupational
accidents
Also engage on joint insurance and
reinsurance

Non-life insurance companies
 liabilities are of short-term maturity
compared with life insurance companies
 the amount and timing of liabilities is
uncertain
 Service and role is increasing compared to
life insurance companies.

Insurance companies are also subject to Adverse
selection( coming for policy are those requiring large payoff)
and Moral Hazard( policy holders are encouraged to take risk).
Insurers/Insurance Agents reduce the above two risks by
applying Proper Insurance management methods:
 Proper screening( against Adverse selection)
 Applying risk-based premium( against moral hazard)
 Restrictive provisions( against Moral hazard)
 Prevention of Fraud( proper investigation of claims- against
moral hazard)
 Deductibles(against moral hazard).
 Coinsurance(requiring the policyholder to share some portion of
the loss like 20%- 80%)
 Limits on the amount of Insurance e.g not insuring higher than
its true value/actual/intrinsic value (but agreed up on value is
insuring the item at its full insured amount disregarding
depreciation)
57
PENSION FUNDS
 a fund established for payment of retirement benefit
 pension plans can be established by both governmental/Public(social
security system: covers all private employees for their retirment pay
and medical) and private organizations(employer-sponsored,
unions/banks/Insurances or individuals). Federal/State/Local also can
establish pension plans for their employees and admin is like other
private pensions
 their financial intermidiation role grown recently; cause have tax
benefits i.e employer contributions to employees are tax deductible
for the employer.
 Since their cash ouflows are predictible, they invest on longterm
securities like stocks and bonds.
 There is time for being vested: usually 5 years
 they can be defined contribution plan or defined benefit plan ( may
be fully funded [ assets of the fund fully cover the pension liabilities
current and anticipated] or underfunded[ the assets of the fund are
less than the current and anticipated pension payments]) or
58 combination of the two.
(1) defined contribution plans
 contributions are defined, but not the benefits.
 sponsors do not guarantee any certain amount upon
retirement
 payment depends on investment performance of the
asset (since sponsor doesnot guarantee a certain
return on its investment, your benefit depends on the
return)
 Money is kept in individual accounts and money is
invested and return credited or debited to the account
 employee bears risk of investment
 Is the common method worldwide this days

(2) defined benefit plans

 benefits are defined
 amount of benefit is determined based on length of service and
earnings of the employee
 all investment risks are borne by plan sponsors
 Given your age, life expectancy, earning, you (but commonly your
employer does the contribution) will contribute some amount
periodically and you are guaranteed a fixed amount ( as lumpsum or
annuity receipt) at retirement
 Employer and/or employer/employee contributions to a defined benefit
pension plan are based on a formula that calculates the contributions
needed to meet the defined benefit. These contributions are actuarially
determined taking into consideration the employee's life expectancy
and normal retirement age, possible changes to interest rates, annual
retirement benefit amount, and the potential for employee turnover.

(3) Hybrid pension plans

 contributions are defined with a
guaranteed minimum benefit
 in case the fund does not generate
sufficient growth to attain pre-set level
of benefit then the employee is obliged
to add amount of the deficit
 investment risk is shared

Finance Companies:
 Issue CPs, stocks, Bonds and lend the money in
small amount( e.g small consumer loans). Opposite
to banks (who collect deposit in small and lend in
large amounts).
Are virtually unregulated compared to commercial
banks and thrift institutions. States regulate the
maximum amount they can loan to individual
consumers and the terms of the debt contract, but
there are no restrictions on branching, the assets they
hold, or how they raise their funds.
There are three types of finance companies: sales,
consumer, and business.
62
Sales finance companies
are owned by a particular retailing or manufacturing company and make
loans to consumers to purchase items from that company. Sears, Roebuck
Acceptance Corporation, for example, finances consumer purchases of all
goods and services at Sears stores, and General Motors Acceptance
Corporation finances purchases of GM cars. Sales finance companies
compete directly with banks for consumer loans and are used by
consumers because loans can frequently be obtained faster and more
conveniently at the location where an item is purchased.
Consumer finance companies
make loans to consumers to buy particular items such as furniture or
home appliances, to make home improvements, or to help refinance small
debts. Consumer finance companies are separate corporations (like
Household Finance Corporation) or are owned by banks (Citigroup owns
Person-to Person Finance Company, which operates offices nationwide).
Typically, these companies make loans to consumers who cannot obtain
credit from other sources and charge higher interest rates.
63
Business finance companies
provide specialized forms of credit to businesses by
making loans and purchasing accounts receivable (bills
owed to the firm) at a discount; this provision of credit
is called factoring. For example, a dressmaking firm
might have outstanding bills (accounts receivable) of
$100,000 owed by the retail stores that have bought its
dresses. If this firm needs cash to buy 100 new sewing
machines, it can sell its accounts receivable for, say,
$90,000 to a finance company, which is now entitled to
collect the $100,000 owed to the firm. Besides
factoring, business finance companies also specialize in
leasing equipment (such as railroad cars, jet planes, and
computers), which they purchase and then lease to
businesses for a set number of years.
64
Mutual funds:
 financial intermediaries that pool the resources of many small
investors by selling them shares and using the proceeds to buy
securities.
 issue shares in small denominations and buying large blocks of
securities, so mutual funds can take advantage of volume discounts
on brokerage commissions and purchase diversified holdings
(portfolios) of securities.
 Are run by brokerage firms, banks or investment advisors
 Held 80% by households.
 structured in two forms: open-end fund( shares are redeemed any
time at a price tied to the price of the asset value of the fund) and
Closed-end fund (fixed number of nonredeemable shares are sold at
an initial offering and are then traded like a common stock of the
fund in the market).
 Most mutual (open-end)funds are currently no-load funds; i.e they
are sold directly to the public with no sales commissioners/brokers.
 Pay a fee of some percentage of the asset value of the fund to the
fund managers.
65
Money Market Mutual funds
 Are results of innovation in Mutual Funds
 Invest only in Money market instruments.
 There is no or only some fluctuation in the market value of
these securities,( as they are short term <= 1 year from date
of issue) so these funds allow their shares to be redeemed at a
fixed value. Are means of cash parking temporarily. Because
these shares can be redeemed at a fixed value, the funds
allow shareholders to redeem shares by writing checks (for
withdrawal)on the fund’s account at a commercial bank.
Also permit any time withdrawal to a certain limit
 In this way, shares in money market mutual funds effectively
function as checkable deposits that earn market interest rates
on short-term debt securities.
 If there are some changes in the market value of the
securities, effect is figured into the interest paid out by the
fund.
66
Hedge Funds
 Are special types of Mutual funds that tend to take more risk
and are generally open only to high net worth investors. Engage
on speculation and are meant for opportunistic investors.
 Operation is similar to traditional mutual funds but have some
requirements like minimum investment by investors, investors
should commit their money for long time, charge large fee of
managing the fund from investors (Hedge funds normally have
Two And Twenty fee structure, meaning they charge two
percent for asset management and take 20% of overall profits
as fees).
 Many hedge funds engage in what are called “market-neutral”
strategies where they buy a security, such as a bond, that seems
cheap and sell an equivalent amount of a similar security that
appears to be overvalued. If interest rates as a whole go up or
down, the fund is hedged, because the decline in value of one
security is matched by the rise in value of the other.
67
Federal/ Government Credit Agencies
The government has become involved in financial
intermediation in two basic ways:
 setting up federal credit agencies that directly engage in
financial intermediation
 supplying government guarantees for private loans.
To promote residential housing, the government has
created three government agencies that provide funds
to the mortgage market by selling bonds and using
the proceeds to buy mortgages:
 the Government National Mortgage Association (GNMA,
or “Ginnie Mae”),
 the Federal National Mortgage Association (FNMA, or
“Fannie Mae”), and
 the Federal Home Loan Mortgage Corporation (FHLMC,
or “Freddie Mac”).
68
 Except for Ginnie Mae, which is a federal agency and
is thus an entity of the U.S. government, the other
agencies are Federally sponsored agencies (FSEs) that
function as private corporations with close ties to the
government. As a result, the debt of sponsored
agencies is not explicitly backed by the U.S.
government, as is the case for Treasury bonds. As a
practical matter, however, it is unlikely that the federal
government would allow a default on the debt of these
sponsored agencies.
 Agriculture is another area in which financial
intermediation by government agencies plays an
important role. The Farm Credit System (composed of
Banks for Cooperatives, Farm Credit banks, and
various farm credit associations) issues securities and
then uses the proceeds to make loans to farmers.
69
Investment banks
 Unlike the name they don't do the normal banking service
 Serve issuers in the primary market( they advice whether to
issue bond or stock, what should be interest and maturity,
what price stock should be etc)
 Also give investment advice.
 They may individually underwrite or underwrite stock issues
in a syndicate( if it is large issue)
 firm commitment sale is underwriting in essence (see also
rights sale)
 Note that primary markets are regulated by SEC. e.g it
requires issuers to file registration statement along with
prospectus at time of any public offering.
 The known US investment banks are: Merrill Lynch,
Salomon Smith Barney, Morgan Stanley Dean Witter,
Goldman Sachs, Lehman Brothers, and Credit Suisse First
Boston
70
Security Firms(Broker-Dealers)
Operate in secondary market( note that secondary
market is also controlled by SEC especially
against insider trading)
Involve Dealers and Brokers
Dealers/ market makers buy and sell in their own
account i.e keep inventory of security, so are
exposed to market risk.
Brokerage firms work for commission so have
less risk(The largest in the United States is
Merrill Lynch). They engage in all three
securities market activities, acting as brokers,
dealers, and investment bankers.
71
Risk Management
in Financial Institutions
Types of risks in FIs
 Types of risks
 credit risk
 liquidity risk
 Interest rate risk
 Insolvency risk
 Market Risk
 Technological and operational risk
 Sovereign risk
 Foreign currency risk
 Off balance sheet risk
 Managing interest rate risk:
 By minimizing Adverse selection and moral hazard
risks using mainly the 5 Cs (Capacity, Conditions,
Character, Capital, and Collatera).
73 of 55
Types of risks
Credit Risk
 the chance that debtors default on their obligation
Financial institutions (FIs) are special because of their ability to transform financial claims of household savers
efficiently into claims issued to corporations, individuals, and governments.
FIs’ ability to process and evaluate information and control and monitor borrowers allows them to transform
these claims at the lowest possible cost to all parties.


74
bt securities with long-term maturity pose more credit risk than securities with short-term maturity
banks, thrifts and life insurance companies have higher degree of exposure to credit risk
Credit risk
Credit allocation is an important type of financial
claim transformation for commercial banks

 FIs make loans to corporations,
individuals, and governments
 FIs accept the risks of loans in
return for interest that (hopefully)
covers the costs of funding—and
are thus exposed to credit risk
75of 55
Types of risks
Credit Risk...
 managerial efficiency and credit risk
management strategy affects credit risk of
a loan portfolio
 Loan diversification can help eliminate
firm specific credit risk
78
Types of risks
Liquidity risk
 the likelihood that a FI becomes unable to meet
demand for withdrawal,loan, or indemnity.
 may compel FIs to dispose illiquid assets at a
cheap price
 may cause a ‘bank run‘ (where depositors seek to
withdraw funds quickly ahead of a possible bank
insolvency)
 de posit insuranc e [The
Federal Deposit Insurance Corporation (FDIC) is
the deposit insurance for the United States for a
limit of $100,000 per account]
79
Types of risks
Interest Rate (funding)Risk
 Caused by maturity mismatch of assets and
liabilities coupled with interest rate volatility
o Refinancing risk –assets have long-term maturity
and liabilities of short-term maturity. Cost of
refinancing may exceed return on assets( high int
rate)
o Reinvestment risk –holding short-term assets
relative to liabilities. Uncertainity about interest
rate at which borrowed funds will be
reinvested( low int. Rate)
o Price risk—effect of change in interest rate on
value of an asset or liability
80
Types of risks
Market Risk
 risk incurred in trading assets due to
change in interest rate, exchange rate, and
other asset prices
 faced by FIs engaged in active trading of
assets
81
Types of risks
Cases of FI failure
1. Barings- a 200-years old british bank
failed in 1995 due to trading losses. It
bought a futures contract that worth
$8bill betting that the Nikkei index
would rise. It became insolvent after a
loss of $1.2bill
82
Types of risks
2. Societe Generale- a French Bank lost

$7.2bill as Jerome Kerviel, the bank‘s
trading clerk, invested in future
contracts in European stock indexes
betting that markets would continue to
rise.
83
Types of risks
Off-balance sheet risk
 arises in relation with contingent assets
and liabilities
Eg. Credit guarantees, LCs
Foreign exchange risk
 risk that exchange rate changes affect the
value of assets and liabilities of a FIs
84
Types of risks
Country (sovereign) Risk
 the risk that repayment from foreign
borrowers may be interrupted because of
interference from foreign governments
 governments may control foreign
currency outflows to mitigate currency
shortages
85
Types of risks
Technology and operational risk
 technology risk arises when FIs
technological investment fails to fetch the
anticipated benefit
economies of scale and economies of scope
The major objectives of technological
expansion are to lower operating costs,
increase profits, and capture new markets.
86
Types of Risk
Economies of scale refer to an FI’s ability to
lower its average costs of operations by
expanding its output of financial services.
Economies of scope The degree to which an

FI can generate cost synergies by producing
multiple financial service products/ producing
87of
more
55
than one output with the same inputs/.
Types of risks
Technology and operational risk...
 operational risk arises when the existing
technology or support system
mulfunctions or breaks down
 may also arise due to employee fraud,
misrepresentations, and account errors
88
Types of risks
Technology risk The risk incurred by an FI

when technological investments do not
produce the cost savings anticipated.
Inflationary risk:
Risk of decline in purchasing power of
money.
89of
55
Types of risks
Insolvency risk
the risk that an FI may not have enough
capital to offset a sudden decline in the value
of its assets relative to its liabilities
Is a consequence or outcome of one or more
of the risks described above: (interest rate,
market, credit, off-balance-sheet, technology,
foreign exchange, sovereign, and liquidity
risks).
90
Managing credit risk
Causes
 the problem of information asymmetry
Asymmetric information—a situation that
arises when one party’s insufficient knowledge
about the other party. Which are manifested in
the risks of:
 adverse selection and moral hazard
91
Managing Credit Risk
Adverse selection is an asymmetric

information problem that occurs before the
transaction.
Potential bad credit risks are the ones who

most actively seek out loans.
92of
55
Moral hazard arises after the transaction
occurs.
 The lender runs the risk that the borrower will
engage in activities that are undesirable from the
lender’s point of view because they make it less
likely that the loan will be paid back
93of
55
To Manage credit risk, Credit Analysis

is essential.
 Consider the 5 C‘s (Capacity, Conditions, Character,
Capital, and Collateral)
 If consumer and small business: more on personal
chx
 If Midium Corporate & Institutional borrowers (C &
I) borrower: use different tchniques of testing
creditworthiness( ratio analysis, CF analysis, other
meanses of checking 5 Cs.)
 If large C & I borrowers: are less risky so can rely
on rating agencies who use sophesticated
mechanisms of credit analysis.
 If Real estate lending: collateral is very important
with its foreclosure and power of sale rights.
Chapter Three
Interest Rates In the Financial System
95
what is Interest Rate?
For financing and investing decision in a dynamic
financial environment, it is crucial for market
participants to understand interest rates as one of the
key aspects of the financial environment.
Interest rate is a rate of return paid by a
borrower/seeker/ of funds to a lender of them, or a price
paid by a borrower/seeker for a service, the right to make
use of funds for a specified period. Thus it is one form of
yield on financial instruments.
Is also a discount factor in asset valuation.
Two questions are being raised by market participants:
 What determines the average rate of interest in an
economy? Determinants of interest rate
 Why do interest rates differ on different types and lengths
of loans and debt instruments? [Term] structure of interest
96 rate
Determinants of Interest Rate
In order to explain the determinants of interest rates in general, the
economic theory assumes there is some particular interest rate, as a
representative of all interest rates in an economy. Such an interest
rate usually depends upon the topic considered, and can be
represented by e.g. interest rate on government short-term or long-
term debt, or the base interest rate of the commercial banks(BLR),
or a short-term money market rate (EURIBOR). In such a case it is
assumed that the interest rate structure is stable and that all interest
rates in the economy are likely to move in the same direction.
Note that Interest rate structure (a topic we see later on) is the
relationships between the various rates of interest in an economy
on financial instruments of different lengths (terms) or of different
degrees of risk.
The lending decision (at a certain offer/ask) and borrowing
decision (at a certain bid) depends on:
 competition among FIs.
Determine average
 Inflationary premium int. rate in an
 the risk premium for specific riskeconomy,
of fundseeseekers.
next
theories
97
Determinants of Interest Rate…
Risk premium is an addition to the interest rate
demanded by a lender to take into account the risk that the
borrower/fund seeker might default on the loan entirely or
may not repay on time(default risk).
There are several factors that determine the risk premium for
a non- Government security, as compared with the
Government security of the same maturity. These are (1) the
perceived creditworthiness of the issuer, (2) provisions of
securities such as conversion provision, call provision, put
provision, seniority(3) interest taxes [(after tax int= before tax
rate(1-T)], and (4) expected liquidity of a security’s issue.; and
also other risks.
Inflationary risk is one of the market (common to all
assets)risks affecting rate of return of all assets.
Inflationary risk premium is required to maintain purchasing
power;

98 i =(1+r)(1+ie)-1, i=Nominal int rate, r= Real rate, ie=inf. rate;
Example
• Assume that a bank is providing a company with a
loan of 1000 thousand Euro for one year at a real
rate of interest of 3 per cent. At the end of the
year it expects to receive back 1030 thousand
Euro of purchasing power at current prices.
However, if the bank expects a 10 per cent rate of
inflation over the next year, it will want 1133
thousand Euro back (10 percent above 1030
thousand Euro). The interest rate required by the
bank would be 13.3 per cent that is:
i =(1+ 0.03)(1 + 0.1) - 1 = (1.03)(1.1) - 1 =
1.133 - 1=0.133 or 13.3 per cent.
• Note that real rate= [(i+1)/(1+ie)] -1
99
The above calculation assumes real rate is
stable over time and what matters interest is
market participants prediction of
inflation(Fisher effect).But real rate itself( as
borrowers and lenders think mostly in terms
of real interest rates) is a variable.
There are two economic theories(called
interest rate theories) explaining the
level/behaviour of real interest rates in an
economy, Generally:
 The loanable funds theory
 Liquidity preference theory
100
The loanable funds theory
The loanable funds theory was formulated by the Swedish economist
Knut Wicksell in the 1900s. According to him, the level of interest rates
is determined by the supply and demand of loanable funds available in an
economy’s credit market (i.e., the sector of the capital markets for long-
term debt instruments). This theory suggests that investment and savings
in the economy determine the level of long-term interest rates. Short-
term interest rates, however, are determined by an economy’s financial
and monetary conditions. According to the loanable funds theory for the
economy as a whole:
 Demand for loanable funds = net investment + net additions to
liquid reserves(at national banks)
 Supply of loanable funds = net savings + increase in the money
supply
Given the importance of loanable funds and that the major suppliers of loanable
funds are commercial banks, the key role of this financial intermediary in the
determination of interest rates is vivid. The central bank is implementing specific
monetary policy, therefore, it influences the supply of loanable funds from
commercial banks and thereby changes the level of interest rates. As central bank
increases (decreases) the supply of credit available from commercial banks, it
101
decreases (increases) the level of interest rates.
The extent to which people are willing to postpone
consumption- time preference affects this market.
Time preference is the extent to which a person is
willing to give up the satisfaction obtained from
present consumption in return for increased
consumption in the future (i.e investment).
Loanable funds are funds borrowed and lent in an
economy during a specified period of time – the flow
of money from surplus to deficit units in the economy.
It simply refers to the sums of money offered for
lending and demanded by consumers and investors
during a given period.
Therefore, the interest rate in the model is determined
by the interaction between potential borrowers and
potential savers.
102
Equilibrium or market clearing price and int rate are
at points Ss is equal to Dd.
Equilibrium or market clearing price and interest rate

are
103 at points where “Ss is equal to Dd”.
The next figure provides an overview of the
factors influencing demand for loadable
funds and thus the general framework for
forecasting interest rates (USA context).
104
Liquidity preference theory
J. M. Keynes has proposed (back in 1936) a simple model, which explains
how interest rates are determined based on the preferences of households to
hold money balances rather than spending or investing those funds.
Money balances can be held in the form of currency or checking accounts,

however it does earn a very low interest rate or no interest at all. A key
element in the theory is the motivation for individuals to hold money
balance despite the loss of interest income. Money is the most liquid of all
financial assets and, of course, can easily be utilized to consume or to
invest. The quantity of money held by individuals depends on their level of
income and, consequently, for an economy the demand for money is
directly related to an economy’s income. There is a trade-off between
holding money balance for purposes of maintaining liquidity and investing
or lending funds in less liquid debt instruments in order to earn a
competitive market interest rate. The difference in the interest rate that can
be earned by investing in interest-bearing debt instruments and money
balances represents an opportunity cost for maintaining liquidity. The
lower the opportunity cost, the greater the demand for money balances; the
higher the opportunity cost, the lower the demand for money balance.
106
The starting point of Keynes’s analysis is his
assumption that there are two main categories of
assets that people use to store their wealth: money
and bonds. Therefore, total wealth in the economy
must equal the total quantity of bonds plus money in
the economy, which equals the quantity of bonds
supplied (Bs) plus the quantity of money supplied
(Ms). The quantity of bonds (Bd) and money (Md)
that people want to hold and thus demand must also
equal the total amount of wealth, because people
cannot purchase more assets than their available
resources allow. The conclusion is that the quantity of
bonds and money supplied must equal the quantity of
bonds and money demanded:
107
Bs+ Ms= Bd+Md Bs-Bd=Md-Ms
Because the definition of money that Keynes used includes
currency (which earns no interest) and checking account
deposits (which in his time typically earned little or no
interest), he assumed that money has a zero rate of return.
Bonds, the only alternative asset to money in Keynes’s
framework, have an expected return equal to the interest rate i.
As this interest rate rises (holding everything else unchanged),
the expected return on money falls relative to the expected
return on bonds, and as the theory of asset demand tells us, this
causes the demand for money to fall.
We can also see that the demand for money and the interest
rate should be negatively related by using the concept of
opportunity cost, the amount of interest (expected return)
sacrificed by not holding the alternative asset—in this case, a
bond. As the interest rate on bonds, i, rises, the opportunity
cost of holding money rises, and so money is less desirable and
the quantity of money demanded must fall.
108
Liquidity preference is preference for holding
financial wealth in the form of short-term,
highly liquid assets rather than long-term illiquid
assets, based principally on the fear that long-
term assets will lose capital value over time.
Generally, According to the liquidity preference
theory, the level of interest rates is determined
by the supply and demand for money balances.
The money supply is controlled by the policy
tools available to the country’s Central Bank.
Conversely, in the loanable funds theory the
level of interest rates is determined by supply
and demand, however it is in the credit market.
109
110
On the previous graph
When the interest rate is 25%, the quantity of money demanded at
point A is $100 billion, yet the quantity of money supplied is $300
billion. The excess supply of money means that people are holding
more money than they desire, so they will try to get rid of their
excess money balances by trying to buy bonds. Accordingly, they
will bid up the price of bonds, and as the bond price rises, the
interest rate will fall toward the equilibrium interest rate of 15%.
This tendency is shown by the downward arrow drawn at the interest
rate of 25%.
Likewise, if the interest rate is 5%, the quantity of money demanded
at point E is $500 billion, but the quantity of money supplied is only
$300 billion. There is now an excess demand for money because
people want to hold more money than they currently have. To try to
obtain more money, they will sell their only other asset—bonds—
and the price will fall. As the price of bonds falls, the interest rate
will rise toward the equilibrium rate of 15%. Only when the interest
rate is at its equilibrium value will there be no tendency for it to
move
111 further, and the interest rate will settle to its equilibrium value.
The variety of interest rates that exist in the
economy and the structure of interest rates is
subject to considerable change due to different
factors. Such changes are important to the
operation of monetary policy. Interest rates vary
because of differences in the time period, the
degree of risk, and the transactions costs
associated with different financial instruments.
The greater the risk of default associated with
an asset, the higher must be the interest rate paid
upon it as compensation for the risk. This
explains why some borrowers pay higher rates
of interest than others.
112
The degree of risk associated with a request for a loan may
be determined based upon a company’s size, profitability or
past performance; or, it may be determined more formally by
credit rating agencies. Some are good rated and are prime
borrowers to get loan from banks. And some are less favored
so have to borrow from other sources at higher rates.
 The same principle applies to the comparison between
interest rates on sound risk-free loans (such as government
bonds) and expected yields on equities. The more risky a
company is thought to be, the lower will be its share price in
relation to its expected average dividend payment – that is, the
higher will be its dividend yield and the more expensive it
will be for the company to raise equity capital.
113
Term structure of interest rates
The relationship between the yields on
comparable securities but different
maturities is called the term structure of
interest rates.
Term is one important factor to consider in
studying structure of interest rate.
The graph that depicts the relationship
between the yield on Treasury securities
with different maturities is known as the
yield curve and, therefore, the maturity
spread is also referred to as the yield curve
spread.
114
Of the several common ways of calculating interest
rates, the most important is the yield to maturity, i, (also
called IRR), the interest rate that equates the present
value of payments received from a debt instrument with
its value today. It shows the real return a certain
asset/investment is offering.
 Note that interest rate (which is only current yield) is different
from return on the asset (Yield) because the later includes the
current yield as well as capital gains.
The other measure of interest rate than YTM commonly
used on financial newspapers for their simplicity are
Current yield(current yield ic=c/p, like consols) and Yield
on a discount basis idp=[( Face Value of discount bond ─
Purchas price of discount bond)/Face Value of discount
bond]*[360 days/days to maturity]
115
For example which of the following assets yields
high income to you (compare them by YTM):
 a) simple loan: one-year loan of $1000 at 10% interest .
i= (Future Value- Present Value)/ Pres. Valu.
 b)Fixed-payment loan: loan of $1000 requiring $126
yearly payment for 25 years
 c) Coupon Bond: $1000 Face Value $100(10%) annual
coupon, 10 years you purchased for a price of $1200.
what if purchased for$1000, or $800
 d) Zero-coupon bond: $1000 Face Value 1year life
purchased for $900
 e) Consol bond: $100 forever and purchased at $2000
but no final principal payment
Note: for consol P=c/i so i=c/p).
Note: when coupon rate=yield, bond price and Face
116
Value are equal.
Answer
a)For simple loans, the simple interest rate
equals the yield to maturity.
b) Use annuity PV formula and get value of I
in interpolation answer is 12%
c)For $1200 price YTM= 7.3%; for price of
1000 YTM=10%, and for price of $800
YTM= 13.81% i.e use annuity formula and
also single sum formula together.
d) 900=$1000/(1+i) i.e (1+i) *900= 1000
answer 11.11% or (FV-price)/FV=i
e) I= 100/2000= 5%
117
Present Value of an Annuity: for you to
remember
 For fixed payment loan, i is

calculated from the following
Annuity PV formula (The present
value P consisting of n payments
of R dollars each, paid at the end of
each investment period where
interest (yield) is i per period)
 1  (1  i )  n 
P  R 
 i 
Present Value : for you to remember
 For coupon bond, i is calculated

from the sum of Annuity PV and
single sum: (PV annuity) + (FV/
(1+i)n)
  1  (1  i ) n

P  R + (FV/ (1+i)n)
 i 
Yield curve: Shows the relationships between the interest
rates(YTM) payable on bonds with different lengths of time
to maturity. That is, it shows the term structure of interest
rates. The primary focus here is the Treasury market. The
focus on the Treasury yield curve functions is due mainly
because of its role as a benchmark for setting yields in many
other sectors of the debt market. However, a Treasury yield
curve based on observed yields on the Treasury market is an
unsatisfactory measure of the relation between required
yield and maturity. The key reason is that securities with the
same maturity may actually provide different yields.
Hence, it is necessary to develop more accurate and reliable
estimates of the Treasury yield curve. It is important to
estimate the theoretical interest rate that the Treasury would
have to pay assuming that the security it issued is a zero-
coupon security.
120
 A plot of the yields on bonds with differing terms to maturity but
the same risk, liquidity, and tax considerations is called a yield
curve, and it describes the term structure of interest rates for
particular types of bonds, such as government bonds. Yield curves
can be classified as upward-sloping, flat, and downward-sloping (the
last sort is often referred to as an inverted yield curve). When yield
curves slope upward, the long-term interest rates are above the
short-term interest rates; when yield curves are flat, short- and long-
term interest rates are the same; and when yield curves are inverted,
long-term interest rates are below short-term interest rates. Yield
curves can also have more complicated shapes in which they first
slope up and then down, or vice versa.
The steepness of the yield curve is typically measured in terms of the maturity
spread between the long-term and short-term yields.
A downward-sloping or inverted yield curve is the one, where yields in general
decline as maturity increases.
A variant of the flat yield is the one in which the yield on short-term and long-
term Treasuries are similar but the yield on intermediate-term Treasuries are
much
121 lower than, for example, the six-month and 30-year yields. Such a yield
122
Theories of term structure of interest rates
There are several major economic theories that explain the observed
shapes of the yield curve:
 Expectations theory (The expectations theory uses long-term
interest rates to predict future short-term interest rates; perfect
substitution between short-term and long term.)
 Liquidity premium theory ( all other things citrus paribus, the
theory believes that investors have liquidity preference so usually need
short term than long term securities. Therefore, they require more yield
on long-term so likely resulting an upward sloping yield curve)
 Market segmentation theory ( markets of different maturity are
unrelated and yield in each is determined by supply & demand in each
market; short term yields are not predicted from short term yield; yield
curve typically slops upward; no substitution)
 Preferred habitat theory (expounds the market segmentation
theory, investors take a shift in category as risk, so if need be they need
more return; differs from expectation theory because in expectation
theory investors are concerned with only yield but here with both yield
and maturity)
123 See details in next slides…..
The theories explain the following facts
Interest rates on bonds of different
maturities move together over time.
Explained by Expectation theory
 When short-term interest rates are low,
yield curves are more likely to have an
upward slope; when short-term interest
rates are high, yield curves are more
likely to slope downward and be
inverted. Explained by Expectation theory.
 Yield curves almost always slope
124
upward. Explained by market segmentation theory
Expectations theory
The pure expectations theory assumes that investors are
indifferent between investing for a long period on the one
hand and investing for a shorter period with a view to
reinvesting the principal plus interest on the other hand. For
example an investor would have no preference between
making a 12-month deposit and making a 6-month deposit
with a view to reinvesting the proceeds for a further six
months so long as the expected interest receipts are the
same. This is equivalent to saying that the pure expectations
theory assumes that investors treat alternative maturities as
perfect substitutes for one another. The pure expectations
theory assumes that investors are risk-neutral. A risk-neutral
investor is not concerned about the possibility that interest
rate expectations will prove to be incorrect, so long as
potential favourable deviations from expectations are as
likely
125 as unfavourable ones. Risk is not regarded
The theory assumes that the interest rate on a long-term
bond will equal an average of short-term interest rates
that people expect to occur over the life of the long-term
bond. For example, if people expect that short-term
interest rates will be 10% on average over the coming
five years, the expectations theory predicts that the
interest rate on bonds with five years to maturity will be
10% too. If short-term interest rates were expected to rise
even higher after this five-year period so that the average
short-term interest rate over the coming 20 years is 11%,
then the interest rate on 20-year bonds would equal 11%
and would be higher than the interest rate on five-year
bonds.
We can see that the explanation provided by the
expectations theory for why interest rates on bonds of
different
126 maturities differ is that short-term interest rates
Another explanation for Expectation theory is to think that
practically, most investors are risk-averse, i.e. they are prepared to
forgo some investment return in order to achieve greater certainty
about return and value of their investments. As a result of risk-
aversion, investors may not be indifferent between alternative
maturities. Attitudes to risk may generate preferences for either short
or long maturities. If such is the case, the term structure of interest
rates (the yield curve) would reflect risk premiums.
If an investment is close to maturity, there is little risk of capital loss
arising from interest rate changes. A bond with a distant maturity (long
duration) would suffer considerable capital loss in the event of a large
rise in interest rates. The risk of such losses is known as capital risk.
To compensate for the risk that capital loss might be realized on long-
term investments, investors may require a risk premium on such
investments. This results in an upward slope to a yield curve. This
tendency towards an upward slope is likely to be reinforced by the
preference of many borrowers to borrow for long periods (rather than
borrowing for a succession of short periods).
 Note :A risk premium is an addition to the interest or yield to
127 compensate investors for accepting risk.
Moreover, Some investors may prefer long maturity investments
because they provide greater certainty of income flows. This
uncertainty is income risk. If investors have a preference for
predictability of interest receipts, they may require a higher rate of
interest on short-term investments to compensate for income risk. This
would tend to cause the yield curve to be inverted (downward
sloping).i.e the less income risk reduces the yield on long-term
investments.
The effects on the slope of the yield curve from factors such as capital
risk and income risk are in addition to the effect of expectations of
future short-term interest rates. If money market participants expect
short-term interest rates to rise, the yield curve would tend to be
upward sloping. If the effect of capital risk were greater than the effect
of income risk, the upward slope would be steeper. If market
expectations were that short-term interest rates would fall in the
future, the yield curve would tend to be downward sloping.
A dominance of capital-risk aversion over income-risk aversion
would render the downward slope less steep (or possibly turn a
128
129
130
General on the graph:
What causes Supply shift: profitability of
investment opportunities (The more profitable plant and
equipment investments that a firm expects it can make, the more willing it will be
to borrow in order to finance these investments.) expected inflation
(the real cost of borrowing is more accurately measured by the real interest
rate, which equals the (nominal) interest rate minus the expected inflation
rate. For a given interest rate, when expected inflation increases, the real
cost of borrowing falls; hence the quantity of bonds supplied increases at
any given bond price and interest rate ), government activities
(when US government sells more bonds to finance its expenditure gaps, the
bond supply increases)
What causes Demand shift: wealth increase,

expected return on bond investments, risk of
131
Liquidity premium theory
Some investors may prefer to own shorter rather than
longer term securities because a shorter maturity
represents greater liquidity. In such case they will be
willing to hold long term securities only if
compensated with a premium for the lower degree of
liquidity. Though long-term securities may be
liquidated prior to maturity, their prices are more
sensitive to interest rate movements. Short-term
securities are usually considered to be more liquid
because they are more likely to be converted to cash
without a loss in value. Thus there is a liquidity
premium for less liquid securities which changes over
time. The impact of liquidity premium on interest
rates
132 is explained by liquidity premium theory.
133
The liquidity premium theory’s key assumption is
that bonds of different maturities are substitutes,
which means that the expected return on one bond
does influence the expected return on a bond of a
different maturity, but it allows investors to prefer
one bond maturity over another. In other words,
bonds of different maturities are assumed to be
substitutes but not perfect substitutes. Investors
tend to prefer short-term bonds because these bonds
bear less interest-rate risk. For these reasons,
investors must be offered a positive liquidity
premium to induce them to hold longerterm bonds.
Is a modification to expectation theory by adding
liquidity premium to average interest in
Market segmentation theory
According to the market segmentation theory, interest rates for different
maturities are determined independently of one another. The interest rate
for short maturities is determined by the supply of and demand for short-
term funds. Long-term interest rates are those that equate the sums that
investors wish to lend long term with the amounts that borrowers are
seeking on a long-term basis.
According to market segmentation theory, investors and borrowers

do not consider their short-term investments or borrowings as
substitutes for long-term ones. This lack of substitutability keeps
interest rates of differing maturities independent of one another. If
investors or borrowers considered alternative maturities as
substitutes, they may switch between maturities. However, if
investors and borrowers switch between maturities in response to
interest rate changes, interest rates for different maturities would
no longer be independent of each other. An interest rate change for
one maturity would affect demand and supply, and hence interest
rates, for other maturities.
The argument for why bonds of different maturities are
not substitutes is that investors have strong preferences for
bonds of one maturity but not for another, so they will be
concerned with the expected returns only for bonds of the
maturity they prefer. This might occur because they have
a particular holding period in mind, and if they match the
maturity of the bond to the desired holding period, they
can obtain a certain return with no risk at all.(if the term
to maturity equals the holding period, the return is known
for certain because it equals the yield exactly, and there is
no interest-rate risk).
Because in the typical situation the demand for long-term
bonds is relatively lower than that for shortterm bonds,
long-term bonds will have lower prices and higher interest
rates, and hence the yield curve will typically slope
upward. So explains fact 3 but; not fact 1 and 2 properly.
136
The preferred habitat theory
Preferred habitat theory is a variation on the market
segmentation theory. The preferred habitat theory
allows for some substitutability between maturities.
However the preferred habitat theory views that
interest premiums are needed to entice investors from
their preferred maturities to other maturities.
Because they prefer bonds of one maturity(preferred
Habitat) over another they will be willing to buy
bonds that do not have the preferred maturity only if
they earn a somewhat higher expected return. Because
investors are likely to prefer the habitat of short-term
bonds over that of longer-term bonds, they are willing
to hold long-term bonds only if they have higher
expected
137 returns. Thus justifying upward yield curve
According to the market segmentation and
preferred habitat explanations, government
can have a direct impact on the yield curve.
Governments borrow by selling bills and
bonds of various maturities. If government
borrows by selling long-term bonds, it will
push up long-term interest rates (by pushing
down long-term bond prices) and cause the
yield curve to be more upward sloping (or
less downward sloping). If the borrowing
were at the short maturity end, short-term
interest rates would be pushed up.
138
Duration
Duration is a measure of the effective maturity of a security.
 Duration incorporates the timing and size of a security’s cash flows.
 Duration measures how price sensitive a security is to changes in interest
rates.
 Duration measures interest sensitivity of an asset or liability‘s value to
small changes in interest rates
 The greater (shorter) the duration, the greater (lesser) the price
sensitivity.
 Duration is an approximate measure of price elasticity of demand
D = - %  security market value/
 R/(1+R)
139
Managing interest rate risk
 The longer the duration, the larger the
change in price for a given change in
interest rates.
140
of
55
Duration is a weighted average of the time
until the expected cash flows from a security
will be received, relative to the security’s
price
Macaulay’s Duration
141
of
55
Example
What is the duration of a bond with a $1,000
face value, 10% annual coupon payments, 3
years to maturity and a 12% YTM? The
bond’s price is $951.96.
142
of
55
Example
What is the duration of a bond with a
$1,000 face value, 10% coupon, 3 years to
maturity but the YTM is 5%?The bond’s
price is $1,136.16.
100 * 1 100 * 2 100 * 3 1,000 * 3

1
+ 2
+ 3
+
(1.05) (1.05) (1.05) (1.05) 3 3,127.31
D  = 2.75 years
1136.16 1,136.16
The Duration of Zero coupon bond is
equal to its maturity
143
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Financial Institutions and Markets

Main objective of the course:

Chapter 1: the Financial system

The financial system in Ethiopia (players, types of

 Don't physically deteriorate/depreciate

include venture capital firm- mostly investment on start ups on seed

letter of credit Accepted by bank so negotiable; is like post dated check),

 for the firm

Low risk High expected

 for the firm

A swap is an agreement whereby two parties (called

Equity, debt instruments,

Services Technical, advisory,

 include commercial banks, savings and loan

36 Financial markets and Institutions

Asset/Liability Problem of DIs

37 Financial markets and Institutions

39 Financial markets and Institutions

40 Financial markets and Institutions

43 Financial markets and Institutions

Capital adequecy requirment:

Also as liquidity requirement:

20% - Municipal general obligation bonds

50% - Municipal revenue bonds

45 Financial markets and Institutions

46 Financial markets and Institutions

 But now in accordance with BASEl III ,the minimum Tier 1

 Note that Tier 2 capital is supplementary capital because it

 tier 1 capital, can absorb losses without a bank being

Example: Consider the following assets of

49 Financial markets and Institutions

Savings and Loan associations(S&Ls)

51 Financial markets and Institutions

53 Financial markets and Institutions

55 Financial markets and Institutions

56 Financial markets and Institutions

59 Financial markets and Institutions

(2) defined benefit plans

60 Financial markets and Institutions

(3) Hybrid pension plans

61 Financial markets and Institutions

Credit allocation is an important type of financial

claim transformation for commercial banks

2. Societe Generale- a French Bank lost

Economies of scale refer to an FI’s ability to

lower its average costs of operations by

expanding its output of financial services.

Economies of scope The degree to which an

Technology risk The risk incurred by an FI

Adverse selection is an asymmetric

Potential bad credit risks are the ones who

To Manage credit risk, Credit Analysis

Interest Rates In the Financial System

Equilibrium or market clearing price and interest rate

Money balances can be held in the form of currency or checking accounts,

 For fixed payment loan, i is

 For coupon bond, i is calculated

What causes Demand shift: wealth increase,

According to market segmentation theory, investors and borrowers

100 * 1 100 * 2 100 * 3 1,000 * 3

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