Chapter One: Financial Institutions

An Overview of Financial Markets and Institutions

1.1 Definition and Concepts

Financial Markets

Financial markets are organized systems or platforms where financial assets are bought and
sold. They facilitate the transfer of funds from surplus units (savers) to deficit units (borrowers).

Key Characteristics:

 Enable buying and selling of financial instruments

 Provide a mechanism for price determination

 Promote efficient allocation of resources

 Facilate liquidity in the economy

Financial Institutions

Financial institutions are legally established and regulated entities that conduct financial
transactions. They serve as intermediaries between savers and borrowers.

Functions:

 Mobilize savings

 Provide credit and loans

 Facilitate payment systems

 Manage financial risks

Financial institutions are essential components of financial markets.

1.2 Types of Financial Markets

There are several types of financial markets. The five common types include:

1. Stock Market – Where shares of companies are bought and sold.

 2. Bond Market – Where government and corporate bonds are traded.

3. Derivative Market – Where financial contracts (futures, options, swaps) are traded.

4. Money Market – Deals with short-term financial instruments (usually less than one
year).

5. Foreign Exchange (Forex) Market – Where currencies are exchanged.

1.3 Objectives of Financial Markets in Ethiopia

The main objectives of financial markets in Ethiopia include:

 Mobilizing domestic savings

 Allocating capital efficiently

 Facilitating economic development

 Ensuring liquidity in the economy

 Maintaining financial stability

 Supporting capital formation

 Assisting in the implementation of monetary policy

The National Bank of Ethiopia (NBE) regulates all financial markets in the country.

1.4 Components of Financial Markets in Ethiopia

The financial market system in Ethiopia consists of:

1. Regulatory Body – National Bank of Ethiopia (NBE)

2. Banking Sector – Commercial banks and development banks

3. Non-Banking Financial Institutions – Insurance companies, microfinance institutions,

leasing companies

4. Semi-formal Financial Sector – Cooperatives and saving associations

5. Informal Financial Sector – Traditional saving systems operating outside formal

regulation
1.5 Basic Features of Financial Markets in Ethiopia

 Bank-dominated financial system

 Limited formal capital market (emerging stock exchange system)

 Focus on money market activities

 Strong government involvement

 Highly regulated environment

 Expansion of microfinance institutions

 Growth of informal financial practices

Chapter Two: The Central Bank and Other Financial Institutions

Types and Functions of Financial Institutions in Ethiopia

All financial institutions in Ethiopia are regulated by the National Bank of Ethiopia (NBE).

They include:

 Commercial Banks

 Investment Banks

 Development Banks

 Central Bank (NBE)

 Insurance Companies (Government and Private)

 Microfinance Institutions

 Leasing Companies

2.1 Microfinance Institutions (MFIs)

Microfinance institutions are specialized financial institutions that provide financial services to
low-income individuals and small businesses.

Main Activities:

 Providing small loans (microcredit)

  Mobilizing savings

 Channeling funds to small enterprises

 Supporting business development

Key Roles:

 Poverty alleviation

 Promoting financial inclusion

 Creating employment opportunities

 Mobilizing savings

 Providing credit to financially underserved groups

 Enhancing payment mechanisms

 Managing financial risks

Microfinance institutions go beyond financing by supporting community empowerment and

entrepreneurship development.

2.2 Commercial Bank of Ethiopia (CBE)

The Commercial Bank of Ethiopia is the largest and most diversified financial institution in
Ethiopia.

Major Functions:

1. Accepting Deposits

 Current accounts

 Savings accounts

 Checking accounts

 Fixed/Time deposits

 International accounts

2. Lending Services

 Personal loans

 Business loans
  Overdraft facilities

 Industrial financing

3. Other Services

 Foreign exchange services

 Buying gold and silver

 Discounting bills of exchange

 Money transfer services

 Promoting other financial institutions

2.3 National Bank of Ethiopia (NBE)

The National Bank of Ethiopia is the central bank of the country.

Major Functions:

 Issuance of currency (sole authority)

 Formulating and implementing monetary policy

 Supervising and regulating financial institutions

 Managing foreign reserves

 Ensuring financial stability

 Acting as banker to the government

Management Structure:

 Governor

 Board of Directors

 Organizational Units

 Bank Supervision Directorate

 Foreign Exchange Directorate

 Monetary Policy Directorate

📘 Study Notes: Primary & Secondary
Financial Markets and Instruments

✅ 1. Financial Markets – Overview

A financial market is a system that facilitates the raising of funds by businesses or governments
and enables the trading of financial instruments among investors. Financial markets help connect
those who have capital (investors) with those who need capital (issuers). (Wikipedia)

Financial markets are usually divided into:

📌 Primary Market
📌 Secondary Market
📌 Other segments (e.g., money market and capital market) – not covered here. (Wikipedia)

🎓 2. Primary Financing & Marketing Instruments

🟢 2.1 What is the Primary Market?

The primary market is the part of the financial system where new securities are issued and sold
to investors for the first time. This means the company or issuer receives the funds directly from
the investors. (Wikipedia)

It is also called the New Issue Market. (Wikipedia)

🟢 2.2 Purpose of the Primary Market

The main purpose of the primary market is to:

🔹 Enable corporations and governments to raise new capital for business expansion, projects, or
public spending. (Encyclopedia Britannica)
🔹 Provide investors the opportunity to buy securities directly from the issuer. (Encyclopedia
Britannica)
🔹 Facilitate economic growth by mobilizing savings into productive investments. (ESX
Academy)

🟢 2.3 Types of Primary Market Instruments

In the primary market, several financial instruments may be issued:

📌 Equity (Shares / Stocks)

Companies issue shares to investors in order to raise equity capital.

 Initial Public Offering (IPO): The first sale of company shares to the public.
(Encyclopedia Britannica)
 Rights Issue: Issuing shares to existing shareholders at a discount. (Wikipedia)
 Private Placement: Securities sold directly to a small group of institutional investors.
(Pearson)

📌 Debt Instruments (Bonds)

Governments and corporations issue bonds to borrow funds. (Wikipedia)

Examples include:

 Government bonds
 Corporate bonds
 Debentures (Wikipedia)

📌 Others
Commercial papers (short-term debt), certificates, and other long-term securities.
(Manonmaniam Sundaranar University)

📊 2.4 Main Features of the Primary Market

Feature Explanation
Investors’ money goes directly to the company or government.
Funds flow to issuer
(Encyclopedia Britannica)
First-time issue Securities are newly created and sold first in this market. (Wikipedia)
Facilitated by Underwriters and investment banks help issue and distribute the
intermediaries securities. (Encyclopedia Britannica)
Must comply with regulators (e.g., securities authority). (Encyclopedia
Regulated process
Britannica)
🧠 3. Secondary Markets Financial Instruments
🔵 3.1 What is the Secondary Market?

The secondary market is where previously issued securities are bought and sold among
investors. The issuing company is not directly involved in these transactions. (Wikipedia)

Examples include stock exchanges where investors trade shares after issuance. (Wikipedia)

🔵 3.2 Purpose of the Secondary Market

The secondary market plays several important roles:

🔹 Liquidity: It allows investors to easily sell their securities and convert them into cash. (OER
Collective)
🔹 Price Discovery: The market determines current prices based on supply and demand.
(Studocu)
🔹 Increases investor confidence: Knowing they can sell securities later encourages
participation in the primary market. (OER Collective)

🔵 3.3 Instruments Traded in Secondary Markets

The secondary market trades almost all financial instruments that were issued in the primary
market:

📌 Equities (Shares/Stocks)

 Traded continuously in stock exchanges. (Wikipedia)

📌 Debt Securities (Bonds)

 Government and corporate bonds traded among investors. (Wikipedia)

📌 Derivatives (Options & Futures)

 Contracts whose value is based on underlying assets (stocks, bonds, indices). (Wikipedia)

🔵 3.4 Key Features of the Secondary Market

 Feature Explanation
No direct funds to
Money changes hands between investor and seller. (Wikipedia)
issuer
Includes stock exchanges and over-the-counter markets. (Encyclopedia
Trading platforms
Britannica)
Continuous price
Prices fluctuate based on market sentiment. (Studocu)
changes

📍 4. Primary vs Secondary Market (Quick Comparison)

Aspect Primary Market Secondary Market
Purpose Raise capital for issuers Provide liquidity and platform for trading
Participants Issuers & investors Investors only
Transaction type First-time securities Trade of existing securities
Funds flow Investors → issuer Investors ↔ investors
Price Formation Set at issue Determined by demand & supply

(Based on general financial market principles)

📘 5. Ethiopian Context (Typical University Notes)

Ethiopian finance lectures similarly define these markets:

✔ Primary market = new issuance of equities and bonds to raise funds. ([Link])
✔ Secondary market = trading of previously issued securities for liquidity and price discovery.
([Link])
✔ Derivatives like futures and options may trade in advanced markets. (ESX Academy)

📚 6. Important Terms to Know

💡 IPO (Initial Public Offering) – The first offering of shares to the public. (Encyclopedia
Britannica)
💡 Underwriter – Financial institution that helps with issuing securities. (Encyclopedia
Britannica)
💡 Liquidity – The ability to quickly convert assets into cash. (OER Collective)
💡 Price Discovery – Determination of a security’s price through trading. (Studocu)
📌 7. Summary
 The Primary Market is where new securities are issued to investors for the first time.
(Wikipedia)
 The Secondary Market is where those securities are traded between investors.
(Wikipedia)
 Both markets are essential in the financial system to raise capital and provide liquidity.
(Encyclopedia Britannica)

📘 Study Notes on Derivatives

✅ 1. What are Derivatives?

Derivatives are financial instruments whose value is derived from the value of an underlying
asset such as stocks, bonds, commodities, interest rates, foreign currencies, or market indices.

A derivative is a financial agreement between two parties whose value changes based on the
price movements of another asset.

Key idea: You do not own the underlying asset — you hold a contract whose value depends on
it.

🧠 2. Purpose of Derivatives

Derivatives are used for:

✔ Hedging – protecting against price risk

✔ Speculation – betting on price changes for profit
✔ Arbitrage – profiting from price differences in markets
✔ Risk management for financial institutions and firms

📊 3. Main Types of Derivatives

Derivative Definition

Futures Standardized forward contracts traded on exchanges

Forwards Customized contracts between two parties

Derivative Definition

Options Contracts giving right (not obligation) to buy/sell

Swaps Agreements to exchange cash flows over time

🔹 4. Futures Contracts

📌 Definition

A futures contract is a standardized agreement traded on a regulated exchange to buy or sell a

specific asset at a predetermined price on a specific future date.

📌 Key Features of Futures

✔ Standardized in terms of quantity & delivery date

✔ Traded on exchanges (e.g., CME, NYSE)
✔ Involve a margin requirement
✔ Marked-to-market daily (gains/losses settled daily)

📌 Example

A wheat farmer could lock in a selling price today by selling futures, protecting against price
drops in future.

🔹 5. Forward Contracts

📌 Definition

A forward contract is a private, customized agreement between two parties to buy or sell an
asset at a specified price on a future date.

📌 Features

✔ Customized terms (amount, date, price)

✔ Traded over-the-counter (OTC — not on exchanges)
✔ Higher counterparty risk (risk that other party might default)
✔ No daily settlement

📌 Example

A coffee importer agrees with a grower today to buy 1,000 kg in 6 months at a fixed price.

🔹 6. Options

📌 Definition

An option is a contract that gives the buyer the right — but not the obligation — to buy or sell
an asset at a pre-set price before or on a specific date.

📌 Types of Options

1. Call Option – Right to BUY the underlying asset

2. Put Option – Right to SELL the underlying asset

📌 Key Concepts

✔ Strike price – The fixed price in the contract

✔ Premium – Price paid for the option
✔ Expiration – The last date the option can be used

📌 Example

 A call option lets an investor buy shares at a fixed price if the market price rises.

 A put option lets them sell at a fixed price if the market price drops.

🔹 7. Swaps

📌 Definition

A swap is a derivative contract where two parties exchange financial cash flows for a set time
period.
📌 Common Types

 Interest Rate Swap – Exchange fixed interest payments for floating rate

 Currency Swap – Exchange cash flows in different currencies

 Commodity Swap – Exchange price exposure of a commodity

📌 Example

A company with variable-rate debt might swap with a bank to get fixed-rate payments, reducing
risk.

🧠 8. Comparison Summary

Feature Futures Forwards Options Swaps

Traded Exchange OTC Exchange/OTC OTC

Standardized Yes No Yes/No No

Obligation Yes Yes No Varies

Counterparty Low High Low/High Medium/High

Risk

Daily Settlement Yes No No No

📌 9. Role of Derivatives in Financial Markets

🔹 Price Discovery: They help determine expected future prices

🔹 Risk Management: Businesses hedge against price changes
🔹 Speculation: Traders make profits from price moves
🔹 Liquidity: Increase the depth and activity of markets