INTRODUCTION TO CAPITAL

MARKET

Module 1

Prepared by; Ethiopian Commodity Exchange Market Authority

January, 2025
 Table of Contents
Chapter – One........................................................................................................................................2
Introduction to the Financial Service Sector................................................................................2
Learning Objectives..........................................................................................................................2
1.1. Introduction.............................................................................................................................3
1.2. Definition of financial System...........................................................................................4
1.3. Financial System Functions: Direct & Indirect Finance.............................................6
1.4. Key Concepts of the Financial System...........................................................................7
1.5. Chapter Key Points..............................................................................................................10
Chapter Two..........................................................................................................................................12
Financial Institutions and Their Functions..................................................................................12
2.1. Introduction...........................................................................................................................12
2.2. Functions of Financial Institutions.................................................................................13
2.3. Classification of Financial Institutions..........................................................................16
2.4. Chapter Key Points..............................................................................................................27

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Module 1- Introduction to the Financial Service
Sector
1. Chapter-1- Introduction to the Financial System

2. Chapter-2 Financial Institutions and Their Functions

3. Chapter-3 Financial markets and Financial Instrument

4. Chapter 4 Ethiopian capital market

5. Chapter-5 Understanding Saving, Investment, Risk &

Return, and Ethics in Financial System

Chapter – One

Introduction to the Financial System

Learning Objectives

At the end of this module, students should be able to:

 Define Key Financial Concepts: Explain the financial system and its key
components, including the roles and functions of financial institutions,

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 markets, instruments, and regulations, and their importance for economic
growth.
 Analyze Financial System Functions: Differentiate between direct and
indirect finance, and analyze how these functions contribute to the efficiency
and stability of the financial system.
 Identify and Classify Financial Institutions: Categorize various financial
institutions and explain the specific roles of these institutions.
 Evaluate Financial Markets: Describe the functions and classifications of
financial markets, including the difference between primary and secondary
markets, and understand the significance of exchange and over-the-counter
markets.
 Understand and Assess Financial Instruments: Identify and differentiate
between financial instruments, such as money market instruments, capital
market instruments, and Sharia-compliant instruments, and explain their
respective roles in investment and financing.
 Examine the Ethiopian Capital Market: Outline the structure of the
Ethiopian capital market, including the regulatory bodies, legal frameworks,
and the role of the Ethiopian Securities Exchange (ESX) in fostering capital
market development.
 Apply Risk and Ethics Frameworks: Evaluate the relationship between risk
and return in investments, apply portfolio theory including CAPM and optimal
portfolio selection, implement risk management techniques, and discuss the
importance of ethics in financial markets to ensure integrity and trust in
financial transactions.

1.1. Introduction
Welcome to the captivating world of the financial system!
This chapter introduces the intricate network of institutions, markets, and
mechanisms that facilitate the flow of funds and resources within an economy.
We will explore how financial intermediaries, such as banks, investment firms,
and insurance companies, play a vital role in channeling savings into productive
investments, thereby fostering economic growth and managing risk.

1.2. Definition of financial System

A financial system refers to the interconnected network of institutions, markets,
and financial instruments that facilitate the flow of funds in an economy. It
encompasses banks, investment firms, insurance companies, and capital
markets, all of which play a crucial role in managing savings, investments, and
risk. The financial system enables efficient resource allocation, supports economic
growth, and provides mechanisms for individuals and organizations to access
capital and manage financial risks.
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Meaning of Finance and Money
Finance is the management of money and other assets, encompassing activities
like investing, borrowing, budgeting, saving, and forecasting financial outcomes.
In essence, finance is the study of how individuals, businesses, and organizations
raises and allocate their resources over time. For example, corporate finance
deals with decisions about how businesses raise and invest capital, while personal
finance is about managing an individual’s financial resources, including
budgeting, savings, and investments.
The role of finance is crucial for individuals, businesses, and governments for a
variety of reasons:

 Resource Allocation: Finance helps allocate resources efficiently,

determining where funds should be invested for optimal returns.
 Capital Formation: Finance facilitates the raising of capital, enabling
businesses to grow and innovate.
 Risk Management: It helps assess and mitigate financial risks through
methods like insurance, hedging, and diversification.
 Strategic Decision-Making: Sound financial management aids in making
informed decisions regarding investments, expansions, and operational
strategies.

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  Sustainability: Proper financial planning ensures long-term sustainability
and growth by managing cash flows and resources effectively.
 Economic Stability: Finance is vital for maintaining economic stability and
growth by facilitating capital flows, investment, and consumption.
 Innovation and Growth: Access to finance fuels innovation, research, and
development, driving progress and competitiveness in various sectors.

Definition of Money
Money is defined as anything that is generally acceptable as a means of
exchange, a measure of value, and a store of value. It serves several critical
functions:

 Medium of Exchange: Money simplifies trade by eliminating the need for

bartering, making it easier to conduct transactions.
 Unit of Account: It provides a standard measure of value, allowing for
easy comparison of the worth of different goods and services.
 Store of Value: Money allows individuals and businesses to save
purchasing power for future use, acting as a convenient and liquid way to
store wealth.

By understanding finance and money, students will gain insights into how these
concepts support financial stability, growth, and prosperity.

1.3. Financial System Functions: Direct & Indirect

Finance
Financial markets perform the essential function of channeling funds from
households, firms, and governments that have saved surplus funds to those that
need funds. This process is known as either direct or indirect finance.
Direct Finance: Here borrowers borrow funds directly from lenders in financial
markets by selling securities. For example, a company might raise funds by
issuing bonds or stocks, which investors purchase directly.
Indirect Finance: In indirect finance, funds are transferred through a financial
intermediary, such as a bank, which borrows from savers and lends to borrowers.
This is the primary route for moving funds from savers to borrowers and is a key
function of financial intermediaries.
The channeling of funds from savers to spenders is vital for economic growth, as
it ensures that capital is allocated efficiently to those who have profitable
investment opportunities.

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 1.4. Key Concepts of the Financial System
The financial system operates based on several fundamental concepts:

 Risk and Reward: Investors expect higher returns for taking on greater
risk.
 Supply and Demand: The prices of financial instruments depend on
supply and demand. When supply exceeds demand, prices fall, and vice
versa.
 No-Arbitrage: There should be no opportunity for risk-free profit through
buying and selling the same asset at different prices in different markets.
 Time Value of Money: Money today is worth more than the same amount
in the future due to its potential earning capacity. Interest rates represent
the reward for deferring consumption.

Understanding these concepts helps in grasping how financial institutions,

instruments, and markets function.
The price of financial instruments such as shares or bonds depends ultimately on
supply and demand. When the supply of a particular futures or options contract
goes up while demand remains the same (or falls), the price must decline, and
vice versa. It can be helpful to remember that, ultimately, supply and demand are
fundamental determinants of the market prices for everything.

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Working alongside supply and demand is a rule that we might call ‘no arbitrage’.
A trader cannot buy a financial instrument in one market at a low price while
simultaneously selling that same thing at a higher price in a different market. If
this were possible, the trader could earn infinite returns at zero risk. That would
contradict the risk–reward trade-off. Finally, have you ever wondered what
interest is and why it exists? An interest rate is the cost of borrowing, or the price
paid for the rental of funds usually expressed as a percentage. In simple terms,
interest is just the reward for waiting. All of the rates of return that we observe on
the financial markets consist of the pure time value of money, plus a premium for
risk, plus a premium for inflation. Whether it is a shareholder’s return, a
bondholder’s bond yield, or a conservative investor’s term deposit rate, the return
is a sum of the pure time value of money, a premium for risk, and a premium for
inflation.

Importance of the Financial Service Sector

The financial services sector plays a vital role in both advanced and developing
economies by:

 Connecting Savers and Borrowers: Through investment chains, the

financial services sector channels capital from savers to businesses and
other entities needing funds for growth.
 Managing Risk: Financial institutions provide insurance and other risk
management tools that help businesses and individuals manage
uncertainties.
 Providing Payment Systems: Banks and other financial services provide
mechanisms for money to be managed, transferred, and received
efficiently, which is essential for commercial activities and international
trade.
 Liquidity Provision: The sector ensures that there is enough liquidity in
the market, allowing individuals and businesses to access cash when
needed.
 Facilitation of Trade: Financial services support international trade by
providing payment systems, foreign exchange, and financing options,
enabling global commerce.
 Financial Inclusion: By providing access to banking and financial services,
the sector promotes financial inclusion, helping underserved populations
build wealth and improve their quality of life.

The financial services sector is fundamental for economic growth and

development. As it provides the necessary infrastructure for efficient capital
allocation, risk management, liquidity, and financial inclusion and payment
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systems, enabling the ecosystem to optimally utilize scarce financial resources.
This framework supports investment, foster innovation, and enhances overall
economic stability, driving sustainable growth.

Key Players/Components of the Modern Financial System

The modern financial system includes:

 Financial Institutions: Such as banks, credit unions, insurance

companies, investment banks, brokers and dealers, which mobilize savings,
provide credit and other financial services.
 Financial Markets: Including stock exchanges, bond markets, and
derivative markets, which enable the trading of financial assets.
 Financial Instruments: Such as stocks, bonds, and derivatives, which are
used for investment and financing.
 Regulatory Bodies: Are agencies that oversee and enforce rules to ensure
stability, integrity, and consumer protection.
 Technology and Infrastructure: Information technology has
revolutionized financial markets, enabling electronic trading, online
banking, and virtual marketplaces, which enhance efficiency, transparency,
and accessibility.

By understanding these components, students will gain insights into how the
financial system facilitates capital flow, investment management, and risk
mitigation, ultimately driving economic growth and prosperity.

1.5. Chapter Key Points

 Definition and Importance of Finance: Finance refers to the management

of money and assets, encompassing activities like investing, borrowing, and
budgeting. It plays a critical role in resource allocation, risk management,
strategic decision-making, and overall economic stability and growth.
 Functions of Money: Money serves as a medium of exchange, a unit of
account, and a store of value, facilitating transactions, enabling price
comparisons, and allowing individuals and businesses to save purchasing
power for future use.
 Overview of the Modern Financial System: A modern financial system
includes financial institutions, instruments, and markets that interact to
facilitate the flow of funds in the economy, promoting investment and
economic growth while enabling central banks to regulate monetary policy.
 Direct vs. Indirect Finance: Direct finance involves borrowers obtaining
funds directly from lenders by selling securities, while indirect finance occurs

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 through financial intermediaries (e.g., banks) that channel funds from lender-
savers to borrower-spenders, playing a crucial role in capital allocation.
 Key Concepts of the Financial System: Fundamental principles such as risk
and reward, supply and demand, no-arbitrage, and the time value of money
underpin the operations of financial markets and instruments, influencing
investment returns and pricing.
 Core Functions of the Financial Services Sector: The sector fulfills vital
roles, including connecting savers and borrowers through investment chains,
managing risks through insurance and derivatives, and providing efficient
payment systems for monetary transactions.
 Major Components of the Financial System: Key players include financial
institutions (banks, insurance companies), financial markets (stock exchanges,
bond markets), financial instruments (stocks, bonds), and regulatory bodies
that ensure market integrity and consumer protection.
 Impact of Technology and Regulation: Technological advancements have
transformed financial markets by enabling electronic trading and increasing
transparency, speed, and efficiency. Regulatory bodies impose rules and
standards to maintain a stable financial environment, prevent abuse, and
protect investors.

Chapter Two

Financial Institutions and Their Functions

2.1. Introduction
Financial institutions are the backbone of the modern economy, playing a pivotal
role in facilitating the smooth functioning of financial markets and intermediating
between borrowers and savers. These institutions encompass a diverse range of
entities, including commercial banks, investment banks, insurance companies,
asset management firms, and credit unions, each serving distinct purposes within
the financial ecosystem. Their primary functions revolve around mobilizing funds
from savers and channeling them towards productive investments, thereby
fostering economic growth and development. Additionally, financial institutions
provide essential services such as payment processing, risk management,
liquidity provision, and financial advisory, catering to the diverse needs of
individuals, businesses, and governments.

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Moreover, financial institutions act as key custodians of savings, offering a safe
avenue for individuals and organizations to deposit funds, earn returns, and
access credit facilities. By leveraging their expertise in assessing risks, managing
liquidity, and allocating capital efficiently, these institutions help allocate
resources optimally across various sectors of the economy, promoting stability
and prosperity. In essence, financial institutions serve as critical intermediaries
that lubricate the wheels of the economy, enabling the efficient flow of capital
and fostering economic progress at both the micro and macro levels.

2.2. Functions of Financial Institutions

Often, the portfolio preferences of savers and borrowers differ. For example, a
risk-averse lender may prefer to receive a lower rate of return in exchange for
maintaining funds that are easily accessible, while a borrower may be willing to
pay a higher rate of return for access to long-term funding. Many savers and
borrowers would likely find it challenging to meet their investment and funding
needs if only direct finance was available. Financial intermediaries solve this
problem by matching the preferences of both parties while making a profit.

Intermediaries can transform short-term deposit funds into longer-term loans. An

essential economic role of an intermediary is to resolve the conflicting
preferences of surplus units (savers) and deficit units (borrowers), thereby
encouraging both savings and productive capital investment. By offering financial
instruments with varying attributes—such as risk, return, liquidity, and timing of
cash flows—intermediaries perform several key functions that benefit both savers
and borrowers:
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  Asset Transformation
 Maturity Transformation
 Credit Risk Diversification and Transformation
 Liquidity Transformation
 Economies of Scale
A. Asset Transformation
The asset transformation function of financial institutions refers to the process by
which these institutions convert or transform various types of financial assets to
meet the needs of different parties. This involves taking funds from savers (who
prefer liquid, low-risk assets) and reallocating them into longer-term investments
or loans (which may carry higher risk and yield).
Intermediaries specialize in pooling small savings into larger amounts that can be
loaned to borrowers, achieving economies of scale in the process.
Financial intermediaries provide a variety of deposit products to meet the needs
and preferences of customers. These products include demand deposit accounts,
current accounts, term deposits, and cash management trusts. At the same time,
intermediaries offer a range of loan products, including overdraft facilities, term
loans, mortgage loans, and credit card facilities.
B. Maturity Transformation
Savers often prefer high liquidity in their financial assets, while borrowers tend to
prefer longer-term funding commitments. By managing the deposits they receive,
intermediaries can offer long-term loans while satisfying savers’ preferences for
short-term savings. This function is known as maturity transformation. Banks are
a prime example of financial intermediaries that perform maturity transformation.
They manage a mismatch between the terms of their funding sources (deposits)
and their loans (liabilities).
Financial intermediaries can perform maturity transformation effectively for two
main reasons:

 Predictable Withdrawals: It is unlikely that all savers will withdraw their

deposits simultaneously. Typically, withdrawals during a specific period are
matched by new deposits.
 Liability Management: When a bank’s deposit base falls below the level
needed to fund its loan portfolio, the bank can adjust interest rates to
attract more deposits or issue securities in money or capital markets to
raise the necessary funds.

C. Credit Risk Diversification and Transformation

Credit risk transformation occurs through the contractual agreements of financial
intermediaries. A saver has an agreement with the intermediary, meaning the

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credit risk exposure of the saver is limited to the risk of the intermediary
defaulting. The intermediary, in turn, has a separate loan agreement with the
borrower and is exposed to the credit risk of the borrower.
Financial intermediaries are better equipped than individual savers to manage
credit risk. They specialize in lending and have developed expertise in assessing
the risks of potential borrowers. This expertise comes from the technical skills of
their employees, loan assessment systems, and information gathered through
prior dealings with borrowers.
D. Liquidity Transformation
Savers typically prefer liquidity in their investments to manage timing
mismatches between income and expenses. In times when income exceeds
expenses, savings are available for investment; during times when expenses
exceed income, savers need access to liquidity. Financial intermediaries perform
liquidity transformation by providing financial assets that are easily convertible to
cash at or near market value. Banks further extend liquidity through systems like
automatic teller machines (ATMs) and electronic funds transfer at point of sale
(EFTPOS).
E. Economies of Scale
Financial intermediaries achieve economies of scale due to their size and
transaction volumes, enabling them to develop cost-efficient distribution systems.
Banks, for instance, maintain extensive branch networks and provide technology-
driven distribution systems such as ATMs, EFTPOS, telephone banking, and
internet banking. Intermediaries also benefit from cost advantages through
effective knowledge management and the accumulation of financial, economic,
and legal expertise. In a competitive market, intermediaries should pass on
efficiency gains to consumers in the form of reduced interest margins and fees.

2.3. Classification of Financial Institutions

Financial institutions are vital components of the economy, facilitating the flow of
funds and providing essential services to individuals, businesses, and
governments. They can be broadly categorized into two main types: depository
and non-depository institutions, each serving distinct functions.
A. Depository Institutions
Depository institutions accept deposits from surplus units and provide credit to
deficit units through loans and purchases of securities. They are popular financial
institutions for the following reasons:

 They offer deposit accounts that can accommodate the amount and liquidity
characteristics desired by most surplus units.

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 They repackage funds received from deposits to provide loans of the size and
maturity desired by deficit units.
 They accept the risk on loans provided.
 They have more expertise than individual surplus units in evaluating the
creditworthiness of deficit units.
 They diversify their loans among numerous deficit units and therefore can
absorb defaulted loans better than individual surplus units could.

To appreciate these advantages, consider the flow of funds from surplus units to
deficit units if depository institutions did not exist. Each surplus unit would have
to identify a deficit unit desiring to borrow the precise amount of funds available
for the precise time period in which funds would be available. Furthermore, each
surplus unit would have to perform the credit evaluation and incur the risk of
default. Under these conditions, many surplus units would likely hold their funds
rather than channel them to deficit units. Hence, the flow of funds from surplus
units to deficit units would be disrupted.
The common types of depository institutions are:

 Commercial Banks
 Savings or Thrift Institutions

A more specific description of each depository institution’s role in the financial

markets follows.
1. Commercial Banks
In aggregate, commercial banks are the most dominant depository institution.
They serve surplus units by offering a wide variety of deposit accounts, and they
transfer deposited funds to deficit units by providing direct loans or purchasing
debt securities. Commercial bank operations are exposed to risk because their
loans and many of their investments in debt securities are subject to the risk of
default by the borrowers.
Commercial banks serve both the private and public sectors, with their deposit
and lending services are utilized by households, businesses, and government
agencies. The interbank money market facilitates the flow of funds between
banks. A bank that has excess funds can lend to a bank with deficient funds for a
short-term period, such as one to seven days. In this way, the interbank money
market facilitates the flow of funds from banks that have excess funds to banks
that are in need of funds.
2. Savings/Thrift Institutions

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Savings institutions, which are sometimes referred to as thrift institutions
including saving banks, saving and loan association (S&Ls), and credit unions.
Like commercial banks, savings institutions offer deposit accounts to surplus units
and then channel these deposits to deficit units. These institutions focus
primarily on accepting deposits and providing loans to individuals, particularly for
purposes like home mortgages and consumer loans.
2.1. Savings Banks
Source of Funds: Savings banks primarily accept deposits from individuals and
businesses.
Use of Funds: They typically use these deposits to provide home mortgages and
personal loans, focusing on retail banking services. Savings banks often
emphasize community development.
2.2. Savings and Loan Associations (S&Ls)
Source of Funds: S&Ls gather funds mainly through savings accounts and time
deposits from customers.
Use of Funds: They primarily provide residential mortgages and home equity
loans, though they may also engage in commercial lending. S&Ls aim to promote
home ownership and support local housing markets.
2.3. Credit Unions
Source of Funds: Credit unions collect deposits from their members, who share a
common bond, such as employment or community affiliation.
Use of Funds: They use these deposits to offer lower-cost loans, including
personal, auto, and mortgage loans, while providing competitive interest rates on
savings accounts. Credit unions focus on member service and financial education.
2.4. Microfinance Institutions
Microfinance institutions (MFIs) are financial entities that provide a range of
financial services to low-income individuals and small businesses that typically
lack access to traditional banking facilities. These services often include
microloans, savings accounts, insurance, and financial literacy training. The
primary goal of MFIs is to empower marginalized communities by enabling them
to engage in income-generating activities, thereby fostering entrepreneurship
and improving their overall quality of life. By offering small-sized financial
products, MFIs play a crucial role in promoting financial inclusion and supporting
the economic development of underserved populations.
In addition to providing financial services, MFIs also focus on social impact by
addressing the barriers faced by low-income individuals. Many MFIs adopt a group
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lending approach, wherein borrowers form small groups that provide mutual
support and accountability, reducing the credit risk associated with lending to
individuals without collateral. This model not only encourages repayment but also
helps build community ties and fosters solidarity among borrowers. Overall,
microfinance institutions serve as vital catalysts for economic growth, as they
equip clients with the resources necessary to escape poverty and improve their
living conditions.
B. Non-Depository Financial Institutions
Non-depository institutions generate funds from sources other than deposits but
also play a major role in financial intermediation. The major types of non-
depository institutions are:

 Finance Companies
 Insurance Companies
 Investment Funds
 Pension Funds
 Investment Banks
 Brokers and Dealers
 Collective Investment Schemes
 Credit Rating Agencies

1. Finance Companies
Finance companies are non-bank financial institutions that provide a range of
financial services, primarily focusing on lending and credit.
Source of Funds: Finance companies typically raise funds through the issuance of
bonds, commercial paper, and by borrowing from banks. They may also use
capital from investors.
Use of Funds: They primarily provide personal loans, auto loans, business loans,
and consumer credit. Unlike banks, finance companies often focus on higher-risk
borrowers, offering loans with varying terms and conditions.
2. Investment Banks
In addition to brokerage and dealer services investment banking and the
securities firms that specialize in these services are sometimes referred to as
investment banks. When securities firms underwrite newly issued securities, they
may sell the securities for a client at a guaranteed price or may simply sell the
securities at the best price they can get for their client. Some securities firms
offer advisory services on mergers and other forms of corporate restructuring. In
addition to helping a company plan it’s restructuring, the securities firm also

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executes the change in the client’s capital structure by placing the securities
issued by the company. Securities firms also provide underwriting and advising
services. The underwriting and advising services are commonly referred to as
3. Insurance Companies
Insurance companies provide individuals and firms with insurance policies that
reduce the financial burden associated with death, illness, and damage to
property. These companies charge premiums in exchange for the insurance that
they provide. They invest the funds received in the form of premiums until the
funds are needed to cover insurance claims. Insurance companies commonly
invest these funds in stocks or bonds issued by corporations or in bonds issued by
the government. In this way, they finance the needs of deficit units and thus
serve as important financial intermediaries.
4. Pension Funds
Many corporations and government agencies offer pension plans to their
employees. The employees and their employers (or both) periodically contribute
funds to the plan. Pension funds provide an efficient way for individuals to save
for their retirement. The pension funds manage the money until the individuals
withdraw the funds from their retirement accounts. The money that is contributed
to individual retirement accounts is commonly invested by pension funds in
stocks or bonds issued by corporations or in bonds issued by the government.
Thus, pension funds are important financial intermediaries that finance the needs
of deficit units.

Financial
Main Sources of Funds Main Uses of Funds
Institutions
Purchases of government
Deposits from households,
and corporate securities;
Commercial Banks businesses, and
loans to businesses and
government agencies
households
Purchases of government
Deposits from households, and corporate securities,
Saving institutions businesses, and mortgages and other
government agencies loans to households;
some loans to businesses
Deposits from credit union Loans to credit union
Credit Unions
members members
Securities sold to
Loans to households and
Finance Companies households and
businesses
businesses
Shares sold to households, Purchases of long-term
Mutual Funds
businesses, and government and
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 government agencies corporate securities
Insurance premiums and Purchases of long-term
Insurance companies earnings from government and
investments corporate securities
Purchases of long-term
Employer/employee
Pension funds government and
contributions
corporate securities

5. Collective Investment Schemes (CIS)

Collective Investment Schemes are pooled investment vehicles that allow
investors to combine their funds to invest in diversified portfolios managed by
professionals. They include mutual funds, hedge funds, exchange-traded funds
(ETFs), and real estate investment trusts (REITs). By pooling funds, CIS allows
individual investors to achieve greater diversification than they might obtain on
their own. Fund managers or investment advisors possess expertise and manage
daily investment decisions on behalf of the investors. Many CIS are regulated to
protect investors, ensuring transparency, proper disclosures, and fair practices.
Types of Collective Investment Schemes:

 A mutual fund is a type of collective investment scheme that allows

individual investors to pool their money with others to invest in a diversified
portfolio of stocks, bonds, or other securities. By investing in a mutual fund,
investors can gain exposure to a broad range of assets managed by
professional fund managers, eliminating the need to manage individual
investments themselves.
 Exchange-Traded Funds (ETFs) are investment funds that trade on stock
exchanges, similar to individual stocks. They pool capital from multiple
investors to create a diversified portfolio of assets, such as stocks, bonds,
or commodities Real Estate Investment Trusts (REITs) are companies that
own, operate, or finance income-producing real estate across various
sectors, such as residential, commercial, and industrial properties. By
pooling capital from multiple investors, REITs provide a way for individuals
to invest in real estate without directly owning properties.
 Hedge funds are alternative investment vehicles that pool capital from
accredited investors and institutional clients to pursue a wide range of
strategies aimed at generating high returns

6. Brokers and Dealers

Brokers are intermediaries who facilitate the buying and selling of securities on
behalf of clients. They do not own the securities themselves but earn a

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commission for their services. Brokers typically work for brokerage firms and
provide services such as research, advice, and market insights to help clients
make informed decisions.
Dealers, on the other hand, buy and sell securities for their own accounts. They
maintain an inventory of securities and profit from the difference between the
buying and selling prices (the spread). Dealers are often involved in market-
making, providing liquidity by being ready to buy or sell at any time. Both brokers
and dealers are subject to regulatory oversight to ensure fair practices,
transparency, and investor protection. Key regulatory bodies include the
Ethiopian Capital Market Authority (ECMA) in Ethiopia, and analogous
organizations worldwide.
7. Credit Rating Agencies (CRAs)
Credit Rating Agencies evaluate the creditworthiness of issuers of debt securities,
providing ratings that indicate the risk associated with investing in those
securities. CRAs help reduce information asymmetry between issuers and
investors by providing independent ratings based on thorough analysis. Credit
ratings guide investor decisions and contribute to orderly market functioning by
identifying risk levels. The major CRAs are Standard & Poor’s (S&P), Moody’s, and
Fitch Ratings. These agencies use standardized rating scales (e.g., AAA, AA, A,
etc.) to indicate credit quality. After the 2008 financial crisis, regulatory entities
have increased scrutiny of CRAs to enhance accountability and improve rating
accuracy.

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Ethiopia’s Eurobond [1] Credit Rating
When Ethiopia issued its first Eurobond in December 2014, it marked a significant
milestone for the country’s economic ambitions and its entry into global capital
markets. This $1 billion, 10-year bond with an interest rate of 6.625% was aimed
at financing infrastructure projects, showcasing Ethiopia’s commitment to rapid
economic growth and infrastructure development.
The Eurobond was issued in a context where Ethiopia’s economy was one of the
fastest-growing in Africa, boasting annual growth rates exceeding 10% for several
years. The government sought to leverage this positive growth narrative to
attract international investors. It also capitalized on the prevailing low global
interest rate environment, which made high-yielding bonds from developing
countries attractive to investors.
Initial Ratings and Investor Response: When the bond was issued, credit
rating agencies evaluated Ethiopia’s economic fundamentals. At that
time, Moody’s assigned Ethiopia a B1 rating, which was a non-investment
grade but indicated a stable outlook. Standard & Poor’s (S&P) and Fitch
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Ratings both provided a similar credit rating of B. This level suggested that while
there was a degree of risk associated with investing in Ethiopia, there was also
potential for higher yields, which attracted investors looking for returns beyond
those available in more developed markets.
The issuance was oversubscribed, signaling strong investor confidence. Demand
for the bond reportedly reached around $2.6 billion, more than twice the amount
sought, and highlighting international interest in Ethiopia’s growth story.
[1] A Eurobond is a type of international bond that is issued in a currency
different from the currency of the country or market in which it is issued. Despite
its name, “Eurobond” is not limited to Europe; it refers to bonds issued in any
currency other than the local currency of the country where the bond is issued.
For example, a bond issued by the Ethiopian Government in U.S. dollars and sold
outside Ethiopia would be considered a Eurobond.

2.4. Chapter Key Points

 Role of Financial Institutions: Financial institutions are essential

intermediaries in the economy that facilitate the flow of funds between savers
and borrowers. They mobilize savings, provide loans, and offer various
financial services, ultimately driving economic growth and stability.
 Functions of Financial Intermediaries: Key functions performed by
financial institutions include asset transformation (converting small deposits
into larger loans), maturity transformation (matching the shorter-term
preferences of savers with the longer-term needs of borrowers), credit risk
diversification, liquidity transformation (providing liquid deposits while offering
loans), and achieving economies of scale to enhance efficiency.
 Types of Financial Institutions: Financial institutions are broadly classified into
depository institutions (e.g., commercial banks, savings institutions, credit
unions) that take deposits and offer loans, and non-depository institutions
(e.g., finance companies, insurance companies, investment funds) that
mobilize funds through means other than deposits to provide financial
intermediation.
 Depository Institutions: These institutions accept deposits from surplus
units and provide credit to deficit units, fulfilling vital roles like evaluating
creditworthiness, absorbing default risk, and repackaging funds. Common
types include commercial banks, which focus on a wide array of loans and
deposits, thrift institutions focusing on residential loans, and credit unions,
which are nonprofit organizations serving specific member groups.
 Non-Depository Financial Institutions: These institutions do not take
deposits but play critical roles in the financial system by providing lending and
investment services. They include finance companies (offering credit),
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 investment funds (pooling funds for diversified investments), insurance
companies (providing coverage and investing premiums), pension funds
(managing retirement savings), and investment banks (offering underwriting
and advisory services).
 Collective Investment Schemes (CIS): Collective Investment Schemes
allow investors to pool their resources to invest in diversified portfolios
managed by professionals. Examples include mutual funds, exchange-traded
funds (ETFs), and hedge funds, enabling individual investors to benefit from
diversification and professional management.
 Brokers and Dealers: Brokers act as intermediaries executing buy and sell
orders for clients, while dealers trade securities for their own accounts. Both
play a crucial role in liquidity and price discovery in financial markets, and are
subject to regulatory oversight to ensure transparent practices and investor
protection.

Chapter Three

Financial markets and Financial Instrument

Chapter Introduction

Financial markets play a pivotal role in the global economy, serving as

platforms where individuals, institutions, and governments can trade financial
securities, commodities, and other fungible items at prices determined by
market forces. These markets provide essential mechanisms for the efficient
allocation of capital, allowing for the transfer of funds from savers to
borrowers. Financial markets can be classified based on various criteria,
including the type of financial assets traded, the maturity of the securities, and
the nature of the transactions. Understanding the classification of financial
markets is crucial for investors and policymakers to comprehend the diverse
functions and dynamics of each market segment, from money markets dealing
with short-term debt securities to capital markets facilitating long-term
investment through stocks and bonds.

3.1. Financial Market

3.1.1. Functions of Financial Market

Financial markets serve as platforms for buyers and sellers to transact in various
financial instruments, acting as a link that facilitates the transfer of assets to
optimal investment opportunities. They help determine the capital value of
securities by allowing market forces to set prices, while also mobilizing funds
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within the economy through the buying and selling of securities, ensuring efficient
savings allocation. The major functions of financial markets are:

 Price Determination: Financial markets facilitate the price discovery of

financial instruments through transactions between buyers and sellers. Prices
are determined by the demand and supply dynamics in the market, enabling
efficient allocation of resources.
 Funds Mobilization: Financial markets facilitate the allocation of funds from
surplus units (investors) to deficit units (borrowers), contributing to economic
growth by mobilizing savings for investment purposes.
 Provide Liquidity: Financial markets ensure liquidity by providing a platform
where buyers and sellers can trade financial instruments, allowing investors
to convert assets into cash quickly and efficiently.
 Risk Sharing: Financial markets allow for the transfer of risk from those
seeking minimizing their risk to those willing to assume it, enabling effective
risk management through various financial instruments.
 Easy Access: Financial markets offer an organized platform for buyers and
sellers to interact, saving time and resources while making trading more
accessible.
 Reducing Transaction Costs: By providing an organized technological
platform, financial markets reduce search and information costs, thereby
lowering the overall transaction costs for participants.
 Capital Formation: Financial markets facilitate the accumulation of capital,
contributing to economic growth by financing projects that enhance
productivity and infrastructure.

Illustration of the Role of Financial Markets in the Transfer of Financial

Risks
Imagine a farmer who grows wheat. The farmer is worried that by the time the
wheat is ready for harvest, the price might drop due to market changes, and they
won’t make enough money to cover their costs. On the other side, there’s a
bread-making company that depends on wheat to produce bread, and they are
concerned that prices might rise and hurt their profit margins.
To manage their risks, they can use a financial market tool called a futures
contract. The farmer can agree to sell the wheat at a fixed price before the
harvest, while the bread company agrees to buy it at that same price. This way:

 The farmer secures a guaranteed price for the wheat, protecting

themselves from the risk of prices falling.
 The bread company locks in the price they will pay for wheat, protecting
themselves from the risk of prices rising.

In this situation, the financial market allows the farmer to transfer the risk of price
fluctuations to the bread company, which is willing to take on this risk in exchange
for the stability of knowing their future costs. Both parties use this arrangement to
manage their respective risks, demonstrating how financial markets help in

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transferring risk from those who want to minimize it to those willing to accept it.

3.1.2. Classification of Financial Markets

Financial markets can be classified in different ways. The most common
classification of financial markets is into primary and secondary markets using
the seasoning of claim criterion. However, the structure of financial markets can
also be classified into different categories by the nature of the claim (debt market
and equity market), by the maturity claim (money and capital market), by the
timing of delivery (cash or spot and futures market), and the organizational
structure (exchange-traded vs. over-the-counter (OTC) market).

1. Primary and Secondary Markets

 Primary Markets: Primary markets facilitate the issuance of new

securities, allowing companies, governments, and other entities to raise
capital by selling financial instruments directly to investors.
 Secondary Markets: Secondary markets provide a platform for the
trading of existing securities, allowing investors to buy and sell securities
among themselves. This market provides liquidity to investors, enabling
them to sell their holdings without holding them until maturity.

2. Debt and Equity Markets

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  Debt Market: A market where debt instruments such as Treasury bills,
bonds and mortgages are traded. These instruments represent a
contractual agreement by the borrower to pay the lender fixed amounts
until maturity.
 Equity Market: A market where equity instruments such as common stock
are traded. Equity represents ownership in a company, and shareholders
are entitled to a share in the profits and assets of the business.

3. Money Markets vs. Capital Markets

 Money Markets: The money market is a segment of the financial market

where short-term instruments with maturities of less than one year are
traded. These instruments are highly liquid and are used by institutions to
manage short-term funding needs.
 Capital Markets: The capital market is where long-term instruments, such
as stocks and long-term debt securities, are traded. It provides funds for
long-term investments in infrastructure, business expansion, and other
projects.

4. Cash or Spot Markets vs. Futures Markets

 Cash or Spot Markets: In cash or spot markets, transactions are settled

immediately or within a short period after the trade are made.
 Futures Markets: Futures markets involve contracts for future delivery of
assets at a predetermined price. These markets are used for hedging risk or
speculation.

5. Exchanges vs. Over-the-Counter Markets

 Exchanges: Organized exchanges are centralized platforms where

securities are traded under a set of rules and regulations. Examples include
the Ethiopia Securities Exchange (ESX) the New York Stock Exchange
(NYSE), The London Stock Exchange Group (LSEG), Nairobi Securities
Exchange (NSE) etc.
 Over-the-Counter (OTC) Markets: OTC markets are decentralized
networks where participants trade financial instruments directly with each
other. This market structure allows for flexibility and is used for trading
instruments that may not be listed on an exchange.

6. Sharia-Compliant Capital Market

Sharia-compliant capital markets refer to financial markets that operate in
accordance with Islamic principles (Sharia). Sharia is an Arabic term, which
literally means ‘the way’ or ‘a path to a watering place’, ‘a clear path to be
followed’, and more precisely, ‘the way which leads to a source.’ The principles
emphasize ethical and moral investing, prohibiting practices such as usury (riba),
gambling (maisir), and investing in haram (forbidden) activities (e.g., alcohol,
pork, gambling). Sharia-compliant capital markets represent a growing market
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within the global financial landscape, marrying the principles of finance with
ethical considerations rooted in Islamic law. They offer a unique alternative for
investors seeking to align their financial goals with their ethical values. As these
markets continue to evolve, they present opportunities and challenges that
require ongoing dialogue among stakeholders, regulators, and scholars within the
finance domain.
Examples of Sharia Compliant securities include:

 Sukuk (‘Islamic Bonds’): Sukuk are the Islamic equivalent of bonds.

Unlike conventional bonds that pay interest, sukuk represent ownership in a
tangible asset, project, or investment, and the returns come from profit-
sharing or rental income rather than interest.
 Islamic Mutual Funds: These funds pool money from investors to
purchase a diversified portfolio of Sharia-compliant equities, sukuk, and
other permissible investments.
 Islamic ETFs (Exchange-Traded Funds): These are funds that track
Sharia-compliant indices and are traded on a securities exchanges like
traditional ETFs.
 Sharia-Compliant Equities: Shares of companies that comply with
Islamic principles, such as those that do not engage in prohibited activities
and have acceptable financial ratios (e.g., low levels of debt).

Shariah Compliance
Aspect Conventional Finance
Finance
Underlying Principles Secular laws and principles Shariah (Islamic Law)
Interest Central to the system Prohibited
Risk and Profit Risk is transferred to the
Risk is shared between parties
Sharing borrower
Asset-Backed Must be linked to tangible
Loans often not asset-backed
Financing assets
Investment Ethical investments, Shariah-
Profit-driven, few restrictions
Guidelines compliant
Social Justice and A key principle (e.g. zakat,
Secondary to profit
Welfare qard al-hasan)
Emphasizes partnerships and
Contract Types Based on loans and interest
profit-sharing
Governance and Financial regulations and Corporate as well as Shariah
Compliance corporate laws governance
Purpose and Maximization of
Equitable distribution of wealth
Philosophy shareholders’ value

3.1.3. Roles of Securities Exchanges

Securities Exchanges (also often called Stock Exchanges, or Stock Market) play a
crucial role in the financial markets by providing a centralized platform where
shares/stock and other securities are bought and sold. They facilitate the trading

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of securities, allowing investors to purchase ownership stakes in companies and
participate in their growth, if the securities are shares, or provide long term
finance to companies, in a form of trading in debt instruments and in the process
earn interest. This process not only enhances liquidity, meaning that investors
can quickly buy or sell their holdings, but also contributes to price discovery, as
the value of shares is determined by supply and demand dynamics. Securities
exchanges also provide transparency, ensuring that all transactions are
conducted according to regulations, which builds investor confidence and helps
maintain fair market practices.
Inside a securities exchange, trading operations involve various activities that
ensure efficient transactions. Market participants, including individual &
institutional investors, send their orders to securities brokers and dealers. The
latter submit buy and sell orders, which are matched using sophisticated
electronic trading systems. These systems analyze orders in real-time, executing
trades at the best available prices. Exchanges also oversee the listing process for
companies wishing to sell shares to the public, requiring them to meet specific
regulatory standards. Exchanges also regulate the intermediaries that are their
members. Additionally, they provide market data, such as share prices and
trading volumes, which are essential for investors to make informed decisions.
Overall, securities exchanges serve as vital intermediaries that connect buyers
and sellers, facilitating capital formation and contributing to the overall health of
the economy.

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Clearing and Settlement Process
Clearing and settlement are key processes in the securities market that ensure
transactions between buyers and sellers are completed accurately and efficiently.
Once a trade is executed on the securities exchange, the clearing process begins.
This involves verifying the details of the trade, such as the number of shares and
the price, and ensuring that both parties have the necessary funds or securities to
complete the transaction. A central Securities Depository (CSD) or clearing
houses act as intermediaries in this process, reducing the risk of default by
guaranteeing that trades will be settled, even if one party fails to fulfill their
obligation.
Settlement occurs after a deal has been executed at the exchange or over the
counter. While the change in economic ownership is immediate, the transfer of
securities from the seller and the payment from the buyer takes some time. The
process consists of several key stages, collectively described as clearing and
settlement:

 Pre-settlement and Clearing: As soon as a trade has been executed,

several procedures and checks must be conducted before settlement can
be completed. These include matching the trade instructions supplied by
each counterparty to ensure that the details they have supplied for the
trade correspond. It also involves conducting checks to ensure that the
seller has sufficient securities to deliver and that the buyer has sufficient
funds to cover the purchase cost.
 Settlement: The process through which legal title (i.e., ownership) of a
security is transferred from seller to buyer in exchange for the equivalent
value in cash. Usually, these two transfers should occur simultaneously.
 Post-settlement: This entails the management of failed transactions and
the subsequent accounting of trades.

When a trade has been executed, a key step in the management of risk in the
post-execution, pre-settlement stage is for the two sides to the trade to compare
trade details, and to eliminate any mismatches prior to the exchange of cash and
securities. This is broadly called the ‘trade confirmation’ step.
Clearing is the process through which the obligations held by the buyer and
seller to a trade are defined and legally formalized. In simple terms, this
procedure establishes what each of the counterparties expects to receive when
the trade is settled. It also defines the obligations each must fulfill, in terms of
delivering securities or funds, for the trade to settle successfully.
Specifically, the clearing process includes:

 Recording key trade information so that counterparties can agree on its

terms
 Formalizing the legal obligation between counterparties
 Matching and confirming trade details
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  Agreeing procedures for settling the transaction
 Calculating settlement obligations and sending out settlement instructions
to the brokers, custodians, and the CSD
 Managing margin and making margin calls, which relates to collateral paid
to the clearing agent by counterparties to guarantee their positions against
default up to settlement

There are two further basic elements to the settlement of trades that can differ
across different instruments and/or markets:

 Timing of Settlement: The length of time it takes for a trade to settle is

based on the trade date plus a set number of business days after the trade
is executed. This is sometimes called the processing cycle. Settlement
length is usually expressed as T (trade date) + the number of days, for
example, T+2 means transaction date plus two business days. Settlement
timing differs across different countries/exchanges and can differ within the
same country/exchange by type of security.
 Structure of the Settlement System: The Bank for International
Settlements (BIS) has identified three common structural
approaches/models for linking delivery and payment in a securities
settlement system that are all typically described as achieving delivery
versus payment (DvP).

The bank of international settlement (BIS) identifies the following three models
for DvP settlement systems:
Model 1 – systems that settle transfer instructions for both securities and
funds on a trade-by-trade (gross) basis, with final (unconditional) transfer of
securities from the seller to the buyer (delivery) occurring at the same time as
final transfer of funds from the buyer to the seller (payment).
Model 2 – systems that settle securities transfer instructions on a gross
basis, with final transfer of securities from the seller to the buyer (delivery)
occurring throughout the processing cycle, but settle funds transfer instructions
on a net basis, with final transfer of funds from the buyer to the seller (payment)
occurring at the end of the processing cycle.
Model 3 – systems that settle transfer instructions for both securities and
funds on a net basis, with final transfers of both securities and funds occurring
at the end of the processing cycle.
Financial markets are essential for promoting economic growth and stability by
providing mechanisms for resource allocation, liquidity, and risk management. A
comprehensive understanding of financial market classifications helps investors
and policymakers make informed decisions and navigate the complexities of the
financial landscape.

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 3.2. Financial Instruments
Financial instruments are contracts that represent an asset to one party and a
liability to another, playing a crucial role in the financial markets. They can be
categorized into two main types: equity instruments, such as stocks, which
represent ownership in a company, and debt instruments, such as bonds, which
signify a loan made by an investor to a borrower. Financial instruments also
include derivatives, like options and futures, which derive their value from
underlying assets. These instruments facilitate various financial activities,
including investment, risk management, and capital raising, providing investors
and institutions with tools to achieve their financial goals and manage risk
effectively. Depending on their maturity period, financial instruments can also be
classified as money market securities and capital market securities.

3.2.1. Money Market Instruments

Money market securities are debt securities with a maturity of one year or less.
Money market securities are commonly purchased by households, corporations
(including financial institutions), and government agencies that have funds
available for a short-term period. Because money market securities have a short-
term maturity and can typically be sold in the secondary market, they provide
liquidity to investors. Money market securities tend to have a low expected return
but also a low degree of credit (default) risk. Most firms and financial institutions
maintain some holdings of money market securities for this reason.
The most popular money market securities are:

 Treasury Bills (T-bills)

 Commercial Paper
 Negotiable Certificates of Deposit
 Repurchase Agreements (Repos)

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 3.2.2. Capital Market Instruments
Capital market instruments are financial tools with an original term to maturity of
more than one year. Businesses and governments use these instruments to raise
long-term funds. They are essential for facilitating long-term investment and
promoting economic growth by providing entities with the capital needed for
development and expansion. They primarily include:
Stocks (Equity Instruments): Represent ownership in a company and entitle
shareholders to a portion of profits, usually in the form of dividends. Stocks can
be common or preferred, each offering different rights and privileges. Bonds
(Debt Instruments): Loans made by investors to issuers (such as corporations
or governments) that pay periodic interest and return the principal at maturity.
Bonds vary in terms of duration, credit quality, and interest rates.

3.2.3. Sharia-Compliant Financial Instruments

Islamic finance refers to financial activities that comply with the principles of
Sharia Law. This has been discussed in the preceding sections.
Derivative instruments are financial contracts whose value is derived from the
performance of underlying assets, indices, or rates. Common types of derivatives
include futures, options, forwards, and swaps. These instruments allow investors
and traders to hedge risk, speculate on price movements, and gain exposure to a
variety of asset classes, including equities, commodities, currencies, and interest
rates. For example, a farmer might use futures contracts to lock in prices for their
crops, providing protection against potential price declines before harvest.
Similarly, investors might use options to speculate on the future price movements
of stocks without needing to purchase the underlying shares directly.
While derivatives can serve useful purposes in risk management and speculation,
they also carry significant risks and complexities. The leverage often involved in
derivative trading can magnify both gains and losses, which can lead to
substantial financial difficulties if markets move unfavorably. Additionally,
derivatives can introduce counterparty risk, as the performance of these
contracts often relies on the financial stability of the other party involved. As a
result, regulatory bodies closely monitor derivative markets to ensure
transparency and minimize systemic risk, especially following the 2008 financial
crisis, which highlighted the potential dangers posed by unregulated derivatives
trading. Overall, while derivatives play a critical role in modern financial markets,
understanding their complexities and risks is essential for effective risk
management.

Chapter Key Points

 Role of Financial Markets: Financial markets serve as platforms for

trading financial securities, commodities, and other assets, facilitating the

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 efficient allocation of capital between savers and borrowers, thereby
enhancing economic growth and stability.
 Functions of Financial Markets: Key functions include price
determination through supply and demand, mobilization of funds from
savers to borrowers, providing liquidity to ease transactions, risk sharing
among investors, and reducing transaction costs while promoting capital
formation for economic development.
 Market Price Formation: Financial markets enable price discovery for
financial instruments based on market forces, allowing for the efficient
setting of prices for newly issued and existing securities.
 Classification of Financial Markets: Financial markets can be classified
into primary and secondary markets (new vs. existing securities), debt and
equity markets (types of financial claims), money and capital markets
(based on maturity), cash vs. futures markets (timing of transactions), and
organized exchanges vs. over-the-counter (OTC) markets (trading
structures).
 Primary vs. Secondary Markets: The primary market is where new
securities are issued to raise funds for the issuer, while the secondary
market allows for the trading of existing securities, which provides liquidity
and enables price discovery for those securities.
 Money Markets vs. Capital Markets: Money markets deal with short-
term debt instruments (less than one year), providing higher liquidity and
lower risk, whereas capital markets focus on long-term financing through
equity and debt instruments, necessary for extensive business investments.

 Cash/Spot Markets vs. Futures Markets: In cash (or spot) markets,

transactions are settled immediately, whereas in futures markets, contracts
are made to buy or sell an asset at a predetermined price at a future date,
with no initial exchange of money.
 Exchanges and OTC Markets: Organized exchanges (e.g., stock
exchanges) facilitate trading in a central location, while OTC markets allow
for decentralized trading where dealers transact directly without a
centralized exchange, promoting flexibility and competition.
 Sharia-Compliant Capital Markets: These markets operate under Islamic
law principles, emphasizing ethical investments and prohibiting interest
(riba), fostering risk-sharing and avoiding excessive uncertainty (gharar).
This niche market appeals to investors seeking socially responsible
investment opportunities.
 Types of Financial Instruments: Financial instruments are broadly
categorized into money market securities (short-term debt instruments)
and capital market securities (long-term debt and equity instruments). Key
examples of money market instruments include Treasury bills and
commercial paper, while capital market instruments include stocks and
bonds.

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 Chapter Four

Ethiopian capital market

4.1. Introduction
The Ethiopian capital market is an emerging financial landscape that plays a
crucial role in supporting the country’s economic development. Historically,
Ethiopia has had a limited capital market, primarily relying on bank financing and
foreign direct investment. However, recent regulatory reforms and initiatives
have paved the way for a more structured and dynamic capital market, aimed at
mobilizing domestic savings and attracting investment. The primary legal
framework governing the capital market includes the Capital Markets
Proclamation No. 1248/2014, which established the Ethiopian Capital Market
Authority (the regulatory agency), the Ethiopian Securities Exchange (ESX) (the
Market) and paved the way for the licensing of various other players that will
participate in the capital market.
In this evolving ecosystem, several key players contribute to the functioning of
the capital market. The Capital Market Authority plays a major regulatory role,
while the Ethiopian Securities Exchange serves as the central marketplace for
trading various financial instruments, including stocks and bonds. The market is
supported by a range of intermediaries, such as brokers, investment banks, etc.
who facilitate transactions and provide advisory services to both issuers and
investors.

4.2. Overview of the Ethiopian Capital Market

The Ethiopian Capital Market is a newly developing sector in Ethiopia’s

financial landscape, marking a significant step in the country’s economic reform
efforts. Ethiopia, historically operating a bank-dominated financial system, had no
formal stock or securities exchange. Recently, the government of Ethiopia (GOE)

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is launched a comprehensive effort as part of its homegrown economic reform
agenda with the goal to safeguard macro-financial stability and rebalance and
sustain economic growth. The primary objective of the agenda is to sustain
economic growth through creating an economic environment supportive of higher
private investment and structural transformation. It builds around three key
pillars: macro-financial, structural, and sectoral level reforms. Macro-financial
reforms aim to reduce risks associated with public debt, lower external
vulnerabilities, arrest inflation, and enhance growth, investment, and exports.
These reforms include:

(i) strengthening public finances by improving the efficiency of state-owned

enterprises (SOEs)
(ii) gradually moving towards a flexible exchange rate regime to address
external imbalances,
(iii) strengthening the monetary policy framework with the objective to stabilize
prices and support economic growth, and
(iv) Enhancing financial sector development and developing capital markets.

Accordingly, the government has initiated steps to establish a capital market that
support long-term economic growth, attract investments, and diversify financial
instruments available to investors.

The establishment of a capital market in Ethiopia marks a significant step in the

country’s economic development, transitioning from a banking-dominated
financial environment to a diversified capital market structure. Predicated on
broader economic reforms, the Ethiopian government has introduced the
Ethiopian Securities Exchange (ESX) as a centralized platform for trading stocks,
bonds, and other securities. This initiative aims not only to stimulate economic
growth by attracting both domestic and foreign investment but also to enhance
financial inclusion in a nation historically characterized by limited access to
financial services. The creation of the Ethiopian Capital Markets Authority (ECMA)
under Capital Market Proclamation No. 1248/202 further solidifies the legal
framework necessary for regulating this new market and ensuring transparency
and investor protection.

Despite its potential, the development of Ethiopia’s capital market faces

considerable challenges, including the need for improved financial literacy,
infrastructure, and regulatory capacity, alongside fostering trust in a system that
lacks historical precedence. Building a robust domestic capital market will help
reduce reliance on bank loans, allowing businesses to access alternative funding
sources while providing investment opportunities across various sectors.
Ultimately, the success of Ethiopia’s capital market will hinge on effective
regulatory implementation, active engagement from local businesses, and overall
economic stability, positioning it as a crucial component in the country’s efforts to
integrate into the global economy.

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 4.3. Regulatory Bodies Governing the Capital Market
Regulation is crucial for the proper functioning of financial markets, providing the
necessary framework to prevent chaos and ensure fairness and reliability.
Regulations aim to prevent unethical practices like fraud and insider trading while
promoting transparency and accountability within the marketplace. In Ethiopia,
the regulatory framework governing the capital market will likely involve several
key bodies, reflecting the nation’s efforts to establish a structured and efficient
financial system. The primary regulatory bodies anticipated to oversee the capital
market in Ethiopia include:

 Ethiopian Capital Markets Authority (ECMA): Is the principal regulatory

body established under the Capital Market Proclamation. ECMA is responsible
for regulating market participants, licensing stockbrokers, ensuring compliance
with securities laws, safeguarding investor protection, and promoting
transparency within the capital markets.
 Ethiopian Securities Exchange (ESX): A central market place, the ESX
serves as a self-regulatory organization (SRO) responsible for establishing
different regulations and monitoring its members and market participants to
ensure fair and efficient trading. To this end, the ESX has developed rulebooks
that outline listing rules, membership rules, trading regulations, and dispute
resolution procedures.
 National Bank of Ethiopia (NBE): As the central bank of the country, the
NBE has a role in regulating financial institutions, ensuring monetary stability,
and implementing policies that may affect the broader financial system,
including capital markets.
 Ministry of Finance: This governmental body will be involved in developing
financial policies, shaping economic strategies, and coordinating with
regulatory agencies to promote investment and economic growth, which can
significantly impact the capital market environment.

4.4. Ethiopian Capital Market Legal Framework

1. The legal framework for Ethiopia’s capital market establishes a comprehensive
system for regulating, operating, and developing the financial sector. At its
core is the Capital Market Proclamation No. 1248/2021, a foundational
document that sets the groundwork for the establishment of Ethiopian Capital
Markets Authority (ECMA). This body is responsible for licensing and regulating
market participants, including brokers, dealers, and exchanges. The
proclamation aims to promote transparency, accountability, and investor
protection across the capital market.
2. Supporting this proclamation is the Capital Market Service Providers Licensing
and Supervision Directive No. 980/2024, which provides specific rules for
licensing and overseeing entities that offer capital market services. This
directive ensures a well-structured regulatory environment, targeting market
participants such as stockbrokers, fund managers, and investment advisers.
The directive not only enhances investor protection but also fosters financial
stability and market integrity, laying a solid foundation for Ethiopia’s
burgeoning capital market.
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3. Investor protection is a key element within both the proclamation and the
directive. These legal provisions include measures to safeguard investor rights,
such as mandatory disclosures, conflict-of-interest regulations, and accessible
complaint mechanisms. By mandating transparency and requiring ethical
standards, the framework helps create a safe investment environment, which
is essential for building a sustainable and stable capital market—especially in
Ethiopia’s developing economy.
4. Furthermore, the Directive on Licensing, Operation, and Supervision of
Securities Exchange, Derivative Exchange, and Over-the-Counter Market No.
1009/2024 specifies regulations for establishing and operating different
trading platforms within Ethiopia. This directive aims to ensure efficient,
transparent, and ethical exchanges, thereby contributing to market stability
and protecting investor interests. Additionally, the ECMA continues to draft and
seek public feedback on further directives, continually enhancing the
regulatory framework to support a secure and equitable capital market.

4.5. Ethiopian Securities Exchange (ESX)

The Ethiopian Securities Exchange (ESX) is the country’s first organized securities
exchange, marking a pivotal step in the development and growth of Ethiopia’s
capital market. The ESX’s primary objective is to facilitate access to capital and
support effective capital allocation, thereby contributing to Ethiopia’s economic
growth. By establishing a regulated and efficient capital market ecosystem, the
ESX enables the mobilization of financial resources for both the government and
the private sector, while providing investors a reliable platform for informed
investment.
Operating as a public-private partnership under Article 31 of the Capital Market
Proclamation No. 1248/2021, the ESX functions as a Self-Regulatory Organization
(SRO) and serves as the central market organizer. It offers an integrated suite of
products across various capital market segments, including equities, fixed
income, and alternative markets.
The ESX comprises three important markets:

 ESX Equity Market: This market features a main segment for large
companies and a growth market segment for small and medium enterprises
(SMEs). The growth market offers flexible listing requirements suited to the
developmental stage of these businesses. The ESX aims to build a formal,
transparent venue for the listing of equity securities and other structured
products in the future.
 ESX Fixed Income Market: This market facilitates the trading of debt
securities, aiming to enhance the efficiency, transparency, and liquidity of
the fixed-income market. It includes a trading platform for short-term
instruments, such as Government Treasury Bills and Commercial Papers,
and long-term instruments, such as Treasury and Corporate Bonds. The
market also encompasses the interbank market with Repurchase
Agreements (Repos).

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  ESX Alternative Market: In addition, to the above two markets, the ESX
also features an alternative market, which includes an over-the-counter
(OTC) market for unlisted securities and a crowd funding platform for
emerging businesses

The Rulebook of the Ethiopian Securities Exchange (ESX) outlines comprehensive

regulations for the operation, management, and control of the ESX. This rulebook
consists of multiple sections that detail key components such as membership,
listings, trading practices, and disciplinary procedures. Key highlights include:

 Membership Rules: Criteria for trading members, covering admission

procedures, obligations, capital requirements, compliance, and disciplinary
actions for violations.
 Listing Rules: Requirements for listing both equity and fixed-income
securities, including issuer obligations around disclosures and governance
practices.
 Trading Rules: Regulations for the trading of securities, such as order
handling, execution standards, and prohibited activities.
 Disciplinary Procedures: Processes for complaint management and dispute
resolution among trading members and participants.
 Compensation Fund: A Clients’ Compensation Fund to protect investors in
cases of member defaults or misconduct.
 Administrative Sanctions: Penalties for rule violations, ranging from fines to
suspension or revocation of membership.

Chapter Key Points

 Transition to a Diversified Capital Market: Ethiopia’s capital market

represents a significant shift from a bank-dominated financial system to a
diversified structure featuring the Ethiopian Securities Exchange (ESX) for
trading various instruments, including stocks and bonds. This initiative seeks

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 to stimulate economic growth, attract both domestic and foreign investments,
and promote financial inclusion.
 Comprehensive Economic Reform Agenda: As part of a broader economic
reform agenda, the Ethiopian government is striving for macro-financial
stability and sustainable growth. This includes strengthening financial sector
development and implementing flexible exchange rate regimes—both
essential for a functioning capital market.
 Regulatory Framework and Investor Protection: The legal framework,
including the Capital Market Proclamation No. 1248/2021 and related
directives, aims to establish a structured and transparent market environment.
The Ethiopian Capital Markets Authority (ECMA) is a central figure in regulating
participants and protecting investors through measures such as mandatory
disclosures and conflict-of-interest regulations.
 Role of the Ethiopian Securities Exchange (ESX): As Ethiopia’s first
organized securities exchange, the ESX facilitates capital access and efficient
allocation. Operating with equity and fixed-income markets, the ESX provides
a platform for companies of varying sizes and enhances the liquidity and
transparency of debt securities.

Chapter-5

Understanding Saving, Investment, Risk & Return, and

Ethics in Financial System

5.1. Introduction
Understanding saving, investment, risk, and return is fundamental to making
informed personal finance and investment decisions. Saving involves setting
aside a portion of income for future needs, ranging from emergencies to long-
term purchases, building a financial stability and a safety net. Investment, in
other side, is the allocation of saved funds into assets like stocks, bonds, or real
estate, with the goal of generating returns over time. This balance between
saving and investing is essential for long-term wealth accumulation and financial
security.
Risk and return are fundamental factors to consider in investing. Risk refers to the
potential loss of invested funds due to various factors, such as market volatility,
while return signifies the gains (or losses) from an investment over a specific
period. Generally, higher returns come with higher risks, underscoring the
importance of understanding this relationship when constructing a diversified
portfolio tailored to personal goals, risk tolerance, and investment horizon.
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 5.2. Objectives of Investment
Investment objectives are defined by what the investor aims to achieve with their
portfolio. These objectives typically focus on risk and return considerations, which
are closely related.
1 Risk Objectives
An investor’s risk objectives reflect both their willingness and ability to accept
risk. Risk tolerance is determined by psychological factors and financial
circumstances, such as financial obligations, spending needs, and wealth targets.
Measuring risk can be approached through:

 Absolute terms, like variance or standard deviation of returns, or

 Relative terms, like tracking risk compared to a benchmark, confident of
variation,

The following steps are undertaken to determine the risk objective:

1. Specify Measure of Risk: Measurement of risk is the most important

issue in portfolio management. Risk is either measured in absolute or
relative terms. Absolute risk measurement will include a specific level of
variance or standard deviation of total return. Relative risk measurement
will include a specific tracking risk.
2. Investor’s Willingness: Individual investors’ willingness to take risks is
different from institutional investors. For individual investors, willingness is
determined by psychological or behavioral factors. Spending needs, long-
term obligations or wealth targets, financial strength, and liabilities are
examples of factors that determine an investor’s willingness to take the
risk.
3. Investor’s Ability: An investor’s ability to take risk depends on financial
and practical factors that bound the amount of risk taken by the investor.
An investor’s short-term horizon will negatively affect his ability. Similarly, if
the investor’s obligation and spending are less than his portfolio, he clearly
has more ability.

2Return Objectives
The following steps are required to determine the return objective of the investor:

1. Specify Measure of Return: A measure of return needs to be specified. It

can be specified in an absolute term or a relative term. It can also be
specified in nominal or real terms. Nominal returns are not adjusted for
inflation, whereas real returns are. One may also distinguish pre-tax returns
from post-tax returns.
2. Desired Return: A return desired by the investor needs to be determined.
The desired return indicates how much return is expected by the investor.
E.g., higher or lower than average returns.
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 3. Required Return: A return required by the investor also needs to be
determined. A required return indicates the return which needs to be
achieved at the minimum for the investor.
4. Specific Return Objectives: The investor’s specific return objectives also
need to be determined so that they are consistent with his risk objectives.
An investor having a high return objective needs to have a portfolio with a
high level of expected risk.

5.3. Types of Investments

Under the Ethiopian Capital Market Proclamation No. 1248/2021, Art. 2/35,
Investment refers to:

1. securities publicly offered,

2. securities listed on a foreign securities exchange or facility,
3. ownership interests and/or units in a collective investment scheme
approved under this Proclamation,
4. funds intended for the purchase of such securities, units or other
instruments; or
5. Any other instruments declared to be investments for this Proclamation by
a directive of the Authority.

Generally speaking, there are different classes of investment alternatives, and

here below are the most common ones.
1. Cash and Commodities
These are typically low-risk investments ideal for risk-averse individuals.

 Gold: A historically significant investment whose value is influenced by

scarcity and external factors.
 Bank Products and CDs: These include savings accounts, money market
accounts, and certificates of deposit (CDs), offering safer returns.
 Cryptocurrency: Digital currencies like Bitcoin, known for volatility and high
risk.

2. Bonds and Stocks

Bonds are relatively low risk, with options including government and corporate
bonds.

 Government Bonds: Backed by the government, making them almost risk-

free.
 Corporate Bonds: Slightly riskier as they depend on the issuing
corporation’s stability.
 Mortgage-Backed Securities: Investments backed by a pool of mortgages,
providing monthly interest and principal payments.

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  Stocks represent shares of ownership in a company, allowing investors to
participate in its growth and success. When individuals purchase stocks,
they acquire a claim on a portion of the company’s assets and earnings,
with the potential for dividends as a return on investment. The value of
stocks can fluctuate based on various factors, including the company’s
performance, market trends, and economic conditions. Investing in stocks
can offer significant financial rewards, but it also carries risks, as stock
prices can be volatile and can decline due to market downturns or poor
company performance. As a result, many investors view stocks as a key
component of diversified investment portfolios, aiming to balance risk and
achieve long-term growth.

3. Money Market Instruments

Money market instruments are short-term financial instruments that are used to
manage liquidity and raise funds in the financial markets. They typically provide a
safe and liquid investment option for investors looking to park their funds for a
short duration, usually less than one year. Common types of money market
instruments include treasury bills, commercial paper, certificates of deposit, and
repurchase agreements. These instruments are characterized by their low risk, as
they are often issued or backed by governments and highly rated financial
institutions. The stability they offer makes them particularly attractive for
conservative investors or institutions seeking to preserve capital while earning a
modest return.
The money market plays a critical role in the overall financial system, facilitating
the efficient allocation of capital and helping companies and governments meet
their short-term funding needs. Through the trading of these instruments, entities
can manage their short-term cash flow requirements, while investors can benefit
from higher yields compared to traditional savings accounts. Additionally, money
market instruments are often used as a benchmark for evaluating other
investments, as their yields reflect the prevailing interest rates in the economy.
Overall, money market instruments serve as a vital component of the financial
landscape, enabling liquidity and stability for both borrowers and lenders.
4. Investment Funds
Funds pool resources from multiple investors and diversify across different assets.

 Mutual Funds: Managed funds combining stocks and bonds, offering

diversification and lower risk.
 Index Funds: Passively managed funds that track market indices, reflecting
broader market trends.
 Exchange-Traded Funds (ETFs): Similar to index funds but traded on the
stock market.

5. Real Assets
Investing in real assets includes:

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  Businesses: Small businesses or startups.
 Farming: Agricultural ventures, given Ethiopia’s economy are agriculture-
based.
 Real Estate: Property investment, a stable and tangible asset class.

5.4. Types of Risks

In finance, risk refers to the chance that actual outcomes will differ from expected
ones. Specifically, risk in investments represents the possibility that actual
returns will vary from expected returns, encompassing both the potential for
gains and losses. This variability can be measured by using standard deviation,
variance and coefficient of variation. Investment risk implies that there is a
chance of losing some, or even all, of the initial investment.

1) Attitude towards Risk

Investors’ decisions are heavily influenced by their risk attitudes, which can be
classified as follows:

 Risk-Indifferent (Risk-Neutral): These investors are unconcerned with

increased risk and do not require a corresponding increase in return. They
focus on potential returns without needing compensation for added risk.
 Risk-Averse: Such investors prefer lower risk and require higher returns to
compensate for any increased risk. They prioritize preserving capital and
are often conservative in their investment approach.
 Risk-Seeking: These investors are willing to accept lower returns in
exchange for higher risk. They enjoy risk and are more inclined toward
speculative investments.

Most investors are risk-averse, accepting increased risk only if it comes with a
proportional rise in expected return. Risk aversion doesn’t imply avoidance of all
risk but reflects a preference for less risk over more risk, assuming other factors
are equal.
2) Systematic and Unsystematic Risks
When investing, the total risk of an asset or portfolio can be broken down into two
components:

A. Systematic Risk: This is the portion of risk that affects the entire market
and cannot be diversified away. It includes factors like interest rates,
inflation, and economic cycles.
B. Unsystematic Risk: This risk is specific to an individual company or
industry. Through diversification—holding various assets across sectors and
asset classes—investors can mitigate unsystematic risk, although they
cannot eliminate systematic risk.

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In other words, diversification reduces risk by spreading investments across
multiple assets. However, no matter how well-diversified a portfolio is, systematic
risk remains, as it is inherent to the overall market environment.
Total risk=Systematic risk + Unsystematic risk

5.5. Relationship between Risk and Return

The risk-return trade-off is fundamental in finance: it suggests that the potential
for higher returns comes with greater risk. If an investor desires higher returns,
they must be prepared to accept higher levels of uncertainty or potential losses.
Lower-risk investments generally yield lower returns, while higher-risk
investments offer the possibility of greater gains but also come with increased
volatility and the potential for loss.
The Capital Asset Pricing Model (CAPM) formalizes this relationship, suggesting a
linear and positive correlation between expected return and systematic risk,
represented by the formula:
Expected Return(Ri)=Rf+βi(Rm−Rf)Expected Return(Ri)=Rf+βi(Rm−Rf)

Where:

 Ri = Expected return of the investment

 Rf = Risk-free rate
 βi = Beta, or the measure of an asset’s systematic risk relative to the
market
 Rm = Expected market return

CAPM illustrates that riskier assets should provide higher returns to compensate
investors for taking on additional risk.

Risk Management: Techniques for Managing Investment Risk

Managing investment risk is crucial for protecting capital and maximizing returns.
Several techniques help investors align their risk exposure with their overall
financial goals:

1. Diversification: Spreading investments across various asset classes

(stocks, bonds, and real estate) helps reduce exposure to any single asset’s
volatility. This strategy minimizes unsystematic risk.

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 2. Asset Allocation: Determining the appropriate mix of asset classes based
on risk tolerance and investment horizon ensures a balanced portfolio.
3. Rebalancing: Periodically adjusting asset allocations to maintain a desired
risk level allows investors to stay aligned with their long-term strategies.
4. Dollar-Cost Averaging: Investing a fixed amount regularly, regardless of
market conditions, minimizes the impact of volatility.
5. Hedging: Using derivatives like options or futures, investors can protect
their investments against adverse price movements, particularly in foreign
exchange or commodity markets.

5.6. Ethics in Financial Markets

Ethics are essential for maintaining trust and integrity in financial markets. They
guide the behavior of individuals and institutions in financial transactions,
promoting fairness, transparency, accountability, and integrity. Ethical behavior
enhances investor confidence, reduces fraud, and fosters a responsible financial
environment where all participants benefit.
Key Ethical Principles Include:

 Fairness: Ensures equal access to information, preventing unfair

advantage.
 Transparency: Involves accurate and open disclosure of information,
enabling informed decision-making.
 Accountability: Implies compliance with laws and regulations, with a focus
on sound risk management.
 Integrity: Involves maintaining honesty and truthfulness in financial
dealings.
 Confidentiality: Protects sensitive information from unauthorized
disclosure, promoting ethical information-sharing practices.
 Fiduciary Responsibility: Compels financial advisors to act in the best
interests of their clients.
 Professional Competence and Due Care: Ensures that financial
professionals have the skills and knowledge necessary to avoid negligence
and make well-informed decisions.

By following these principles, financial market participants help ensure a stable,

efficient, and fair financial system, supporting sustainable economic growth and
benefiting both individual investors and the broader global economy.

Module Key points

1. Overview of the Financial System: The financial system is a framework
that facilitates the movement of funds across different sectors of the economy.
It includes financial institutions, markets, and instruments that enable savings
and investment. Finance, defined as the management of money and assets,
plays a crucial role in efficient resource allocation, risk management, and

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 strategic decision-making. Money, as a core element of this system, acts as a
medium of exchange, a unit of account, and a store of value, thus facilitating
economic activities. Financial literacy is essential for individuals and
businesses to make informed financial decisions aligned with their long-term
goals.
2. Evolution of the Financial System: Modern financial systems are
interconnected networks of institutions, instruments, and regulatory
frameworks that collectively support economic growth by mobilizing capital
efficiently. Central banks, commercial banks, and investment firms are pivotal
in maintaining financial stability and shaping interest rates and lending
practices. The evolution of the financial system has seen notable
developments, from the creation of banking systems and stock exchanges to
the integration of cutting-edge technologies in financial transactions. These
innovations enable efficient capital allocation and create a stable environment
for economic activities, ultimately fostering growth and development.
3. Functions of the Financial System: The financial system performs critical
functions such as channeling funds from savers to borrowers, providing
liquidity to markets, enabling risk-sharing, and promoting economic stability.
There are two primary forms of finance within this system: direct and indirect.
Direct finance occurs when borrowers sell securities directly to investors, while
indirect finance involves financial intermediaries, like banks, facilitating fund
transfers. This dual structure accommodates different risk preferences and
investment horizons, ensuring efficient capital allocation across the economy.
4. Role of Financial Institutions: Financial institutions are key intermediaries
within the financial system, connecting those with excess funds to those
needing financing. They engage in asset transformation, maturity
transformation, and credit risk management, making it possible to mobilize
savings and allocate capital for investment. Institutions can be categorized
into depository institutions, which accept deposits and provide loans, and non-
depository institutions, which enable financial intermediation without
traditional deposit-taking. This structured approach ensures that the financial
system operates smoothly, delivering essential services to individuals,
businesses, and governments.
5. Interplay between Saving, Investment, and Risk: Understanding the
relationship between saving, investment, and risk is crucial for individuals
navigating financial decisions. Saving involves setting aside funds for future
needs, while investment allocates these funds into assets with the expectation
of generating returns. Higher returns typically come with increased risk,
underscoring the importance of balancing these factors in investment
strategies. Furthermore, ethical considerations in financial markets—such as
integrity, transparency, and accountability—are vital for fostering a fair and
effective system. By promoting these ethical principles, financial systems can
maintain stability, encourage responsible decision-making, and support
sustainable economic growth.

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