INTRODUCTION TO CAPITAL

MARKET

Module 2

Prepared by; Ethiopian Commodity Exchange Market Authority

[Type the document subtitle]

Andarg B

January, 2025
Contents
Learning Objectives..........................................................................................................................1
Chapter One............................................................................................................................................3
Overview of Capital Market...............................................................................................................3
1.1. Understanding Capital and Capital Markets................................................................3
1.2. The Capital Market Ecosystem: An Overview..............................................................3
1.3. Key Participants of Capital Markets................................................................................5
1.4. Types of Financial Instruments.........................................................................................6
1.5. Classification of the Capital Market................................................................................7
1.6. Chapter Key points.............................................................................................................10
Chapter Two..........................................................................................................................................12
Key Players and Institutions in Capital Market.........................................................................12
2.1. Introduction...........................................................................................................................12
2.2. Regulators: Keeping the Market Fair.............................................................................12
2.3. Investment Banks and Advisors: The Financial Architects....................................12

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Learning Objectives
by the end of this module, you will be able to:

1. Understand Capital and Capital Markets

 Define capital and recognize its different forms, such as stocks, bonds,
and real estate.
 Explain the role of capital markets in connecting investors with businesses
and governments that need funds.
2. Describe the Capital Market Ecosystem
 Identify the key participants in the capital market, including investors,
issuers, intermediaries, and regulators.
 Understand the function of primary and secondary markets and how they
facilitate the flow of capital.
3. Differentiate Financial Instruments
 Distinguish between various financial instruments, including stocks,
bonds, mutual funds, ETFs, and derivatives.
 Recognize the benefits and risks associated with each type of financial
instrument.
4. Explain the Roles of Key Institutions in Capital Markets
 Outline the functions of investment banks, brokers, dealers, and central
securities depositories.
 Describe the role of regulators in ensuring market integrity and investor
protection.
5. Understand Equities and Stock Markets
 Define equities and explain their basic features, such as ownership,
dividends, and capital appreciation.
 Understand how shares are traded in stock markets and the role of
market indices in tracking market performance.
6. Analyze the Role of Capital Markets in the Economy
 Explain how capital markets contribute to capital formation, economic
growth, and resource allocation.
 Understand the importance of regulation and oversight in maintaining
market transparency and stability.

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 Chapter One

Overview of Capital Market

1.1. Understanding Capital and Capital Markets

What is capital?

Think of capital as any financial resource that can generate wealth or

income. This can be money in your bank account, stocks in a company,
bonds, real estate, or even intellectual property like patents. Capital is the
fuel that powers businesses—allowing them to buy what they need to grow,
pay employees, invest in new ideas, and keep the wheels turning.

What is capital market?

Capital markets, on the other hand, are places where capital is exchanged.
Imagine it as a large, marketplace where businesses, governments, and
individuals come to raise money (capital) by issuing securities like shares
and bonds. Investors, individuals and institutions, come to this market to
invest their money, hoping to earn a return.

Capital markets are essential because they connect people and

organizations that have capital with those that need it. This flow of capital
helps businesses grow, creates jobs, and supports innovation, all of which
are vital for the economy.

1.2. The Capital Market Ecosystem: An Overview

The capital market ecosystem facilitates the efficient allocation of capital
between investors and issuers, ensuring that funds flow to where they are
most needed while maintaining protections for all participants. This
ecosystem plays a vital role in economic development by enabling
companies and governments to raise capital and offering investors
opportunities for returns. A comprehensive understanding of its components,

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participants, and regulatory environment is essential for anyone engaged in
finance or investing.

Key Objectives of the Capital Market Ecosystem

1. Transparency and Trust: Prioritizing disclosures and regulatory

oversight fosters investor confidence, which is fundamental for market
participation.
2. Efficient Capital Allocation: Resources are channeled toward
productive economic activities through the collaboration of issuers,
regulators, intermediaries, and investors.
3. Risk Mitigation: Disclosure requirements and oversight protect investors
from fraud and systemic risks.
4. Market Integrity: Well-functioning markets enable businesses to raise
capital effectively and allow investors to earn returns while supporting
economic growth.

Now let us discuss the components of the eco system

1. Participants: Includes various actors such as individual and institutional

investors, corporations, governments, investment banks, brokers, and
regulatory bodies. Each plays a critical role in capital markets by providing
capital, issuing securities, or ensuring regulatory compliance.
2. Instruments: Financial products/instruments traded in capital markets
include stocks, bonds, derivatives, mutual funds, and Exchange traded
funds (ETFs). These instruments facilitate capital raising and allow
investors to achieve returns.
3. Market Infrastructure: Comprises securities exchanges, such as the
Ethiopian Securities Exchange, over the counter (OTC) markets,
clearinghouses, and settlement systems (central security depository
(CSD)) that ensure secure and efficient transactions.

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4. Regulators and Oversight: Regulatory authorities, including the
Ethiopian Capital Market Authority (ECMA) and international bodies like
The International Organization of Securities Commissions (IOSCO), ensure
market integrity, protect investors, and promote transparency.
5. Information and Technology: The flow of information through market
data feeds, financial news outlets, and advanced trading platforms is
critical for informed decision-making by market participants.

1.3. Key Participants of Capital Markets

Imagine you’re watching a sports game. There are players, referees,
coaches, the playing ground and fans—all necessary for the game to happen.
The capital market works similarly:

 Investors: These can be individuals or large institutions, such as

pension funds, seeking to earn returns on their capital. Typically, they
participate in the market through brokers or dealers who facilitate their
transactions.
 Issuers: These are businesses or governments in need of capital. They
issue securities, such as stocks (representing ownership in the company)
or bonds (which are loans to be repaid with interest). Like investors,
issuers generally engage with the market through brokers or dealers to
facilitate their offerings.
 Regulators are like referees. They ensure the game is played fairly. In
Ethiopia, the ECMA is the main regulator.
 Investment Banks and Advisors are like coaches. They help
companies figure out the best strategies to raise money and grow their
business.
 Brokers and Dealers are like the players. They actively participate by
buying and selling securities, making sure there’s always someone to
trade with.

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  Stock/Securities Exchanges are the playing ground. Is the filed
through which exchange of securities executed between the
buyer and seller. In Ethiopia the Ethiopian Securities Exchange
(ESX) serves this role.
 Central Securities Depository (CSD) is like a safe and the
scoreboard keeper, making sure all the trades are recorded accurately,
and everyone knows who owns what. In Ethiopia the CSD is hosted
under the National Bank of Ethiopia.

In general, the different participants in the capital market helps businesses

get the funding they need and ensures that investors can trust the system to
protect their interests.

1.4. Types of Financial Instruments

Capital markets offer a variety of financial instruments that cater to different
investment goals and risk appetites. Let’s explore some of the key types:

 Stocks (Equities): Represent ownership in a company. When you buy a

stock, you’re purchasing a share of that company’s assets and earnings.
Stocks can appreciate and may provide dividends.

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 Bonds (Debt Securities): These are essentially loans made by investors
to corporations or governments. In return, the issuer agrees to pay back
the principal amount on a specific date, along with periodic interest
payments.
 Mutual Funds: These pooled investment vehicles allow investors to
purchase a diversified portfolio of stocks, bonds, or other securities.
Managed by professionals, mutual funds provide diversification and are
accessible to retail investors.
 Exchange-Traded Funds (ETFs): Similar to mutual funds but traded on
stock exchanges, ETFs offer the flexibility of trading like a stock while
providing diversification across a range of assets.
 Derivatives: Financial contracts whose value is derived from the
performance of an underlying asset, index, or rate. Common derivatives
include options, futures, and swaps. They are often used for hedging risks
or for speculative purposes.
 Money Market Instruments: These are short-term debt instruments,
often maturing within a year, and are generally considered low risk.
Examples include Treasury bills, commercial paper, and certificates of
deposit.
 Real Estate Investment Trusts (REITs): Companies that own, operate,
or finance income-generating real estate properties. Investors can buy
shares in REITs, providing exposure to the real estate market without
directly owning property.

Understanding these instruments is key to navigating the capital markets,

whether you’re investing for growth, income, or risk management.

1.5. Classification of the Capital Market

Depending on different base capital market can be classified into different
categories.

1. Primary Market vs. Secondary Market.

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Depending on whether securities traded in the market are newly issued or
already outstanding securities, capital market can be classified as primary
market or secondary market.

A. Primary Market: This is where new securities are issued for the first
time. When a company decides to go public, it issues new shares in the
primary market through an Initial Public Offering (IPO). The funds raised in
this market go directly to the issuing company, which uses them for
business expansion, debt repayment, or other purposes.

In most developed capital markets, issuers, with the support of investment

banks interact with institutional investors. Investment banks often
underwrite the securities (i.e. buy the securities from the issuers) before
selling them at a margin to other investors, including retail investors.
Therefore in the primary market, it is mostly the institutions that interact
with the issuer. However, occasionally, issuers also directly sell their
securities to non-institutional investors. The primary market is therefore,
similar to a wholesaler market. Just like Wholesalers buy produce or goods
from the farmer/manufacturer in bulk, in the primary capital market
investment banks and institutional investors buy shares from the issuer in
bulk.

B. Secondary Market: After securities are issued in the primary market,

they are traded among investors in the secondary market. The company
does not receive any funds from these trades. Instead, the secondary
market provides liquidity, allowing investors to buy and sell securities
easily. Stock exchanges like the Ethiopian Securities Exchange (ESX), the
New York Stock Exchange (NYSE) or the London Stock Exchange Group
(LSEG) are examples of secondary markets.

In the secondary market investors that participated in the primary market

sell their securities to other investors. Similarly various types of investors
may exchange their securities among themselves. The secondary market is

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about providing a platform for the trading of existing securities, contributing
to market liquidity and price discovery.

2. Debt Market vs. Equity Market

The debt market deals with the issuance and trading of debt securities like
bonds, where investors lend money to governments or corporations in
exchange for regular interest payments. Debt securities have fixed maturity
dates and offer stable, predictable returns, making them ideal for risk-averse
investors. Factors like interest rates, credit ratings, and economic conditions
influence borrowing costs in the debt market.

On the other hand, the equity market involves buying and selling shares of
issuing companies. When you buy equity, you’re purchasing part ownership
in a company, giving you potential profits through dividends and capital
appreciation, along with possible voting rights. Unlike the fixed and known
returns of debt, the equity market offers higher growth potential but with
greater risk and price volatility, reflecting investor expectations about a
company’s future.

Both markets are vital to the economy, catering to different investor

preferences while supporting capital formation and liquidity.

3. Money Market vs. Capital Market

The money market focuses on short-term borrowing and lending, typically

for periods of one year or less. It includes instruments like Treasury bills,
commercial paper, and certificates of deposit, which offer high liquidity and
low risk. The money market helps entities meet short-term funding needs
and allows investors to temporarily invest their funds in low-risk assets.

In contrast, the capital market deals with long-term financing and

investments, including both stocks (equity market) and long-term bonds
(debt market). Capital markets support business growth, infrastructure
projects, and long-term investments, offering higher potential returns but

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with increased risk over longer time horizons. By connecting savers and
borrowers for extended periods, the capital market is crucial for economic
growth and financial stability.

4. Exchange vs. OTC Market

The exchange market operates on centralized platforms like the Ethiopian

Securities Exchange (ESX), the New York Stock Exchange (NYSE), or Nasdaq.
Here, trades are executed publicly, ensuring greater transparency, liquidity,
and price discovery. Securities traded on exchanges are subject to higher
regulatory oversight, which helps protect investors and maintain market
fairness. Exchange markets are generally associated with larger, more
established companies and offer clear advantages in terms of price visibility
and efficient trade execution.

In contrast, the over the counter (OTC) market is a decentralized trading

venue where transactions occur directly between parties, without a central
exchange. OTC markets handle a range of assets, including stocks, bonds,
commodities, and derivatives that are not listed on formal exchanges. While
OTC trades offer flexibility and customization, they may lack transparency
and visibility. This market is often used for less liquid assets or smaller
companies, making it ideal for specialized transactions.

1.6. Chapter Key points

 Capital: Capital refers to financial assets or resources that can be used to

generate wealth or income. It encompasses a variety of forms, including
cash, stocks, bonds, real estate, and intellectual property, essential for
business operations and growth.
 Primary vs. Secondary Markets: The primary market is where new
securities are issued for the first time (e.g., Initial Public Offerings or
IPOs), allowing companies to raise capital. The secondary market, on the
other hand, involves trading existing securities among investors,

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 providing liquidity and an avenue for portfolio adjustments without
involving the issuing entity.
 Money market vs. capital markets: Money market is a market for
short-term debt instruments, typically with maturity period of one year or
less. Meanwhile, the capital markets involve long-term securities, such as
stocks and bonds that mature in more than one year.
 Debt market vs. Equity market. A debt market is a market for credit
instruments where the issuer and investor borrow and lend money.
Whereas Equity market is a market for securities which provides an
ownership interest to the holder on the issuing company.
 OTC vs. Exchange market: OTC markets allow investors to trade
stocks, bonds, derivatives, and other financial instruments directly
between two parties without the supervision of a formal exchange. On the
other hand, exchange market is Centralized exchange which is supervised
by regulatory body and only standardized contracts are traded
 Components of the Capital Market Ecosystem: The capital market
ecosystem consists of participants (investors, issuers, intermediaries),
financial instruments (stocks, bonds, derivatives), market infrastructure
(exchanges, OTC markets), and regulatory frameworks that facilitate
capital raising, trading, and investment processes.
 Types of Financial Instruments: Financial instruments available in
capital markets include stocks (equities), bonds (debt securities), mutual
funds, ETFs, derivatives, money market instruments, preferred stocks,
and REITs. These instruments differ in risk profiles, returns, and liquidity,
catering to various investor needs and preferences.
 Regulatory Framework: Regulatory bodies (e.g., Ethiopian Capital
Market Authority, U.S. Securities and Exchange Commission) oversee
capital markets to maintain fair trading practices, protect investors,
ensure transparency, and uphold market integrity. Regulations are
designed to mitigate risks and promote trust within the capital market
ecosystem.

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 Chapter Two

Key Players and Institutions in Capital Market

2.1. Introduction
Capital markets are like a complex machine, with many moving parts
working together to keep everything running smoothly. In this chapter, we’ll
dive deeper into the roles of the main players and institutions that make up
the capital market.

2.2. Regulators: Keeping the Market Fair

Regulators are the watchdogs of the capital market. Their job is to ensure
that everything operates fairly and transparently. Imagine a referee in a
sports game—regulators play a similar role. They make sure that all the
players follow the rules, protecting investors from fraud and ensuring that
the market functions smoothly.

In Ethiopia, the Ethiopian Capital Market Authority (ECMA) is the main

regulatory body. Their job is to:

 Protect Investors: Ensure that your money is safe and that you have
the information you need to make informed decisions.
 Maintain Fairness: Make sure the market operates in a way that is
fair for everyone involved.

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  Reduce Risk: Implement rules that help prevent big problems that
could affect the entire market.
 Promote Development: Create an environment where businesses
can grow and raise money, which in turn helps the economy.

2.3. Investment Banks and Advisors: The Financial Architects

Investment banks and advisors are like the architects of the financial world.
They help design and structure complex financial deals, guiding businesses
through the process of raising money, whether it’s through issuing stocks,
bonds, or other financial instruments.

 Investment Banks: These are the players that help companies with
major financial transactions. They might advise a company on buying
another company (a merger), help them raise money by issuing new
stocks or bonds, or manage large investment portfolios. Think of them as
the architects who plan and execute big construction projects.
 Investment Advisors: These professionals work more closely with
individual clients or smaller companies, helping them plan their
investments and manage their portfolios. They’re like personal trainers,
giving tailored advice to help you reach your financial goals.

While investment banks primarily serve corporate and institutional clients in

executing complex financial transactions, investment advisors focus on
providing personalized financial advice and investment management
services to individual investors. Both play crucial roles in the financial
ecosystem, catering to different segments of the market and serving distinct
client needs.

Just as how a big corporation is structured, an investment bank is also

organized with front office, middle office and back office. The front office
adds the most value to the bank, while the middle and back office are
supporting divisions that make the bank’s operation smooth.

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 1. Front Office
An investment bank’s front office comprises mainly 4 divisions including
Investment Banking or Corporate Finance (IBD), Sales and Trading (S&T),
Equity Research (ER) or Research, and Asset Management (AM). The number
of divisions varies depending on how a bank splits up their services. But
these four main divisions are what most full-fledged investment banks have.

1.1 Investment Banking (or Corporate Finance – IBD)

The investment banking division (IBD) is split up into either Product Groups
or Industry Groups. While the Product Groups focus on performing specific
deal types such as mergers and acquisitions, equity or debt issuance,
derivative transactions, and work across various industries, the Industry
Groups specialize in a particular industry but work on many deal types for
just the industry it serves.

 Product Groups, as said, are further divided into smaller groups including:
o Mergers & Acquisitions (M&A): advises companies and execute
transactions when companies want to sell, acquire smaller companies
and divest specific assets or divisions in other corporations
o Origination (Equity and Debt Capital Market): raises funds by trading
debt securities or equity securities in primary markets
o Leverage Finance: analyses clients’ capital structures to determine the
amount and the type of debt that is appropriate.
o Restructuring: modifies capital structures for companies so that they
can thrive.
 Industry Groups consist of many industries including: Healthcare, Real
Estate, Infrastructure, Public Finance, Media & Telecommunication, Digital
Media, Technology, Industrials, Power & Utilities, Renewable Energy,
Chemicals, Metals & Mining, Oil & Gas, Transportation, Maritime &
Shipping, and Sports.

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1.2 Sales & Trading (S&T)

Sales & Trading, as the name suggests, has the sales side, and the trading
side. This division collaborates closely with the investment banking division
to advise clients on trading securities and distributing securities to potential
investors. Its clients are mostly institutional investors, for example, hedge
funds and asset management firms.

 Salespeople build relationships with clients and pitch ideas to them.

 Trading people, meanwhile, make the market and execute the orders for
clients.

In essence, Sales & Trading is more of matchmakers, matching promising

buyers such as investment funds with companies issuing stocks and bonds,
for the sake of simplicity.

1.3 Equity Research (or Research – ER)

Equity Research analyzes companies, speaks with management investors,

and makes buy, sell, and hold recommendations on the stocks and bonds.
People like to call it Equity Research, but it writes reports on both Equity and
Fixed Income. In investment banks, the research expertise comes from this
division. Other divisions in investment banks are not solely clients of the
Research Division. It also serves external clients, who need their
comprehensive analysis, at a fee.

2. Middle Office and Back Office

The middle office and back office are supporting functions of an investment
bank. Middle office supports revenue-related processes and includes risk
management, treasury, and financial control. Back office, meanwhile, refers
to compliance, information technology, accounting, and human resources.
Irrespective of how the firm performs, the back office is an indispensable
part of an investment bank. These divisions are very important in the
operation of an investment bank. Though not directly bringing in huge

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 revenues for the firm, they help front-office divisions not only work smoothly
but also allow deals and transactions to be executed correctly and
successfully.

2.4. Brokers and Dealers: The Market Movers

Brokers and dealers are the hands-on players in the market. They’re the
ones who actually make the trades happen, connecting buyers and sellers of
securities.

 Brokers: Brokers trade on behalf of their client. They don’t own the
securities themselves, but they help you buy and sell securities. Brokers
work on your behalf to find the best deals and execute trades. Depending
on the level of service, they might just handle the transactions (often
called discount brokers) or offer more comprehensive advice and
portfolio management (full-service brokers).
 Dealers: Dealers trade on behalf of their clients as well as trade on their
own account. They own the securities themselves and are ready to buy
or sell them at any time. They make money from the difference between
the buying price and the selling price (called the “spread”). Dealers play
a crucial role in ensuring there’s the market is liquid.

Brokers help clients execute trades by connecting buyers and sellers, while
dealers actively participate in the market by buying and selling securities.
Both brokers and dealers play vital roles in ensuring the smooth functioning
of financial markets and providing investors with access to a wide range of
investment opportunities.

Aspect Brokers Dealers

Act as intermediaries
Buy and sell securities directly
Role connecting buyers and sellers
from their own accounts.
in the market.

Execution Execute trades on behalf of Trade securities using their own

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Aspect Brokers Dealers
clients based on their
capital, taking on market risk.
instructions.
Earn commissions or fees for Profit from the bid-ask spread and
Compensation
facilitating trades. price movements of securities.
Provide access to multiple Focus on specific markets or
Market Access markets and investment products where they have
products. expertise.
Work on behalf of clients to Act as principals in transactions,
Client Interaction
find the best deals and prices. managing their own risk.
Limited risk exposure as they
Assume market risk by holding
Risk Exposure do not hold positions in
inventory of securities.
securities.
Regulated by financial Subject to regulations governing
Regulatory
authorities to ensure fair and market-making activities and risk
Oversight
transparent practices. management.
Capital Typically require lower capital Require substantial capital to
Requirements compared to dealers. support market-making activities.

2.5. Central Securities Depository (CSD): The Record Keepers

The Central Securities Depository (CSD) is like a giant safe for securities.
Instead of holding physical stock certificates or bonds, everything is stored
electronically. The CSD ensures that when a trade happens, the securities
move from the seller’s account to the buyer’s, and the money moves the
other way. They also handle things like dividend payments and stock splits,
making sure everything are processed smoothly and accurately.

A Central Securities Depository (CSD) is a crucial institution in the financial

markets responsible for the safekeeping and administration of securities.
Here’s how it functions:

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  Safekeeping: A CSD holds securities such as stocks, bonds, and other
financial instruments in electronic form, eliminating the need for
physical certificates. This centralized storage system ensures the
security and integrity of these assets.
 Settlement: CSDs facilitate the settlement of trades by transferring
securities from the seller’s account to the buyer’s account and
transferring funds in the opposite direction. This process ensures the
smooth and efficient transfer of securities and funds between market
participants.
 Corporate Actions: CSDs also play a role in processing corporate
actions such as dividend payments, stock splits, mergers, and other
events that impact securities held by investors. They ensure that these
actions are executed accurately and in compliance with regulations.
 Record-Keeping: CSDs maintain accurate records of ownership for
securities held in electronic form. This helps investors track their
holdings and facilitates trading and other transactions in the financial
markets.

An example of a well-known CSD is Euroclear, which operates in multiple

countries and provides post-trade services for a wide range of securities.
CSDs play a critical role in the infrastructure of financial markets by
enhancing efficiency, reducing risk, and providing a secure environment for
the holding and transfer of securities.

CSDs can be categorized based on their operational scope:

 National CSDs: These operate within a specific country and are

responsible for the securities issued in that jurisdiction.
 International CSDs: These facilitate cross-border transactions and
hold securities from multiple countries, providing services to global
investors.

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