UNIT FOUR

FINANCIAL MARKETS

4.1 THE NATURE AND ROLE OF FINANCIAL MARKETS

Financial markets are markets in which funds are transferred from people who have an excess
of available funds to people who have a shortage. Financial markets such as bond and stock
markets are crucial to promoting greater economic efficiency by channeling funds from people
who do not have a productive use for them to those who do. Indeed, well-functioning financial
markets are a key factor in producing high economic growth, and poorly performing financial
markets are one reason that many countries in the world remain desperately poor. Activities in
financial markets also have direct effects on personal wealth, the behavior of businesses and
consumers, and the cyclical performance of the economy.
Thus, a financial market is an institution or arrangement that facilitates the exchange of financial
instruments including deposits & loans, stocks, bonds etc. In short, a financial market is a market
where in financial assets are traded.
4.1.2 FUNCTIONS OF FINANCIAL MARKETS.
Financial markets perform the essential economic function of channeling funds from households,
firms, and governments that have saved surplus funds by spending less than their income to those
that have a shortage of funds because they wish to spend more than their income.
This function is shown schematically in Figure 1, below. Those who have saved and are lending
funds, the lender-savers, are at the left and those who must borrow funds to finance their
spending, the borrower-spenders, are at the right.
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 The principal lender/savers are households, but business enterprises and the government
(particularly state and local government), as well as foreigners and their governments, sometimes
also find themselves with excess funds and so lend them out. The most important
borrower/spenders are businesses and the government (particularly the federal government), but
households and foreigners also borrow to finance their purchases of cars, furniture, and houses.
The arrows show that funds flow from lender savers to borrower-spenders via two routes.
4.1.3. STRUCTURE OF FINANCIAL MARKETS
Now that we understand the basic function of financial markets, let’s look at their structure. The
following descriptions of several categorizations of financial markets illustrate essential features
of these markets.
A. Debt and Equity markets
What the difference between debt and equity markets?
A firm or an individual can obtain funds in a financial market in two ways. The most common
method is to issue a debt instrument, such as a bond or a mortgage, which is a contractual
agreement by the borrower to pay the holder of the instrument fixed Birr amounts at regular
intervals (interest and principal payments) until a specified date (the maturity date), when a final
payment is made.
The maturity of a debt instrument is the number of years (term) until that instrument’s expiration
date.
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 A debt instrument is short term if its maturity is less than a year and long-term if its maturity is
ten years or longer. Debt instruments with a maturity between one and ten years are said to be
intermediate term.
The second method of raising funds is by issuing equities, such as common stock, which are
claims to share in the net income (income after expenses and taxes) and the assets of a business.
If you own one share of common stock in a company that has issued one million shares, you are
entitled to one-millionth of the firm’s net income and one millionth of the firm’s assets. Equities
often make periodic payments (dividends) to their holders and are considered long-term
securities because they have no maturity date. In addition, owning stock means that you own a
portion of the firm and thus have the right to vote on issues important to the firm and to elect its
directors.
The main disadvantage of owning a corporation’s equities rather than its debt is that an equity
holder is a residual claimant; that is, the corporation must pay all its debt holders before it pays
its equity holders. The advantage of holding equities is that equity holders benefit directly from
any increases in the corporation’s profitability or asset value because equities confer ownership
rights on the equity holders. Debt holders do not share in this benefit, because their Birr
payments are fixed
ii. Primary and Secondary Markets
A primary market is a financial market in which new issues of a security, such as a bond or a stock,
are sold to initial buyers by the corporation or government agency borrowing the funds.
A secondary market is a financial market in which securities that have been previously issued (and
are thus secondhand) can be resold.
An important financial institution that assists in the initial sale of securities in the primary market
is the investment bank. It does this by underwriting securities: It guarantees a price for a
corporation.
Securities brokers and dealers are crucial to a well-functioning secondary market.
Brokers are agents of investors who match buyers with sellers of securities; dealers’ link
Buyers and sellers by buying and selling securities at stated prices. Ration’s securities and then
sell them to the public.
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 III. Money and Capital Markets
Another way of distinguishing between markets is on the basis of the maturity of the securities
traded in each market.
The money market is a financial market in which only short-term debt instruments (generally
those with original maturity of less than one year) are traded.
The capital market is the market in which longer-term debt (generally those with original maturity of
one year or greater) and equity instruments are traded.
Money market securities are usually more widely traded than longer-term securities and so tend
To be more liquid.
Capital market securities, such as stocks and long-term bonds, are often held by financial
intermediaries such as insurance companies and pension funds, which have little uncertainty
about the amount of funds they will have available in the future.
4.2 FINANCIAL MARKET INSTRUMENTS
What do you understand about financial market and what are those financial instruments traded in the
financial market?

1. MONEY MARKET INSTRUMENTS

What does mean money market instruments and what are financial instruments included under
this category?
Those markets are dealing with short-term securities that have a life of one year or less. Because
of their short terms to maturity, the debt instruments traded in the money market undergo the
least price fluctuations and so are the least risky investments.
The principal money market instruments are:
i. Treasury Bills
These short-term debt instruments of the government are issued in 3-, 6-, and 12-month
maturities to finance the federal government. Treasury bills are the most liquid of all the money
market instruments, because they are the most actively traded. They are also the safest of all
money market instruments, because there is almost no possibility of default, a situation in which
the party issuing the debt instrument (the federal government, in this case) is unable to make
interest payments or pay off the amount owed when the instrument matures. The federal
government is always able to meet its debt obligations, because it can raise taxes or issue
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 currency (paper money or coins) to pay off its debts. Treasury bills are held mainly by banks,
although small amounts are held by households, Corporations, and other financial intermediaries.
They pay a set amount at maturity and have no interest payments, but they effectively pay
interest by initially selling at a discount, that is, at a price lower than the set amount paid at
maturity.
For instance, you might pay Br. 9,000 in May 2004 for a one year Treasury bill that can be
redeemed in May 2005 for Br. 10,000.

ii. Negotiable Bank Certificates of Deposit

A certificate of deposit (CD) is a debt instrument, sold by a bank to depositors, that pays annual
interest of a given amount and at maturity, pays back the original purchase price. CDs are an
extremely important source of funds for commercial banks, from corporations, money market
mutual funds, charitable institutions, and government agencies.

iii. Commercial Paper

Commercial paper is a short-term debt instrument issued by large banks and well-known
corporations, selling to other financial intermediaries and corporations for their immediate
borrowing needs; in other words, they engage in direct finance.

B. CAPITAL MARKET INSTRUMENTS

What does mean capital market instruments and what are financial instruments included under this
category?
Capital market instruments are debt and equity instruments with maturities of greater than one
year. They have far wider price fluctuations than money market instruments and are considered
to be fairly risky investments.
The principal capital market instruments are:
I. Stocks
Stocks are equity claims on the net income and assets of a corporation. A share of a stock in a
corporation represents ownership. A stockholder owns a proportionate interest in the company
consistent with the percentage of outstanding stocks held. Stockholder is an owner in contrast
with the bondholder who is a creditor of the firm.
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 Investor can get return from a stock in two ways: The price of the stock raise over time and the
corporation pays the stock dividend. Being owners they have the right of residual claim and right
to vote. There are two type of stock: Preferred Stock and Common Stock.

II. Mortgages
Mortgages are loans to households or firms to purchase housing, land, or other real structures,
where the structure or land it serves as collateral for the loans. Savings and loan associations and
mutual savings banks have been the primary lenders in the residential mortgage market, although
commercial banks may enter this market.
iii. Corporate Bonds
These are long-term bonds issued by corporations with very strong credit ratings. The typical
corporate bond sends the holder an interest payment and pays off the face value when the bond
matures. Some corporate bonds, called convertible bonds, have the additional feature of allowing
the holder to convert them into a specified number of shares of stock at any time up to the
maturity date. This feature makes these convertible bonds more desirable to prospective
purchasers than bonds without it, and allows the corporation to reduce its interest payments,
because these bonds can increase in value if the price of the stock appreciates sufficiently
Because the outstanding amount of both convertible and nonconvertible bonds for any given
corporation is small, they are not nearly as liquid as other securities such as government bonds.
iv. Government Securities
These long-term debt instruments are issued by the Government Treasury to finance the
Deficits of the federal government. Because they are the most widely traded bonds in the market,
they are the most liquid security traded in the capital market.
V. State and Local Government Bonds
State and local bonds, also called municipal bonds, are long-term debt instruments issued by
state and local governments to finance expenditures on schools, roads, and other large programs.
An important feature of these bonds is that their interest payments are exempt from federal
income tax and generally from state taxes in the issuing state.

TYPES OF RISK FOUND IN FINANCIAL MARKETS

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The following is a list of some of the types of risk which financial institutions and investors have
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to worry about in financial markets.

  Credit risk: this is the risk we take when lending money, namely the possibility that the
borrower may be unable or unwilling to pay back his loan, causing us a loss.
 Liquidity risk: this is the risk we take when holding a less liquid investment, in that we may
be forced to accept a loss because we are forced to sell the investment in a hurry.
 foreign exchange (fx) risk: this is the risk we take that we may suffer a loss from changes in
the exchange rates between currencies, because we have entered into an arrangement where
we are required to deliver, or are due to receive, a sum in a foreign currency at some later
date.
 Interest rate risk: this is the risk that the value of our assets (investments) will change
because the market interest rate did.

Participants in Financial Markets

Modern financial markets are characterized by the involvement of a variety of participants with a
wide range of motivations. These include individuals, commercial and investment banks,
financial institutions, investment companies, insurance and pension funds, businesses,
multinationals, local and central government, and international institutions such as the European
Investment Bank (EIB) and the World Bank, Treasuries and central banks. There are also
brokers who act on behalf of a third party and regulators who seek to ensure the smooth
functioning of market activity. The relative importance of the various market participants can
vary greatly form one financial center to another; over the years, however, there has been a
pronounced increase in the relative importance of institutional investors, a process known as
the institutionalization of financial markets. Institutional investors, because they buy and sell
large volumes of securities, require a high degree of liquidity so that their trades do not adversely
affect the share price they deal in.
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