FINANCIAL INSTITUTIONS AND MARKETS CH04: FINANCIAL MARKETS IN THE FINANCIAL

SYSTEM

CHAPTER FOUR
4. FINANCIAL MARKETS IN THE FINANCIAL SYSTEM
Introduction
Financial market is a mechanism that allows people to buy and sell (trade) financial securities
(such as stocks and bonds) at low transaction cost and at prices that reflect the efficient market
hypothesis. It is structures for which funds flow. In finance, financial markets facilitate:
 The raising of capital (in the capital market)
 The transfer of risk (in the derivative markets)
 International trade (in the currency market)
Typically, a borrower issues a receipt to the lender promising to pay back the capital. These
receipts are securities, which may be freely bought or sold. In return for lending money to the
borrower, the lender will expect some compensation in the form of interest or dividend. In other
words, financial market is a market where financial assets are exchanged or traded.
According to Brigham, Eurene F. “financial markets are the place where people and organization
wanting to borrow money are brought together with those having surplus funds.
To study the effects of financial markets and financial intermediaries on the economy, we need to
acquire an understanding of their general structure and operation

4.1. The Organization and Structure of Markets

Conceptually financial system includes a complex of institution and mechanism which affects the
generation of saving and transfers to those who will invest. The financial system may be said to
be made all of those channels through which savings become available for investments.
Financial market performs the function in financial system as Facilitating organizations. Unlike
financial institution they are not source of funds but are a link and provide a forum in which
supplier of the funds and demanders of the Loans can transact business directly. While the loans
and investments of financial institution are made without the direct knowledge of the suppliers of
the funds (i.e. investor), suppliers in financial market know where their funds are invested.
The following several categorizations of financial markets illustrate essential features,
organization and structure of these markets.

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4.2. Primary Markets and Secondary Markets

A. Primary Market
A primary market issues new securities on an exchange. Companies, governments and other
groups obtain financing through debt or equity based securities. Primary markets, also known as
"new issue markets," are facilitated by underwriting groups, which consist of investment banks
that will set a beginning price range for a given security and then oversee its sale directly to
investors. The primary markets are where investors have their first chance to participate in a new
security issuance. The issuing company or group receives cash proceeds from the sale, which is
then used to fund operations or expand the business.
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’s securities and then sells them to the public.
B. Secondary Market
The secondary market is where investors purchase securities or assets from other investors, rather
than from issuing companies themselves. The Securities and Exchange Commission (SEC)
registers securities prior to their primary issuance, then they start trading in the secondary market
on the New York Stock Exchange, NASDAQ or other venue where the securities have been
accepted for listing and trading. The secondary market is where the bulk of exchange trading
occurs each day. Primary markets can see increased volatility over secondary markets because it
is difficult to accurately gauge investor demand for a new security until several days of trading
have occurred. In the primary market, prices are often set beforehand, whereas in the secondary
market only basic forces like supply and demand determine the price of the security.
Note that, in any secondary market trade, the cash proceeds go to an investor rather than to the
underlying company/entity directly.
Secondary markets serve two important functions:
 First, they make it easier and quicker to sell these financial in strumpets to raise cash; that
is they make the financial instruments liquid. The increased liquidity of these instruments

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then makes them more desirable and thus easier for the issuing firm to sell in the primary
market.
 Second, they determine the price of the security that the issuing firm sells in the primary
market. The investors who buy securities in the primary market will set for this security.
The higher the security’s price in the secondary market, the higher the price that the issuing
firm will receive for a new security in the primary market, and hence the greater the amount
of financial capital it can raise. Conditions in the secondary market are therefore the most
relevant to corporations issuing securities.
Third vs. Fourth Markets
You might also hear the terms "third" and "fourth markets." These do not concern individual
investors because they involve significant volumes of shares to be transacted per trade. These
markets deal with transactions between broker-dealers and large institutions through over-the-
counter electronic networks. The third market comprises OTC transactions between broker-
dealers and large institutions. The fourth market is made up of transactions that take place between
large institutions. The main reason these third and fourth market transactions occur is to avoid
placing these orders through the main exchange, which could greatly affect the price of the
security. Because access to the third and fourth markets is limited, their activities have little effect
on the average investor.

4.3. Money Market

The money market is a segment of the financial market in which financial instruments with high
liquidity and very short maturities are traded. The money market is used by participants as a means
for borrowing and lending in the short term, from several days to just under a year. Money market
investments are also called cash investments because of their short maturities.
Common money market instruments
1. Treasury bills: short-term debt obligation of national government that are issued to mature
in 3 to 12 months. It is a very safe short-term investment issued by the federal government
and some provinces. This bill they do not pay interest prior to maturity. Government Issue
treasury bills in a very large denominations of million or so. Banks and investment dealers

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break these up and sell them to investors. The investors always buy Treasury bill at discount
to its face value. That means you pay less than what you will get back when government
cashes it for you. You might pay $975 for T-bill and get back $1000 when it matures one
year later. Regular weekly T-bills are commonly issued with maturity dates of 28 days (or
4 weeks, about a month ), 91 days (or 13 weeks, about 3 month)and 182 days other types of
treasury bill treasury note mature in two to ten years. They have coupon payment every six
months, and are commonly issued with maturities dates of 2, 5, or10 years, for denominations
from $ 1,000 to $1,000,000. Treasury bond -have the longest maturity from ten years to
thirty years. They have coupon payment (Interest) every six months.
2. Banker’s acceptance: is a time draft drawn on or accepted by the bank. Before acceptance,
the draft is not an obligation of the bank. It is merely the order merely an order by the drawer
to the bank to pay specified sum of money on specified date to the named person or the bearer
of the draft. A banker’s acceptance starts as an order to the bank by a banks customer to pay
a sum of money at the future date, typically within six months. It is considered very safe
assets, as they allow trader to substitute the banks credit standing for their own. They are
widely used in international trade where the creditworthiness of one trader is unknown to
trading partner. Acceptance sells at a discount from the face value of the payment orders.
The rate at which they traded is called bankers’ acceptance rates. The bank may hold the
acceptance in its portfolio or it may sell or, re discount in secondary market.
3. A certificate of deposit or CD: is a time deposit, financial product commonly offered to
customers by banks, saving institutions and credit unions. Such CDs are similar to the saving
accounts in that they are insured and virtual risk free; they are money in bank.
They are different from saving account in that the CDs has specific, fixed term (often three
months, Six months, one to five years) and usually fixed interest rates. It is intended that the CD
be held until maturity, at which time money may be withdrawn together with the accrued interest.
How CDs work
a. Buying a CDs – it typically require the minimum deposit and may offer higher rates for
larger deposits. The customer who opens a CD may receive a passbook or paper
certificate.

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b. Interest payment - At most institution the CD purchaser can arrange to have an interest
periodically mailed as check or transferred in checking or saving accounts.
c. Closing a CD − withdrawals before maturity is subject to substantial penalty. This
penalty insures that it is generally not in holder best interest to withdraw the money the
money before maturity. Commonly the issuer of the instrument made a notice to the CD
holder shortly before the CD matures .the notice usually offer the choice of withdrawing
the principal and accumulated interest or rolling it over (depositing it into new CDs
4. Repurchase agreement (repo): Better known as a sale and repurchase agreement has
borrower (seller/cash receiver) sell security for cash to a lender (buyer/cash provider) and
agrees to repurchase those securities at later date for more cash. The repo rate is the difference
between borrowed and paid back cash expressed as a percentage. It is economically similar
to secured loans, with the buyer receiving securities as collateral to protect against default.
Types of repo
There are three types of repo maturity
a. Overnight repo-it refers one-day maturity transaction.
b. Term repo-refers to a repo with specified end date.
c. Open repo-simply has no end date.
5. Commercial paper: is money market security issued by large banks and corporations. It is
not generally used to finance long-term investments but rather to purchase inventory or to
manage working capital. It is commonly bought by money funds (the issuing amounts are
more often too high for individual investors) are generally regarded as a very safe investment.
There are four basic kinds of commercial paper
1. Promissory notes 3. Checks
2. Drafts 4. Certificate of deposits
6. Municipal bond is a bond issued by states, cities, and countries or their agency (the principal
issuer) to raise funds. The methods and practices of issuing debt are governed by an extensive
system of laws and regulations. Bonds bear interest at either a fixed or a variable rate of
interest. The interest received by the holder of the municipal bonds often exempt from the
federal income tax and from the income tax of the state in which they are issued . The issuer

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of the municipal bond receives a cash payment at the time of issuance in exchange for
promise to repay the investors who provide the cash payment (the bondholder) over time.
Characteristics of municipal bonds
a. Taxability-provide tax exempt income. Interest paid by the issuer to the bondholders is
often exempt from all federal and local taxes.
b. Risk the risk of municipal bond is low.
7. Federal funds: are overnight borrowings by the banks to maintain their banks reserves at
Federal Reserve. Banks keeps reserves at federal reserve banks (central banks in our country)
to meet their reserve requirement and clear financial transaction in federal funds market
enable depository institutions with reserve balances in excess of reserve requirement to lend
reserves to institutions with reserve deficiencies. These loans are usually made for one day
only, i.e. over night. The interest rate at which these deals are done is called the federal funds
rate.

4.4. Capital Markets

A capital market is financial relationship created by a number of institutions and arrangements

that allows supplier and demanders of long term funds (i.e. funds with maturity exceeds one year)
to make transactions. It is one in which individuals and institutions trade financial securities.
Organizations and institutions in the public and private sectors also often sell securities on the
capital markets in order to raise funds. Thus, this type of market is composed of both the primary
and secondary markets. Any government or corporation requires capital (funds) to finance its
operations and to engage in its own long-term investments. To do this, a company raises money
through the sale of securities - stocks and bonds in the company's name. These are bought and sold
in the capital markets. In capital market, a firm or an individual can obtain funds in a financial
market in two ways. These are debt market and stock markets
4.4.1. Debt Markets
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 dollar amounts at
regular intervals (interest and principal payments) until a specified date (the maturity date) when

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a final payment is made. The maturity of a debt instrument is the number of the years (term) until
that instrument’s expiration date. 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.
4.4.2. Equity Market
The method of raising funds 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 shares, you are entitled to one millionth of the firm’s net income and 1 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 import hat
to the firm and to elect its directors.
The main advantage 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. 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 dollar payments are fixed.
4.5. Exchanges Vs. Over-The-Counter Markets
Secondary markets can be organized in two ways- one method is to organize exchanges, where
buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct
traders. The New York and American stock exchange for stocks and the Chicago board of trade
for Commodities (wheat, corn, silver, and other raw materials) are examples of organized
exchanges. Many common stocks are traded over-the-counter, although a majority of the largest
corporations have their shares traded at organized stock exchanges. The OTC Market (over-the-
counter market) is a type of secondary market also referred to as a dealer market. The term "over-
the-counter" refers to stocks that are not trading on a stock exchange such as the NASDAQ, NYSE
or American Stock Exchange (AMEX). This generally means that the stock trades either on the
over-the-counter bulletin board (OTCBB) or the pink sheets. Neither of these networks is an
exchange; in fact, they describe themselves as providers of pricing information for securities.

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OTCBB and pink sheet companies have far fewer regulations to comply with than those that trade
shares on a stock exchange. Most securities that trade this way are penny stocks or are from very
small companies.
4.6. Derivative Vs. Foreign Exchange Markets
4.6.1. Derivatives Markets
A derivative is simply a contract, which entitles the holder to buy or sell a commodity at some
future date for a predetermined price. Therefore, while a stock or a bond has intrinsic value (a
stock or a bond represents a claim to some asset or income stream), a derivative has no intrinsic
value. Its value is “derived” from the underlying asset. Examples of common derivatives are
forwards, futures, options, swaps…
 Future: The owner of a future has the OBLIGATION to sell or buy something in the
future at a predetermined price.
 Forwards: The owner of a forward has the OBLIGATION to sell or buy something in the
future at a predetermined price. The difference to a future contract is that forwards are not
standardized.
 Options: The owner of option has the OPTION to buy or sell something at a
predetermined price and is therefore more costly than a futures contract.
 Swaps: A swap is an agreement between two parties to exchange a sequence of cash flows.
Those contracts are called derivative instruments and the markets in which they trade are referred
to as derivative markets.
4.6.2. Foreign Exchange Markets
The foreign exchange market is where international currencies trade and exchange rates are set.
i.e., it is market where currencies are traded. It is a market were buying and selling of different
currencies take places. The price of one currency in terms of another currency is known as
Exchange rate. There are three main centers of trading, which handle the majority of all foreign
exchange transaction. This are;
United state
United kingdom and
Japan

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The forex market is the largest, most liquid market in the world with an average traded value that
exceeds $1.9 trillion per day and includes all of the currencies in the world. The forex is the largest
market in the world in terms of the total cash value traded, and any person, firm or country may
participate in this market.
There is no central marketplace for currency exchange; trade is conducted over the counter. The
forex market is open 24 hours a day, five days a week and currencies are traded worldwide among
the major financial centers of London, New York, Tokyo, Zürich, Frankfurt, Hong Kong,
Singapore, Paris and Sydney. Until recently, forex trading in the currency market had largely been
the domain of large financial institutions, corporations, central banks, hedge funds and extremely
wealthy individuals. The emergence of the internet has changed all of this, and now it is possible
for average investors to buy and sell currencies easily with the click of a mouse through online
brokerage accounts.
No unified or centrally cleared market for the majority of foreign exchange trades. Due to the Over
the counter (OTC) nature of the currency markets, there are a number of interconnected market
places, where different currency instruments are traded .This implies there is no single dollar rate
but rather a number of different rates (price), depend on bank or market maker.
Foreign exchange consists of trading one type of currency for another. Unlike other financial
market, The FX MKT has no physical location and no central exchange. It operates “over the
counter” through the network of the banks, corporation and individual trading one currency for
another. FX is the largest financial market in the world. It Operates 24 hours a day. UN like other
financial market, investor can respond to the currency fluctuation caused by economic, political
and social events.
FX MKT is unique because of
 Largest trading volume
 Large number of, and variety of, traders in the market.
 Cover high geographical location
 Trading 24 hours
 There are different factor affecting exchange rate

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 Low profit compares with other market of fixed income, but profit is high due to very large
trading volumes.

FX MKT is denominated by four currency, dollar, Euro, Yen (Japan), and pound in term of trading
volume. Together these account for over 80% of the market.
Exchange Rate: In finance exchange rate is known as FX.RATE. Which implies between two
currencies specific show much one currency is worth’s in term of the other.
Example: Exchange rate of 27.5-cent Ethiopian birr to the USA one dollar.
Quotations of exchange rate: an exchange rate quotation is given by stating the number of units
of “term currency” or “price currency” that can be bought in term of one unit of currency (also
called base currency).
Example: - In quotation Euro currency to USA dollar Exchange rate is 1.3 (1.3 USD per EUR)
that is EURUSD =1.3 USD EUR. The term currency is USD was as Base currency is EUR. Quotes
using a country home currency as the price currency
Example: Euro 1.00 = $ 1.45 US are known as direct quotation or price quotation. Quotes using
a countries home currency as a unit currency are known as indirect quotation or quantity quotation.
Direct quotation: 1 foreign currency unit = X home currency units
Indirect quotation: 1 home currency unit = X foreign currency unit
Example
1. For Ethiopia 1 USA dollar = 55 birr is direct quotation
For Ethiopia 55 birr = is 1 USA dollar is indirect quotation
Note; using direct quotation, if the home currency is strengthening (that is appreciating or
becoming more valuable) the exchange rate decreases.
Example If 1USD = 10 birr rather than 1USD = 12.4 birr it is exchange rate decreases. In contrary
if the foreign currency is strengthen, the exchange rate increases and home currency deprecation.
Cross Rate: The theoretical exchange rate between two countries other than us dollar can be
inferred from the exchange rate with the US dollar. This is called cross rate.
Quote in American in term of currency x
Quote in American in term of currency y

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Example; The exchange rate for the two currencies in term of USA dollar is 0.6234 for German
mark and $ 0.009860 per Japanese Yen. Calculate the cross rate between two country.
o The number of Japan yen(y) per unit of German marks(x) is:
$0.6234
= = 63.23 (𝑦𝑒𝑛/𝑚𝑎𝑟𝑘)
$0.009860
o The number of German marks(y) per unit of Japans yen (x) is:
$0.009860
= = 0.1581 (𝑀𝑎𝑟𝑘/𝑦𝑒𝑛)
0.6234
Fluctuations in exchange rate
A market-based exchange rate will change whenever the value of either the two-component
currency change. The currency becomes more valuable when demand is greater than supply. In
addition, inverse is true that is the currency become less valuable when demand is less than supply
of currency. Increased demand for currency is due to either increased transaction demand for
money or increased speculative demand for money.
Participant of FOREX
 Banks
 Commercial companies
 Central banks
 Investment management firms
 Retail FOREX brokers
1. banks-the inter-bank market center for both the majority of commercial turnover and large
amount of speculative trading every day
2. Commercial companies:-this market comes from the financial activities of companies seeking
foreign exchange to pay for goods and service.
3. central bank-national or central banks control; the-
- Money supply
- Inflation
- Interest rate
Central banks do that to buy foreign exchange, when the exchange rate is too low, and to sell when
the rate is too high to get profit. The main objective of central bank is to stabilize currency
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4. Investment management firms: Investment management firms (such as pension funds and
endowment) use the foreign exchange market to facilitate transaction in foreign countries-
Example. An investment manager at an international equity portfolio will need to buy and sell
foreign currencies in the spot market in order to pay for purchases of foreign equities.
5. Retail for ex brokers : there are two types of retail broker(brokers speculative trading and
offering physical delivery- bought currency is delivered to a bank account)

Factor Affecting Currency Trading

Supply and demand for any given currency, and thus its value are not influenced by any single
element, rather by several. These elements generally fall into three categories:
1. Economic factors-include balance of trade levels, inflation level-economic growth
2. Political condition
3. Market psychology
International Bond Market, Eurobonds, and Eurocurrencies
The traditional instruments in the international bond market are known as foreign bonds. Foreign
bonds are sold in a foreign country and are denominated in that country’s currency. For example,
if the German automaker Porsche sells a bond in the United States denominated in U.S. dollars, it
is classified as a foreign bond. Foreign bonds have been an important instrument in the
international capital market for centuries. In fact, a large percentage of U.S. railroads built in the
nineteenth century were financed by sales of foreign bonds in Britain.
A more recent innovation in the international bond market is the Eurobond, a bond denominated
in a currency other than that of the country in which it is sold. For example, a bond denominated
in U.S. dollars sold in London. Currently, over 80% of the new issues in the international bond
market are Eurobonds, and the market for these securities has grown very rapidly. As a result, the
Eurobond market is now larger than the U.S. corporate bond market
A variant of the Eurobond is Eurocurrencies, which are foreign currencies deposited in banks
outside the home country. The most important of the Eurocurrencies are Eurodollars, which are
U.S. dollars deposited in foreign banks outside the United States or in foreign branches of U.S.
banks. Because these short-term deposits earn interest, they are similar to short-term Eurobonds.

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American banks borrow Eurodollar deposits from other banks or from their own foreign branches,
and Eurodollars are now an important source of funds for American banks. Note that the euro, the
currency used by countries in the European Monetary System, can create some confusion about
the terms Eurobond, Eurocurrencies, and Eurodollars.
A bond denominated in euros is called a Eurobond only if it is sold outside the countries that have
adopted the euro. In fact, most Eurobonds are not denominated in euros but are instead
denominated in U.S. dollars. Similarly, Eurodollars have nothing to do with euros, but are instead
U.S. dollars deposited in banks outside the United States.

…………. END OF CHAPTER FOUR ……………….

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