Financial Markets and

Institutions

Instructor
Teferi Deyuu (Ph.D.)
 Chapter 1:
Introduction to the financial system
Introduction
A financial system plays a vital role in the economic
growth of a country.

Financial system intermediates between the flow of

funds belonging to those who save a part of their
income those who invest in productive assets.

A financial system is a complex, well integrated of

subsystems of financial institutions, markets,
instruments and services.
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Introduction (Contd…)
 There are two types of financial systems:

 Informal Financial Sectors and

 Formal Financial Sectors.

 The informal financial sector is an unorganized,

noninstitutional, and nonregulated system dealing with the
traditional rural spheres of the economy. This sector
includes: Idir, Iqub, individual money lenders.

 The formal financial sector is characterized by the

existence of an organized, institutional and regulated system
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 Component of formal Financial System

The formal financial system consists of four

components:

1. Financial Institutions

2. Financial Markets

3. Financial Instruments

4. Financial Services

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 1. Financial Institutions
 Financial institutions are intermediaries that
mobilize savings and facilitate the allocation of
funds in an efficient manner.
 They can be classified as banking and non-banking
financial institutions.

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 2. Financial Markets
Financial markets are a mechanism enabling
participants to deal in financial claims.

There are two types of financial markets: Money

market and capital market. Money market – is a market
for short-term securities while capital market is a
market for long-term securities.

Financial markets can also be classified as primary

market and secondary market.
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3. Financial Instruments
A financial instrument is a claim against a person or an
institution for payment, at a future date, of a sum of
money and/or a periodic payment in the form of
interest or dividend.

Financial instruments represent shares, bonds and

notes.

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 4. Financial Services
These are those that help with borrowing and
funding, lending and investing, buying and selling
securities, making and enabling payments and
settlements, and managing risk exposures in financial
markets.

The major categories of financial services are fund

intermediation, payment mechanisms, provision of
liquidity, risk management, and financial
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 Functions of A Financial System
 Mobilizing and allocating savings.

 Monitoring Corporate performance.

 Providing payment and settlement systems.

 Optimum allocation of risk-bearing and reduction

 Disseminating price related information.

 Offering portfolio adjustment facility.
 Lowering cost of reduction, and
 Promoting the process of financial deepening and
broadening.
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 Key Elements of A Well – Functioning Financial
System
o A strong legal and regulatory environment.

o Stable Money.

o Sound public finances and public debt.

o A central bank.

o Sound banking system.

o Information system, and

o Well-functioning securities market.

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12 The role of financial resources

 transfer funds from surplus units to deficit

units
 redistribute the unavoidable risk associated
with the cash flow generated by tangible
assets among the deficit units and surplus
units.

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13 Characteristics of financial assets
 Moneyness-used as a medium of exchange
 Divisibility & denomination-denominated
in smaller sizes
 Reversibility-ability to be converted back
to cash at a lower cost(low round trip cost)

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14
Characteristics of financial assets (Contd…)

 Term to maturity-length of time between

when the instrument is issued and its
liquidation.
 Some instruments are liquidated upon
demand by the creditor
 Instruments may be issued with the term of
a few days to so many years. Eg. T.bill Vs
Bonds
 instruments may be liquidated prematurely
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 Characteristics of financial assets (Contd…)
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 Liquidity-can be resold without substantial

loss of value.
 liquidity differes based on the issuer‘s identity
the degree of market capitalization.(thin/tick)
 Convertability-ability to be converted into
other financial assets
 Currency- are denominated in a certain
currency.
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16
Characteristics of financial assets (Contd…)

 Cash flow and return predictability-

return on a financial asset depends on the
cash flow expected to be received
 Complexity- some financial assets may
be combinations of two or simpler assets.
 Tax status-financial assets have different
tax status.
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17 The role and type of financial markets
The role of financial markets
Eliminate arbitrage
Raising capital
 Commercial transactions- financial
markets provide the grease that makes
many commercial transactions possible

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18
The role and type of financial markets (Contd…)

The role of financial markets

 Investing- provide an opportunity to earn
a return on funds that are not immediately
needed
 Risk management- futures, options and
other derivatives contracts can provide
protection against many types of risk

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The role and type of financial markets (Contd…)
Classification of financial markets
 Money markets and Capital markets
 Primary and secondary market
 Fixed claim and residual claim markets

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20 The role and type of financial Institutions
The role of financial Institutions
 Maturity intermediation- they create loans
of long term maturity out of deposits that
mature in the short term.
 Risk reduction through diversification-they
diversify risk by investing in different
sectors of the economy.

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21
The role and type of financial Institutions (Contd…)

The role of financial Institutions

 Reducing the cost of contracting and
information processing-they are better
equipped in completing contracts and
processing information
 Providing a payment mechanism-enable
individuals and businesses to effect
payments using checks, credit cards, debit
cards, and through electronic transfer.
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22
The role and type of financial Institutions (Contd…)

Types of financial Institutions

 Deposit taking institutions
 Commercial Banks
 Saving and Loan Associations
 Microfinance Institutions
 Non-deposit taking institutions
 Insurance companies
 Mutual funds
 Pension funds
 Investment Banks
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23 Financial asset innovation
Types of financial Innovations
 Market broadening instruments
 Risk management instruments
 Arbitrage instruments

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24 Financial asset innovation (Contd…)
 Market broadening instruments
increase market liquidity and availability
of funds by attracting new investors and
offering new opportunities for borrowers
E.g:- Mortgage backed securities.
 Risk management instruments-reallocate
financial risk to the less risk averse, who
have offsetting position and thus have the
ability to shoulder them
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25 Financial asset innovation (Contd…)
 Arbitraging instruments and processes
enable traders to take advantages of
difference in the costs and returns between
markets.

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26 Financial asset innovation (Contd…)
Drivers of financial innovation
 endeavor to circumvent regulations and find
loopholes in tax rules.
 a need to efficiently redistribute risks among
market participants
 Increased volatility of interest rate, inflation
and equity prices and exchange rates
 advances in computer and communication
technologies
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 End of Chapter 1

Thank You for Your Attention!!!