OVERVIEW OF THE

FINANCIAL SYSTEM1
CHAPTER ONE

Gashahun Edossa/Addis Ababa University 1

OUTLINE
1. Overview
2. The financial system
3. Meaning of financial instruments and financial markets
4. Meaning of financial institutions
5. Why study financial markets and institutions?

Gashahun Edossa/Addis Ababa University 2

 Chapter Objectives
After completing this chapter, you should be able to:
• describe the financial system
• discuss financial instruments, financial markets, and financial institutions
• Identify financial institutions which are currently operating in Ethiopia

Gashahun Edossa/Addis Ababa University 3

 The Financial System
 The financial system is the process by which money flows from savers to users

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 The Financial System (cont’d)
 The financial system consists of :

• Savers (surplus unit) and users (deficit unit) of funds

• Financial services
• Financial markets
• Financial institutions
• Financial instruments
• Dealers and brokers
 The financial system may be direct or indirect
 Direct finance – Savers and users meet without the involvement of intermediaries
 Indirect finance - Savers and users meet their needs through intermediaries.
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 Functions of the financial system
1. Savings Function
 Provides a conduit for the public’s savings through the system of
financial markets & institutions
 Provides a profitable, relatively low-risk outlet for the public’s savings
2. Wealth Function
• Provides a means to store (wealth or value) purchasing power (using
financial instruments) until needed at a future date for spending on goods &
services
• Storing our wealth in things (like automobiles and clothes) may result
in great risk of loss because they are subject to depreciation.
However, financial instruments do not wear over time and usually
generate income and, normally, the risk of loss is much less than for
other forms of stored wealth.
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 Functions of the Financial System (cont.)
3. Credit Function
• Provides a continuing supply of credit to businesses, consumers and governments to
support both investment and consumption spending through financial markets &
institutions
4. Liquidity Function
• Provides a means of raising funds by selling securities in to cash balances (through the
financial market places) with little risk of loss.
5.Risk Function
• Provides means to protect businesses, consumers, & governments against risks to
people, property, & income.
• Example is the sale of life & property casualty insurance policies
6. Payment Function
• Provides mechanisms for making payments to purchase goods & services
• Examples include checking accounts, visa cards, electronic payments, letter of credit
etc.

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 Functions of the Financial System (cont.)
7. Policy Function

• Provides a channel for government policy (through financial markets) to

achieve societal goals of high employment, low inflation, & sustainable
economic growth
• By manipulating interest rates & the availability of credit,
government (central banks) can affect the borrowing and spending plans
of the public which, in turn, influence the growth of jobs, production, &
prices.

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Financial instruments and Financial
markets
• What is a financial instrument? What does financial
instruments include?
• What is a financial market? What are the difference
forms of financial markets?

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 FINANCIAL INSTRUMENTS
Definition of financial instrument

Any contract that gives rise to both a financial asset of one

entity and a financial liability or equity instrument of
another entity.

Financial instruments
Financial Assets

Financial
Liabilities

Equity instrument

Derivatives

10
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Financial instruments (cont’d)
Real assets are assets in physical
form (e.g., land, equipment,
houses,...), including "human
Real (physical) capital" assets embodied in people
assets (natural abilities, learned skills,
knowledge,..).
Assets
Financial Financial assets are claims against
assets real assets, either directly (e.g.,
stock share equity claims) or
indirectly (e.g., money holdings, or
claims to future income streams
that originate ultimately from real
assets)
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Financial instruments (cont’d)
• Financialassets are claims against real assets, either directly
(e.g., stock share equity claims) or indirectly (e.g., money
holdings, or claims to future income streams that originate
ultimately from real assets).
• They represent the written legal obligation of one party to
transfer something of value, usually money, to another party at
some future date, under certain conditions

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Financial instruments (cont’d)
• Examples of financial assets include cash, receivables,
investment in securities etc.
• Examples of debt instruments are bonds, commercial paper,
treasury bill, loans etc.
• Examples of equity instruments are stock or shares
• Examples of derivatives include options, futures, and swaps

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OVERVIEW OF FINANCIAL INSTRUMENTS

Financial instruments
• Financial assets
• Financial liabilities
Equity instrument

Primary

Derivatives

14
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Financial instruments (cont’d)
 Financial instruments may also be divided in to two classes:
1. Underlying instruments - Underlying instruments are used by
savers/lenders to transfer resources directly to investors/borrowers.
 This improves the efficient allocation of resources.
 Examples: stocks and bonds.

2. Derivative instruments - Derivative instruments are those where

their value and payoffs are “derived” from the behavior of the
underlying instruments.
• Examples are futures and options.
• The primary use is to shift risk among investors.
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Financial instruments (cont’d)
The characteristics of financial instruments are:
• The enforceability of the obligation is important.
• Financial
instruments obligate one party (person, company, or
government) to transfer something to another party.
• Financialinstruments specify payment will be made at some
future date.
• Financial
instruments specify certain conditions under which a
payment will be made.

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 Uses of Financial Instruments
• Three functions:
 Financial instruments act as a means of payment (like money).
• Employees take stock options as payment for working.
 Financial instruments act as stores of value (like money).
• Financial instruments generate increases in wealth that are larger
than from holding money.
• Financial instruments can be used to transfer purchasing power into
the future.
 Financial instruments allow for the transfer of risk (unlike money).
• Futures and insurance contracts allows one person to transfer risk to
another.

3-17 Gashahun Edossa/Addis Ababa University

What is market?
• Market is the channel through which buyers & sellers meet to exchange
goods, services & resources.
• Market is an institutional set up by society to allocate resources that are
scarce relative to the demand for them.

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 Types of markets
Within the economic system, there are three different types of markets:
1. Factor Market
 Allocates factors of production (land, labor, & capital)
 Labor & other resources are sold by the consuming units to the producing units in
return for income
 The consuming units use most of their income to buy goods and services in
product market (eg. Food, shelter, books, etc)
2. Product market
Provides goods and services to consuming units

3. Financial Market
 Channels funds to those who need more funds for spending than are provided by their
current income
 the channel through which savers can directly provide funds to borrowers.

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 Financial markets
• A financial market is a market in which financial assets are traded.
• In addition to enabling exchange of previously issued financial assets, financial
markets facilitate borrowing and lending by facilitating the sale of newly issued
financial assets.
• Examples of financial markets include Nairobi Stock Exchange, Johannesburg
Stock Exchange, the New York Stock Exchange (resale of previously issued stock
shares), the U.S. government bond market (resale of previously issued bonds),
and the U.S. Treasury bills auction (sales of newly issued T-bills).
• Ethiopia does not have organized financial markets. This does not mean that
financial instruments are traded.
• National Bank of Ethiopia sells treasury bill and government bonds.
• Share companies sell shares (stock) by themselves or through agents which are
typically commercial banks

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Financial markets (cont’d)
Types of financial market
• Primary Markets versus Secondary Markets
• Money Markets versus Capital Markets
• Foreign Exchange Markets
• Open Market Vs Negotiated Market
• Spot, Futures, & Option Markets

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Financial markets (cont’d)
• Primary Markets versus Secondary Markets
Primary markets are markets in which users of funds (e.g.
corporations, governments) raise funds by issuing financial
instruments (e.g. stocks and bonds).
New securities are sold
Secondary markets are markets where financial instruments are
traded among investors (e.g. NYSE, Nairobi Stock Exchange).

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 Financial markets (cont’d)
Money Markets versus Capital Markets
 Money markets are markets that trade securities with maturities of one year or less
(e.g. Treasury bill, commercial paper, certificate of deposits, bankers’
acceptances etc.)
 Capital markets are markets that trade debt (bonds) and equity (stock) instruments
with maturities of more than one year. e.g.
 Mortgage loans (to build homes, & business structures)
 Government or municipal bonds
 Consumer loans (to buy automobiles, home appliances etc.)
 Corporate stock
 Corporate bonds and notes

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Financial markets (cont’d)
Foreign Exchange (FX) Markets

 “FX” markets deal in trading one currency for another (e.g. dollar
for ETB). There are two types of FX markets: Spot & forward.
 The “spot” FX transaction involves the immediate exchange of
currencies at the current exchange rate.
 The “forward” FX transaction involves the exchange of currencies
at a specified date in the future and at a specified exchange rate.

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Financial markets (cont’d)
Open Market Vs Negotiated Market
1. Open Market
 Market in which financial securities are sold to the highest bidder &
bought & sold any number of times before they mature & paid off

2. Negotiated market
 Market in which securities are sold to one or a few buyers under
private contract

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Financial markets (cont’d)
Spot, Futures, & Option Markets
1. Spot Markets
 Market in which financial securities are traded for immediate
delivery, usually within one or two business days.
2. Futures (forward) market
 Market designed to trade contracts requiring the future delivery of
financial instruments.
 The purpose of such contract is to reduce investor risk by agreeing on
a price today.
3. Option Markets
The market in which financial securities which convey the right (not
obligation) in a future transaction are traded.
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 Factors Tying All Financial Markets Together
 To some extent, each corner of the financial system
represents a distinct market with its own special
characteristics.
 However, there are forces at work to tie all financial markets
together. Some of them are:
1. Credit
 Is the common (basic) commodity traded in all financial
markets

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Factors Tying All Financial Markets
Together (cont’d)
2. Speculation and Arbitrage
 Speculation- the process of continually looking for
opportunities to make profit from forecasts of future market
developments
Speculators gamble that security prices will move in a
direction that will result in quick gains, buy the security when
the prices are low and sell them when prices are high
The gains depend on the ability of the speculator in
outguessing the market’s collective judgments.
Many speculators are risk-seekers

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Factors Tying All Financial Markets
Together (cont’d)
Arbitrage- transferring funds from one market to another
market whenever the prices of securities in different
markets appear to be out of line with each other. Such
investors are called arbitrageurs

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Factors Tying All Financial Markets
Together (cont’d)
3. Perfect and Efficient Markets
 All financial markets are closely tied to one another because of their
perfection and efficiency.
 Perfect market is the market in which:
1.All information is freely available to everyone
2. The cost of carrying transactions is zero or nearly so
3. All market participants are price-takers
4. There are no government restrictions on trading & the movement
of funds
5. Competition among buyers & sellers set the terms of trade
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Factors Tying All Financial Markets
Together (cont’d)
In a perfect market, the prices of financial instruments accurately
reflect their inherent value & fully reflect all available information.
In a perfect market, any new information supplied to the market
will quickly be impounded in a new set of prices
Efficient Market is the market in which prices fully reflect all of the
latest available information.
In an efficient market, no information that might affect security
prices or interest rates is wasted.
In an efficient market, no buyer or seller can expect to reap excess
profits from collecting information and then trading on the basis of
that information.
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 Revision Questions 1

1. In what ways is the financial system linked to the economy as a

whole?
2. What are the principal functions of the financial system?
3. Distinguish between money market and capital market; open
market & negotiated market; primary market & secondary market;
spot, forward, & future markets.
4. Distinguish between perfect market & efficient market.

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Revision Questions 2
Classify the following financial transactions as to whether they fit in (a)
money market or capital market (b) open market or negotiated market (c)
primary market or secondary market (d) spot market or future market
1. You visited Dashen bank today and secured a five-year loan to finance
the purchase of home automobile.
2. You purchase government treasury bill for Br. 50,000 for delivery
today.
3. Concerned about inflation in the price of shares, you entered in to a
contract with Lion International Bank to purchase 2000 shares at
today’s Br. 1000 per share for delivery of shares in eight months.
4. Your company fall short of working capital of Br. 60,000 and
decides to sell commercial papers maturing in 60 days. You
advertise the sale on Ethiopian television and expect to sale all the
notes within two days.
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Revision Questions 3
What function(s) of the financial system do the following transactions
represent?
1. Ato Belete bought accident insurance policy through his company’
2. Ato Chera uses his Dashen visa card to purchase food stuff from various
supermarkets
3. Having a fear that the rate of economic growth will be slowdown, the
National Bank of Ethiopia decided to decrease interest rate in order to
accelerate the growth of the nation’s money supply.
4. 4. W/r Metty placed Br. 30,000 in Awash International Bank’s Certificate of
Deposit in order to use it to buy home automobile after a year.
5. 5. The Ministry of Finance & Economic Development issued new bonds in
the open market to finance budget deficit.
6. 6. W/t Chaltu sold ABC company’s stock, which she bought five years
before, for Br. 40,000 to personal home.
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Financial institutions
• Financial institutions are institutions that perform the essential function of
channeling funds from those with surplus funds (surplus unit) to those with
shortages of funds (deficit Unit).
• A financial institution is an institution whose primary source of profits is
through financial asset transactions.
• Examples of such financial institutions include banks, insurance companies,
saving and credit associations, Micro finance institutions, credit union, pension
funds, mutual funds etc.

1. List out banks which are currently operating in Ethiopia.

2. List the name of insurance companies operating in Ethiopia
3. List the names of microfinance institutions in Ethiopia
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Flow of Funds in a World without FIs: Direct Transfer

Financial Claims
(Equity and debt
instruments)
Suppliers of
Users of Funds
Funds
(Corporations)
(Households)
Cash

Example: A firm sells shares directly to investors without going

through a financial institution

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Flow of Funds in a world with FIs: Indirect transfer

FI
Users of Funds Suppliers of Funds
(Brokers)

FI
(Asset
transformers)
Financial Claims Financial Claims
(Equity and debt securities) (Deposits and Insurance policies)

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What Services Do FIs Provide?
• Reduce Information asymmetry
• Liquidity
• Reduced Transaction Costs
• Transmission of Monetary Policy
• Credit Allocation
• Payment Services
• Intergenerational Wealth Transfer

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Financial institutions – Banks & Insurance
No Name of Bank Ownership As of October
1 Commercial Bank of Ethiopia Government 2016, there are 17
2 Dashen Bank Private insurance
3 Awash International Bank Private companies and 18
4 Oromia International Bank Private commercial banks
5 Bank of Abyssinia Private
in Ethiopia. Two
out of 18 banks
6 Nib International Bank Private
(Commercial Bank
7 Cooperative Bank of Oromia Private
of Ethiopia and
8 United Bank Private Development
9 Abay Bank Private Bank of Ethiopia
10 Anbessa Bank Private belong to the
11 Enat Bank Private Federal
12 Addis International Bank Private Democratic
13 Zemen Bank Private Republic of
14 Debub Global Bank Private
Ethiopia
15 Bunna International Bank Private
16 Wegagen Bank Private
17 Berhan International Bank Private Ethiopian Insurance Corporation is Government –
18 Development Bank of Ethiopia Government owned
Gashahun Edossa/Addis while the rest are under private ownership39
Ababa University
Financial institutions - MFIs (cont’d)
No Name of MFI 21 Meklit Microfinance S.C
1 Amhara Credit and Saving Institutions S.C (ACSI) 22 Metemamen MIcrofinance S.C
2 Addis Credit and saving Institutions S.C (ADCSI) 23 Nisir Microfinance S.C
3 Adeday Microfinance Institution 24 Oromia Credit and saving S.C (Ocssco)
4 Afar Microfinance S.C 25 Omo MIcrofinance S.C
5 Aggar Microfinance S.C 26 Rays Microfinance S.C
6 Africa Vilage Financial services S.C (AVFS) Poverty Eradication and Community Empowerment Microfinance
7 Benshangul Gumuz MIcrofinance S.C 27 Institutions S.c (PEACE)
8 Bussa Gonofa MIcrofinance S.C 28 Specialized Financial and Promotional Institutions S.C (SFPI)
9 Dedebit Credit and saving Institutions S.C (DECSI) 29 Shashimene eddir yelimat Agar S.C (SEYAMFI)
10 Diredawa MIcrofinance S.C (Dire) 30 Sidama MIcrofinance S.C

11 Digaf MIcrofinance S.C 31 Somali Microfinance Institutions S.C

12 Dynamic Microfinance Inst.S.C 32 Wasasa MIcrofinance S.C

33 Vision Fund MIcrofinance S.C
13 Eshet MIcrofinance S.C
14 Gambela MIcrofinance S.C
15 Gasha MIcrofinance S.C
The above list may not be exhaustive
16 Harar MIcrofinance S.C
17 Harbu MIcrofinance S.C
18 Lefayeda Credit and Saving S.C
19 Letta Microfinance S.C
20 Lideta Microfinance S.C Gashahun Edossa/Addis Ababa University 40
Why study Financial Markets and
Institutions?
• They are the cornerstones of the overall financial system
in which financial managers operate
• Individuals use both for investing
• Corporations and governments use both for financing

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Review Questions
1. List out at least four elements of a country’s financial system
2. What are financial instruments? Give some examples of
financial instruments.
3. What is a financial market? Give some examples of financial
assets
4. Define a financial institution. Give some examples of financial
institutions, especially in Ethiopia

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The end

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