Chapter Two

Financial Market and Instruments

 Contents in Chapter Two
– Introduction
– Primary, secondary, third and fourth market
– The Money Markets
– Capital Markets
– Derivative Markets
– Foreign Exchange Markets
Introduction

 A market is any organized system for connecting

buyers and sellers.

 Financial markets are no different. In financial markets

funds are exchanged.

 The sellers of the funds have excess funds and the

buyers need those funds.

 The equilibrium in these markets determines the price

and quantity of financial instruments.

3
Definition

 A financial market can be defined as an

institution or arrangement that facilitates the
exchange of financial instruments, including
deposits & loans, stocks, bonds etc.

 A Financial Market is a market in which

financial assets (securities) can be purchased
or sold.
4
Con’t

• Financial markets facilitate transfers of funds

from person or business without investment
opportunities (i.e., “Lender-Savers”, or “Surplus
Unit”) to those who have investment
opportunities (i.e., “Borrower-Spenders”, or
“Deficit Unit”).
• Both buyers and sellers benefit from the market

5
Con’t

 There are many security markets

 Markets may have a physical location
The New York Stock Exchange

 Or exist only as computer networks

 The London Stock Exchange

6
7
 Characteristics of a Good Financial Market

• Availability of past transaction information

– must be timely and accurate
• Liquidity
– marketability
– price continuity
– Depth: large number of buyers and sellers
• Low Transaction costs
• Rapid adjustment of prices to new information
8
Functions of Financial Market

1. Transfer of resources: Financial markets facilitate

the transfer of real economic resources from
lenders to ultimate borrowers.
2. Enhancing income: financial markets allow
lenders earn interest /dividend on their surplus
investible funds, thus contributing to the
enhancement of the individual & the national
income.
9
Con’t

3. Productive usage: Financial markets allow for

the productive use of the funds borrowed, thus
enhancing the income & the gross national
production.
4. Capital formations: financial markets provide a
channel through which new savings flow to aid
capital formation of a country.

10
Con’t

5. Price determination: financial markets allow for

the determination of the price of the traded
financial asset through the interaction of buyers &
sellers, i.e., through demand & supply.
6. Sale mechanism: financial markets provide a
mechanism for selling of a financial asset by an
investor so as to offer the benefits of marketability
& liquidity of such assets.
11
Con’t

7. Information: the activities of the

participants in the financial market result
in the generation and the consequent
dissemination of information to the various
segments of the market, so as to reduce the
cost of transaction of financial assets.

12
Organization of the Securities Market
 Financial markets includes:

1. Primary market
2. Secondary market
3. Third market
4. Fourth Market
5. Money market
6. Capital markets
7. Derivative market
8. Foreign exchange markets
13
Primary markets

• Primary market is a market in which newly-

issued securities are sold to initial buyers by the
corporation or government borrowing the funds.
• Securities available for the first time are offered
through the primary market.
• That is, in the primary market, companies interact
with investors directly while in the secondary
market investors interact with themselves.
14
Features of Primary Market

• It is related with new issues

• It has no particular place: Primary market is not
the name of any particular place but the activity
of bringing new issues.
• It has various methods of floating capital like
public issue, private placement offer for sale.

15
Con’t

New issues are divided into two groups

1. Initial public offerings (IPOs) - a firm selling
its common stock to the public for the first time
2. Seasoned new issues (also known as Follow
Public Offering)- new shares offered by firms
that already have stock outstanding

16
Con’t

• The traditional middleman in the primary

market is called an investment banker.
• Investment banking firms play an important
role in many primary market transactions by
underwriting securities: they guarantee a price
for a corporation’s securities and then sell those
securities to the public.

17
Con’t

• That is, it buys the new issue from the issuer at

an agreed upon price and hopes to resell it to the
investing public at a higher price.
• Usually, a group of investment bankers joins to
underwrite a security offering and form what is
called an underwriting syndicate.

18
Con’t

• Companies raise new capital in the

primary market through:
` 1. Public issues
2. Right issue
3. Private placement

19
Con’t

1. In public issue/ offering: They will be

established companies sell new securities to the
public. The company invites the general public to
purchase the new security.
2. In right issue: Offering of securities may be made
only to the existing shareholders. Thus, when
securities are offered only to the company’s
existing shareholders, it is called right issue.
20
Con’t

3. Private placement: Instead of public issue of

securities, a company may offer securities privately
only to a few investors (such as institutional investors
like mutual fund).
• The investment bankers may act as a finder, that is, he
locates the institutional buyer for a fee.

21
Functions of Primary Market

 The main service functions of the primary market are:

a.Origination: deals with the origin of the new issue (i.e., the
nature of the security, the size of the issue, timing of the
issue, and floatation method of the issue.
b. Underwriting: It makes the share predictable and removes
the element of uncertainty in the subscription.
c. Distribution: refers to the sale of securities to investors.

22
Con’t

es
riti
cu

Underwriter
se

Issuer
Company Investors
Broker-Dealer

ds
n
Fu
23
Con’t

Issuer

Investment
banker

Syndicate Syndicate Syndicate

member 1 member 2 member 3

Broker Broker Broker Broker Broker Broker

24
Secondary markets

 Market where outstanding securities are bought

and sold by investors.
 The issuing unit does not receive any funds in a
secondary market transaction
 That is, the issuer of the asset doesn’t receive
funds from the buyer.

25
Features of Secondary Market

• It creates liquidity
• It comes after primary market
• It has a particular place
• It encourages new investments

26
Functions of Secondary Markets

• Provides regular information about the value of

security.
• Offers to investors liquidity for their assets.
• It brings together many interested parties & so can
reduce the costs of searching for likely buyers &
sellers of the assets.
• It keeps the cost of transactions low.

27
 Con’t

• There are a number of professional participants of a

securities market and these include; broker-dealers,
market-makers, investment managers, speculators as
well as those providing the infrastructure, such as
clearing-houses and securities depositories.

28
Requirements for Listing
• Securities to be listed in stock exchange center,
companies have to meet certain minimum
requirements with respect to:
– The number of shareholders
– Trading activity
– The number and value of shares held in public
hands
– Annual earnings
29
 Relationship between the primary and secondary
market

1. The new issue market can’t function without the

secondary market. The secondary market or the stock
market provides liquidity for the issued securities.

2. The stock exchange through their listing requirements,

exercise control over the primary market. The company
seeking for listing on the respective stock exchange has to
comply with all the rules and regulations given by the
stock exchange.
30
Con’t

3. The primary market provides a direct link between the

prospective investors and the company. By providing
liquidity and safety, the stock market encourages the
public to subscribe to the new issues. The marketability
and capital appreciation provides in the stock market are
the major factors that attract the investing public
towards the stock market. Thus, it provides an indirect
link between the savers and the company.

31
OTC market

• Over-the-counter (OTC) or off-exchange trading is to

trade financial instruments such as stocks, bonds,
commodities or derivatives directly between two
parties.
• It is a negotiated market (investors negotiate directly
with dealers or another investor)

32
Con’t

• OTC stocks are not usually listed nor traded on any

stock exchanges, though exchange listed stocks can
be traded OTC on the third market.
• Any security can be traded in OTC (no minimum
requirement) as long as a registered dealer wants to
make a market.

33
Third Market

• Trading by non exchange-member brokers/dealers and

institutional investors of exchange-listed stocks.
• In other words, the third market involves exchange-
listed securities that are being traded over-the-
counter between brokers/dealers and large
institutional investors competes with trades on
exchanges.
• It is OTC trading of shares listed on an exchange
34
Con’t

• May be open when the stock exchange is closed or

trading suspended.
• Typical institutional investors who take part in the
third market include investment firms (like mutual
fund) and pension plans.

35
Fourth Market

• The Over-the-counter market for the sale of listed

securities between institutional investors.
• It is a direct trading of securities between two parties
with no broker intermediary
• Usually both parties are institutions
• These transactions occur in large blocks without the
use of brokers, which save counterparties from
significant fees (can save transaction costs)
36
Con’t

• For example, when a mutual fund and a pension fund

enter into a large block trade with each other, rather
than over a recognized exchange such as the New York
Stock Exchange (NYSE), this would generally occur in the
fourth market.
• By executing the transaction this way, both parties
avoid brokerage and exchange transaction fees.
• They also avoid the possibility of distorting the market
price or the volume traded on an exchange.
37
 Exchange Centres

• An exchange can be defined as any organization,

association, or group of persons, whether incorporated or
unincorporated, which constitutes, maintains, or provides a
market place or facilities for bringing together purchasers
and sellers of securities.

• An exchange is a physical or virtual meeting place drawing

together brokers, dealers and traders to facilitate the

buying and selling of securities.

38
Con’t

• Exchanges include the floor-based markets and

screen-based systems provided by Electronic
Communications Networks (ECNs).
• Exchanges are intended to provide for orderly, liquid
and continuous markets for the securities they trade.

39
Trading on Exchanges
• Trading Methods

1. Continuous Auction/ selling by bid: In a continuous market,

trades occur at any the market is open, priced by auction or by
dealers.
– Thus, prices are determined continuously throughout the trading
day as buyers and sellers submit orders.

2. Call Method: Call markets trade individual stocks at specified

times. In which orders are batched or grouped together for
simultaneos execution at the same price.

40
• Example for continuous market: Given the order flow at
10:00, the market clearing price of a stock may be $70;
at 11:00 of the same trading day, the market clearing
price goes up $80 with different order flows.(example
for continous markets)
• Example for call market: London gold bullion market,
records prices set at the ‘morning fix’ and the
‘afternoon fix’. These fixes take place at the two call
auctions which are held daily.
41
• Types of Orders
1. Market order: The simplest type of order and that order
to buy/sell at prevailing/best price in the market.
• Buyers give priority offering lower price. sellers give
offering higher price.

• Thus, buy at the lowest offering price available and sell

at the highest bid available
• If there are more than one order at the same price, the
priority rule is based on the time of arrival of the order.
42
The danger of a market order is that an adverse move may
take place between the time the investor places the order
and the time the order is executed.

43
2. Limit order: order to buy/sell at a certain price or within a certain
time period.

• It designates a price treshold for the execution of trade.It is a

conditional order.

• A buy limit order indicates that the security may be purchased only
at the designated price or lower.

• A sell limit order indicates that the security may be sold at the
designated price or higher.

• The danger of limit order is that it comes with no guarantee it will be

executed at all because the designated price may not be obtainable.

44
3. Stop-loss order: stop-loss order is an order to sell if the price falls
below a certain level; or conditional order to sell stock if it drops
to a given price
• A stop-buy order to buy if price is above a certain level --- these
orders are accompanied by short sales.
• Investor who sold short may want to limit loss if stock increases
in price
 Short sales

– Sell overpriced stock that you don’t own and purchase it back
later (at a lower price) or borrow the stock from another
investor (through your broker) 45
• The investor may be able to sell the security without

owning it.This practice of selling securities that are not

owned at the time of sale is referred to as selling short.

• A profit will be realized if the purchase price is less than

the price that the investor sold short the security.

4. Time Specific Order: Orders may be placed to buy or

sell at the open or close of trading for the day that is
time specific orders.
46
Margin Transactions

• On any type order, instead of paying 100% cash, borrow a portion of

the transaction, using the stock as collateral.

• A transaction in which an investor borrows to buy additional

securities using the securities themselves as collateral is called

buying on margin.

• Interest rate on margin credit may be below prime rate (Bank rate)

• Regulations limit proportion borrowed: Margin requirements are

from 50% up

• Changes in price affect investor’s equity

47
Con’t

Buy 200 shares at $50 = $10,000 position

Borrow 50%, investment of $5,000
If price increases to $60, position
– Value is $12,000
– Less - $5,000 borrowed
– Leaves $7,000 equity for a
– $7,000/$12,000 = 58% equity position

48
Con’t

Buy 200 shares at $50 = $10,000 position

Borrow 50%, investment of $5,000
If price decreases to $40, position
– Value is $8,000
– Less - $5,000 borrowed
– Leaves $3,000 equity for a
– $3,000/$8,000 = 37.5% equity position

49
Con’t

• Initial margin requirement at least 50%.

• Maintenance margin
– Requirement proportion of equity to stock
– Protects broker if stock price declines

– Minimum requirement is 25%

– Margin call on under-margined account to meet margin
requirement
– If margin call not met, stock will be sold to pay off the
loan
50
 How to Trade in the Stock Exchanges

 All orders will match automatically.

 Orders which are at the most favorable price, that is,
at the lowest selling or highest buying price, shall be
executed first.
 If two or more orders are listed in the order book at
the same price, the oldest order shall be executed
first.

51
Con’t

 Orders that cannot immediately be executed shall be

queued/list of data for future execution in a specific
order of priority mainly based on price and time of
entry.
 If an order is executed partly, the remaining part of
such order shall not lose its priority.
 The queue priority is determined by the system
through an interactive process.
52
Trade Confirmation

 Trade confirmation note is a proof of the transaction issued by

broker;

 The broker shall issue a trade confirmation note to his client

within twenty four hours of the execution of order and it should
be numbered and time stamped;

 The trade confirmation note shall show:

 Date of the trade;

 Name and quantity of the security bought or sold;

 Price of the security, brokerage and other charges;

53
 Flow Chart of Clearing and Settlement

Day-0 Trading
Day

Selling Buying
Broker Securities Cheque Broker
T+1 T+1

DSE Clearing
Cheque T+3 House Securities T+3

54
Con’t

• In settlement of trade, the buying and selling brokers

deposit cheque and securities respectively to the
clearing house on 2nd day of the trade (T+1)
• Then the clearing house deliver securities and give
cheque to the buying and selling broker respectively
on 4th day of the trade (T+3).

55
 Money Market
&
Capital Market

07/21/2021 56
 THE MONEY MARKET
• Money market is the term designed to include the financial
institutions which handle the purchase, sale & transfers of
short term credit instruments.
• Money-Currency-is not traded in the money markets.
• Only those securities having short term maturity period and
are close to being money securities are traded.
• The money market, therefore, is a component of the
financial markets for assets involved in short-term
borrowing and lending with original maturities of one year
or shorter time frames.
07/21/2021 57
Why Money Markets?
•Money markets have a cost advantage over banks
because of two facts.

1.Reserve requirement by central banks of a country

reduces the total amount of investible funds
received from depositors by setting a minimum
reserve requirement to commercial banks.

07/21/2021 58
 2. Interest rate restrictions are used to avoid
competition among banks. This substantially
reduce the competitiveness of the banking
industry with money markets which do not
worry about such restrictions especially during
the times of high inflation

• The above two have contributed immensely for

the development of money markets.

07/21/2021 59
Characteristics of The Money Market
• The money market securities have three basic common
characteristics:
1. They are usually sold in large denominations. Money
Market Mutual funds can mitigate (alleviate) this
problem
2. They have low default risk

3. They mature in one year or less from their original

issue date. Most money market instruments mature in
less than 120 days
07/21/2021 60
4. Money market transactions do not take place in
one particular location or building rather traders
usually arrange purchase and sales between
participants over a phone and complete them
electronically.

07/21/2021 61
5. Active secondary markets makes money market
securities very flexible instruments to use to fill short
term financial needs that is the only reason why most
organizations in countries having well-developed
financial markets report them as cash on their balance
sheets.
6. Money markets are wholesale markets: most
transactions are very large as a result of this large size
most individual investors cannot invest their money
directly in the money markets.
07/21/2021 62
• To solve this problem dealers and brokers,
operating in trading rooms of large banks and
brokerage houses, bring customers together.
• Despite the wholesale nature of the market,
innovative securities and trading methods help
investors enjoy the benefits of money market
securities.

07/21/2021 63
 The Purpose of the Money Markets

1. The well developed secondary market for money market

instruments makes the money market an ideal place for
economic units to warehouse surplus funds temporarily.
2. Similarly, the money markets provide a low cost source
of funds to firms, governments (state and local), and
intermediaries that need a short-term infusion of funds.

3. Money market funds provide a means to invest idle

funds and to reduce opportunity cost of lost interest

income because of not investing.

07/21/2021 64
Participants of the Money Market
1. Central banks
• Central Banks are frequently engaged in
injection and absorption of money supply in the
economy using a tool known as open market
operations.
• The central bank’s responsibility for money
supply makes them the single most influential
participant in the money market.
07/21/2021 65
2. Commercial Banks (CBs)

• CBs hold a large percentages of government

securities than any other institutions in many
countries including Ethiopia.
• Commercial banks in Ethiopia are the dominant
players in the country’s money market.
• In many countries regulations prohibit CBs from
investing in high risk corporate bonds and stocks
that have a higher rate of returns but entail huge
associated risks.
07/21/2021 66
• Since money markets instruments provide almost riskless
investment opportunity with an added advantage of high
liquidity, the CBs are major issuers of money market
instruments.
3. Businesses
• Many business firms buy and sell securities in the money
market to finance their short-term capital needs as well as
to warehouse their excess funds.
• Many large corporations and firms engage in both sides
of the market as money market investments are
substantial in size.
07/21/2021 67
4. Investment Companies: are large diversified
brokerage firms that are active in the market to
trade on behalf of their commercial accounts.
• They are very important to the liquidity of the
money market because they ensure that both
buyers and sellers can readily market their
securities.
5. Finance Companies: lend funds to individuals

07/21/2021 68
 6. Insurance Companies: property and casualty
insurance companies must maintain the liquidity
because of their unpredictable need for funds.
• Such firms, therefore, should invest some amount of
their investment funds in money market securities to
raise cash during emergency situations.
7. Pension Funds: these companies invest a portion of
their cash in money markets so that they can take
advantage of investment opportunities that they may
identify in the stock or bond markets.
07/21/2021 69
8. Individuals
• With the special help of the money market
mutual funds individual investors with
relatively small amounts of cash to invest can get
an access to invest on large denomination money
market instruments.

07/21/2021 70
Money Market Instruments

• Many number of money market instruments are available to

meet the needs of a wide range of participants in the money
market.

• The following sections discuss the following major ones:

1. Treasury bills

2. Federal Funds

3. Repurchase Agreements

4. Certificates of Deposits (CDs)

5. Commercial Papers

6. Bankers Acceptances

07/21/2021 7. Eurodollars 71
Treasury Bill
• T-bills are one of the debt securities that a government issues
having a great advantage of liquidity.
• The Treasury Bill market is the only active primary market in
Ethiopia.
• Tenders are offered periodically by the Central Bank.
• The government offers 28‐day, 91 day and 182‐day bills.
• A sample of the amounts offered and yields on T‐Bills is
shown in the table that appear in the following slide.
• Any one can participate in the auction of Treasury Bills with
the minimum amount of birr 5000.
07/21/2021 72
07/21/2021 73
• Most money market instruments do not pay
interest. Rather the investor pays less for the
security than it will be worth when it matures, and
the increase in price provides a return.
• In simple terms, short-term securities are issued at
discount and redeemed at par. This is because they
often mature before the issuer can mail out interest
checks.

07/21/2021 74
• The yield on an investment is found by computing the
increase in value in the security during its holding
period.
• i.e. the annualized yield on the investment is found
using the following formula:

• For example, let's say you buy a 91 days T-bill priced at
$9,800. Essentially, the government writes you an IOU
(I owe you) for $10,000 that it agrees to pay back in 91
days. 
07/21/2021 75
• You will not receive regular payments as you would
with a coupon bond, for example. 
• Instead, the value to you that you will get comes from the
difference between the discounted value you originally
paid and the amount you receive back ,10,000. 
• In this case, the T-bill pays you a 2.04% interest rate of
return ($200/$9,800 = 2.04%) over a 91days period. The
annualized yield on investment can be:

07/21/2021 76
T-bills risk
• T-bills virtual have zero default risk because the
government can’t fail to pay interest and maturity
value on the maturity date.
• For this reason, t-bill rate are usually considered as
the risk free rate of return when valuing different
securities.

07/21/2021 77
• The t-bills in countries having good financial
market conditions is deep and liquid.
• Deep: presence of many buyers and sellers of a
security in a market.
• Liquid: when securities can be transferred
from on investor to another quickly and
without incurring substantial transaction costs.

07/21/2021 78
Features of TB
• Issuer: it is issued by the government for raisings
short term funds for bridging temporary gaps
between revenue and expenditure.
• Liquidity: it enjoys high degree of liquidity
• Monetary Mgt: TBs serve as an important tool of
monetary management used by the central bank of
the country to influence liquidity in to the economy.

07/21/2021 79
2. Federal Funds(interbank lending)/call money
• Are short-term funds transferred among financial
institutions usually for a period of one day.
• One of the regulation tools that central banks can
use to ensure the investor protection and liquidity
in the financial sector is setting a minimum reserve
requirement for banks that a certain portion of
their funds collected from savers in the national
bank account without earning interest.
07/21/2021 80
• To meet these reserve requirements, banks must
maintain adequate deposits in their central bank
account. At the end of daily transactions some
banks may fall short of the requirements while
some ended up with excess funds in their accounts.
• Therefore banks with shortages will borrow from
banks having excess funds for overnight. The
government can indirectly control the federal funds
market by altering the reserve requirement.
07/21/2021 81
Terms of Federal Funds
• Terms of agreements for federal funds is one day and
frequently referred to as overnight investments (call
money).
• Banks analyze their reserve position on a daily basis and
either borrow or invest in these funds, depending on
whether they have excess or deficit reserves.
• A bank with excess money will call up on its
correspondent banks having reciprocal accounts and sell
its excess funds to bank(s) that offer highest rate.
07/21/2021 82
• When the dealing concludes the investor bank
immediately transfers the contracted amount to
borrowers account in the central bank using
electronic communications.
• The next day, the funds are transferred back, and
the process begins again.
• The federal funds are short-term unsecured loans
as deals are completed by oral communications of
participants.
07/21/2021 83
Characteristics of call money market
1. The maturity period is one day

2. “The fund" is repayable on the immediate next working day

3. The transactions are not covered by any collateral security

because call loans are repayable on demand at the option of the

borrower or lender or at a very short notice.

4. This market is the most sensitive segment of the financial system

because any change in demand & supply of short term funds in

the financial system is quickly reflected in call money rate.

07/21/2021 84
Repurchase Agreements (Repos)
• Repos are much like federal funds except that non
banks can participate. In repos a firm can sell
treasury securities by agreeing to buy them back at
a specified future date.
• Most repos have a short-term maturity usually
from 3 to 14 days. However, there are also markets
for 1-3 months repos.

07/21/2021 85
• Government security dealers usually engage in repos.
The dealers may sell it to a bank with a promise that it
will buy the securities back the next day this makes
repo a short-term collateralized loan.
• Because of their collateralized nature they hold low
risk of default and ultimately have low interest rate
returns.
• Central banks also engage in repos market to conduct
the monetary policy.

07/21/2021 86
Negotiable Certificates of Deposits (CDs)
• Certificate of deposit is a financial document showing
that a person or organization has a specified sum on
deposit at a bank, usually for a specific period, at
special interest rate.
• A negotiable CD is a bearer instrument that whoever
holds the instrument at the date of maturity can
receive the principal and interest. The CD can be
bought and sold in the secondary market until
maturity.
07/21/2021 87
• The maturity of CDs usually ranges from1-4
months.
• CDs charge a rate slightly higher than T-bills
because that have a slightly greater chance of
default.
• CDs are usually denominated in higher currency
values.

07/21/2021 88
Characteristics of CD
• Negotiable instrument: CDs are negotiable term
deposit certificate issued by commercial banks.
• Maturity: The maturity period of CDs ranges from 15
days to one year.

Commercial Papers (CPs)

• CP securities are unsecured promissory notes issued
by corporations that mature in no more than 270 days
(9 months).
07/21/2021 89
• Since CP is unsecured, only largest and most
creditworthy corporations issue them.
• Just like T-bills, CPs are issued at discount and
mature on face value.
• Thus, a commercial paper is defined as a debt
instrument that is issued by well known, high
creditworthy corporations for raising short term
financial resources from money market.

07/21/2021 90
Characteristics of CP

 They are unsecured debts of corporate.

 They are issued in the form of promissory notes

 They are redeemable at par to the holder at

maturity, i.e., they are issued at discount to face
value.

 They are issued by top rated corporate

07/21/2021 91
Bankers Acceptances
• Banker’s acceptance is a bank draft (a promise of payment
similar to a check) issued by a firm, payable at some
future date and guaranteed for by a fee by the bank that
stamps it as “accepted”.

• It is a short-term discount instrument that usually arises in

the course of international trade.

• It can also be defined as a short term credit investment
created by a non- financial firm and guaranteed by a bank
to make payment.
07/21/2021 92
• The firm issuing the instrument is required to
deposit the necessary funds into its account to
cover the draft.
• If the firm fails to do so, the bank’s guarantee
obligate the bank to cover the draft.
• These “accepted” drafts are often resold in a
secondary market at discount similarly as
Treasury Bill.

07/21/2021 93
Eurodollar
• Many contracts from various countries around the
world require payments be made in U.S. Dollars
due to dollar’s stability.
• For this reason many companies and governments
choose to hold dollars.
• Before cold war, these currency deposits were
made in New York money center banks.

07/21/2021 94
• Starting from cold war, with the fear that these deposits may be
expropriated some large London based banks responded by
offering to hold dollar denominated deposits in British banks.

• These deposits are then named as Eurodollars.

• The Eurodollar market continued to grow for the following

reasons:

1. Depositors can receive higher returns on dollar deposits in the

Eurodollar markets than in the domestic markets.

2. Borrowers can be able to receive a more favorable rate in the

Eurodollar markets than in the domestic markets.

07/21/2021 95
• It has to be noted that the Eurodollar market is the
replacement of the federal funds that banks from
around the world buy and sell overnight funds in this
market.
• The rate paid by banks borrowing from Eurodollar
market are called London Interbank Bid rate LIBID.
• Funds are offered for sale in Eurodollar market at a
rate called London Interbank offer rate LIBOR. The
difference between the LIBID and LIBOR is the
proceed to the dealer.
07/21/2021 96
Money Issuer Buyer Usual Secondary
market Maturity Market
security
T-Bills Government Consumers and 4 weeks -1 Excellent
companies year

Federal Banks Banks 1-7 days none

Funds
Repos Business and banks Businesses and 1-15 days Good
banks

CDs Large Banks Businesses 14-120 days Good

CPs Finance Companies Businesses 1-270 days Poor
and businesses

Banker’s Banks Businesses 30-180 days Good

Acceptances

Eurodollar Foreign or non-U.S. Businesses, 1day to 1 poor

deposits Banks gov’ts and year
banks

07/21/2021 97
CAPITAL MARKETS

• Capital market is a market in which individual and

institutional investors trade long-term financial securities

(Debt and Equity) among themselves.

• Capital market instruments are defined as long term

instruments with an original maturity of greater than one

year.

• Proceeds from the sale of capital market instruments are

usually invested in assets of a permanent nature such as

industrial plants, equipment, buildings, and inventory.

07/21/2021 98
Capital Market Participants
1. Capital market bring together BORROWERS and
SUPPLIERS of long term funds.

2. The market also allows people who hold previously

issued securities to trade those securities for cash in
the secondary capital markets.

3. Financial intermediaries purchase funds from

individuals and others, and then issue their own
securities in exchange.
07/21/2021 99
4. Individuals and households may invest
DIRECTLY in the capital markets but, more
likely, they purchase stocks and bonds through
financial institutions such as commercial banks,
insurance companies, mutual funds and pension
funds.

07/21/2021 100
I.I.The
TheBond
BondMarket
Market
•• A
A bond
bond isis aa promise
promise to
to make
make periodic
periodic coupon
coupon payments
payments
and
and to
to repay
repay principal
principal at
at maturity;
maturity; breach
breach of
of this
this promise
promise isis
an
anevent
eventof
ofdefault,
default,or
or
•• Bond
Bondisisaadebt
debtinvestment in
investment inwhich
whichan investor
an investorloans
loansmoney
money
to
to an
an entity
entity (corporate
(corporate or
or governmental)
governmental) that
that borrows
borrows the
the
funds
fundsfor
foraadefined
definedperiod
periodof
oftime
timeat
ataafixed interest
fixed interestrate.
rate.
•• Carry
Carryoriginal
originalmaturities
maturitiesgreater
greaterthan
than one
oneyear
yearso
sobonds
bondsare
are
instruments
instruments of
of the
the capital
capital markets
markets and
and issuers
issuers are
are
corporations
corporationsand
andgovernment
governmentunits
units

07/21/2021 101
• Bonds are used as a means of financing variety of
projects and activities by companies, municipalities,
state, local and foreign governments.
• Bonds are commonly referred to as fixed-income
securities and are one of the three main financial
asset classes, along with stocks and cash equivalents
(i.e., money market securities).
• The place where bonds and other debt instruments
are sold is called the debt market.
07/21/2021 102
Basics of Bonds
• Corporate borrowers issue bonds both to raise finance
for major projects and to cover ongoing and
operational expenses.
• Bonds are also issued by public authorities, credit
institutions, companies and
supranational(Multinational) institutions in the
primary markets.
• The most common process of issuing bonds is through
underwriting.
07/21/2021 103
• In underwriting, one or more security firms or
banks, forming a syndicate/association, buy an
entire issue of bonds from an issuer and re-sell
them to investors.
• The security firm takes the risk of being unable to
sell on the issue to end investors.

07/21/2021 104
Treasury
TreasuryNotes
Notesand
andBonds
Bonds
•• T-notes
T-notes and
and T-bonds
T-bonds issued
issued by
by the
the U.S.
U.S. treasury
treasury to
to finance
finance
the
thenational
nationaldebt
debtand
andother
otherfederal
federalgovernment
governmentexpenditures
expenditures
•• Backed
Backed by
by the
the full
full faith
faith and
and credit
credit of
of the
the U.S.
U.S. government
government
and
andare
aredefault
defaultrisk
riskfree
free
•• Pay
Payrelatively
relativelylow
lowrates
ratesof
ofinterest
interest(yields
(yieldsto
tomaturity
maturity
•• Given
Given their
their longer
longer maturity,
maturity, not
not entirely
entirely risk
risk free
free due
due to
to
interest
interestrate
ratefluctuations
fluctuations
•• Pay
Pay coupon
coupon interest
interest (semiannually),
(semiannually), notes
notes have
have maturities
maturities
from
from1-10
1-10yrs,
yrs,bonds
bonds10-30
10-30yrs
yrs

07/21/2021 105
Municipal
MunicipalBonds
Bonds
•• Securities
Securities issued
issued by
by state
state and
and local
local governments
governments to
to fund
fund
either
either temporary
temporary imbalances
imbalances between
between operating
operating
expenditures
expenditures and
and receipts
receipts or
or to
to finance
finance long-term
long-term capital
capital
outlays
outlays for
for activities
activities such
such as
as school
school construction,
construction, public
public
utility
utilityconstruction
constructionor
ortransportation
transportationsystems
systems
•• Tax
Tax receipts
receipts or
or revenues
revenues generated
generated are
are the
the source
source of
of
repayment
repayment
•• Attractive
Attractive to
to household
household investors
investors because
because interest
interest (but
(but
not
notcapital
capitalgains)
gains)are
aretax
taxexempt
exempt
07/21/2021 106
Corporate
Corporate Bonds
Bonds
•• All
All long-term
long-term bonds
bonds issued
issued by
by corporations
corporations
•• Minimum
Minimum denominations
denominations publicly
publicly traded
traded
corporate
corporate bonds
bonds is
is $1,000
$1,000
•• Generally
Generally pay
pay interest
interest semiannually
semiannually
•• Bond
Bond indenture/agreement:
indenture/agreement: is
is aa legal
legal contract
contract
that
that specifies
specifies the
the rights
rights and
and obligations
obligations of
of the
the
bond
bond issuer
issuer and
and the
the bond
bond holder
holder
07/21/2021 107
Cost of Bonds to the Issuer

• Cost of bond financing > short-term borrowing

• Major factors affecting the cost, i.e. interest rate

paid by the bond issuer:

– Maturity

– Issuer’s risk

– Cost of money
07/21/2021 108
• The longer the bond’s maturity, the higher the interest rate
(or cost) to the firm.
– Long-term debt pays higher interest rates than short-
term debt
– The longer the maturity of bond, the less accuracy there
is in predicting future interest rates; so the greater the
bondholder’s risk of giving up an opportunity to lend
money at a higher rate.
– The longer the term, the greater the chance that the
issuer might default.
07/21/2021 109
• The greater the default risk of the issuer, the
higher the cost of the issue (interest rate).

– Some of this risk can be reduced through the

inclusion of appropriate restrictive provisions in
the bond indenture.

– Bondholders must be compensated with higher

returns for taking greater risk.

– Bond buyers frequently rely on bond ratings to

determine the issuer’s overall risk.
07/21/2021 110
• The cost of money in the capital market is the
basis for determining a bond’s coupon interest
rate.

– The rate on US Treasury securities of equal

maturity is used as the lowest-risk cost of
money.

– To that basic rate is added a risk premium that

reflects the above factors: maturity, and issuer’s
risk.
07/21/2021 111
Stock Markets
• Organizations/institutions in the public and
private sectors also often sell securities on the
capital markets in order to raise funds.
• Places where equity securities are traded are
called stock markets.

07/21/2021 112
Stock Markets

Primary Markets
 A primary market sale may be a first-time issue by a
private firm going public called initial Public Offerings
(IPOs) or it can be issuance of new stock by a firm which
already placed its some shares in primary markets.
 In a primary market, stocks can be issued through either a
public sale where the stock is offered to the general
investing public or a private placement where the stock is
sold privately to the limited number of large investors.

07/21/2021 113
Secondary Stock Markets
 Secondary markets are markets in which stocks, once
issued, are traded.
 The following are the major Secondary stock markets:

Stock Exchanges & their Trading Process

 Are physical places in which stocks are traded.
 Include New York Stock Exchange (NYSE) & the American
Stock Exchange (AMEX).
 All transactions occurring on the NYSE occur at a specific
place on the floor of the exchange called trading post.
07/21/2021 114
The American Stock Exchange (AMEX)
 Located at New York, AMEX lists stocks of smaller firms
that are of national interest.
The National Association of Securities Dealers Automated Quotation (NASDAQ)

 Securities not sold in the organized exchanges such as

NYSE & AMEX, are traded over the counter.
 It does not have a physical trading floor where transactions
are completed via an electronic market.
 It is primarily a dealer market, in which dealers are the
market makers who buy & sell particular securities.
07/21/2021 115
 Firms that do not meet the requirements for exchange
listing trade on the NASDAQ.
 Thus, most NASDAQ firms are smaller firms with
newly registering public issues with brief history of
trading .

07/21/2021 116
Derivative Market

117
 Derivative Market

 Derivative is a tradable financial instrument or product

whose value depends on the value of some underlying
asset.
 Very often, the underlying derivatives are the price of the
traded asset.
 For example, a stock future is a derivative whose value
depends on the price of the stock.

118
 Derivative securities provide a number of useful functions
in the areas of risk management and investment.
 In fact, derivatives were originally designed to enable
market participants to eliminate risks.
 A wheat farmer, for example, can fix the price of his crop
before it is planted to eliminate price risk.
 An exporter can fix a foreign exchange rate even before
beginning to manufacture the product, eliminating foreign
exchange risk.
119
Forward contract

 Forward contract is an agreement that obligates the

holder to buy or sell an asset at a predetermined
delivery price during a specified future time.
 In other words, a contract made today for delivery of
an asset at a pre-specified time in the future at a price

agreed upon today.

120
 The buyer of a forward contract agrees to take
delivery of an underlying asset at a future time, T, at
a price agreed upon today.
 No money changes hands until time T.
 The seller also agrees to deliver the underlying asset
at a future time, T, at a price agreed upon today.
 Again, no money changes hands until time T.

121
 A forward contract, therefore, simply amounts to setting a
price today for a trade that will occur in the future.
 Forward contracts are traded on the Over-the-Counter
market (OTC) rather than on exchange –Usually between
two financial institutions or between financial institution
and its clients.

 There are two positions in forward contract:

1. Long Position
2. Short Position

122
1. Long position: A party assumes a long position
agrees to buy the underlying asset on a specified
date for a specified price.
2. Short position: party assumes a short position
agrees to sell the underlying asset on a specified date
for a specified price.

123
Example:

 A wheat farmer has just planted a crop that is expected to

yield 500 quintals.
 To eliminate the risk of a decline in the price of wheat before
the harvest, the farmer can sell 500 quintals of wheat forward.
 Dire Dawa food complex factory may be willing to take the
other side of the contract.
 The two parties agree today on a forward price of Birr 850
per quintal, for delivery four months from now when the crop
is harvested.
 No money changes hands now.
 In four months, the farmer delivers the 500 quintals of wheat
to Dire Dawa food complex factory in exchange of Birr
425,000.

124
 Cont’d

 Note that this price is fixed and not depend upon the
spot price of wheat at the time of delivery and
payment.
 Moreover, in forward contract, the whole gain or loss
is realized at the end of the life of the contact.

125
Payoffs from forward contract

 The contract obligates Dire Dawa food complex to

buy 500 quintals for Br 850 per quintal and again
obligates the farmer to sell 500 quintals of wheat at
the same price at the end of the fourth month.
 If the spot price of wheat rose to, say, Br 900 per
quintal at the end of 4 month, the forward contract
would be worth Br 25,000 (Br 450,000 – Br 425,000)
to Dire Dawa food complex factory.
126
 Cont’d

 The contract enable Dire Dawa food complex to

purchase 500 quintals of wheat at Br 850 per quintal
rather than at Br 900.
 Similarly, if the spot exchange rate fell to Br 800 at
the end of 4 months, the forward contract would have
a negative value to Dire Dawa food complex of Br
25,000 because it would lead to the Dire Dawa food
complex paying Br 25,000 more than the market price
for the wheat.
127
 Cont’d

• In general, the payoff from forward contact can be

calculated for long and short position holders as
follows:
For long position holder: Payoff = ST  K
If ST is greater than K, the buyer will be benefited.

For short position holder: payoff = K  ST

If K is greater than ST, the seller will be benefited.

• Where, K is the delivery price and ST is the spot

price of the asset at maturity of the contract.

128
Future contract

 Future contract is a contact that obligates the holder

to buy or sell an asset at a predetermined delivery
price during a specified future time.

 It is similar to a forward contract except for two

important differences.

 First, because of its daily settlement procedure,

intermediate gains or losses are posted each day
during the life of the futures contract. This feature is
known as marking to market.

129
 Second, unlike forward contract, future contracts are
traded on an exchange.
 To make the trade possible, the exchange specifies
certain standardized features of the contract like
contract size (number of units delivered in one
contract), delivery date, quality of the underlying
asset.

130
 Comparison between forward contract and future contract

Forward Contract Future Contract

 Private contract between two parties. Traded on an exchange

 Not standardized. Standardized contract

 Usually one specific delivery date. Ranges of delivery date

 Settled at the end of contract. Settled daily.

 Some credit risk. No credit risk.

131
 Example:
 Suppose that Dire Dawa food complex factory purchases
500-quintal wheat future contract on the Ethiopian
Commodity Exchange (ECX) at 8:30 AM on August 10,
2014.
 At that time, the future price is Birr 850 per quintal.
 At the close of the trading day on August 10, the future price
has fallen to Birr 820 per quintal.
 Because of the decline of the wheat price, the buyer’s
position has changed by 500 Quintal (Birr 820 – Birr 850) =
- Birr 15,000.
 Since the buyer (Dire Dawa food complex factory) has
bought the future contracts and the price has gone down, it
has lost money on the day and its broker will immediately
take Birr 15,000 out of its account.
132
 On the opposite side of the buyer’s buy order, there was
a seller, who has made a gain of Birr 15,000.
 The Birr 15,000 is credited to the seller’s account.
 Suppose that again at the close of trading the following
day, the future price of wheat is Birr 870 per quintal.
 Since the buyer has bought the future and the price has
gone up, it makes money: 500 (Birr 870 – Birr 820) = +
Birr 25,000 and it is credited to buyer’s account.
 This money, of course, comes from the seller’s account.
Thus, the future trading is a Zero-sum-game, whatever
one party loses, the counterparty gains.

133
 Note that contracts are marked-to-market at the close of
each trading day until the contract expires.
 At expiration, there are two different mechanisms for
settlement.
 Most financial future contracts, such as stock index,
foreign exchange and interest rate futures, are cash
settled, where as most physical futures like agricultural,
metal etc, are settled by delivery of the physical
commodity.
134
Margin

 Although futures contracts require no initial

investment, futures exchanges require both the buyer
and seller to post a security deposit known as
margin.
 Margin rules are stated in terms of initial margin
(which must be posted when entering the contract)
and maintenance margin (which is the minimum
acceptable balance in the margin account).
 If the balance of the account falls below the
maintenance level, the exchange makes a margin
call upon the individual, who must then restore the
account to the level of initial margin before the start
of trading the following day.
135
Example: Suppose a contract requires initial margin of
Birr 7,000 and maintenance margin of Birr 5,000. The
following table illustrates the margining procedure and
the cash flows required for the buyer of a futures contract.

Value of Futures Margin Balance Margin Margin Balance

Time
Contract before Calls Call after Calls
0 25,000 0 7,000 7,000
1 24,000 6,000 0 6,000
2 22,000 4,000 3,000 7,000
3 24,500 7,000 0 7,000
136
• Note that when the margin balance falls below the
maintenance margin, it must be restored to the initial
level.
• Note also that when the futures moves favorably (as
at time 3) the marking-to-market cash inflow can be
immediately withdrawn - it should not remain in the
margin account. The buyer has withdrew it (i.e., Br
2,500).

137
Option

 It is the right to buy or sell an asset.

 There are two types of options:
Call Option
Put Option
 Call Option: It gives the holder of the option the right, not an
obligation, to buy an asset by a certain date for a certain price.
 Put Option: It gives the holder of the option the right, not an
obligation, to sell an asset by a certain date for a certain price.

138
 The date specified in the contract is known as the
expiration or maturity date.
 The price specified in the contract is known as the
exercise price or strike price.
 Options can also be classified in to two based on the
date to exercise the right.
 America Option: It can be exercised at any time up to
the expiration date.
 European Option: It can be exercised only on the
expiration date.
 Thus, most of the options that are traded on the
exchange are American.

139
Call Option
Example: Assume that an investor buys a European call
option with a strike price of Birr 100 per share to
purchase 100 shares of NILE Company for a cost of
Birr 5 per share. The expiration date of the option is
in 90 days. The current price of the stock is Birr 98.
1. What would be the total transaction cost?
2. In what condition a holder exercise its right?
3. What would be the net profit or loss if the price of the stock
is Birr 104 and 107 on the expiration date?
4. What would be the maximum net loss of an investor if he
does not exercise his right?

140
Solution

1. Total transaction cost = Transaction cost per

share × Number of share
= Birr 5/ share × 100 shares
= Birr 500
2. Since the holder of the call option is hoping
that the price of the underlying asset will
increase, it should always be exercised at the
expiration date if the stock price is above the
strike price. (i.e., above Birr 100).

141
3. Net profit or loss = Total revenue – Total cost
 Total Revenue = Selling price × Number of share
= Birr 104/share × 100 shares = Birr 10,400
 Total cost = Purchase cost + transaction cost
= ( Birr 100/ share × 100 shares) + Birr 500
= Birr 10,000 + Birr 500 = Birr 10,500
Thus, Net loss = 10,400 – 10,500 = (Birr 100)
• When price is Br 107, profit will be Br 200
4. The maximum loss will be equal to total transaction cost. Thus, it
is Birr 500.
142
Put Option

Example: Assume that an investor buys a European put

option to sale 100 shares of Y-company with a stick
price of Birr 70. The price of an option to sell on
share is Birr 7 per share. The current stock price is
Birr 65 and the expiration date is in 3 months.

1. What will be the total transaction cost or initial

investment?
2. At what share price a holder exercise its right?
3. What would be the net profit /loss, if the stock price
is Birr 72 and Birr 61 on the expiration date?

143
Solution
1. The transaction cost = Birr 7 /share X 100 shares=
Birr700
2. An investor will exercise his right, when the stock
price is below Birr 70 on the expiration date.
3. Assumption 1. Stock price is Birr 72
• Since the stock price is greater than the exercise
/strike price on the expiration data, exercising the
right will increase the total loss. That is, exercising
the right will increase the total loss to Birr 900.
• But if an investor does not exercise his right, his net
loss will only be the transaction cost, i.e. Birr 700.
Thus, an investor shall not exercise his right. So loss
will be Br 700.
144
Assumption 2.Stock price is Birr 61
• Since the stock price is less than the exercise /strike
price on the expiration date, an investor can buy 100
share of Y-company for Birr 61 /share and sell the same
share for Birr 70 under the terms of the put option.
 As a result the net gain is Birr 200.
 Total cost = (Birr 61/share X 100 share) + (Birr 7/share
X 100 share) = Birr 6100 + 700 = Br. 6,800
 Total revenue= Birr 70/share X 100 share = $ 7,000
 Net gain = 7,000 – 6,800 = Birr 200
 Thus purchase of a put option is hoping that the price of
underlying asset will decrease

145
Graphical presentation

Put Option
Profits
30

20

12
63
0
40 60 70 80 90 100
-7 Price of
stocks

146
Option Position
 Every option contract has two sides:
1. Long position: This position is taken by an
investor who has bought the position.
2. Short position: it is taken by an investor who has
sold or written the option.
 The writer of an option receives cash up front,
but has potential liabilities latter.
 Therefore, the writer’s profit or loss is the
reverse of that for the purchaser of the option.

147
Swap

 A swap is an agreement between two parties to

exchange cash flows in the future.
 It involves two parties who agree to exchange cash
flows results in benefits for both parties.
 Single currency interest rate swap is usually just
called an interest rate swap and cross-currency
interest rate swap is called a currency swap.

148
Interest rate swap
 It involves the exchange of interest payments.
 It usually occurs when a person /firm needs fixed-rate
fund but can get a better deal on floating rate funds and
the other party needs floating rate fund but can get a
better deal on fixed rate funds.
 The two counter-parties exchange the interest
payments and feel as if they are using the loan

according to their own choice.

149
 It is the swap dealer, usually a bank, which brings together
the two counterparties for the swap. The essential condition
for the interest rate swap is that:
1. The amount of loan has to be identical in the two cases,

2. The periodic payment of interest has to be taken place in

the same currency.

3. There must be synchronization of interest between the two

parties, i.e., one party has to get a cheaper fixed rate fund
and the other party has to get a cheaper floating rate fund.

150
 Note that since the principals are the same /identical in size,
they are not exchanged. They are only notional.
 Example; Suppose firm A needs fixed rate funds which are
available to him at the rate of 10.5% to be computed
annually, but it has access to cheaper floating rate funds
available to it at LIBOR + 0.3.
 Firm B needs floating-rate funds available to it one-year
LIBOR but has access to cheaper fixed rate funds available
to it at the rate of 9.5% to be computed annually.

151
Assumption
– Both the principals are identical in size on maturity and
are in the same currency.
– Thus, the interest swap will take place in the following
stages;
Stage 1. Since firm A has access to floating-rate loan market,
it will borrow from floating rate loan market.
• Similarly, firm B having access to fixed rate loan market,
will borrow fixed-rate loan.

152
 Cont’d

Fixed Rate Loan Principal

Market
Principal
Floating Rate
Loan Market

Firm A Firm B

153
 Stage 2

 Since both firms have not borrowed according to their choice, they
approach a swap dealer.
 Since firm A needs fixed rate loan, the swap dealer asks him to pay
fixed rate interest to it (swap dealer) as if it has borrowed fixed rate
loans.
 Thus, the fixed rate of interest payable through the swap dealer is
higher than what firm B has to pay to the lender in the fixed rate loan
market but lower than what firm A has to pay to the lender if it had
borrowed from the fixed-loan mkt. say 9.75%.
 The swap dealer pays interest to firm B, 9.65% and firm B pays
interest 9.5% to the lender. 154
 Firm A attracted to the swap dealer.
1. He uses the loan according to his own choice.
2. He has got a fixed rate of interest payable fund by it is lower
than what he had to pay for borrowing from the fixed rate
loan mkt.

 Firm B also attracted for the swap deal

1. He is using the loan according to his choice
2. He gets an interest rate which is higher than what he has to
pay to the ultimate lender.

 The swap dealer is attracted to the swap deal:

Because of the earning that he has earned from the deal.

155
Stage II

9.5%
Fixed Rate
Loan Market
LIBOR +0.3% Floating Rate
Loan Market

9.75% 9.65%
Swap
Firm A Firm B
LIBOR Dealer LIBOR

156
 Stage 3.

 At the maturity date, the two firms repay the loan. Firm
A repays the floating rate loan and firm B repays fixed
rate loan. Principal
Fixed Rate
Loan Market

Principal Floating Rate

Loan Market

Firm A Firm B

157
Firm A Cost of Borrowing

 Cost of floating rate loan……. LIBOR + 0.3%

 Less: floating interest rate received …LIBOR
 Net cost differential ………………… 0.3%
 Add: swap coupon …………………. 9.75%
 Total cost of borrowing …………… 10.05%

 Firm A saving Interest Payment = 10.5%-10.05%

= 0.45%

158
 Firm B cost of Borrowing
 Cost of fixed rate borrowing ……….… 9.50%
 Less: fixed rate received …………….. 9.65
 Net cost differential ………………….. -0.15%
 Add: floating rate ……………………. LIBOR
 Total cost of borrowing …………. LIBRO - 0.15%

 As a result of swap deal, B has to pay LIBOR - 0.15%.

 This means that he has saved interest payment of equivalent to
0.15%.
 Benefit of swap dealer is 9.75% - 9.65% = 0.10%

159
Foreign Exchange Market
Introduction
 Different countries have different currencies and the
settlement of all business transactions with in a country is
done in the local currency.
 The foreign exchange market provides a forum where the
currency of one country is traded for the currency of another
country.
 Example, suppose an Ethiopian importer import goods from
the USA and has to make payments in US Dollars. To do so,
an Ethiopian importer has to purchase US Dollars in the
foreign exchange market and pay to US firm.
 Therefore, the foreign exchange market is a market where
foreign currencies are bought and sold.

161
Major Participants

The participants in the foreign exchange market are:

1. Individuals: are normally the tourists who exchange
the currencies, as also migrants sending a part of
their income to their family members living in their
home countries.
2. The firms: are generally the importers and
exporters. An exporter prefers to get the payment in
its own currencies or in a strong convertible
currency.
• Importers need foreign exchange for making
payments for their import.

162
 Cont’

3. Banks: When firms and individual approaches the local branch

of a bank, the local branch in turn approaches the foreign
exchange department in its head office.
4. Government: Though it is a fact that commercial banks
dominate, the government or monetary authorities too participate
in the foreign exchange market but to help stabilize the value of
domestic currencies.
5. International agencies: They buy and sell foreign currencies in
the foreign exchange market, but that is not a routine affairs.

163
Foreign Exchange Rates

 An exchange rate is the amount of one currency that

can be exchanged per unit of another currency or the
price of one currency in terms of another currency.
 For example, consider the exchange rate between the
US Dollar and Ethiopian Birr. The exchange rate
could be quoted in one of two ways:

164
 Cont’d

1. The amount of US dollars necessary to acquire one

Ethiopian Birr, or the dollar price of one Ethiopian
Birr. (Dollar/One Birr). It is an indirect quotation.
$0.049/Birr 1.
• Indirect quote is the number of units of a foreign
currency that can be exchanged for one unit of a
local currency.

165
 Cont’d

2. The amount of Ethiopian Birr necessary to acquire

one US dollar, or the Ethiopian Birr price of one
dollar. (Birr/ One USD). It is a direct quotation. Birr
11.35/$1.
• Direct quote is the number of units of a local
currency exchangeable for one unit of a foreign
currency

166
 Foreign Exchange Risk
 From the perspective of an Ethiopian investor, the cash
flows of assets denominated in a foreign currency expose
the investor to uncertainty as to the cash flow in Ethiopian
Birr.
 The actual Ethiopian Birr that the investor gets depend on
the exchange rate between Ethiopian Birr and foreign
currency, if there is a direct conversion. Otherwise between
foreign currency and hard currency and again between hard
currency and Ethiopian Birr.
 Therefore, if the foreign currency depreciates (declines in
value) relative to hard currency, the birr value of the cash
flows will be proportionately less. This referred to as
foreign exchange risk.

167
Spot Market Vs Forward market

 The foreign exchange market is classified either as

spot market or as forward market.
 It is the timing of actual delivery of foreign exchange
that distinguishes between spot and forward market
transactions.

168
Spot Market
 In the spot market, currencies are traded for
immediate delivery at a rate existing on the day of
transaction.
 It is a market for settlement within two business days.
 The spot rate is applicable to the purchase and sell of
foreign exchange on an immediate delivery basis.
 Example. Suppose that Ethiopia Airlines has bought
an air craft from USA. It is to convert Ethiopian Birr
in to USD. In case the terms of payment are
immediate, Ethiopia airlines is to arrange the
spontaneous purchase of the required sum of USD at
the spot rate from the spot market.
169
 Currency arbitrage in the spot market
 With fast development in the telecommunication system,
rates are expected to be uniform in different foreign
exchange markets.
 Nevertheless, inconsistency exists at times. As a result, the
arbitrage takes advantage of the inconsistency and garner
profits by buying and selling of currencies.
 That means, they buy a particular currency at a cheaper rate
in one market and sell it at higher rate in the other market.
This process is known as currency arbitrage.
170
 Cont’d

 The process influences the demand for, and supply of,

the particular currency in the two markets which
leads ultimately to removal of inconsistency in the
value of currencies in two markets.
 Suppose, in New York: $1.98/£ and in London
$1.96/£. The arbitrage will buy the dollar in New
York and sell it in London making a profit of $1.98 -
$1.96 = $0.02 per pound sterling.

171
 Speculation in Spot market
 Speculation occurs when the speculator anticipates a
change in the value of a currency, especially an
appreciation in the value of foreign currency.
 Example: suppose that the exchange rate today is Birr
19.75/1USD. The speculator anticipates this rate to become Birr
20.50/1USD with in the coming two months. As a result, he will
buy and hold a USD for two months. When the target exchange
rate is reached, he will sell the USD and earn a profit of Birr
0.75/USD.

172
Forward Market

 In the forward market, contracts are made to

buy and sell currencies for future delivery, say
after a fortnight, one month, two months and
so on.
 It is an agreement to buy or sell a currency at a
certain future time for a certain price.

173
 One of the parties to a forward contact assumes a
long position and agrees to buy the underlying asset
on a certain specified future date for a certain
specified price.
[

 The other party assumes a short position and agrees

to sell the asset on the same date for the same price.
 That is, forward exchange rates are applicable for the
delivery of foreign exchange at a future date.

174
• Example, assume that, on August 16, 2014 G.C., an
Ethiopian airline purchases an aircraft $10 million from
US firm and agrees to make payment after 90 days, as
per the credit terms from the US firm. Ethiopian Airline
has two options:
1. On the due date of payment (after 3 months), make
purchase of the due sum of USD from the spot market, at
the spot rate prevailing at the point of time, and then
remit the payment of the US firm.
175
2. In order to avoid the uncertainty of the exchange
rate three months from now, Ethiopian airline is to
purchase the required USD in the forward market at
the forward exchange rate that is decided at the time
of the agreement.
 The agreed forward rate is valid for settlement
irrespective of the actual spot rate on the date of
maturity of the forward contract (i.e., 90 days from
today).
 In this case, the delivery of USD and the payment
of Ethiopian Birr will be taken place 90 days latter,
on the date of settlement.
 Thus, Ethiopian airline has eliminated exchange
risk by entering in to a forward contract.
176
 Spot and forward quotes for Birr/USD, exchange rate on
August 16, 2014 G.C.

Bid rate Offer rate

Spot rate 19.25 19.92

1 Month forward 19.52 20.21
3 Months forward 19.80 20.45
6 Months forward 19.97 20.55
• What would be the amount of Birr required to settle the
obligation according to the contact?

177
 The amount of Birr required by Ethiopian
Airline = $10 million × Birr 20.45/USD = Birr
204.5 million
 Thus, Ethiopian Airlines is sure that it will
require Birr 204.5 million in order to settle its
transaction with US firm.

178
Thank you!

179