Arba Minch University

College of Business and Economics

Department of Economics

Financial Economics (Econ-3091)

MODULE

Prepared By: Firew Kunta (MSc)

December, 2022/23

1
 CHAPTER-ONE

NATURE AND ROLE OF FINANCIAL SYSTEM IN ECONOMIC DEVELOPMENT

2
 1.1. Introduction to the concept Financial Economics
Economics is the foundation discipline for many other disciplines such as finance, marketing,
management and others, as we will see in this chapter.

Financial economics is a special branch of economics that also deals with the efficient allocation
of economic (financial) resources, including money, but within a different context. Specifically,
the allocation of resources is done across time and in an uncertain (or risky) environment.
Financial economics studies the relationships among financial variables such as interest rates,
yields and securities prices or the functioning of financial magnitudes within the global financial
market.

According to Miller (1999), financial economics possesses two main areas of focus: asset pricing
(investments) and corporate finance. The first area highlights the providers of (financial) capital,
that is, the investors, and is sometimes called investment management because it deals with the
management of individuals‘ or institutions‘ funds. Investment management involves four
activities: establishing an investment policy (objectives, constraints and investment horizon),
selecting an investment strategy, selecting the specific assets, and measuring and evaluating
investment performance. The second focus area underscores the users of capital, that is,
companies (businesses). Corporate finance is also known as financial management (or even
business finance) and is concerned with financial decision-making within a business entity.

There is also a third area of finance, that of financial markets, instruments, and institutions. In
that area, the global money and capital markets and their instruments are discussed (along with
derivative securities), the various financial institutions such as commercial banks, investment
banks and other financial intermediaries such as (mutual) funds, insurance companies, credit
unions, etc., and financial regulators. This area (field) focuses on the study of the financial system,
the structure of interest rates and the pricing of risky assets. This third area of finance will be the
main topic of discussion in this course.

1.2. Role of the financial system in economic development

To consider the role of the financial system in economic development, read the following
example:
Kalkidan has designed a tuktuk (like a bajaj) which uses electricity as fuel. With current shortage
of benzine, many bajaj drivers are interested to purchase an electric powered tuktuk, but Kalkidan
has no funds to put her wonderful invention into production.
3
Habtamu has plenty of savings, which he and his wife accumulated over the years. Currently the
savings loose value, because the inflation rate is high and Habtamu does not want to start his own
business. If Kalkidan and Habtamu could get together so that Habtamu could provide funds to
Kalkidan, Kalkidan‘s tuktuk can be produced, and the economy would be better off.

Financial markets (bond and stock markets) and financial intermediaries (such as banks,
insurance companies, and pension funds) serve the basic function of getting people like Kalkidan
and Habtamu together so that funds can move from those who have a surplus of funds (Habtamu)
to those who have a shortage of funds (Kalkidan).

More realistically, when Techno invents a better smartphone, it may need funds to bring its new
product to market. When Ethio Telecom wants to expand the capacity to use the 4G network it
needs funds. Similarly, when the SNNPR needs to build a road or a school, it may require more
funds than local property taxes provide. Well-functioning financial markets and financial
intermediaries are crucial to economic health, because they efficiently allocate capital.

Now we can see why financial markets have such an important function in the economy. They
allow funds to move from people who lack productive investment opportunities to people who
have such opportunities. Financial markets are critical for producing an efficient allocation of
capital (wealth, either financial or physical, that is employed to produce more wealth), which
contributes to higher production and efficiency for the overall economy. Well-functioning
financial markets also directly improve the well-being of consumers by allowing them to time
their purchases better. They provide funds to young people to buy what they need (and will
eventually be able to afford) without forcing them to wait until they have saved up the entire
purchase price. Financial markets that are operating efficiently improve the economic welfare of
everyone in the society.

Financial markets perform the essential economic function of channeling funds from households,
firms, and governments that have saved surplus funds by spending less than their income to those
that have a shortage of funds because they wish to spend more than their income. This function is
displayed in Figure 1 below.

Funds can be channeled from lenders to borrowers in two ways:

1. Direct finance: borrowers borrow funds directly from lenders in financial markets by selling
the lenders securities (also called financial instruments), which are claims on the borrower‘s

4
 future income or assets. Securities are assets for the person who buys them but liabilities
(IOUs or debts) for the individual or firm that sells (issues) them.
For example, if Ethio Telecom needs to borrow funds to pay for the expansion of the 4G network,
it might borrow the funds from savers by selling them a bond, a debt security that promises to
make periodic payments for a specified period of time, or a stock, a security that entitles the owner
to a share of the company‘s profits and assets.
2. Indirect finance: financial intermediary borrows funds from lender-savers and then uses these
funds to make loans to borrower-spenders.
For example, if you have an account in the Commercial Bank of Ethiopia (CBE), it means that you
have ‗saved‘ some money there, which can be lend out to a textile factory that purchases a new
sewing machine. As long as you don‘t withdraw your money from the CBE bank account the bank
can allow it to be used by the textile factory.
Figure 1: Function of the financial market

1.3.Structure of the financial system

The financial system is complex, comprising many different types of private sector financial
institutions, including banks, insurance companies, mutual funds, finance companies, and
investment banks, all of which are heavily regulated by the government. If an individual wanted to
make a loan to Ethiopian Airlines, for example, he or she would not go directly to the president of
the company and offer a loan. Like discussed in the previous section, he or she would lend to such
a company indirectly through financial intermediaries, which are institutions that borrow funds
from people who have saved and in turn make loans to people who need funds.
In general, the structure of the financial system consists of financial institutions, financial markets,
financial assets and financial services. Each of these will be introduced in this section.
5
Financial institutions:
Financial institutions are the financial intermediaries that connect fund suppliers to fund
demanders. Examples of financial institutions are central banks, commercial banks, microfinance
institutes and insurance companies. They can be sub-divided into banking institutions (depository
institutions) and non-banking institutions (non-depository).

Banking institutions accept a deposit, which means that they allow clients to deposit (save)
money on an account. Examples of banking institutions in Ethiopia are the National Bank of
Ethiopia (central bank), the Buna International Bank (commercial bank), Omo Microfinance
Institution (microfinance institute).
For example, Andualem makes 8,000 birr per month. He needs only 7,000 birr to cover his
expenses. The other 1,000 birr he deposits in Awash International Bank. He plans to withdraw
(take out) these savings when he gets married in the future.

Non-banking institutions provide financial services, but do not accept deposits (savings). An
example of an Ethiopian non-banking institute is the Ethiopian Insurance Corporation (insurance
company). An insurance is a contract in which the client pays a fee in order to receive financial
protection or reimbursement against losses. An insurance company does supply funds to the
financial market (the money that the insured clients paid), but the clients of an insurance company
do not deposit money in the insurance company.
For example: Beteha purchased a car. She rents the car to a driver, who uses the car to driver
tourists around in Nechisar park. Driving a car is dangerous, and an accident may harm the car,
but also the persons and other objects and persons on the street. Beteha pays a fee of 400 Birr per
month to the Ethiopian Insurance Corporation to insure the car. That means that, in case the driver
has an accident, the Ethiopian Insurance Corporation will (partially) reimburse the costs of
repairing the damages made. The Ethiopian Insurance Corporation supplies this money (400 birr
from Beteha, but also the payments of thousands other clients) as a fund to the financial market.
One day, the driver accidentally hits a bajajs and the repair costs are 12,000 Birr. Beteha contacts
the Ethiopian Insurance Corporation. After investigating the case it is concluded that indeed
Beteha‘s car made the mistake. Therefore, the Ethiopian Insurance Corporation reimburses the
12,000 birr to repair the bajaj.

Financial assets: There are various types of assets in the financial markets. The four most
common types are bank deposits, debt, equity and a derivative:
Bank deposits consist of the money which is available in a bank account. This is completely
liquid. That means that the owner of the bank deposit can immediately withdraw and use the
money.
6
Debt is the promise to repay in the future. The two most common debt instruments are bonds and
loans. If a company needs funding, it can issue a debt instrument, which is a contractual agreement
by the borrower to pay the holder of the instrument fixed amounts at regular intervals (interest and
principal payments) until a specified date (the maturity date), when a final payment is made.
For example: a large commercial coffee farmer may issue 1000 bonds of 10,000 Birr each. The
bond promises to repay 1,000 birr + 15% interest rate per 6 months for the period of 5 years. The
maturity of this bond is 5 years. This promise to repay is a financial asset for the owner of the
bond (the one who lend the money to the coffee farmer).

Equity is a share of a company. Examples of equity are shares or common stock, which are claims
to share in the net income (income after expenses, investment and taxes) and the assets of a
business. Equities often make periodic payments (dividends) to their holders and are considered
long-term securities because they have no maturity date. In addition, owning stock means that you
own a portion of the firm and thus have the right to vote on issues important to the firm and to
elect its directors.
For example: If you own one share of a large commercial coffee farm that has issued one thousand
shares, you are entitled to 1 one-thousands of the firm‘s net income and 1 one-thousands of the
firm‘s assets. If the firm makes a net income of 1,000,000 Birr in 2014 E.C., you will get 1,000
Birr dividend that year. When making important decisions, for example, what type of new coffee
trees to plant, the company may invite all the shareholders to vote on the selection of the tree type.

In general, what is more attractive? Is it best to hold financial assets in bank deposits, to hold debt
instruments or to hold equity? Suppose you‘ve a fund of 15,000 birr. If you expect you need it
soon, it is best to leave it in the bank deposit. This ensures that your fund is liquid (immediately
usable). If you do not need the money soon, and you consider investing it in, for example, an
Ethiopian sport betting company (Hulu Sport), you may consider the following issues:
- The company must pay all its debt holders before it pays its equity holders, so if you fear Hulu
Sport will not do well in the future, it is wiser to buy debt.
- The advantage of holding equities is that equity holders benefit directly from any increases in
the corporation‘s profitability or asset value because equities confer ownership rights on the
equity holders. Debt holders do not share in this benefit, because their re-payment amounts are
fixed. So, if you expect Hulu Sport to do well in the future it may be wiser to buy equity.
Derivatives are special financial assets, because their value depends on the value of other financial
assets or commodities.
7
A derivative can be defined as a financial instrument (asset) whose value depends on (or derives
from) the values of other, more basic, underlying variables. Very often the variables underlying
derivatives are the prices of traded assets. The value of a commodity derivative, for example,
depends on the price of a commodity. However, derivatives can be dependent on almost any
variable, from the price of benzene to the amount of rainfall on the land of a farmer. Later, we will
discuss various types of derivatives, but now it is crucial to understand how derivatives function.
Therefore, consider this simplified example:
Mirkat owns a large coffee farm and expects a harvest of 1 ton of Arabica coffee beans around
January 1, 2023. Currently, the price of 1 ton of Arabica coffee is approximately 175,000 birr on
the Ethiopian Commodity Exchange (ECX), but this price may change. If the price increases, it is
good for Mirkat. If the price decreases, it is bad for Mirkat.
Ahn wants to buy coffee for her coffee bar in Vietnam. Ahn planned and concluded that she needs
to buy 1 ton of Ethiopian Arabica coffee beans on January 1, 2023. Currently, the price is 175,000
birr, but this price may change. If the price increases, it is bad for Ahn. If the price decreases, it is
good for Ahn.
Note that Mirkat and Ahn are interested in the same commodity (arabica coffee) at the same time
period (January 1, 2023), but their interests are opposite. Therefore, they can sign a derivative
contract to hedge their risk. Hedging means smoothening or reducing the risk. See figure 2 for the
(fictive) contract that Mirkat and Ahn could sign.
By signing this derivative contract, Mirkat is sure that her harvest will result in a net revenue of
175000 birr. If the price is more than 175000, she has to pay the ‗surplus‘ to Ahn. If the price is
less than 175000 birr she gets the ‗deficit‘ of Ahn. By this method, Mirkat hedged her risk.
Ahn also hedged her risk, because she is sure that the net price of the coffee will be 175000 birr. If
the market price is higher, Mirkat will compensate her ‗deficit‘. If the market price is lower, Ahn
has to pay the ‗surplus‘ to Mirkat.
Note that the underlying commodity of this derivative is Arabica coffee.
Now, suppose that on January 1 2023 the price of Arabica coffee is 180000 birr per ton on the
ECX. This means that Mirkat gets more money for her harvest, but must pay 180000-
175000=5000 birr to Ahn. Ahn pays a higher price for the coffee, but gets 5000 birr from Mirkat.
Both are, in this way, secured of a future price of 175000 birr per ton of Arabica coffee.

Contract
On January 1, 2023 the following payment will be made:
- Mirkat pays Ahn [MARKET PRICE-175000] if the price of 1 ton Arabica coffee >175000birr
- Ahn pays Mirkat [175000-MARKET PRICE] if8the price of 1 ton Arabica coffee <175000birr
Signature Mirkat: Signature Ahn:
 1.4. Primary and secondary markets
Financial assets are traded in the primary market and the secondary market. A primary market is
a financial market in which newly issued assets, such as a bond or a stock, are sold to initial
buyers by the corporation or government agency borrowing the funds. Primary markets are not
well known to the public, because deals usually happen behind closed doors.

A secondary market is the place where investors trade previously issued assets (for example,
stocks and bonds). Here, investors can buy assets from other people, not from the issuing
organization. The most known secondary markets are stock exchange markets. On stock exchange
markets, equity of large & known companies is traded. You may have heard of the Shanghai stock
exchange, New York Stock Exchange, NASDAQ (National Association of Securities Dealers
Automated Quotation System), Johannesburg Stock Exchange, EURONEXT. Ethiopia does not
yet have a stock exchange market, but Ethiopian law makers made a proposal in 2021 to start an
Ethiopian stock market through private and public partnership.

Another example of a secondary market is the foreign exchange market. Foreign exchange
markets facilitate trading in currencies, for example buying and selling US$ for Ethiopian Birr.
Next to stock markets and foreign exchange market, there are other secondary markets: bond
markets, futures markets, and options markets. Later in this course we‘ll discuss what stocks,
bonds, futures and options exactly are.

Why is a secondary market relevant? When an individual buys a security in the secondary
market, the person who has sold the security receives money in exchange for the security, but the
corporation that issued the security acquires no new funds. A corporation acquires new funds only
when its securities are first sold in the primary market. Nonetheless, secondary markets serve two
important functions:
(1) First, they make it easier and quicker to sell these financial instruments to raise cash; that is,
they make the financial instruments more liquid. The increased liquidity of these instruments
then makes them more desirable and thus easier for the issuing firm to sell in the primary
market.
(2) Second, secondary markets determine the price of the security that the issuing firm sells in the
primary market. The investors who buy securities in the primary market will pay the issuing
corporation no more than the price they think the secondary market will set for this security.
The higher the security‘s price in the secondary market, the higher the price the issuing firm
will receive for a new security in the primary market, and hence the greater the amount of
9
 financial capital it can raise. Conditions in the secondary market are therefore the most
relevant to corporations issuing securities.
Therefore, in this course about Financial Economics we mostly discuss the behavior of secondary
markets rather than primary markets.

1.5. The asset transformation role of financial institutions

Banking institutions make profits by selling liabilities with one set of characteristics (a particular
combination of liquidity, risk, size, and return) and using the proceeds to buy assets with a
different set of characteristics. This process is often referred to as asset transformation. A
savings deposit held by one person can provide the funds that enable the bank to provide a loan for
another person. The bank has, in effect, transformed the savings deposit (an asset held by the
depositor) into a loan (an asset held by the bank).
For example: From the day he is born, Ali‘s parents save 500 birr per month for his education.
They store this money in a savings deposit of Dashen Bank. The parents of Ali have the asset
‗saving deposit‘.
Dashen bank does not put the 500 birr per month in a vault but uses this money (and money of
many other saving deposit holders) to provide a loan of 2 million birr for Haile Resort, so that
Haile Resort buys new kitchen machines. This loan to Haile resort is a debt asset to Dashen bank.
Note that Dashen bank transformed the asset ‗saving deposit‘ to ‗debt asset‘.

The process of transforming assets and providing a set of services (check clearing, record keeping,
credit analysis, and so forth) is like any other production process in a firm. If the bank produces
desirable services at low cost and earns substantial income on its assets, it earns profits; if not, the
bank suffers losses.

1.6. Debt and Inalienability of Human Capital

As stated above, the financial market facilitates transactions between those with excess funds and
those in need of funds (e.g. an entrepreneur who starts a businesses). In some of these cases,
lenders may not be willing to provide the fund, even if it is a profitable operation, because of the
inalienability of human capital.

Inalienable means that something cannot be transferred to someone or something else. In the case
of human capital, it means that some skills of the entrepreneur are the entrepreneur‘s skills, and
not the business skills. The entrepreneur may not always stay active in this business, and if he
quits the business project for which the loan is taken, the business misses his skills (human

10
capital) and may fail. In that case, repayments fail, so the bank‘s debt asset becomes worthless. As
a consequence, the bank decides not to provide the funds.
For example: Rebecca is a very talented motivational speaker. She started a business called
‗Tesfa‘ with which she organizes seminars. Her dream is to expand the business by a training-
camp, in which she will coach unemployed youth to become self-employed. To start training, she
needs to make initial investments (like training space, furniture, office equipment etc.) for which
she does not have sufficient funds. Therefore, she approaches Dashen Bank with a beautiful
business plan. Rebecca is a talented motivational speaker with followers, so there is no doubt that
the business will be profitable if Rebecca stays involved. But if Rebecca would sell the business
after some months (to pursue other dreams), Dashen bank is not sure if the business will perform
well. Therefore, Dashen bank deems it too risky to provide the funds. In the end, Rebecca is
unable to expand the business by the training camp.

Note that the inalienability of human capital is a market inefficiency, because economically
profitable projects are not funded.

1.7. Introduction to financial theories

This section discusses important financial concepts and theories, which must be understood before
continuing this course.

 Capital allocation
Capital allocation is the process of allocating financial resources to different areas of a business to
increase efficiency and maximize profits. As stated in section 1.1, financial markets facilitate the
efficient allocation of capital, because it connects those with access of funds to those with the most
promising business ideas.
Empirically, it is visible that countries with a more developed financial sector are more able to get
funds for (investments in) growing industries, leading to a more efficient capital allocation (Figure
3).

11
Figure 2: Relation between Financial development and the Efficiency of capital allocation. Each dot represents one country.
In general, the higher the financial development, the more efficient capital resources are allocated. Source: Wurgler (2000)

• Risk and return

Risk is the possibility that actual returns will deviate from expected returns. Returns may be
higher than expected (no problem), but also be lower than expected (problematic). Usually risk is
discussed, because investors fear that the return (and therefore the assets value) is less than
expected. There are two types of risk: systematic risk (caused by macro-economic factors,
affecting all assets simultaneously) and unsystematic risks (affecting assets or industries
individually).
Example of a systematic risk: At the start of 2019, Wei Hong invested in PetroChina, an oil
company listed in the Shanghai Stock Exchange. He purchased 10,000 shares each worth 7.19
CNY. Due to the COVID-19 pandemic, the Chinese productive output decreased, reducing the
demand for oil. The value of the share dropped from 7.19 CNY to 4.07 CNY. A global pandemic
leading to an economic crisis is a systematic risk, because it affects almost all the companies in the
system. PetroChina was negatively affected, but also the shares of all other companies on the
Shanghai Stock Exchange lost value.

Example of an unsystematic risk: On March 1, 2019, Ahmed bought 100 shares Boeing, each
worth 440US$. These shares are listed in NASDAQ. On March 10, unfortunately a Boeing
airplane of Ethiopian Airlines crashed, which negatively affected the image of the company.
Investors thought that other Boeing planes would also be unsafe and wanted to sell Boeing shares.
Therefore, the value of one share dropped to 362US$ within 2 weeks. This is an unsystematic risk
because the risk is only relevant for one company (Boeing). The other companies listed in
NASDAQ did not experience a drop in the value of a share.

12
Return is the reward from holding the assets. It may be repayment, interest payment, dividend or
an increased value of the asset in the secondary market. Note that most assets have two sources for
reward: reward from the issuer of the asset in cash (repayment, interest payment, and dividend)
and reward from selling and reselling the asset on the secondary market. For example, Tesla, an
US-based company producing electrical cars, has never paid dividend to its shareholders, but it
still yields returns, because the price of a share Tesla increased from 50US$ in 2019 to 809.87US$
in 2022. In contrary to the real return, investors mostly make decisions based on the expected
return of an asset, because it is not yet known what the return will be.

Instead of considering the absolute return, it is common to consider the rate of return, which is
calculated as follows:

Where is the rate of return on the asset held from time t to time t+1. is the secondary
market price of the security at the end of the holding period (t+1), is the price of the security at
the beginning of the holding period (t) and C is cash payments (may be dividend, or loan
repayments or interest payments) made in the period t to t+1. For the rest of these notes, the term
‗return‘ refers to the ‗rate of return‘ rather than the absolute return.

In general, the relation between risk and the rate of return is positive: the higher the risk of an
investment, the higher the expected return demanded by an investor.
For example: Heldana wants to invest 1,000,000 US$ in government bonds. She is in doubt
between buying Venezuelan bonds, or Swiss bonds. The government of Venezuela has a bad
history of repaying loans: it defaulted 10 times in recent history. The unsystematic risk of losing a
debt asset issued by the Venezuelan government is big. The government of Switzerland never
defaulted because the country and its economy are very stable. In case of Swiss government
bonds, the risk is very low. The interest rate on a 10-year Venezuelan bond is 10%, and the
secondary market expectations are that the price will reduce by 5%. The interest rate on a 10-year
Swiss bond is 0.28% and the secondary market expectations are that the price will increase by 2%.
Expected rate of return Venezuelan bond:

Expected rate of return Swiss bond:

13
Here it is revealed that the investment with high risk (10 year Venezuelan government bond)
yields a higher expected net return (5%) than the investment with low risk (the 10 year Swiss
government bond).

Some investors are very risk avoiding. They will just save the money in a secure bank and save a
secure, but low, interest rate ( . Other investors are willing to take some risk, to get a higher
expected rate of return ( ). The extra return that an investor gets as ‗reward‘ for risk is called the
risk premium. Note that , so , where is the
expected rate of return from the asset and is the risk-free interest rate.
For example: Abdu has 1,000,000 US$ and he doubts between safety and high returns. If he saves
the money in the bank, he gets only 0.5% interest rate, but he is sure of this return. If he invests the
money in a share Tesla, the market predicts a return rate of 24%, but, obviously, this return is very
uncertain (risky). The risk premium = 24%-0.5%= 23.5%. By choosing for the Tesla
share Abdu faces risks for which the expected reward (=risk premium) is 23.5%.

• Portfolio theory
Portfolio theory describes strategies to get a package of assets with the best return/risk ratio. The
lower the risk and the higher the return, the better the portfolio is. To reduce the risk, investors
prefer to hold a portfolio of diverse assets (diversification), rather than having a lot of the same
assets, to spread the risk. Holding a portfolio with diverse assets may reduce unsystematic risks,
but not systematic risks, because systematic risks usually affect all types of assets in a similar way.
This is visualised in Figure 4.

Figure 3: Unsystematic risk of a portfolio reduces if more assets (=securities) are included in
the portfolio.

14
The big question is: how to compose the portfolio so that it minimizes the risk and maximizes
return? Try to think along: which of the following portfolios would you choose?
Portfolio 1 Portfolio 2 Portfolio 3
10 shares Techno 10 shares Samsung 2 government
10 shares Ethiopian Airlines 10 shares Ethiopian Airlines bonds US (1%
10 5-yr government bonds ET 3 5-yr government bonds Turkey interest)
(6.9% interest) (23.8% interest) Total estimated
10 Gird-bonds (≈ 2% interest) 10 corporate bonds (2% interest) asset value:
Total estimated asset value: Total estimated asset value: 1.5 million birr
1.5 million birr 1.5 million birr

Based on the assets included in the portfolio‘s it is reasonable to say that Portfolio 1 has high
systematic risk, because all the assets are issued in Ethiopia. If a shock hits the Ethiopian
economy, all assets are at risk of losing value. Portfolio 2 has a nationally diverse mix of types of
assets and companies involved, so it seems to score moderate on risk and return. Portfolio 3 holds
only one type of asset. US government bonds hold low risk (the US did not default recently), but
there is little reward and little diversification. Therefore, most investors would prefer Portfolio 2.

In modern portfolio theory, risk and return are weighted by considering the mean value of past
returns as indicator for expected return and the variance of the asset’s value as indicator for its
risk. It further assumes that investors are risk averse. That means: if there are two portfolios with
the same expected return, but a difference in risk level, the investor always prefers the portfolio
with the lower risk.

Consider this simplified example: Amaresh wants to invest in the automotive industry. She is in
doubt between buying shares of Toyota or BMW. Over the past 5 years Toyota gave 4% dividend
and the share value increased by 7% in the market. The variance of a share Toyota was 7% of the
share‘s current value. Over the past 5 years BMW gave 5% dividend and the share value
increased by 6%. The variance of a share BMW was 10% of the share‘s current value. Which of
the two companies does Amaresh invest in, given that she is a common risk averse investor?
Using the mean value of past returns (4%+7% for Toyota, 5%+6% for BMW) and the variance of
the asset‘s value (7% for Toyota, 10% for BMW), it is most rational to prefer Toyota shares,
because the expected return is equal, but the fluctuation of its value (indicator of risk), is lower.

15
Therefore, Amaresh is relatively more secured that she‘ll get a reward close to the expected
revenue.

Figure 5 visualises the relation between expected return and risks of assets and portfolios
(combinations of assets). Note that is the return of a risk free loan (as the risk is 0 at that point).
Each dot represents a possible asset, and you can read the expected return and risk from the Y and
X axes respectively. As Figure 4 showed, by adding diverse assets to the portfolio, unsystematic
risk reduces. Therefore, the return/risk relationship of a whole portfolio is usually better than that
of an individual asset. For each level of risk, an optimal portfolio (with the right proportion of the
available assets) can be composed that maximizes the return given the level of risk. These optimal
proportions of assets are displayed on the Efficient frontier curve in Figure 5 Each point on the
efficient frontier represents the highest return given the level of risk.
However, for each level of risk there is an efficient portfolio available, so how can the investor
choose the optimal amount of risk? This is done by considering both risk and return, in the
Sharpe Ratio.

Where =the expected return of the portfolio, =the risk-free interest rate and =standard
deviation of the portfolio‘s return.
The optimal portfolio to choose is the one with the highest sharpe ratio, because it shows a good
pay-off between expected returns and risk.

.
Figure 4: The relation between expected return and risk of assets and portfolios (packages of
assets)

For example: Kebede has 2,000,000 Birr available for investment. He wants to include the
following assets: bonds, shares, loans. The risk-free interest rate is 1%. A financial advisor

16
proposes efficient (i.e.: max return given level of risk) portfolios for him, both including bonds
and shares with different proportions and risk levels.
Portfolio 1: expected return: 4%, standard deviation of the return: 3%
Portfolio 2: expected return: 12%, standard deviation of the return: 8%
Which one is best for Kebede?

Sharpe ratio portfolio 1:

Sharpe ratio portfolio 2:

Portfolio 2 is better for Kebede, because it has a higher Sharpe Ratio.

 Capital Asset Pricing Model and Single Index Model

The price of a financial asset depends on the expected returns of the assets. As stated above:
expected returns depend on the returns obtained from the issuer (dividend, repayment, interest
payment) and the returns obtained from a value increase on the secondary market. To investigate
the expected returns of an asset in the financial market, two major models can be used. The first
one is the Capital Asset Pricing Model, and the second one is the Single Index Model.

The Capital Asset Pricing Model (CAPM) describes the relationship between risk and expected
return for assets. The model has four assumptions:
1. Investors are risk averse and they evaluate assets solely based on expected return and standard
deviation of return (risk).
2. Capital markets are working perfectly: no transaction costs, selling restrictions or taxes, full
information for all and all actors can borrow and lend at a risk-free interest rate ( ).
3. All investors have access to the same investment opportunities.
4. Investors all make the same estimates of individual assets expected returns, standard
deviations of return and the correlations among asset returns.

Under these assumptions, all investors will find the same optimal Sharpe Ratio, which reduces the
unsystematic risk as much as possible (see Portfolio theory discussion above). All investors hold
risky assets in relatively the same proportion, which is the optimal proportion (the one
corresponding with the Sharpe Ratio).
If an investor has a low risk tolerance, he will invest only a small share of his wealth in assets (he
puts the remainder of his wealth in a bank account, where he receives the risk-free interest rate ),
if an investor has a high-risk tolerance, he will invest a large part of his wealth in assets.

17
Key in the CAPM is the sensitivity to systematic risk (), which expresses to what extent the value
of the asset moves together with the value of all assets in the market. A stock with a =1 rises and
falls at the same percentage as the whole market. Stocks with >1 tend to rise and fall by a greater
percentage than the market—that is, they have a high level of systematic risk and are very
sensitive to market changes. Conversely, a stock with <1 has a low level of systematic risk and is
less sensitive to market swings.

These assumptions allow us to find the equilibrium, where the expected return of an asset ( ) is
given by:

Where = the expected return of an asset, is the risk-free return, is the sensitivity to
systematic risk and is the expected return on the whole market.

Note that the CAPM model only considers the premium on systematic risk, and not the premium
on unsystematic risk. Since unsystematic risk can be easily eliminated through diversification, it
does not increase a security‘s expected return. If an asset‘s return has a strong positive relationship
with the return on the market and thus has a high , it will be priced to yield a high expected
return; if it has a low , it will be priced to yield a low expected return. Therefore, according to the
CAPM, financial markets care only about systematic risk.

In the second model, the Single Index Model (SIM), the risk premium of an asset (that is: the
returns minus the risk-free interest rate ) is a linear function of the market returns. The
approach of the SIM is statistical, and not economic & equilibrium-based like the CAPM.
The statistical model assumes that the return to asset a, , is linearly related to a single common
underlying factor (mostly a market index).

Where is the return of asset a, is the return on the common factor (mostly the market index),
is the expected return if = the sensitivity of to and is the random asset
specific component of the return.

To make this model practical, it is good to have a basic understanding of a market index, and its
expected return ( ). A market index is a hypothetical portfolio of investment holdings that
represents a part of the financial market. The calculation of the index value comes from the prices
of the underlying holdings. The most important market indexes are published daily in newspapers

18
and online. For example, the Dow Jones Index in the USA considers the 30 largest stocks in the
US. If the prices of these stocks increase, the Down Jones Index increases. If the prices of these
stocks decrease, the Down Jones Index decreases. Figure 6 displays the Down Jones Index over
time, starting from the value 100 in 1896 G.C., its current index number is approximately 33,294.
This means that the value of the 30 largest stocks in the US increased drastically over the period
1896-2022.

Figure 5: Development of the Down Jones Index, starting from 1896 to 2022.
By considering the index, it is possible to observe developments of a market over time. Figure 7,
for example, describes 5 major European stock indices. It is visible that the start of the COVID19
lockdown time, the stock market lost value. 2021 was a year of recovery, but in 2022 the value of
stocks seems to go down again, possibly due to the war between Russia and Ukraine.

Figure 6: 5 European market indices, and their development over time.

Once you‘ve selected a market index, you can collect data about the return of the asset of interest
( ) and the data of the market index ( ) and use linear regression to find the values of and
. If is large, it means that the asset‘s return is high, if the market return is 0. If is small, or
negative, it means that the asset gives small returns or losses if the market returns are 0. If is
large, it means that the asset‘s return strongly moves with the market return. If is small, it
means the asset is hardly subject to systematic risks.
Therefore, the return can be cut into two parts:

19
 o is the asset specific return
o is the index driven return
For example (fictive): to predict the return of your EthioTelecom stock, you use the Morgan
Stanley Capital International (MSCI) Emerging Markets Index as market index. After collecting
the data, you run the regression and the result is in Figure 8. The is 0.659% and the is 0.22.
If you expect the MSCI Emerging Markets Index to increase by 8% next week, you expect
EthioTelecom stock to increase by 0.659%+0.22*8%=2.4%

Figure 7: Results of the regression between return Ethio-telecom return and market return

 Market efficiency
Market efficiency refers to the degree to which market prices reflect all available, relevant
information. Remember that the rate of return of an asset is a function of , and C (

).

When an investor buys an asset, he knows the value of , but he is not sure about the values of
and C, so the exact rate of return ( is unknown in time t.

The investor uses other information (return from the past, market index forecasts, macroeconomic
data, the company‘s business planning) to predict and C. If an investor expects that and
C are high (that means: he expects a high return rate between t and t+1), he is willing to pay a high
. If the expectations of and C are bad, he will only pay a low . If all investors have
similar information available, a change in market expectations (information available about the
likely future performance of the asset) will change the demand for that asset. We know that a
change in demand affects the equilibrium price (in general), and this also holds for financial
markets. Therefore, current prices in a financial market will be set so that the optimal

20
forecast of an asset’s return (using all available information) equals the asset’s equilibrium
return. Financial economists state it more simply: In an efficient market, an asset‘s price fully
reflects all available information.

This system works especially because some people do it fulltime, as their work. They are called
traders or arbitrageurs. The arbitrageur takes on some risk when eliminating the unexploited
profit opportunities.
For example: Suppose that the common equilibrium return ( on Samsung stock is 10% at an
annual rate. Because the demand for smartphones increases, the stock‘s current price, , is lower
than the forecasted tomorrow‘s price . Andualem, an arbitrageur, expects that an increase of
the stock‘s value will lead to an annual return rate of 50%, which is greater than the equilibrium
return of 10%. Because the expected return (50%) is higher than the equilibrium return (10%)
there is an unexploited profit opportunity. Andualem knows that, on average, he can earn an
abnormally high rate of return on Samsung stock, so he buys more stock. Not only Andualem does
this, but also many other traders who see this opportunity to make profits. This will drive up the
stock‘s current price, , relative to its expected future price With a higher , the will
decrease and after some time the profit opportunity is exploited.

 Equity valuation
If an investor has a fund available, he must choose which equity he‘ll invest in. To that end he
compares the price of the equity with the value of the equity. Therefore, equity valuation is very
important. The main purpose of equity valuation is to estimate a value for a firm or the assets it
issued. A key assumption of any fundamental value technique is that the value of the asset (in this
case an equity or a stock) is driven by the fundamentals of the firm‘s business activities. There are
three primary equity valuation models: the discounted cash flow (DCF) approach, the cost
approach, and the comparable approach.

o The Discounted Cash Flow (DCF) model (or the income approach)
The purpose of DCF analysis is to estimate the income an investor would receive from an
investment, adjusted for the time value of money. The time value of money assumes that a birr
today is worth more than a birr tomorrow because it can be invested.
In the DCF the value of equity is

21
Where n is the number of years an asset exists (until maturity date), r is the discount rate, CF1 is
the expected cash flow in dividend/payment from year 1, C2 the expected cash flow in
dividend/payment from year 2 and CFn the expected cash flow in dividend/payment from year n.
The discount rate is usually the risk-free interest rate, because if the investor does not invest in the
stock, he rather saves this money for a risk-free interest rate in the bank.
Example: Abdul issues shares for his electronics business. He expects to pay 600 Birr dividend per
year to the shareholders. Mesay considers buying a share and holding it on for 4 years. The risk
free interest rate on her bank account is 7%. The current price of Abdul‘s shares is 5,000 Birr, and
it is expected that the price stays 5,000 Birr over time. To evaluate if this price is better/worse than
the value of the equity, Mesay uses the DCF formula:

Note that the last predicted cashflow is the expected dividend (600 Birr) plus the sales price of the
share (expected: 5,000 Birr). Because the equity value (5846.8 Birr) exceeds the price of the
equity (5,000 Birr), Mesay will buy the share. However, in reality the dividend, the risk-free
interest rate (discount rate) and the price of the asset may change over time, leading to a risk for
the shareholder.

This CDF approach can only be used if the future cash flows, the discount rate and the asset price are
relatively stable. In a market with high risks, this approach leads to over- or undervaluation of equity.

o The cost approach (or asset approach)

Rather than focusing on the income flow (CDF), the cost approach validates the business from a
balance sheet perspective. In other words, a valuation expert will determine the overall enterprise
value based on the underlying value of the business‘s assets net of its liabilities. Consider, for
example, the balance sheet in Figure 9. The company has $250,000 in assets (what it owns) and
$100,000 in liabilities (what it owes). The net worth is $150,000. If you get the option to buy one
share (and the total number of shares issued is 100), the cost approach values the equity (1 share)
at 150,000$/100 shares =1,500$.

22
This approach is often used to
valuate real estate
equity. It is not suitable
for companies with
intangible assets like
excellent human resources, as these assets are not included in the company‘s balance sheet.
The market approach (or the comparable approach)

The Market Approach validates equity of a business by comparing it to similar companies that
have a value attached to them that is publicly known. An investor (a willing buyer) would look at
the values of what is referred to as the ―comparable companies‖ and would value the equity of a
company according to the values of these similar companies. There are various sources for this
information: one can use a market index from the industry that the company operates in, check
sales transactions of similar companies or see the share value of publicly traded similar
companies.

If this information about similar companies is available, this method is the best for an uncertain
market, because it includes intangible assets and it includes efficient forecasts for this particular
sector (remember: public trading leads to market efficiency).
Example of valuing equity: Hong Li wants to invest in Crown Bioscience, a US drug development
company. Currently, a share is valued 122$. The following information is provided:
- Dividends were 0$ for the past 5 years, but if Crown Bioscience invents an innovative drug,
the profit can be high, leading to potentially high dividends in the near future.
- The company has 126.13 million outstanding shares. Its assets are worth 13.88B$, total
liabilities 11.55B$.
- The biotech industry is doing quite well, especially since the COVID19 crisis, which
emphasized the importance of drugs. Consider the Nasdaq Biotechnology Index in Figure 10
to see the trend of the Biotechnology industry over the past 3 years.
Should Hong Li buy shares of Crown Bioscience?
Based on the CDF approach, the discounted cash flow is lower than the current asset price
(dividend is 0, so the discounted value of the share will be less than 122$ in the future). However,
there is great uncertainty. If the company develops good medicines and pays high dividend, the
CDF may suddenly be much higher. With the current information, however, Hong Li should not

23
buy CrownBiotech shares according to the CDF approach, because the market price is higher than
the CDF equity validation.
Based on the cost approach, the companies net worth is its assets – its liabilities=13.88B$-
11.44B$=2.33B$. divided over 126.13 million shares, the net value of each share is
2.33B$/126.13million=18.47$, which is far below the current market price of 122$. So based on
this approach, Hong Li should not buy CrownBiotech shares.
Based on the market approach, it is visible that in the past half year Biotechnology equity
reduced in value. Therefore, if this trend persists, it is likely that CrownBiotech shares will also
loose value over time. Based on this information (only) Hong Li should not buy CrownBiotech
shares. However, Hong Li could search for more specific information on CrownBiotech‘s
activities and see if they perform better than the overall Biotech market.

Self-Test Exercise
1. Indicate if the following transactions are about direct finance or indirect finance & why:
- Haile resort borrows 5 million Birr from Dashen bank to renovate the kitchen
- Muluken borrows 2000 from Kebede to buy graduation clothes
- Lemlem saves monthly 500 birr in a Micro and Credit Institute so she can buy an injera
stove after a year
- Amin buys 10 shares of Tecno and 5 shares of Samsung
2. Imagine you have 2 million Birr. You do not need this amount at this moment. You can
choose to hold deposits, buy debt or to buy equity. For the deposit, you can get 8% interest
rate per six months at the Commercial Bank of Ethiopia. For debt you consider buying
Ethiopian Airlines bonds with a maturity of 5 years and interest rate of 12%. Or you can buy
stock of Ethiopian Airlines. What would you choose if…
- …you need the 2 million Birr to buy a car after 6 months?
- …you don‘t need the money soon, but you think Ethiopian Airlines will do well in the near
future because more and more tourists are visiting Ethiopia
3. Almaz wants to buy a car after six months, when she starts working in the rural area. Kayranto
will sell his car after six months, because he needs the money to get married in a resort. The
current price of the type of car Almaz wants and Kayranto has, is 1.5 million Birr. How can
Kayranto and Almaz hedge their risk by signing a derivative contract? Make the contract and
show that it guarantees Kayranto and Almaz of a fixed pay-off, no matter the price of the car
after six months.

24
4. Gech needs €1000 in June but has an income in Birr. Amarech needs 60,000 Birr in June, but
her income is in euro. How can they hedge their risks by signing a derivative contract?
5. Explain how the bank can use ‗asset transformations‘ to make profit.
6. Sosina deposits 2,000,000 Birr in her Awash Bank account. The bank lends the money to
Crocodile Farm, to build a new cage for the crocodiles. The Crocodile farm pays an annual
interest rate of 19%. What interest rate can Awash Bank maximally offer Sosena? Explain
what the bank must consider in setting this rate.
7. Suppose you‘re working for Buna International Bank. Tariku Dishita works with Hope
Entertainment to organize a concert in Nechisar Park. Hope Entertainment applies for a loan of
12 million Birr to build the stage and organize the concert. Hope Entertainment is sure that
Ethiopian singers will come, most likely Tariku Dishita, but it may be another singer. Based
on this promise, will you approve the loan, or are you hesitant? In your answer, discuss to
what extent Tariku Dishita‘s talent/status is inalienable.
8. Are the following cases about systematic risks or unsystematic risks? Explain your answer:
 Increased transportation costs due to high oil prices
 High labor turnover reduces profit of Tecno
 Increased inflation and interest rates
 Fraudulent behavior by the CEO of Buna International Bank
 Fraudulent manipulation in the company‘s financial reporting
 Worldwide pandemic
 Very small parts of dog meat found in IndoMie Noodles
9. One year ago, Selam bought a 1 million birr government bond of the Ethiopian government
(treasury bond) for 990,000 Birr. Now, the bond provides in cash 9% interest rate payment and
500,000 Birr payment of the principal. Just after this payment, Selam sells it in the secondary
market for 450,000 Birr. What was the rate of return? Is this a good rate of return?
10. A share Amazon was 853US$ March 2017, and it is 2910US$ now. Amazon never paid
dividend to its shareholders.
a. What is the rate of return over the last 5 years?
b. Would you like to buy Amazon stock? Why (not)?
11. Why, do you think, are interest rates higher for micro lenders (small entrepreneurs) than for
large established corporations?

25
12. Over the period March 2021-March 2022 the annual interest rate on a female Commercial
Bank of Ethiopia deposit was 9%. Account holders with >1 million Birr were encouraged to
invest in government bonds with an annual interest rate of 12%.
a. What is the risk premium on the government bonds?
b. If the interest rate on government bonds was 25% in the period 1990-1991, was the risk
higher or lower that time, compared to the period March 2021-2022? Explain your
answer.
13. Switzerland is a very rich country. Its government is stable, the country always avoids war and
other crises and its currency, the Swiss Franc, has a high stable value. The interest rate on
Swiss government bonds is 0%. Explain why investors want to lend money to the Swiss
government for 0% interest rate.
14. Explain why it is impossible to reduce all risk, according to portfolio theory.
15. Explain how, by adding types of assets/securities, unsystematic risk in a portfolio reduced.
16. Haile wants to invest in the Fast Moving Consumer Goods industry. He doubts between stock
of Colgate, stock of Proctor & Gamble or stock of Nestle. Which stock will he buy, given
modern portfolio theory? Explain your answer.
Colgate Proctor & Gamble Nestle
Dividend past 5 Annual 2.5% Annual 2.4% Annual 4.21%
years
Share value past 5 +1.15% +59.31% +57.5%
years
Variance of share 10% 10% 11%
value past 5 years
17. Almaz has 45,000 Birr available for investments. A financial advisor proposes two portfolios
with different types of assets included: public and corporate bonds and stock from various
countries. Portfolio 1 has an expected rate of return of 13% and a standard deviation of 2.3%
in the last years. Portfolio 2 has an expected rate of return of 25%, but its standard deviation
was 14% in the last years.
A. Calculate the Sharpe ratio‘s for all possibilities
B. Why is the Sharpe ratio of the stock lower than those of the portfolios? Use the word
‗diversification‘ in your answer.
C. Which portfolio has the best Sharpe ratio?

26
 D. What would be the best option if the risk free interest rate changes to 10%, but the other
expected returns (and risks) stay equal?
18. Identify the four assumptions of the Capital Asset Pricing Model (CAMP).
19. What is the main determinant of risk premium in the CAMP?
20. Define each element in the function ra=rj+*(Em-rj)
21. Would a risk avoiding investor like to add assets to his portfolio if they have a high ? Explain
your answer.
22. In the Single Index Model, the expected return of an asset is a function of the market index.
What is a market index?
23. The following output displays the expected return on Microsoft stock, based on the market
index S&P500. Is Microsoft Stock very sensitive to market swings? Explain your answer.

24. The following table presents the outcome of the Single Index Model of various Indian
Exchange Traded Funds (ETFs). Which fund is most sensitive to market swings? Which one
least? Which one, do you expect, has the highest expected return? Why?

25. Explain how market efficiency in the financial markets makes sure that the return of an asset
always tends to move back to the equilibrium return of that asset.
26. How do arbitrageurs contribute to equilibrium in the financial market?
27. Use the Discounted Cash Flow model to find out if Habtamu (who currently receives an rj of
3%) should hold the following stock for the period of 2 years:
Pt Expected dividend/ yr Expected Pt+2

27
 A $ 5,000 $200 $5200
B 1 million Birr 13,000 Birr 990,000 Birr
C € 10,000 €150 €9,950
28. A company as real estate assets worth 45 million Birr, stock worth 20 million Birr and a
deposit of 20,000 Birr. The liabilities of the company are a 20 million Birr loan and 30 million
Birr in bonds.
a. What is the net worth of the company?
b. If the company issued 10,000 shares, what is the value of a share according to the cost
approach?
29. Aaron is considering investing money in Bayer AG ADR, which is a large publicly traded
agricultural company: they produce agricultural chemicals (like pesticides and fertilizers) and
genetically modified seeds.
- One share price is currently €16, but this has changed often over the past years. The share
price is expected to increase by 10% annually, but it could be a lot less.
- Dividends are around 2% of the share value.
- The company‘s total assets are 126,778 million € and the company‘s total liabilities are
€93,610 million. Until now, the company issued 3.93 billion shares.
- The agricultural industry is doing well. The S&P GSCI Agriculture market index showed a
one-year return of 43% over the past year. This is fueled by world-wide uncertainties and
high food prices.
Try to use all three methods (DCF method, cost approach and market approach) to value
equity to evaluate if Aaron should buy Bayer AG ADR shares.

30. For the following cases, indicate which method can be used to evaluate the value of the
company‘s equity: DCF, cost approach or market approach. Explain your choice.
a. Tesla is using innovative ways to conquer the electrical vehicle market.
b. Pepsico is an established soft drink company with stable equity value and dividend.
c. Ethiopian Petroleum Enterprise is responsible to import petroleum products
commensurate to the demands of Ethiopia.
d. Hope entertainment brings Ethiopian music content online.

28
 Chapter Two
Interest Rate Determination

2.1. The level of interest rates

Dear students, why we need to study about interest rates? Interest rates are among the most closely
watched variables in the economy. Their movements are reported daily by the news media because
they directly affect our everyday lives and have important consequences for the health of the
economy. They influence personal decisions such as whether to consume or save, whether to buy a
house, and whether to purchase bonds or put funds into a savings account. Interest rates also affect
the economic decisions of businesses and households, such as whether to use their funds to invest
in new equipment for factories or to save rather than spend their money.

Before we can go on with the study of money, banking, and financial markets, we must understand
exactly what the term interest rate means. There are essentially three main types of interest rates:
real interest rates, effective rates and nominal interest rates. In this chapter, we‘ll explore the
distinction between them.

An interest rate is the amount due per period, as a proportion of the amount lent, deposited, or
borrowed. In other words, interest is the cost of borrowing money. Typically expressed as a
percentage, it amounts to a fee or extra charge the borrower pays the lender for the financed sum.
Interest rate is also the percentage of the lender or bank to the borrower for the use of its assets or
money for a specific time period. Also, the rate a bank pays to its depositors for keeping money in
a savings account, recurring deposit, or fixed deposit is also termed as the interest rate.

Nominal interest rate is interest rate that you earn (pay) on a loan; this is the amount you see on a
sign advertising interest rates. Real interest rate is the nominal interest rate adjusted for inflation;
this is the effective interest rate that you earn (pay). A higher real interest rate reduces a borrowing
firm‘s profit and hence its willingness to borrow. An effective interest rate is the real return on a
savings account or any interest-paying investment when the effects of compounding overtime are
considered. It also reflects the real percentage rate owed in interest on a loan, a credit card, or any
other debt. Increasing the number of compounding periods makes the effective annual interest rate
increase as time goes by. The effective annual rate is normally higher than the nominal rate
because the nominal rate quotes a yearly percentage rate regardless of compounding. Why should
investors know the difference between nominal and real interest rates? This is because nominal
interest rates will tell him what is prevailing in the market and how the market is moving whereas,
29
real interest rates will tell him what actual returns he can make from the market to grow his
capital.

Based on effective interest rates above, the interest can be either simple or compounded. Simple
interest is based on the principal amount of a loan or deposit. In contrast, compound interest
(interest on interest) is based on the principal amount and the interest that accumulates on it in
every period.

Generally, simple interest paid or received over a certain period is a fixed percentage of the
principal amount (interest rate) that was borrowed or lent. Compound interest accrues and is
added to the accumulated interest of previous periods, so borrowers must pay interest on interest
as well as the principal. From the investor‘s perspective, compound interest is an interest paid on
earlier-received interest which the investor reinvested. Simple interest is calculated only on the
principal amount of a loan or deposit, so it is easier to determine than compound interest. The
interest payment for a given simple interest rate can be calculated by the following formula:

Total amount to be paid=

We can calculate simple interest as follows: Suppose a student obtains a simple-interest loan to
pay one year of college tuition, which costs Birr 18,000, and the annual interest rate on the loan is
6%. The student repays the loan over three years. The amount of simple interest paid is Birr
3,240 (=Birr 18,000×0.06×3) and the total amount paid is: Birr 21,240 (= Birr 18,000+Birr 3,240).

Example 1: If Sami lends $5000 to his friend for one year and asks an annual interest rate of 20%,
what amount should the friend repay?

Total amount to be paid=

The compound interest amount can be calculated by the following formula:

CI = P (1 + – P = P [(1 + – 1]
Where P = Principal amount; R = Rate of interest; T = Time period in a year and CI = Compound
Interest.
If the interest at the annual rate of R per year is compounded M times a year on a principal P, then
the interest rate per conversion period is:

I= =

30
Now if the interest is compounded for t years, then there will be N =MT conversion periods in T
years. Thus, we have the future value of compound interest given by:
A = P (1 +

Example 2: take a three-year loan of $10,000 at an interest rate of 5% that compounds annually.
What would be the amount of interest? In this case, it would be:
$10,000 [(1 + 0.05)3 – 1] = $10,000 [1.157625 – 1] = $1,576.25
Hence, the future value (A) =$ 10,000 + $1,576.25 = $11,576.25
Example 3: Find the amount of interest on a deposit of Birr 2000 in an account compounded
annually with annual interest rate of 6% for 3 years. In this case we are given P = Birr 2000, R =
0.06, T = 3 years. Thus, future value A is: A = P (1 +
A = 2000(1 + = Birr 2382.032, the amount of interest I = A-P = 2382.032 – 2000 = Birr
382.032.
Example 4: Suppose also that a bank offers to pay a nominal annual interest rate of 6% if the
money stays deposited for 2 years. Assume that a principal P of birr 5000 is deposited. Find the
total amount A after the 2 years term if the interest is compounded:
A. Semi-annually
B. Quarterly
Solutions: A) A = 5000(1 + = 5000(1.03 = 5627.54

B) A = 5000(1 + = 5000(1.015 = 5632.46

2.3. Bond prices and interest rate risk

Before understanding the role of interest rates on bond prices, it is good to understand what a bond
is. Bonds are a form or loans contracted by corporations and governments from financial markets.
Unlike a bank loan which ties the bank to the corporation that contracted it bonds are securities
which mean that they can be bought and sold freely in the financial markets. They are issued in the
primary market, where the issuers sell the bonds to investors, usually through an investment bank.
After issuing, bonds are traded in the secondary market, where investors buy and sell existing
bonds.

Most bonds make regular interest payments (coupons) before the final payment at maturity (the
repayment of the principal). For example, a five-year 4% interest rate coupon bond with a $1000
face value would pay a total of five $40 coupons every year and a final payment of $1000 along

31
with the last coupon. The yield of a bond is the return the bond makes. Annual bond yield is
calculated by the following formula:

When the price of the bond in the secondary market changes, so does the yield. For example,
suppose you buy in the primary market a bond of Y1,000 with 10 years maturity and a 10%
coupon. If you keep the bond, it's simple. The issuer pays you Y100 a year for 10 years, and then
pays you back the Y1,000 on the scheduled date. The yield is therefore 10% (Y100/Y1000). If,
however, you decide to sell it on the market, you won't get Y1,000. Why? Because bond prices in
the secondary market change daily, based on the demand for and the supply of bonds.

If the price of the bond in the market is Y800, it's selling under face value or at a discount. If the
price of the bond in the market is Y1,200, it's selling above face value, or at a premium.
Regardless of the market price of a bond, the coupon remains the same. In our example, the bond
holder continues to receive Y100 a year. What changes is the bond yield. If you sell it for Y800,
the yield will be 12.5% (Y100/Y800) for the person who buys it. If you sell it for Y1,200, the
yield will be 8.33% (Y100/Y1,200) for the person who buys it. See also Table 1 for another
example of a bond.
Table1: Example of what is on a government bond. In this case, the government bond pays an
annual coupon amount of $100 to the bond holder at the date stated on the coupon. Also, it repays
the principal (face value) of $10,000 on 1-1-2019 to whoever is the bondholder at that moment.
The price of this bond is $10,000 when it is issued, and its yield is 10%, but the price of the bond
and the yield may change when the bonds are traded in the secondary market.

Ethiopian government bond of $10,000

Interest rate: 10%

Date issued: 1-1-2013

Maturity date: 1-1-2019

Coupon 1: $100 1-1-2014 Coupon 3: $100 1-1-2016 Coupon 5: $100 1-1-2018

Coupon 2: $100 1-1-2015 Coupon 4: $100 1-1-2017 Coupon 6: $100 1-1-2019

32
What determines the price of a bond on the secondary market?
The bond price in the primary market is the principal (the amount of the loan). However, after
purchasing the bond on the primary market, it can be traded in the secondary market, where the
price is not fixed but depends on demand for this bond and supply of this bond. The price of this
bond depends on contract features, credit risk and interest rate risk. They will be discussed in
this section.

Contract features are the first determinants of the price of a bond. Relevant contract features are:
what is the coupon, what is the maturity and what is the face value (that means: the principal, i.e.
the amount that the holder gets at the maturity date)?

Secondly, credit risk (or default risk) of the bond. The company or government who issued the
bond may not be able to make a coupon or principal payment to its bond holders. The secondary
market translates this risk into the bond prices (remember from chapter 1: market efficiency in the
financial market). Bonds issued by companies that are more likely to default are at a discount
(cheaper, so they give a relatively higher yield, if they pay) than those that are financially
trustworthy (they may become more expensive, leading to a lower but more secured yield). For
example, because of the Ukraine war sanctions, investors don‘t consider it likely that the Russian
government pays coupons and the principal of dollar bonds. Therefore, the price of Russian dollar
bonds decreased in half a month from more than 100 dollar cents ($1) to less than 20 dollar cents
($0.2) per dollar (see Figure 1).

Figure 8: Price of dollar bonds issued by the Russian government

The third and most important determinant of the price of bonds is the interest rate in the financial
market. This interest rate risk is the possibility that a change in overall interest rates will reduce
the value of a bond. As interest rates rise, it is more attractive to get a higher interest rate
33
elsewhere, so investors will supply bonds, and investors are demanding less bonds, which make
bond prices fall. This means that the market price of existing bonds drops to offset the more
attractive rates of newly issued bonds and alternative debt assets.

On the other hand, if interest rates decrease, bonds (with fixed coupon rates) are attractive, so
supply of bonds will decrease and the demand for bonds will increase. The relation between bond
prices and interest rates in the financial market is displayed in Figure 2.

Figure 9: When interest rates rise, bond prices fall. Conversely, when interest rates fall, bond
prices rise. This is because when interest rates rise, investors can get a better rate of return
elsewhere.

2.3 The structure of interest rates

The term structure of interest rates describes the annualized rate or yield offered by fixed-
income securities across various maturities, all measured at one point in time. Bonds with identical
yield, face value, coupons and credit risk may
have different interest rates because their times
remaining to maturity are different. When these
yields are plotted against time to maturity, from
short term to long term, the resulting figure is
called a yield curve.

The yield curve can have three patterns (see

Figure 3): Figure 10: Three types of yield
curves
- A flat yield curve indicates that short-term interest rates are currently equal to long-term
interest rates. This is usually when the market is uncertain about which way the economy will
go; when investors are not sure whether interest rates will move up or go down, the yields for
bonds with different terms tend to converge. Also, a flat curve indicates slowdown of

34
 economy. This usually happens when central banks try to contain inflation by increasing
interest rates, thus increasing short term yields.
- An upward sloping yield curve is considered normal because, investors expect higher yields
for fixed income instruments with long-term maturities that occur farther into the future. In
other words, the market expects long-term fixed income securities to offer higher yields than
short-term fixed income securities. This is a normal expectation of the market because short-
term instruments generally hold less risk than long-term instruments; the farther into the future
the bond‘s maturity, the more time and, therefore, uncertainty the bondholder faces before
being paid back the principal.
- A downward sloping, or inverted, yield curve is very rare. Such a yield curve indicates that
the market believes interest rates will soon go down. Though short term yields are greater, few
investors may still seek long term bonds as they expect a further economic slowdown where
interest rates will further decline resulting in
still lower yields.

An example of an upward sloping yield curve is

given in Figure 4 which shows South Africa‘s
yield curve. The yield on a bond with 12Y (=12
years) residual maturity is about 10%, in
contrary to the yield on a bond with only 2Y (=2
years) residual maturity, which is only 5.5%. The investors expect a higher interest rate in the
future and/or they want to get extra risk premium because they are uncertain about the interest rate
in the future.

Self-Test Exercise

1. Determine which of the following scenarios is true:

35
 (1) Historically in the U.S. interest rates on three-month Treasury bills on average are higher
than interest rates on Treasury bonds.
(2) Historically in the U.S. interest rates on Treasury bonds on average are lower than interest
rates on corporate Baa bonds.
(a) (1) is true, (2) is false.
(b) Both are true.
(c) (1) is false, (2) is true.
(d) Both are false.
2. Which of the following are true concerning the distinction between interest rates and return?
(a) The return can be expressed as the sum of the current yield and the rate of capital gains.
(b) The rate of return on a bond will not necessarily equal the interest rate on that bond.
(c) The rate of return will be greater than the interest rate when the price of the bond rises
between time t and time t+1.
(d) All of the above are true. (e) Only (a) and (b) of the above are true.
3. Determine whether the below statements are true or false. I. Bond prices are positively
related to interest rates. II. The greater a bond‘s duration, the greater its interest-rate risk.
(a) Both are true. (c) I is false, II true.
(b) I is true, II false. (d) Both are false.
4. If you expect the inflation rate to be 4 percent over the next year and a one-year bond has a
yield to maturity of 4 percent, then the real interest rate on this bond is
(a) -2 percent. (b) -1 percent. (c) -12 percent.
(d) 2 percent. (e) none of the above.
5. A bond investor faces reinvestment risk if his or her holding period is
(a) shorter than the maturity of the bond.
(b) identical to the maturity of the bond.
(c) longer than the maturity of the bond.
(d) none of the above.
6. When people expect interest rates to fall in the future, the −−−−−−− curve for bonds shifts to
the −−−−−−−.
(a) demand; right (c) supply; right
(b) supply; left (d) demand; left
7. Decreases in the expected rate of inflation will −−−−−−− the expected return on bonds
relative to that on −−−−−−− assets.

36
 (a) Reduce; financial (c) Raise; financial
(b) Reduce; real (d) Raise; real
8. The price paid for the rental of borrowed funds (usually expressed as a percentage of the
rental of $100 per year) is commonly referred to as the
(a) Inflation rate. (c) Interest rate.
(b) Exchange rate. (d) Aggregate price level
9. What determines the price of a bond on the 2ndary market? Discuss them briefly.
10. List and briefly explain the patterns of yield curve.
11. Suppose that Awash Bank offers to pay a nominal interest rate of 6% on money left on
deposit for 4 years. Assume that the principal Birr 2500 is deposited. Find the final amount
after 4 years term if the interest is compounded:
A. Quarterly
B. Weekly
C. Daily

Chapter 3

37
 Financial Institutions: Deposit Type, Contractual, and Other Financial Institutions

Introduction

The financial market is composed of a number of financial institutions that perform a variety of
functions. In most contexts, financial institutions can be considered synonymous with financial
intermediaries in the financial markets. In a nutshell, financial intermediaries are the financial
institutions that pool resources and channel funds from savers/lenders to spenders/borrowers.
Smooth functioning of these institutions is very important for:

 an efficient financial market, which stimulates economic activity (ch 1)

 proper functioning of monetary policy, which aims to stabilize the price level.
 proper functioning of fiscal policy, because in case of a budget deficit, financing is
obtained through financial institutions. On the other hand, in cases of a budget surplus, the
government may deposit in a financial institution.

Due to their crucial importance, almost all financial intermediaries are regulated—some are
subjected to very tight regulations whereas others operate under less stringent regulations.

Financial Intermediaries/Institution
A large number of financial institutions serve as financial intermediaries. The essential economic
function of the financial markets is to channel surplus funds from individuals who have saved
from their incomes to individuals who want to finance consumption or businesses that need funds
to finance capital investments.
Table 2 provides an overview of Ethiopia‘s financial institutions. As visible there, most assets are
hold by depository institutions/corporations.
From the commercial banks, one (the CBE) is owned by the government, but it competes in the
market of other commercial banks which are owned by shareholders.

38
This chapter will discuss four types of financial institutions: depository institutes, contractual
saving institutes, investment funds and others. As a reference, you may read page 88-92 of
Mishkin (2019).

3.1. Deposit type of institutions

Depository institutions, which are usually just called banks, are categorized as such because their
primary source of funding is the deposits of savers. In most developed countries, their savings
accounts are insured by a governmental organisation. For example, if an American bank is unable
to repay saving deposits, the Federal Deposit Insurance Corporation (FDIC) will repay it for them
up to certain limits.

There are three types of depository institutions: commercial banks, thrifts and credit unions. They
will be discussed in this section.

3.1.1. Commercial banks

The primary business of commercial banks is to serve businesses, although with banking
deregulation they have entered into the consumer business as well. Commercial banks provide the
widest variety of banking services. The commercial bank‘s major activities in Ethiopia are savings
accounts, checking services, consumer loans, commercial and industrial loans, import loans and
credit cards. Furthermore, they provide ATMs which allow us to withdraw money from our
deposit.

The deposit itself is a liability owed by the bank to the depositor. Bank deposits refer to this
liability rather than to the actual funds that have been deposited. When someone opens a bank
account and makes cash deposit, he gives the cash to the bank, so the cash becomes an asset of the
bank. In turn, the account is a liability to the bank.
There are different types of deposit accounts, of which the two most known are the current
account and the savings account.
 Current account/ checking account/ demand deposit
A current account is a basic checking account or a demand deposit. Consumers deposit money and
the deposited money can be withdrawn as the account holder desires on demand. This implies
liquidity for the account holder. These accounts often allow the account holder to withdraw funds
using bank cards. In the case of Ethiopia, the current account holders receive interest on demand
deposits.
39
  Savings accounts
Savings accounts offer account holders more interest on their deposits. However, in some cases,
when the savings are below the agreed threshold, the bank may refuse to pay interest. Although
savings accounts are not linked to paper checks or cards like current accounts, their funds are
relatively easy for account holders to access.
Worldwide more than 65% of people aged 15+ have access to a commercial bank account. Table
A.1.2 reveals that this differs by income level and by region.

40
For the banking section in Ethiopia, specifically, read the article form a 2018 World Bank blog
written by Mengistu Bessir:

The World Bank Group (WBG), with private and public sector partners, set an ambitious target to
achieve Universal Financial Access (UFA) by 2020. The UFA goal envisions that, by 2020, adults globally will
be able to have access to a transaction account or electronic instrument to store money, send and receive
payments. The WBG has committed to enabling one billion people to gain access to a transaction account
through targeted interventions. Ethiopia is one of the 25 priority countries for UFA initiative.
So where does Ethiopia stand in terms of financial inclusion? The Global Findex database tracks how adults
save, borrow, make payments, and manage risk. Here are 10 takeaways for Ethiopia from the newly released
Global Findex.
Double digit growth in account ownership
In 2017, the percentage of adults with an account rose to 35%, up from 22% in 2014. Account usage has
improved as well. Now 26% of adults save at financial institutions (as compared to 14% in 2014) and 11%
borrow from financial institutions (as compared to 7% in 2014).
… but still Ethiopia lags behind other Sub-Saharan African countries
Despite this increase in account ownership, Ethiopia lags behind its neighboring countries. In Kenya, for
example, 82% of adults have an account, while in Rwanda, account ownership stands at 50%. And in the region
overall, 43% of adults have an account.
People rely more on informal institutions for their financial needs
Although 62% of Ethiopians reported saving money in the past year, only 26% saved formally at financial
institutions, while 38% saved with a person outside of a family or at an informal saving club (for example,
Iqub is a rotating saving and credit association where each member agrees to regularly pay a small sum into a
common pool so that each, in rotation, can receive one large sum). During the same period, 41% of Ethiopians
said they borrowed money, but only 11% borrowed from financial institutions. The rest borrowed from family
or friends (31 percent) and 8% borrowed from a saving club (8%).
The gender gap is widening
Women account for a disproportionate share of the unbanked, and the gap is widening. In 2017, the gender gap
jumped to 12% from being virtually insignificant in 2014!
Now, 41% of men have an account, compared to 29% of women, whereas in 2014 account ownership was
essentially even, with 23% of men and 21% of women with an account.
Account ownership among men has nearly doubled in three years, but for women it has increased by only eight
percentage points.
Wealthier adults are twice as likely as poorer ones to have an account
Among adults in the richest 60% of households within Ethiopia, 43% have an account as compared to 22%
account ownership among the poorest 40% of adults.
In general, women, rural, less educated, unemployed, and poorer adults are less likely to own an account.
Key Barriers for financial inclusion
Of the total unbanked surveyed adults, 85% reported insufficient funds as a reason for not opening an account.
This seems to signal a perception among adults that ‗financial services are not meant for the poor.‘ Distance
(cited by 20% adults) and lack of documentation (cited by 11% of adults) were mentioned as the second and
third barriers for financial inclusion. The cost of financial services doesn‘t seem to be much of a barrier, cited
by only 5% of adults without an account. This is not surprising considering that banks and microfinance
institutions (MFIs) provide free of charge basic financial transactions like opening an account, and making
deposits and withdrawals. The minimum balance to open an account is less than a dollar (Birr 25).
Cash is an overwhelmingly dominant payment method
Most people still rely on cash to pay utility bills and receive payments. Almost all (99%) adults pay utility bills
with cash, compared to 12% of people in Kenya and 59% 41 in the region as a whole.
3.1.2 Thrifts (savings and loan associations and savings banks)
Saving and loan associations are similar to a bank, but they are owned and managed by the
clients (the depositors and the borrowers). That means that, if you are member of a saving and
loan association, you co-own the association, but you also save and/or borrow from this same
association. Therefore, depositors and borrowers have voting rights in important decisions.
Worldwide they are known to facilitate mortgage loans (loan to buy a house) and other loans for
expensive household investments (for example, a car).

Saving banks have a core task to collect household savings and to supply them in the financial
market. They are not owned by its members.

Note that in the Ethiopian context, many households do not use officially registered savings- and
loan- institutions, but rather rely on informal financing methods such as equb or idir. These are
informal and bottom-up, which is in many cases a solution to the lack of access to formal thrifts.

3.1.3 Credit unions

Credit unions are non-profit depository institutions that are financial cooperatives owned by
people belonging to a particular group, such as the employees of a particular company, a union, or
a religious group, or who live in a specific area, and they are governed by a board of volunteers.
Because they are non-profits and owned by their customers, they charge lower loan rates and pay
higher interest rates on savings, and they offer a wide variety of financial services for their
owners.

Credit unions can also be used to deposit and to borrow money, so for all practical purposes,
members of a credit union can consider it as a bank. Membership in the credit union is not,
however, as open as commercial banks—one must belong to the particular group to use its
services. According to Addis Fortune, such credit service is provided in Ethiopia by more than
21,000 cooperatives and 131 unions. They have an aggregate capital of over 21 billion Birr and
some five million members. These institutions disbursed over 3.7 billion Birr in loans to under one
million borrowers in 2020.

3.2 Contractual Savings Institutions

Contractual savings institutions are financial intermediaries that acquire funds periodically on a
contractual basis and invest them in such a way that they have financial instruments maturing
when contractual obligations must be met. For depository institutions (see 3.1) it is not exactly

42
clear when clients will deposit and how much they will deposit, but for contractual saving
institutions it is clear when money will be transferred.

Contractual saving institutions are mostly present in developed countries, in the form of (life)
insurance companies, private pension funds, mutual funds and funded social pension insurance
systems. In some countries, such as Switzerland, the Netherlands, and the United Kingdom, the
resources mobilized by life insurance companies and pension funds correspond to well over 100
percent of annual GDP. They have long-term liabilities and stable cash flows and are therefore
ideal providers of term finance, not only to government and industry, but also to municipal
authorities and the housing sector.

Except for Singapore, Malaysia, and a few other countries, most developing countries have small
and insignificant contractual savings industries, because high inflation strongly discourages such
long-term saving schedules. Furthermore, issues like pensions are mostly organised by the
employer (which is often the government). However, there is an insurance sector in most
developing countries. The basic concept of insurance is that one party, the insurer, will guarantee
payment for an uncertain future event. Meanwhile, another party, the insured or the policyholder,
pays a smaller premium to the insurer in exchange for that protection on that uncertain future
occurrence.

Life insurance companies insure people against financial hazards following a death and they also
provide annuities (that is: annual income payments after retirement). They acquire funds from the
premiums that people pay to keep their policies in force and use them mainly to buy corporate
bonds, mortgages and stocks. In Ethiopia, in contrary to most developed countries, only 7.6% of
the insurance premiums written are life insurances.

Fire and Casualty Insurance Companies insure people against loss from theft, fire, and
accidents. They are very much like life insurance companies, receiving funds through premiums
for their policies, but they have a greater possibility of loss of funds if major disasters occur. For
this reason, they use their funds to buy more liquid assets than life insurance companies do. Their
largest holding of assets consists of bonds.

Two types of insurance are mandatory in Ethiopia:

- Motor third-party liability insurance (insures damage to third party health and property caused
by an accident for which driver and/or owner of the car was responsible)

43
- Professional indemnity insurance (a business insurance of compensating clients for loss or
damage resulting from negligent services or advice provided by a business).

3.3. Investment funds/ investment intermediaries

An investment intermediary makes a very large portfolio containing diverse stocks and bonds, in
order to facilitate investments for a whole group of investors. As discussed in chapter 1, the
benefit from investing in a portfolio of diverse assets as a group is that the unsystematic risks are
reduced. Investment funds allow to:
 hire professional investment managers, who may offer better returns and more adequate risk
management;
 benefit from economies of scale, i.e., lower transaction costs;
 increase the asset diversification to reduce unsystematic risk. Remember the portfolio
discussion of chapter 1? Investment funds help investors to optimize the portfolio, so that the
return is acceptable and the risk is relatively low.

With investment funds, individual investors do not make decisions about how a fund's assets
should be invested. They simply choose a fund based on its goals, risk, fees and other factors. A
fund manager oversees the fund and decides which assets it should hold, in what quantities and
when the assets should be bought and sold. An investment fund can be broad-based, such as an
index fund that tracks the S&P 500, or it can be tightly focused, such as an ETF that invests only
in small technology stocks. There are three types of funds: mutual funds, ETF‘s and hedge funds.

Mutual funds: Open-end vs. closed-end

Mutual funds are the traditional form of investment funds. A mutual fund pools the money of
many investors together, and this money is used to buy a large portfolio with many stocks and
bonds. Most investment fund assets belong to open-end mutual funds. These funds consist of
shares which the investor can buy. The open-end fund issues new shares as investors add money to
the pool and retire shares as investors take their money back from the fund. These funds are
typically priced just once at the end of the trading day.

Closed-end funds trade more similarly to stocks than open-end funds. Closed-end funds are
managed investment funds that issue a fixed number of shares, and trade on an exchange. While a
net asset value (NAV) for the fund is calculated, the fund trades based on investor supply and
demand. Therefore, a closed-end fund may trade at a premium or a discount to its NAV.

44
ETFs
Exchange-traded funds (ETFs) emerged as an alternative to mutual funds for traders who wanted
more flexibility with their investment funds. Similar to closed-end funds, ETFs trade on
exchanges, and are priced and available for trading throughout the business day. Many mutual
funds, such as the Vanguard 500 Index Fund, have ETF equivalents. The Vanguard S&P 500 ETF
is essentially the same fund, but came to be bought and sold during the whole day, instead of only
at the end of the day. Compared to mutual funds, ETFs are more flexible (they can be bought and
sold at any moment) and have slightly lower managing costs.

Hedge Funds
A hedge fund is an investment type which is only available to accredited very rich investors that
want to invest in the longer run. Hedge funds are private and not publicly traded. Typically, hedge
funds are known for taking higher risk positions with the goal of higher returns for the investor.
As such, they do not only include bonds and stock, but they also include derivatives like options
and alternative assets. Overall, hedge funds are usually managed much more aggressively (that
means: more risk but also more returns) than mutual funds and ETF‘s.
Table 3: summarizes the investment fund characteristics.
Mutual fund ETF‘s Hedge funds
How often is trading Once a day Always Not flexible
possible?
For what types of Medium to very rich For anyone Very rich only
investors
Private/publicly Publicly Publicly Private
traded
Managing costs Medium Low High (commonly at
(reward for the fund least 20% of the profit)
manager)
Risks Low Low High
Expected return Low Low High
Types of assets Stock & bonds Stock & bonds Stock, bonds,
derivatives, currencies,
commodities.

45
3.4. Other types of financial institutions
Most financial institutions have been discussed in this chapter, but a particular one, Capital Goods
Finance Companies (CGFCs), has not yet been discussed. CGFCs provide capital to purchase
capital goods. Capital goods are durable goods (ones that do not quickly wear out) that are used
for the production of more capital goods as well as consumer goods. According to Capital Goods
Leasing Business (Amendment) Proclamation No. 807/2013 Art. 2(3), a Capital Good is defined
as any equipment or machine that may be used to produce products or to provide services and
includes accessories.

CGFCs are established with the aim of providing financial services through finance lease and/or
hire purchase that is equated with bank loans where physical assets in the form of machinery,
equipment are disbursed in return for periodic rental payments to the lender. Lease financing
enables manufactures and other producers to use equipment and machineries without having to
pay the full costs of the investment goods upfront. A lease is a contractual arrangement under
which the owner of an asset agrees to allow the use of his asset by another partly in consideration
of periodic payments for a specific period. In lease financing, the owner of an asset gives another
person the right to use that asset against periodical payments. The owner of the asset is known as
lessor and the user is called lessee.

In the case of Ethiopia, a CGFC is a company that is licensed by the National Bank of Ethiopia to
undertake Capital Goods Finance Business. UP to August 9, 2019, six companies have been
granted Capital Goods Finance Business License to operate in different regions of the country.
Namely:
1) Waliya capital goods finance company – Amhara region;
2) Oromia capital goods finance company – Oromiya region;
3) Debub capital goods finance company – SNNPRS;
4) Addis capital goods finance company – Addis Ababa City Administration;
5) Kaza capital goods finance business company – Tigray region; and
6) Ethio Lease Ethiopian capital goods finance company – Addis Ababa

Basically, CGFCs are established with the aim of providing financial service to individuals and/or
enterprises that have the desire, knowledge and profession to participate in various investment
activities but could not act due to a lack of capital. It is intended to create and enable an
environment for the establishment of alternative sources of financing. In this regard, the SMEs
46
will be the primary beneficiaries of these companies because they lack collateral to access loan
from classical banks.

The role of CGFCs in the economy of a given country basically emanates from its contribution
towards provision of finance service of SMEs Sector. SMEs are considered as a springboard for
economic development of developing countries like Ethiopia. The Growth and Transformation
Plan (GTP) also considered this sector as a potential resource to boost employment, increase
production of import substitute in goods, and accelerate a transition from agricultural led to
industrial led economy. However, this sector was challenged to bring about expected
transformation due to a critical lack of capital for owning manufacturing machineries that help in
increasing the quality and quantity of their products. Hence, CGFCs bridge this gap and provides
opportunity for SMEs sector to get service without the requirement of pledge to any collateral.

For instance, Ethio Lease represents an amazing opportunity: tens of millions of dollars of
American capital; the latest in manufacturing, agriculture, and construction equipment technology;
and a sustainable financial model that unleashes the potential of Ethiopian businesses without
adding to Ethiopia‘s debt burden. This is a prime example of how the United States invests in
Ethiopia.

The equipment Ethio Lease is bringing into Ethiopia will help ensure that farms are ploughed
faster and better to boost agricultural output; that manufacturing facilities operate more efficiently
while targeting their resources to maximize growth; and that buildings are constructed more
quickly, durably, and cost-effectively throughout Ethiopia. Ethio Lease will have the capacity to
lease equipment across the full spectrum of Ethiopia‘s economy, from the largest corporations to
the smallest start-ups and landholdings. It will offer a truly democratic opportunity for everyone to
access the latest equipment and technology at affordable rental rates.

Self-Test Exercise

1. Explain how Capital Good Financial Companies and Lease Companies are contributing to
Ethiopia‘s economic development. In the explanation, include their main financing activities.
2. Why are financial institutions important?
3. What is the relationship between financial institutions and financial markets?
4. What kinds of institutions take part in the financial markets?
5. Why are financial markets and institutions important to our daily lives?

47
6. Why do we need to study financial markets and institutions in relation to monetary policy of
the government?
7. List and explain financial instruments within financial system.
8. What are the roles of the financial institutions, financial instruments and financial market with
in financial system?
9. Why are financial markets important?

48
 Chapter 4
Financial Markets: Money Markets & Capital Markets

4.1 Money Markets vs. Capital Markets

On the basis of the maturity of the securities traded in each market, financial market is divided as
money and capital markets. The money market is a financial market in which only short-term debt
instruments (generally those with original maturity terms of less than one year) are traded; the
capital market is the market in which longer-term debt instruments (generally those with original
maturity terms of one year or greater) and equity instruments are traded. Money market securities
are usually more widely traded than longer-term securities and so tend to be more liquid. In
addition, short-term securities have smaller fluctuations in prices than long-term securities,
making them safer investments. As a result, corporations and banks actively use the money market
to earn interest on surplus funds that they expect to have only temporarily. Capital market
securities, such as stocks and long-term bonds, are often held by financial intermediaries such as
insurance companies and pension funds, which have little uncertainty about the amount of funds
they will have available in the future. Due to higher liquidity and lower maturity duration in
money markets, instruments in money markets are a lower risk, whereas capital markets are
comparatively high risk.

Money market instruments are the debt instruments with maturities of greater than one year. These
are bank accounts, treasury bills, term certificates of deposit (large denominations), money market
mutual funds, commercial paper, interbank loans (loans between banks) and securities lending and
repurchase agreements. On the other hand, capital market instruments are debt and equity
instruments with maturities of greater than one year. These are stock or shares and bonds, such as
corporate stocks, residential mortgages, corporate bonds, government securities, bank commercial
loans, consumer loans, commercial and farm mortgages. Investment objective of the money
market is to maintain wealth among investors; however investment of capital market is to generate
wealth among its investors.

Though both markets are different in many perspectives, they do have some similarities. Indeed,
both are important components of international finance market. Both markets permit investors to
purchase debt securities. Businesses and governments depend on both the markets for raising
money for operations.

49
4.2 Bond markets
The bond market—often called the debt market, fixed-income market, or credit market—is the
collective name given to all trades and issues of debt securities. Governments typically issue
bonds in order to raise capital to pay down debts or fund infrastructural improvements. Publicly
traded companies issue bonds when they need to finance business expansion projects or maintain
on-going operations. The bond market broadly describes a marketplace where investors buy debt
securities that are brought to the market by either governmental entities or corporations.

National governments generally use the proceeds from bonds to finance infrastructural
improvements and pay down debts. Companies issue bonds to raise the capital needed to maintain
operations, grow their product lines, or open new locations. Bonds are either issued on the primary
market, which rolls out new debt, or on the secondary market, in which investors may purchase
existing debt via brokers or other third parties. Bonds tend to be less volatile and more
conservative than stock investments, but also have lower expected returns.

Types of Bond Markets

The general bond market can be segmented into the following bond classifications, each with its
own set of attributes.

Corporate Bonds
Companies issue corporate bonds to raise money for a sundry of reasons, such as financing current
operations, expanding product lines, or opening up new manufacturing facilities. Corporate bonds
usually describe longer-term debt instruments that provide a maturity of at least one year.

Corporate bonds are typically classified as investment-grade or else high-yield (or "junk"). This
categorization is based on the credit rating assigned to the bond and its issuer. An investment-
grade is a rating that signifies a high-quality bond that presents a relatively low risk of default.
Bond-rating firms like Standard & Poor‘s and Moody's use different designations, consisting of
the upper- and lower-case letters "A" and "B," to identify a bond's credit quality rating.

Junk bonds are bonds that carry a higher risk of default than most bonds issued by corporations
and governments. A bond is a debt or promise to pay investors interest payments along with the
return of invested principal in exchange for buying the bond. Junk bonds represent bonds issued
by companies that are financially struggling and have a high risk of defaulting or not paying their
interest payments or repaying the principal to investors. Junk bonds are also called high-yield
bonds since the higher yield is needed to help offset any risk of default.
50
Government Bonds
National-issued government bonds (or sovereign bonds) entice buyers by paying out the face value
listed on the bond certificate, on the agreed maturity date, while also issuing periodic interest
payments along the way. This characteristic makes government bonds attractive to conservative
investors. Because sovereign debt is backed by a government that can tax its citizens or print
money to cover the payments, these are considered the least risky type of bonds, in general.

In the U.S., government bonds are known as Treasuries, and are by far the most active and liquid
bond market today. A Treasury Bill (T-Bill) is a short-term U.S. government debt obligation
backed by the Treasury Department with a maturity of one year or less. A Treasury note (T-note)
is a marketable U.S. government debt security with a fixed interest rate and a maturity between
one and 10 years. Treasury bonds (T-bonds) are government debt securities issued by the U.S.
Federal government that have maturities greater than 20 years.

Municipal Bonds
Municipal bonds—commonly abbreviated as "muni" bonds—are locally issued by states, cities,
special-purpose districts, public utility districts, school districts, publicly-owned airports and
seaports, and other government-owned entities who seek to raise cash to fund various projects.
Municipal bonds are commonly tax-free at the federal level and can also be tax-exempt at state or
local tax levels too, making them attractive to qualified tax-conscious investors.

Munis come in two main types. A general obligation bond (GO) is issued by governmental entities
and not backed by revenue from a specific project, such as a toll road. Some GO bonds are backed
by dedicated property taxes; others are payable from general funds. A revenue bond instead
secures principal and interest payments through the issuer or sales, fuel, hotel occupancy, or other
taxes. When a municipality is a conduit issuer of bonds, a third party covers interest and principal
payments.

Mortgage-Backed Bonds (MBS)

MBS issues, which consist of pooled mortgages on real estate properties, are locked in by the
pledge of particular collateralized assets. The investor who buys a mortgage-backed security is
essentially lending money to homebuyers through their lenders. These typically pay monthly,
quarterly, or semi-annual interest.

51
The MBS is a type of asset-backed security (ABS). As became glaringly obvious in the subprime
mortgage meltdown of 2007-2008, a mortgage-backed security is only as sound as the mortgages
that back it up.

Emerging Market Bonds

These are bonds issued by governments and companies located in emerging market economies,
these bonds provide much greater growth opportunities, but also greater risk, than domestic or
developed bond markets. Throughout most of the 20th century, countries with emerging economies
issued bonds only intermittently. In the 1980s, however, then-Treasury Secretary Nicholas Brady
began a program to help global economies restructure their debt via bond issues, mostly
denominated in U.S. dollars. Many countries in Latin America issued these so-called Brady bonds
throughout the next two decades, marking an upswing in the issuance of emerging market debt.
Today, bonds are issued in developing nations and by corporations located in these countries all
over the world, including from Asia, Latin America, Eastern Europe, Africa, and the Middle East.

The risks of investing in emerging market bonds include the standard risks that accompany all
debt issues, such as the variables of the issuer's economic or financial performance and the ability
of the issuer to meet payment obligations. These risks are heightened, however, due to the
potential political and economic volatility of developing nations. Although emerging countries,
overall, have taken great strides in limiting country risks or sovereign risk, it is undeniable that the
chance of socioeconomic instability is more considerable in these nations than in developed
countries, particularly the U.S.

Emerging markets also pose other cross-border risks, including exchange rate fluctuations and
currency devaluations. If a bond is issued in a local currency, the rate of the dollar versus that
currency can positively or negatively affect your yield. When that local currency is strong
compared to the dollar, your returns will be positively impacted, while a weak local currency
adversely affects the exchange rate and negatively impacts the yield.

Bond Indices

Just as the S&P 500 and the Russell indices track equities, big-name bond indices like the
Bloomberg Aggregate Bond Index, the Merrill Lynch Domestic Master, and the Citigroup U.S.
Broad Investment-Grade Bond Index, track and measure corporate bond portfolio performance.
Many bond indices are members of broader indices that measure the performances of global bond
portfolios.
52
The Bloomberg (formerly Lehman Brothers) Government/Corporate Bond Index, also known as
the 'Agg', is an important market-weighted benchmark index. Like other benchmark indexes, it
provides investors with a standard against which they can evaluate the performance of a fund or
security. As the name implies, this index includes both government and corporate bonds. The
index consists of investment-grade corporate debt instruments with issues higher than $100
million and maturities of one year or more. The Index is a total return benchmark index for many
bond funds and ETFs.

4.3 Mortgage market

Mortgages are loans to households or firms to purchase land, housing, or other real structures, in
which the structure or land itself serves as collateral for the loans. Collateral is what the lender
may claim if the borrower fails to meet his/her repayment duties.

For example, suppose Andualem has a 10-year mortgage with an annual interest rate of 15% to
finance his 2 million birr house in Secha he must pay approximately 32,000 birr per month to the
bank. For some reason, Andualem failed to pay this amount in April. Therefore, the bank reminds
him to pay the money. If Andualem is truly unable to repay the loan, the bank will take his house
(collateral) and sell it in the market. This is a security for the bank that, even if Andualem is
unable to repay, their debt asset will not lose value.

Mortgages are provided by financial institutions such as savings and loan associations, mutual
savings banks, commercial banks, microfinance institutes and other financial intermediaries.
However, in recent years a growing amount of the funds for mortgages have been provided by
mortgage-backed securities. These securities are like bonds, but then not issued by a corporation
or a government, but backed by a bundle of individual mortgages. These individual mortgages‘
interest and principal payments are collectively paid to the holders of the security.

For example, suppose that the CBE provided 10,000 mortgages to individuals in 2013. The CBE
decides to put them together in a mortgage fund, which issues 100 mortgage-backed securities.
Lion Insurances has a 20,000,000 birr fund available and wants to invest it in the mortgage
market. Therefore, Lion Insurances buys several of these mortgage-backed securities from the
CBE. In this way, the CBE is responsible for collecting the principal and interest payments of the
10,000 individuals and channels the income to Lion Insurances. If an individual do not meet the
repayment duties, the CBE must claim the house and sell it. However, if the house has low/no
value the return from the mortgage-backed security may be lower, which is a business risk for the
53
mortgage fund holders, which is (together with the other investors) Lion Insurances (not the CBE).
These mortgage-backed securities played an important role in the last large financial crisis
(starting at 2008 G.C).

Securitization (that means: the process of bundling small and otherwise illiquid financial assets
(such as residential mortgages, auto loans, and credit card receivables) into marketable capital
market securities) is an important financial innovation which arose with better availability and
more intensive use of computers in the financial sector. It enables shadow banking. In traditional
banking, one entity engages in the process of asset transformation—that is, it issues liabilities with
one set of desirable characteristics (say, deposits with high liquidity and low risk) to fund the
purchase of assets with a different set of characteristics (say, loans with low liquidity and high
returns).

Securitization, on the other hand, is a process of asset transformation that involves a number of
different financial institutions working together. These institutions comprise the shadow banking
system. In other words, asset transformation accomplished through securitization and the shadow
banking system is not done ―in the same office,‖ as is traditional banking. For example, a
mortgage broker will arrange for a residential mortgage loan to be made by a financial institution
that will then service the loan (that is, collect the interest and principal payments). This servicer
then sells the mortgage to another financial institution, which bundles the mortgage with a large
number of other residential mortgages. The bundler takes the interest and principal payments on
the portfolio of mortgages and ―passes them through‖ (pays them out) to third parties. The bundler
goes to a distributor (typically an investment bank), which designs a security that divides the
portfolio of loans into standardized amounts. The distributor then sells the claims to these interest
and principal payments as securities, mostly to other financial intermediaries that are also part of
the shadow banking system—for example, a money market mutual fund or a pension fund.

Schematically, the securitization process is described by the following sequence:

Loan origination  Servicing  Bundling  Distribution
Because the securitization process involves the origination of loans and then finally the
distribution of securities, securitization is also characterized as an originate-to-distribute business
model. At each step of the securitization process, the loan originator, servicer, bundler, and
distributor earn a fee. Each of these four institutions has specialized in a particular element of the
financial intermediation process. The shadow banking system, which comprises all of the financial

54
institutions involved in the securitization process, can thus be very profitable if transaction costs
and the costs of collecting information are low. Therefore, the use of computers and information
technology was so important for the growth of securitization and the shadow banking system.
Lower costs of acquiring information make it far easier to sell capital market securities, while
lower transaction costs make it cheaper for financial institutions to collect interest and principal
payments on bundled loans and then pay them out to the securities holders.

A particularly important financial innovation as a result of securitization and the shadow banking
system is the subprime mortgage, a new type of residential mortgages offered to higher-risk
borrowers (e.g. borrowers with low incomes, with no wealth or even unemployed borrowers). This
was especially popular in the United States of America. Advances in computer technology and
new statistical techniques, known as data mining, led to enhanced, quantitative evaluation of the
credit risk for residential mortgages. Households for which information is available (e.g.
repayment of the past, employment status, household size, wealth, etc.) can now be assigned a
numerical credit score, that predict how likely the household repays its loan payments. Because it
is easier to assess the risk associated with a pool of subprime mortgages, it is possible to bundle
them into a mortgage backed security, providing a new source of funding for these mortgages. The
result was, around 2000 G.C. an explosion of subprime mortgage lending, which led to a large
global financial crisis in 2007-2009 G.C.

The subprime mortgage lending led to a global financial crisis because of the principal-agent
problem. The principal-agent problem arises if the principal hires an agent to do work for him,
but the agent is not fully acting in the principal‘s interest and rather serves his own interest. For
example: Mesfin (principal) wants to buy a second hand car and asks Hirpa (agent) to search a
good car in the second hand market on Mesfin‘s behalf. As Hirpa is rewarded with a share of the
car price, he will not select the best price/quality car option for Mesfin, but rather choose an
expensive car (so that his reward is higher).

In a same way, in the mortgage market, the mortgage brokers who arrange mortgages for a client
who wants to buy a house did not make a strong effort to evaluate whether this client could pay off
the mortgage, since they planned to quickly sell (distribute) the loans to investors in the form of
mortgage-backed securities. In this example, the mortgage brokers acted as agents for investors
(the principals) but did not have the investors‘ best interests at heart. Once the mortgage broker
earns his or her fee, why should the broker care if the borrower repays the mortgage well? The

55
more mortgages the broker arranges, the more money the broker makes. The principal–agent
problem also created incentives for mortgage brokers to encourage households to take on
mortgages they could not afford or to commit fraud by falsifying information on borrowers‘
mortgage applications in order to qualify them for mortgages. The mortgage brokers were not
strictly regulated by the government, so they gave no information to borrowers that would have
helped them assess whether they could afford the loans. Also, commercial and investment banks,
which were earning large fees, also had weak incentives to make sure that the ultimate holders of
the securities would make profits.

Overall, the financial intermediaries in the securitization process faced little risk and high return
for facilitating more mortgages. Many mortgage takers failed to repay the mortgage, so their
houses (collateral) were taken and sold. As, at that time, many houses were supplied (and few
demanded), the price of a house was often lower than the value of the mortgage, leading to losses
for the ultimate mortgage-backed security holders. The holders were banks, pension funds, and
many other financial intermediaries, which led to huge losses and several bankruptcies.

In Ethiopia, the state-owned Commercial Bank of Ethiopia (CBE) is the sole source of mortgage origination for
the government-backed housing scheme, the Integrated Housing Development Program (IHDP). In 2017 G.C.,
the CBE held 69% of the total mortgage market share by value, approximately 247,000 current mortgages,
compared to the six largest commercial mortgage lenders and microfinance institutions (MFIs)

As part of its efforts to deliver affordable housing, the state has made a significant investment in housing
through the IHDP, estimated at Br 243.8 billion (US$5.6billion) over 15 years. Through the IHDP, and its
linked mortgage facility, Ethiopians who qualify can access a more affordable mortgage facility. The lending
rate is currently 8.3% for mortgage financing available to beneficiaries of the program. Commercial bank rates
can be as high as 17%.

State-originated mortgages are based on four standard housing products: a studio apartment (32m2), and a one,
two, or three-bedroom apartment (51, 75, or 100m2, respectively). Deposit requirements are between 10% and
40% upfront, and loan terms are between 10 and 20 years, with larger units requiring higher deposits. Some
commercial banks provide housing loans. Zemen Bank, for example, requires 20% of the price of the house as
an up-front deposit, with another 20% saved over a six to 12 month period. The loan term is seven years.
Dashen Bank allows for greater loan coverage, up to 90% of the house value, for salaried persons, with a much
longer-term of 20 years. In both these cases, however, the ability to access these loans on these terms is a
challenge for the majority. Only 16% of the population receives a formal salary, and households saving ability is
limited. As a result, only a small number of mortgages, not more than 6000, are held by commercial banks.

There are 41 MFIs with nearly 1800 branches, 4.7 million borrowers, and 16 million accounts as of June 2021.
MFIs hold more than 10 times the value of housing and construction project loans than banks. Loans offered by
MFIs are cheaper with an interest rate of 14.3% a year. Despite this, most households still depend on loans from
friends and family to purchase a house.

Source: https://housingfinanceafrica.org/

56
4.4 Equity market
Common stock is the principal medium through which corporations raise equity capital.
Stockholders (those who hold stock in a corporation) own a part of the corporation equal to the
percentage of outstanding shares they own. This ownership gives them a bundle of rights. The
most important are the right to vote and to be a residual claimant of all funds flowing into the firm
(known as cash flows), meaning that the stockholder receives whatever remains after all other
claims against the firm‘s assets (such as salaries of the workers, rent for the office, debt
repayments to lenders, etc.) have been satisfied. Stockholders may receive dividends from the net
earnings of the corporation. Dividends are payments made periodically, usually every quarter, to
stockholders. The board of directors of the firm sets the level of the dividend, usually based on the
recommendation of management.

In addition, the stockholder has the right to sell the stock. The value of stock is the value in
today‘s currency of all future cash flows (like discussed in the Discounted Cash Flow approach
discussed in chapter 1). The expected future cash flows depend on rational expectations, which is
the optimal forecasts (the best guess of the future) using all available information. Information
may be related to annual reports published by the companies, the share price developments of the
past, the industry performance of the company‘s industry, macro-economic figures of the
country/region in which the company operates, etc.

Recap efficient market hypothesis

Remember the efficient market hypothesis from chapter 1? It states that, in an efficient market, the
rate of return of stocks always tends to go to the equilibrium, through the formula .

Traders (arbitrageurs) are exploring the stock markets each day to identify unexploited profit
opportunities. If a stock with an equilibrium rate of return ( of 14% is expected to give a rate of
return ( of 20% (e.g. because of higher than expected profit figures), the demand for the stock
will increase, which increases the secondary market price (Pt), leading to a reduction in from
20% back to 14%. Oppositely, if the expected return is only 2% (e.g. because the news announced
that an armed conflict destroyed a part of the company‘s assets), the demand of the stock will
decrease, leading to a lower Pt, resulting in an increase in the rate of return back to 14%.

Based on the description thus far you may think: how can I get rich (or at least not poor) by
investing in the stock market? Suppose you have just read in the newspaper that experts expect a
boom in coffee stocks (companies producing & processing coffee) because there is a worldwide
57
coffee shortage. Should you proceed to withdraw all of your savings from the bank and invest
them in coffee stocks? The efficient market hypothesis tells us that when purchasing a financial
asset, we cannot expect to earn an abnormally high return, or a return greater than the equilibrium
return. Information in newspapers and in the published reports of investment advisers is readily
available to many market participants and is already reflected in market prices. So, acting on this
information will not yield abnormally high returns, on average. The empirical evidence confirms
that recommendations from investment advisers cannot help us outperform the general market,
because everyone is informed.

On the contrary, if someone shares new information which gives you an edge on the rest of the
market, you may be able to get additional profit. For example, if you heard informally that the
Ethiopian government considers ordering a 10b birr road construction projects from China
Communications Construction Company (CCCC), you may earn extra profit if you quickly buy
shares of CCCC, assuming that the large road construction project will generate good profit for
CCCC in the near future. If other market participants have gotten this information before you, you
should not invest extra, because as soon as the information is commonly known amongst traders,
this good news is already reflected in the higher share price of CCCC, so the unexploited profit
opportunity it creates was already eliminated.

If the world is hit by a systematic shock/crisis, this information is considered as something which
will reduce the rate of return of all stocks. COVID-19 was such a shock, which immediately
affected the stock market (see Figure 1 and remember that Shanghai, Dow Jones etc. are market
indices, that represent a large bundle of influential stocks). After the drop in stock value, market
slowly recovered (see Figure 2).

Figure 11: Stock market crash after Covid-19 hit the world. Figure 12: Stock market recovery after
Covid-19 crash
58
Some stock market crashes (quick reductions in value of all stocks) are the results of stock
market bubbles. They are caused by two mechanisms:
 Over-optimistic and enthusiastic investors (irrational exuberance)
 Low interest rates drive investors away from bonds and saving deposits (too much cheap
credit is available)

In the case of such a stock market bubble, the demand for stock is so high that the price far
exceeds the fundamental value of the share (that is, their values based on realistic expectations of
the share‘s future income streams). When stock prices go up, investors attribute their profits to
their intelligence and continue investing more, also promoting it to their friends. This word-of-
mouth enthusiasm and glowing media reports then can produce an environment in which even
more investors think stock prices will rise in the future. The result is a positive feedback loop in
which prices continue to rise, producing a speculative bubble, which finally crashes when prices
get too far out of line with fundamentals. This usually results in a worldwide economic recession.

An example of a bubble caused by irrational exuberance is the dotcom bubble. The dotcom bubble
was an asset valuation bubble that occurred in the 90s. Many investors believed that internet-based
businesses that were just developing at that time had big profit potential. The bubble burst in early
2000 after investors realized many of these internet companies had business models that weren't
viable. The bubble is visible in Figure 3.

Figure 13: Dotcom bubble

4.5 Derivative markets

When, in 1975, the financial market was more and more relying on information technology,
derivative contracts were introduced. Financial derivatives are used for several purposes including
risk management, hedging, and speculation. Risk management and hedging is usually done by

59
organizations/investors that are risk averse. Speculation is done by traders who are willing to take
additional risk to gain a high return. These contracts were already introduced in chapter 1, and this
section provides depth by describing some types of derivative contracts.

Financial derivatives enable parties to trade specific financial risks (such as interest rate risk,
currency, equity and commodity price risk, and credit risk, etc.) to other entities who are more
willing, or better suited, to take or manage these risks—typically, but not always, without trading
in a primary asset or commodity. Financial derivatives contracts are usually settled by net
payments of cash on the maturity date, or before that on a public exchange. Settlement is in cash
(not in the item of the underlying value) because it is common to trade in derivatives without
owning the underlying item or without the wish to actually buy the underlying item. However,
some financial derivative contracts, particularly foreign currency derivatives, it is mandatory to
settle in the underlying item.

Derivatives can be grouped in two groups: those exchange traded (publicly) are those traded over-
the-counter (OTC, which means not publicly). As you can see in Figure 4 both the exchange
traded derivatives and OTC traded derivative market is huge with trillions of US dollars in daily
average turnover.

Figure 14: OTC and exchange traded derivatives

1. Exchange traded derivatives

Publicly traded derivatives are traded in an exchange just like the stock market, the bond market,
the commodity market and the currency market. The market consists of many demanders and
suppliers that, together, set the equilibrium price for a given item (commodity/currency/stock) and
a given quantity of that item.

60
Futures are a type of derivative contract agreement to buy or sell a specific item
(asset/commodity/share) at a set future date for a set price. For example, consider ICE‘s coffee
future with maturity date July 22 (Figure 5). The contract prices physical delivery of exchange-
grade green beans, from one of 20 countries of origin in a licensed warehouse to one of several
ports in the U. S. and Europe. The contract size is 37,500 pounds. The y-axis displays the price in
US$ cents per pound (0.45 kilo) of coffee. That means that the equilibrium futures price (those
that demanders and suppliers agree on) is around 2.25$ per pound of coffee on April 27 (the latest
day in this graph).

There are two positions that a company/individual can take in this contract:
1. Long position: pays a reward if the actual price of coffee is >$2.25 per pound on July 22, but
results in a loss if the actual price of coffee is <$2.25 per pound on July 22. This position is
taken by:
- Companies that want to buy coffee in July ‘22
- Speculators who expect the price of coffee to be more than 2,25$ per pound in July ‘22
2. Short position: pays a reward if the actual price of coffee is <$2.25 per pound on July 22,
but results in a loss if the actual price of coffee is >$2.25 per pound on July 22. This
position is taken by:
- Companies that want to sell coffee in July ‘22
- Speculators who expect the price of coffee to be less than 2,25$ per pound in July ‘22

Figure 15: Coffee Future pricing

For example, consider Dagmawit, who has a large coffee farm and will have the green bean
harvest of 37,500 ready by July 22. She is afraid that the coffee price will be low on July 22.
Therefore, she takes a short position in one Coffee derivative contract of ICE. In this way she is
100% sure that she will get $2.25 per pound of coffee.

61
Heruy, who has no coffee farm and no wish to buy/sell coffee in the future, believes that the
current coffee prices are too high (market bubble), and he expects the prices to be a lot lower in
July 22. Therefore, he takes a short position in a Coffee derivative contract of ICE. If he is right,
he can sell this short position shortly before the maturity date and make a profit. If he is wrong, he
will make a loss because he must pay money to settle his short position.

Abdul, who has no coffee farm and no wish to purchase coffee, has some information weather
forecasts based on which he believes that coffee will be very scarce and expensive in the future.
Therefore, he takes a long position in an ICE coffee derivative contract. If he is right, he can sell
the long position just before the maturity date for a higher amount and make profit. If he is wrong
he has to pay money to settle his long position.

Anika has a coffee bar franchise in Germany and needs 37,500 pounds of coffee by July 22. She is
afraid that the price may increase and therefore she takes a long position in the ICE coffee
derivative contract. In this way she is sure that she pays only $2.25 per pound of coffee. This
example discusses a coffee future, but the underlying item of a futures contract may be other types
of commodities, precious metals, the interest rate, foreign exchange, stock prices, bond prices, etc.

Options
There are two types of options. A call option gives the holder the right to buy the underlying asset
by a certain date for a certain price. A put option gives the holder the right to sell the underlying
asset by a certain date for a certain price. The price in the contract is known as the exercise price
or strike price; the date in the contract is known as the expiration date or maturity. The option
gives the holder the right to do something, but it is not mandatory for him to exercise this right.
This is the difference between options and future contracts, where the holder is obligated to buy or
sell the underlying asset.

For example: suppose Habtamu‘s company needs 1000 barrels of crude oil in December 2022.
Therefore, he fears a high oil price, so he takes a long position in a future contract. This is cheap
(only transaction costs), but if the oil price is low in the future, Habtamu must pay the person who
took the short position. Instead, Habtamu can decide to buy a crude oil call option of the CME
group, which gives him the right to buy oil in December 2022 at a fixed strike price. Therefore, he
checks an exchange and finds the following deals:
Table2:Source:https://www.cmegroup.com/markets/energy/crude-oil/light
sweetcrude.quotes.options.html

62
 July 2022 December 2022 June 2023
Strike price Put call put call put call
98.00 6.20 8.88 11.28 13.88 12.43 15.54
98.50 6.45 8.63 11.54 13.64 12.64 15.27
99.00 6.70 8.38 11.81 13.41 12.87 15.00
99.50 6.76 8.14 12.07 13.18 13.09 14.73

If Habtamu decides to buy a call option with a strike price of 98.50$ per barrel and a maturity date
in December 2022, he has to pay 1000*$13.64=$13,640. If the price of crude oil does not rise
above $98.50 by December 22, 2022, the option is not exercised and Habtamu loses $13,640. But
if the crude oil price indeed increases above $98.50 per barrel Habtamu will exercise the option
and buy oil for $98.50 per barrel.

Consider these two scenarios:

1. The crude oil price is in Dec ‘22 $100 per barrel. In this case, Habtamu exercises the option.
The total cost for getting 1000 barrels of oil is $98.50*1000+$13,640=$112,140
2. The crude oil price is in Dec ‘22 $98 per barrel. In this case, Habtamu does not exercise the
option. The total cost for getting 1000 barrels of oil is $98*1000+$13.640=$111,640
Note that, no matter the market price in Dec ‘22, the maximum payment that Habtamu will make
for the oil is $112,140.

2. Over-the-counter derivatives (OTC derivatives)

The above described derivatives (futures and options) are publicly traded in exchange markets.
Their prices vary during the day and are transparently communicated to anyone who has interest to
know them. Speculators are active in exploring unexploited profit opportunities and other
organizations (like governments and companies) are active in using them to hedge risks.
However, many derivatives are traded Over The Counter (OTC) instead of publicly. Traditionally,
participants in the OTC derivatives markets have contacted each other directly by phone and
email, or have found counterparties for their trades using an interdealer broker. Banks often act as
market makers for the more commonly traded instruments. This means that they are always
prepared to quote a bid price (at which they are prepared to take one side of a derivatives
transaction) and an offer price (at which they are prepared to take the other side). Two common
OTC derivatives are forward contracts and swaps.

63
Forward contracts
A relatively simple derivative is a forward contract. It is an agreement to buy or sell an asset at a
certain future time for a certain price. It is like a futures contract, but then tailor made to the two
parties involved. One of the parties to a forward contract 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.

Forward contracts are very popular to hedge currency risks. Suppose, for example, that
Meskerem agreed to sell 10,000 traditional woven fabrics to Japan for a price of 1 million
Japanese Yen in December 2022, Meskerem experiences exchange rate risk. Currently, the
exchange rate is 1 Yen = 0.4 Birr, but this may reduce in the future, which will reduce
Meskerem‘s Birr revenue from the traditional woven fabrics. Therefore, Meskerem can already
sell the 1 million Yen in the forward market. If she offers one Yen in December ‘22, she is able to
get 0.411 Birr for it in the forward contract. Therefore, she agrees with another party to give the 1
million Yen in Dec ‘22 and to get in return 0.411*1 million=411,000 Birr in return in Dec ‗22.
Spot and forward quotes for JPY/ETB exchange rate, April
28, 2022
bid offer
Spot 0.401 0.402
July ‗22 0.403 0.405
December ‗22 0.410 0.411

After signing the contract, time will tell if it was a wise decision of Meskerem to participate in the
contract. Consider the following two scenarios:
1. The exchange rate JPY/ETB increases (JPY appreciates) and is 0.5 in December ‗22. This
means that Meskerem gets only 0.411 Birr per Yen, whereas she could have gotten 0.5 Birr per
Yen in the market. She loses from the forward contract.

64
2. The exchange rate JPY/ETB decreases (JPY depreciates) and is 0.35 in December ‘22. This
means that Meskerem gets 0.411 Birr per Yen, instead of the low market price of only 0.35
Birr per Yen. She gains from the forward contract.

Swaps
A swap is an over-the-counter agreement between two companies to exchange cash flows in the
future. The agreement defines the dates when the cash flows are to be paid and the way in which
they are to be calculated. Usually the calculation of the cash flows involves the future value of an
interest rate, an exchange rate, or other market variable. A forward contract can be viewed as a
simple example of a swap. Suppose it is March 1, 2016, and a company enters into a forward
contract to buy 100 ounces of gold for $1,500 per ounce in 1 year. The company can sell the gold
in 1 year as soon as it is received. The forward contract is therefore equivalent to a swap where the
company agrees that it will pay $150,000 and receive 100S on March 1, 2017, where S is the
market price of 1 ounce of gold on that date. However, whereas a forward contract is equivalent to
the exchange of cash flows on just one future date, swaps typically lead to cash flow exchanges on
several future dates.

A very popular swap is the interest rate swap, which is based on the LIBOR. In an interest rate
swap, one company agrees to pay to another company cash flow equal to interest at a
predetermined fixed rate on a principal for a predetermined number of years. In return, it receives
interest at a floating rate on the same principal for the same period of time from the other
company. The floating rate in most interest rate swap agreements is the London Interbank Offered

Rate (LIBOR). Figure 6 displays how the LIBOR developed over the past 6 years.

Figure 16: LIBOR over the past 6 years

65
For example, suppose that Arba Minch University (AMU) borrowed 100 million Birr for a
construction project, with a 3 year maturity and the interest rate of LIBOR+8%. If the LIBOR is
low (e.g. like in Feb 2021), this is a good rate, but with the current increasing LIBOR AMU fears
the interest rate risk. Ethio-telecom, on the other hand, also borrowed 100 million birr, to improve
the 4-G network, and Ethio-telecom pays a fixed interest rate of 10%. Ethio-telecom believes that
the LIBOR will decrease soon, and prefers a (most likely) lower interest rate for the coming three
years. Therefore, AMU and Ethio-telecom initiate a 3-year swap on May 5, 2022. AMU agrees to
pay Ethio-telecom an interest rate of 10% per annum on a principal of B100 million, and in return
Ethio-telecom agrees to pay AMU LIBOR+8% on the same principal. AMU is the fixed-rate
payer; Ethio-telecom is the floating rate payer. We assume the agreement specifies that payments
are to be exchanged every 6 months and that the 10% interest rate is quoted with semi-annual
compounding. In this way, both AMU and Ethio-telecom gain.

Self-Test-Exercise
1. How has the modern mortgage market changed over recent years?
2. Explain the features of mortgage loans that are designed to reduce the livelihood of default.
3. What is the purpose of the modern mortgage market?
4. How does an amortizing mortgage loan differ from a balloon mortgage loan?
5. Evaluate the advantages and disadvantages, from both the lender‘s and the borrower‘s
perspective, of fixed-rate and adjustable-rate mortgages.
6. Why has the on-line lending market developed in recent years and what are the advantages
and disadvantages of this development?
7. What are mortgage-backed securities, why were they developed, what types of mortgage-
backed securities are there, and how do they work?
8. How do corporate stocks differ from bonds?
9. How do common stocks differ from preferred stock?
10. How do over-the-counter markets differ from organized exchanges?
11. What is the role of specialists on a stock exchange?
12. What are the advantages and disadvantages of Electronic Communications Networks
(ECNs) for trading stocks?
13. What is the role of the required return on equity investments in stock valuation models?
14. What are the objectives of the Securities and Exchange Commission?
15. What is the purpose of the capital market? How do capital market securities differ from
money market securities in their general characteristics?
66
16. What role do restrictive covenants play in bond markets?
17. What is the difference between a general obligation and a revenue bond?
18. What is a convertible bond? How does the convertibility feature affect the bond‘s price and
interest rate?
19. What is a bond‘s current yield? How does the current yield differ from yield to maturity
and what determines how close the two values are?
20. What is a callable bond? How does the callability feature affect the bond‘s price and
interest rate?
21. Explain why banks, which would seem to have a comparative advantage in gathering
information, have not eliminated the need for the money markets.
22. Explain how the Federal Reserve can influence the federal funds interest rate.
23. Explain why the money markets are referred to as wholesale markets.
24. Explain why money market interest rates move so closely together over time.
25. How are Treasury bills sold? How do competitive and non-competitive bids differ?
26. What are the main characteristics of money markets securities?
27. What are the major types of securities and who are the major participants in the money
markets?
28. What are the two possible causes of a stock market bubble? Explain them each by using 1-
2 sentences.

67
 Chapter-Five

Financial Market and Institutions in Ethiopia

To get more insight in Ethiopia‘s financial market and financial institutions, this chapter consist of
parts of the 2020-2021 first quarter report of the National Bank of Ethiopia (NBE, 2021) and a
report from Cepheus Capital, an Ethiopian investment consultancy company (CC, 2020). Some
information we already shared in earlier chapters, but by compiling it together we hope you get an
overview of major issues in Ethiopia‘s formal financial sector.

Banking sector
The number of banks operating in Ethiopia is19 of which 17 are private and 2 state owed. These
banks have opened 117 new bank branches during the review period thereby raising the total
number of bank branches to 6,628. As a result, population to bank branch ratio stood at 15,2131
persons per branch. About 34.2 percent of the total bank branches were located in Addis Ababa.
Of the total bank branches, the share of state-owned banks was 28.7 percent and that of private
banks 71.3 percent. Total capital of the banking system amounted to Birr 117.2 billion, of which
state-owned banks accounted for 50.9 percent and private banks 49.1 percent. The share of
Commercial Bank of Ethiopia, the biggest state-owned bank in total capital of the banking system,
was 44.3 percent. During the review quarter, Birr 55 billion was disbursed in fresh loans,
indicating a 16.8 percent annual increase. Of the total new loans disbursed, the share of state-
owned banks was 30.3 percent and that of private banks was 69.7 percent. Of the total new loans,
domestic trade was the major beneficiary, accounting for Birr 11.6 billion (21.2 percent) followed
by international trade (Birr 10.8 billion or 19.7 percent), industry (Birr 9.6 billion or 17.5 percent),
housing & construction (Birr 5.1 billion or 9.3 percent), and agriculture (Birr 4.4 billion or 8
percent). Check Table 4.11 for a more extensive overview of the loan beneficiaries.

68
During the review period, the banking system collected loans to the tune of Birr 35 billion, about
14.9 percent lower than a year earlier. Of the total loans, 60.6 percent was collected by private
banks and 39.4 percent by state owned banks. Total outstanding credit of the banking system
(including corporate bonds) reached Birr 1.1 trillion, which is about 22.4 percent higher than last
year same quarter. NBE‘s directives setting daily cash withdrawal and cash holding limits as well
as demonetization measures have contributed to such a remarkable performance in deposit
mobilization. Out of the total outstanding credit, the share of private banks was 35.2 percent while
that of state-owned banks stood at 64.8 percent.
Total resources mobilized by the banking system (the sum of net change in deposit, loans
collected and net change in borrowings) rose by 132.5 percent over the last year due to policy
changes related to holding and withdrawing cash.

Insurance market

The number of insurance companies‘ is18, of which 17 are private and 1 is state owned. Their
branches increased to 616 from 574 a year ago. Of the total branches, about 54.5 percent were
located in Addis Ababa. Likewise, the total capital of insurance companies reached Birr 10.3
billion, of which 71.7 percent was that of private insurance companies.

Microfinance market
There are 39 micro-finance institutions (MFIs) operating in the country which mobilized Birr 47
billion in saving deposit which grew 13.9 percent over last year. Their total outstanding credit

69
increased by 4.9 percent and reached Birr 64.6 billion while their total asset expanded 12.6 percent
to Birr 93.4 billion. The top five largest MFIs namely; Amhara, Dedebit, Oromia, Omo & Addis
Credit and Savings Institutions accounted for 81.4 percent of the total capital, 89.9 percent of total
deposit, 85.3 percent of total credit and 85.9 percent of total assets of MFIs. The largest MFIs are
expected to be converted to banks, as that would allow them to trade in foreign exchange and to
increase the lending limits. Another trend is micro-lending through digital channels, which is
already successful in other countries in the region (e.g. Kenya).
Bond market
The amount of government bonds supplied to the biweekly market reached Birr 33.2 billion during
the first quarter of 2020/21 reflecting a 70.0 percent year-on-year contraction. Similarly, the
demand for government bonds contracted by 54.4 percent to Birr 53.3 billion. The amount of
government bonds sold at Birr 33.4 billion, showed a 71.4 percent decline compared to last year
the same quarter. Non-bank institutions bought government bonds worth Birr 19 billion while the
remaining balance (Birr 14.3 billion) was taken up by banks. Thus, total outstanding government
bonds at the end of the first quarter reached Birr 38.8 billion, implying a 73.2 percent annual
decrease. Average weighted government bonds yield stood at 6.28 percent.
Commercial Bank of Ethiopia remained the sole purchaser of corporate bonds. Accordingly, CBE
purchased corporate bonds worth Birr 5.8 billion during the review quarter of which Railways
Corporation and Ethiopian Electric Power (EEP) and Ethiopian Electric Utility (EEU) issued bond
worth Birr 3.0 billion and Birr 2.8 billion, respectively. Hence, at the end of the review quarter, the
stock of corporate bonds held by the CBE stood at Birr 414.3 billion, of which 89.1 percent was
claims on public enterprises and the remaining balance on regional governments. Corporate bonds
issued by EEP&EEU accounted for 48.6 percent of the bonds issued by public enterprises and
73.6 percent of the total outstanding corporate bond balance.

Trends: where is Ethiopia’s financial sector heading?

Cepheus Capital (2020) identifies some trends in Ethiopian banking which will definitely change
banking in the upcoming years.

First trend: private banks are gaining market share, and the CBE is losing market share.

70
Second trend: competition will increase amongst banks. Approximately 20 banks are currently
under formation, potentially bringing 20-40bn in paid-up capital. Possible entrants: Zemzem
Bank, Gadaa Bank, Selam Bank, Ethiopian Diaspora Bank. It is, however, not likely that foreign
banks will soon be permitted to enter the market.

Third trend: non-bank funding from a future stock market will represent an alternative option for
Ethiopia‘s largest firms. A few dozen firms (with revenue of >500m birr) could choose stock
market funding rather than bank loans. However, stock market lauch and activity is unlikely to be
in place in the coming years. The start of stock and bond markets is expected to bring associated
business opportunities for banks, advisory firms and brokerage services. Furthermore, it is also
expected to attract foreign investors.

Fourth trend: there are now 6 leasing companies (remember the CGFC‘s from ch 3). Low entry
requirements (only 400m Birr in capital) and openness to foreign investors should attract
additional entrants, as these companies are supportive for SMEs.

Self-Test-Exercise
1. Which statement about Ethiopia‘s financial sector is incorrect?
A. The government owned bank‘s (CBE‘s) market share is expected to decrease.
B. The microfinance market is dominated by the five largest MFI‘s.
C. Most corporate bonds are issued by private companies.
D. The CBE is the major buyer of both corporate and government bonds.
E. Most insurance company branch offices are located in Addis Ababa.
2. Which source of credit is easiest accessible for median households in Ethiopia?
A. Household loan from a bank C. Informal credit (equb)
B. Mortgage from a bank D. Issuing bonds

71
 E. Micro loan from a IMF
3. Disscus with banking sector in Ethiopia and elsewhere.
4. Identify financial markets and institutions in Ethiopia.
Chapter-Six

Financial Regulations and introduction to the Basel Agreements

6.1 Why are financial sector regulations needed?

We have seen the various ways in which financial institutions fulfil a role which is crucial for a
society. Most financial institutions are private, which means that they are not owned and managed
by the government. Despite that, the financial industry is relatively heavily regulated by the
government. Why?

The deal that financial institutions make with their clients (which may be borrowers or investors)
is beneficial for the institution and for the client, as far as they can both understand the details of
the deal. However, as financial products are getting more and more complex, it is unrealistic that
clients of financial institutions understand all the details of the transaction, especially the types and
severity of risks. Also, not all information about a bank‘s assets and liabilities is transparently
available and easily accessible to the clients.

Consider the following examples:

- Lion International Bank collects savings from deposit holders worth 220 million Birr. The
management decided that 215 million Birr of this can be lend to an industrial park, with a
maturity of 10 years and a high interest rate, which is good for the profitability of the bank.
Only 5 million Birr liquid funds will be kept in the bank. Over time, the deposit holders
transfer 4.9 million Birr from the saving account and take the money from an ATM. Now the
management of Lion International Bank is worried, because only 0.1 million Birr liquidity is
left. One employee of the bank shares this information with his friend, who is one of the
deposit holders. He immediately transfers all his money away from the saving deposit and
informs his other friends. Once the news is out, all deposit holders want their money back and
Lion International Bank does not have the liquidity to arrange their transactions. This means
that Lion International Bank experiences a bank run. The deposit holders go to the bank
branch and start using violence to get as much money as possible, there is chaos, and several
people are wounded. Also, Zemen bank, who has a large deposit in Lion International Bank,
loses a lot of money this way, so all Zemen‘s deposit holders also start to ‗run the bank‘. This

72
 has consequences for Buna International Bank, who has deposits both at Lion International
Bank and Zemen bank. Banks are highly interconnected, so if one bank falls, they may all
fall. To avoid a collapse of the financial system, the government supports Lion International
Bank by using taxpayer‘s money.
- Habtamu wants to invest his money in the mortgage market, because he desires families to
have good access to housing and he wants to get a good rate of return.
Yohannis, who is the mortgage broker, finds many families that want to take a mortgage.
Yohannis arranges the mortgage, even for families with low and uncertain incomes, because
Yohannis gets a fee per mortgage he arranges (the risk is not considered). Yohannis sells the
mortgage to the servicer, who sells it to the bundler, who sells it to the distributor. In the end,
the distributor sells a share of the package of mortgages to Habtamu. Because brokers, like
Yohannis, facilitated many mortgages for households that are unable to repay, many houses
were taken from the families and sold in the market. Therefore, the house prices decreased and
Habtamu had to take a negative rate of return from his investments in the mortgage market.

The two examples show the often-arising Principal-Agent problem. There is incentive for
financial institutions (agents) to think about their own good, rather than only about the advantages
for their clients (principals) and the whole economy. In the past, banks would take too much risk.
If the risk-taking pays off, the banks shares in the reward (profit), but if the risk-taking fails, it is
not the banks who take the full losses (rather: the investors, or in rare cases the government by
bailing the bank out). This is called moral hazard: someone has an incentive to increase its
exposure to risk because he does not bear the full costs of that risk. Moral hazard can occur if
there is information asymmetry: the bank is more aware of and more informed about the risk it
takes than the clients, who will pay the consequences of the risk if things go badly. To avoid moral
hazard and to minimize the principal agent problem, governments made regulations that financial
intermediaries must follow up. Objectives of financial regulations are:
- To sustain financial stability.
- To safeguard trust in the financial system.
- To protect investors.

Examples of financial regulations of the National Bank of Ethiopia are:

- Any person is not allowed to hold more than 2 percent of a bank‘s total shares either on his
own or jointly with his relatives (his spouse or with a person who is below the age of 18
related to him).

73
- Banks are not allowed to be too much interconnected with other financial institutions. Their
total investments may not exceed 20% in an insurance company, non-banking business and
real estate and may not exceed 10% of the bank‘s equity capital. The bank may not invest
more than 10% of its net worth in other securities and the banks investments may not 50% of
the bank‘s net worth (excluding investment in government securities).
- Minimum deposit interest rate of commercial banks is 4%
- From a bank‘s total annual profit 25% must be transferred to its reserve account until the
reserve equals its capital (if their reserve reaches the capital of the bank, only 10% of profit is
required to be transferred to their reserve account).
- Banks must maintain 5% of their liabilities (birr and foreign exchange) and liabilities held in
the form of demand deposit (currency, saving and time deposits) in its reserve account.
- Any bank cannot lend more than 15% of its net worth to a single borrower, and the total sum
of loans to all related parties at any one time shall not exceed 35% of the total capital of the
bank.

6.2 Basel agreements basics

As you saw in the previous section, the National Bank of Ethiopia has several regulations for
financial institutions in Ethiopia. However, many consider regulating the financial sector not as a
national issue, but rather an international one. In highly developed financial markets, banks are
international (that means: they facilitate finances activities all over the world), so there must be
international banking regulations to avoid a global financial system collapse.

With this idea the central bankers of the richest countries sat together in Basel (city in Switzerland,
Europe) three times, and they developed regulations for the global financial system. These
regulations are summarized in three pillars.

74
 Table 3: asset types categorized by risk

Pillar I: Minimum capital requirement. To find out if a bank meets the minimum capital
requirements, two elements must be considered. (1) how many risky assets the bank is holding and
(2) the bank‘s net worth (assets-liabilities), which is also called shareholder‘s equity or the capital
of the bank.

All assets of a bank (may be shares, bonds, mortgages, deposits at other banks, etc.) are rated
based on their risk (i.e. the probability to default). For low-risk assets, the bank does not need to
hold capital. But for high-risk assets, the banks must make sure they have capital reserves. Table 1
provides an overview of the weights of the various types of assets. The risk of losing assets from
Category I is close to 0, so the bank does not need capital reserves to compensate possible losses
for Category I assets. However, assets from Category II, III and IV may lose value (due to
systematic and unsystematic risks), so to avoid that the bank cannot repay deposit holders and
other lenders, the bank must maintain good capital buffers. The minimum capital requirement is
4.5% of the risk-weighted assets.

For example, suppose Zemen Bank‘s capital is 0.4b$ and its assets per category are: Category I:
0.5b$, Category II: 1b$, Category III: 2b$ and Category IV: 3b$, the risk weighted assets are
0.5b$(0%)+1b$(20%)+2b$(50%)+3b$(100%)=4.2b$. Zemen‘s capital as a percentage of the risk
weighted assets is 0.4b$/4.2b$=0.095, which is 9.5%. That means Zemen bank meets the capital
requirement set by the Basel agreements.

If a bank‘s capital falls below this level, the bank must adjust its portfolio of assets to reduce the
risk. On top of this, there are some other requirements in the Basel agreements, but it is beyond the
scope of this course to discuss them in detail.

Pillar II: Supervisory review process. To make sure that he minimal capital ratio is met, there
must be a supervision system. This system is worked out in pillar two, and includes which entities
have which roles. For example, the banks must supervise a lot by themselves, but there are also
(inter)national reviewers who check their work.

Pillar III: Market discipline. This pillar describes public disclosure requirements that provide
the bank‘s clients (investors) with sufficient information to assess an internationally active bank's
risks and capital reserves. Public disclosure means what information banks must report to the

75
public. The information that banks report is considered good if it is clear, comprehensive,
meaningful, consistent over time and comparable to other banks‘ performances.

Self-Test-Exercise
1. When and why financial sector to be regulated by the government?
2. What is the main theme of Basel agreements under financial regulation?
3. What is Basel accord? What are the main principles of the Basel accord?
4. What is the main requirement of the Basel accords? What is Basel in banking sector?
5. What types of risk are the Basel accords seeking to address? What was the significance of the
Basel accord?
6. How do Basel accords help in regulating financial market?
7. How many Basel accords have been introduced as of now?
8. What does the Basel actually protects? What is Basel full form? Why did Basel fail?
9. What are some of the limitations to the Basel and Basel-II accords?

76