woLAITA SODO UNIVERSITY

SCHOOL OF GRADUATE
STUDIES
DEPARTMENT C E D
N IA T L OF
V A C N Instructor: Million
MANAGEMENT
A D N A N EME
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P T I O
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R O N C N T
I NT N A E
FI E M
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1.1.1. What is Finance?
Finance is a distinct area of study that
comprises facts, theories, concepts, principles,
techniques and practices related with raising
and utilizing of funds (money) by individuals,
businesses, and governments.
Finance is also an area of study that deals with
how, where, by whom, why, and through what
money is transferred among and between
individuals, businesses, and governments.
It applies economic principles and concepts to
business decision-making and problem solving.
 What…. Cont’d
The field of Finance comprises three
broad categories:
 Financial Management (Corporate Finance or
Business Finance)
 Investments
 Financial Institutions (plus International
Finance)
(1) FINANCIAL MANAGEMENT
FM can be clearly defined by viewing it as a subject, a
process, or a function.
As a subject: FM is one major area of study under finance.
 It deals with decisions made by a business firm that affect its
finances. FM is sometimes called corporate finance, business
finance, and managerial finance.
As a process: FM can also be defined as a decision making
process concerned with planning for raising, and utilizing
funds in a manner that achieves the goal of a firm.
As a function: business functions performed by a business
unit include marketing, production, human resource
management, and financial management.
 FM is a specified business function that deals with the management
of capital sources and uses of a firm.
Financial Management… Cont’d
FM addresses the ff questions:
 Capital budgeting: What long-term
investments should the firm engage in?
 Capital structure: How can the firm raise the
money for the required investments?
 Working capital management: How much
short-term cash flow does a company need to
pay its bills?
Financial Management … Cont’d
Financial management decisions include
 Maintaining cash balances
 Extending credit
 Acquiring other firms
 Borrowing from banks
 Issuing stocks and bonds
(2) INVESTMENTS
Focuses on the behavior of financial
markets and the pricing of securities
An investment manager’s tasks may include
 valuing common stocks,
 measuring a portfolio’s performance
 etc
(3) FINANCIAL INSTITUTIONS

Deals with banks and other firms that

specialize in linking suppliers and users
of funds.
FINANCIAL MANAGEMENT DECISIONS

 A company need to obtain financing in order to invest it in

assets

Curre Current
Net Working
nt Liability
Capital
Asset

Long-
Fixed Term
Asset Debt
 The two sides are: s Value of Assets
The
 Investment Side Shareholder
 Financing Side Investment Side
s’ Equity
Financing Side

The
Value of the
firm to
investors
Financial Management … Cont’d
Financial management can be thought of
as the study of the following three
questions:
(1) In what long-lived assets should the firm
invest?
(2) How can the firm raise cash for required
capital expenditures?
(3) How should short-term operating cash flows
be managed?
Financial Management… Cont’d
(1)In what long-lived assets should the
firm invest?
 Refers to investment decisions concerned
with the use of funds – the buying, holding,
or selling of all types of assets
Terms like capital budgeting and capital
expenditures are used to describe the
process of making and managing
expenditures on long lived assets.
Financial Management … Cont’d
Should we buy a new machine?
Should we introduce a new product line?
Sell the old production facility?
Buy an existing company?
Build a warehouse?
Keep our cash in the bank?
Financial Management … Cont’d
(2) How can the firm raise cash for
required capital expenditures?
The answer involves the firm’s capital
structure, which represents the
proportionsአመጣጠን(አያያዝ) of the firm’s
financing from current and long-term debt
and equity.
Financing decisions are concerned with the
acquisition of funds to be used for investing
and financing day-to-day operations.
Financial Management… Cont’d
Should managers use the money raised
through the firms’ revenues or seek from
outside of the business?
A company’s operations and investment
can be financed from outside the
business:
by incurring debts, such as through bank loans
and the sale of bonds …. which entails interest,
or
by selling ownership interests … which entails
distribution of profit (dividend)
Financial Management … Cont’d
Many business decisions simultaneously
involve both investing and financing decisions
Example: a company may wish to acquire
another firm—an investment decision. But the
success of the acquisition may depend on how
it is financed:
 by borrowing cash to meet the purchase price,
 by selling additional shares of stock, or
 by exchanging existing shares of stock.
Financial Management … Cont’d
Transfers of capital between borrowers and
savers take place
(1) by direct transfers of money and securities;
(2) by transfers through investment banking
houses, which act as middlemen; and
(3) by transfers through financial
intermediaries, which create new securities.
Financial Management… Cont’d
Capital Formation Process:
1. Direct Transfers Saver
Securities (Stocks or Bonds)
Business
Dollars

2. Indirect Transfers through Investment Banker

Securities Saver
Securities
Business Investmen
Dollars Dollars
t banking
house

3. Indirect Transfers through a financial Intermediaries

Business’sFinancial
Security Saversecurity
Intermediary
Business Intermedi
Dollars aries Dollars
Financial Management … Cont’d
The major financial intermediaries include:
 commercial banks,
 savings and loan associations,
 mutual savings banks,
 credit unions,
 pension funds,
 insurance companies, and
 mutual funds.

Reading Assignment I: Differentiate these

institutions!
Financial Management … Cont’d
Financing Decisions:
1) Internal corporate financing:……Retained
earnings
2) External sources of funds:
A) Direct financing (Financial Markets
Instruments)
 Stocks and Debt instruments (bonds)
B) Indirect Financing (Financial
Intermediaries)
 Loans
Financial Management … Cont’d
A financial decision also concerned with
two specific factors: expected return and
risk.
1. Expected return: is the difference
between potential benefits and potential
costs.
2. Risk: is the degree of uncertainty
associated with these expected returns.
Financial Management … Cont’d
(3) How should short-term operating cash
flows be managed?
There is often a mismatch between the timing
of cash inflows and cash outflows during
operating activities.
The amount and timing of operating cash
flows are not known with certainty.
The financial manager must attempt to
manage the gap in cash flow.
Financial Management … Cont’d
From a balance-sheet perspective, short-
term management of cash flow is associated
with a firm’s net working capital (Net
working capital defined as current assets
minus current liabilities)

From a financial perspective, the short-

term cash flow problem comes from the
mismatch of cash inflows and outflows
 1.1.2. THE FUNCTIONS OF FINANCIAL
MANAGEMENT

The functions of financial management are

planning for acquiring and utilizing funds by
a firm as well as distributing funds to the
owners in ways that achieve goal of the firm.
These are:
1. Investment decisions
2. Financing decisions
3. Dividend decisions
 1 . Investment Decisions
 They deal with allocation of the firm’s scarce financial resources
among competing uses.
 Specifically, the investment decisions include:
a) Determining the asset mix or composition: - determining
the total amount of the firm’s finance to be invested in current
and fixed assets.
b) Determining the asset type: - determining which specific
assets to maintain within the categories of current and fixed
assets.
c) Managing the asset structure, i.e., maintaining the
composition of current and fixed assets and the type of specific
assets under each category.
 Generally, the investment decisions of a firm deal with the left side of the
basic accounting equation: A = L + OE (Assets = Liabilities + Owners’
Equity).
2. Financing Decisions
The financing decisions deal with the
financing of the firm’s investments, i.e.,
decisions whether the firm should use equity
or debt funds in order to finance its assets.
the financing decisions deal with determining
the best financing mix or capital structure of
the firm.
The financing decisions of a firm are
generally concerned with the right side of the
basic accounting equation.
3. Dividend Decisions
The dividend decisions address the question
how much of the cash a firm generates from
operations should be distributed to owners in
the form of dividends and how much should be
retained by the business for further expansion.
On the one hand, paying out more dividends
will make the firm to be perceived strong and
healthy by investors; on the other hand, it will
affect the future growth of the firm.
So the dividend decision of a firm should be
analyzed in relation to its financing decisions.
 1.1.3. FORMS OF BUSINESS
ORGANIZATION

There are three main forms of business

organization:
(1) sole proprietorships,
(2) partnerships, and
(3) corporations, and several hybrid forms:
Each form has advantages and disadvantages
A. SOLE PROPRIETORSHIP

A sole proprietorship is an unincorporated

business owned by one individual.
three important advantages:
(1) It is easily and inexpensively formed,
(2) It is subjected to few government
regulations, and
(3) The business avoids corporate income taxes
Sole Proprietorship … Cont’d
three important limitations:
(1) It is difficult for a proprietorship to obtain
large sums of capital;
(2) the proprietor has unlimited personal
liability for the business’s debts, which can
result in losses that exceed the money he or
she has invested in the company; and
(3) the life of a business organized as a
proprietorship is limited to the life of the
individual who created it.
B. PARTNERSHIP

A partnership exists whenever two or more

persons associate to conduct a non corporate
business.
Partnerships may operate under different
degrees of formality, ranging from informal,
oral understandings to formal agreements
Partnership … cont’d
The major advantage are
 its low cost
 ease of formation.
 The tax treatment of a partnership is similar to
that for proprietorships,
The disadvantages are
(1) unlimited liability,
(2) limited life of the organization,
(3) difficulty of transferring ownership, and
(4) difficulty of raising large amounts of capital.
C. CORPORATION
A corporation is a legal entity created by a state, and
it is separate and distinct from its owners and
managers.
This separateness gives the corporation three major
advantages:
(1) Unlimited life. A corporation can continue after its
original owners and managers are deceased.
(2) Easy transferability of ownership interest. Ownership
interests can be divided into shares of stock, which,
in turn, can be transferred far more easily than can
proprietorship or partnership interests.
(3) Limited liability
Corporation … cont’d
disadvantages:
(1) Corporate earnings may be subject to double
taxation —the earnings of the corporation are
taxed at the corporate level, and then any
earnings paid out as dividends are taxed
again as income to the stockholders.
(2) Setting up a corporation, and filing the many
required state and federal reports, is more
complex and time-consuming than for a
proprietorship or a partnership.
D. HYBRID FORMS OF ORGANIZATION
Example:
 it is possible to limit the liabilities of some of the
partners by establishing a limited partnership,
wherein certain partners are designated general
partners and others limited partners.
 In a limited partnership, the limited partners are
liable only for the amount of their investment in
the partnership, while the general partners have
unlimited liability. However, the limited partners
typically have no control, which rests solely with
the general partners, and their returns are
likewise limited.
 1.1.4. THE GOAL OF A FIRM IN FINANCIAL
MANAGEMENT
A goal provides a framework for the decision
maker
It is an explicit operational guide or decision
rule for the decision maker.
Good goal has the following characteristics:
1. It is clear and unambiguous
2. It provides a clear and timely measure to evaluate
the success or failure of decisions
3. It does not affect the specific benefits of a firm
4. It does not affect the welfare of the society
5. It is based on long-term success of the firm
A) PROFIT MAXIMIZATION AS A DECISION RULE
Profit maximization is a function of
maximizing revenue and /or minimizing costs.
 If a firm is able to maximize its revenues for a given
level of costs or minimizing costs for a given level of
revenues, it is considered to be efficient.
Profit maximization focuses on the total
amount of benefits of any courses of action.
Profit … cont’d
Profit maximization, though widely professed,
should not be used as a good goal of a firm in
financial management because it fails to meet
many of the characteristics of a good goal.

Limitations of Profit Maximization

1) Ambiguity: There are many different economic
and accounting definitions of profit, each open
to its own set of interpretations.
2) Cash flows: The profit a firm has reported does
not represent the cash flows to the business.
Profit … cont’d
3) Timing of Benefits. The profit maximization criterion
ignores the differences in the time pattern of benefits
received from investment proposals.
 Example: Akaki Manufacturing Share Company wants to
choose between two projects: project X and project Y. both
projects cost the same, are equally risky and are expected
to provide the following benefits over three years period.
BENEFITS (PROFITS)
YEAR PROJECT X PROJECT Y
1 Br. 25,000 Br. –0-
2 50,000 50,000
3 –0- 25,000
TOTAL Br. 75,000 Br. 75,000
Profit … cont’d
The profit maximization criterion ranks both
projects as being equal. However, project X
provides higher benefits in earlier years and
project Y provides larger benefits in latter years.
4) Quality of Benefits (Risk of Benefits). Profit
maximization assumes that risk or uncertainty of
future benefits is of no concern to stockholders
 Risk is defined as the probability that actual benefit will
differ from the expected benefit.
 Financial decision making involves a risk-return trade-off.

This means that in exchange for taking greater risk, the

firm expects a higher return.
Profit … cont’d
 Example: Nyala Merchandising Plc. must choose
between two projects. Both projects cost the same.
Project A has a 50% chance that its cash flows would
be actual over the next three years. Project B, on the
other hand, has a 90% probability that its cash flows
for the next three years would be realized.
BENEFITS____________
YEAR PROJECT A PROJECT B
1 Br. 60,000 Br. 45,000
2 65,000 50,000
3 95,000 85,000
TOTAL Br. 220,000 Br. 180,000
Profit … cont’d
Under profit maximization, project A is more
attractive because it adds more to Nyala than
project B. However, if we consider the risk of
the two projects, the situation would be
reversed.
Expected benefit of project A = Br. 220,000 x
50% = Br. 110,000
Expected benefit of project B = Br. 180,000 x
90% = Br. 162,000
B) WEALTH MAXIMIZATION AS A DECISION RULE
Wealth maximization means maximization
of the value of a firm.
 Hence wealth maximization is also called
value maximization or net present value
(NPV) maximization.
Stockholders’ wellbeing depends on both
current and expected dividend payments
and market price of the firm’s common
stock.
Wealth … cont’d
Wealth maximization as a decision criterion is
considered to be an ideal goal of a firm in financial
management.
There are several reasons why WM decision
criterion is superior to PM criteria.
1. it has an exact measurement unlike profit maximization.
It depends on cash flows (inflows and outflows).
2. wealth maximization as a decision criterion consider the
quality as well as the time pattern of benefits.
3. it emphasizes on the long-term and sustainable
maximization of a firm’s common stock price in the
financial market.
4. wealth maximization gives a recognition to the interest
of other stakeholders and to the societal welfare on the
long-term basis.
Wealth …cont’d
Technically, wealth maximization as a
decision rule involves a comparison of VALUE
to COST.
 Thus, an action that has a discounted value
that exceeds its cost can be said to create
value and such action should be undertaken.
 Whereas an action with less discounted value

than cost reduces wealth and, therefore,

should be rejected.
The discounted value is a value which takes
risk and timing of benefits into account.
Limitations
 of Wealthis Maximization
If wealth maximization taken as the sole decision
rule, there is a possibility that the benefits of the
society at large might be forgone.
When managers of a corporation are separate from
owners, there is a potential for a conflict of interest
between them.
 This conflict of interest can lead to the maximization of
manages’ interest instead of the welfare of
stockholders.
When the goal of a firm is stated in terms of
stockholders wealth, actions that increase the
wealth of stockholders could be taken as the
expense of other stakeholders like debt-hodlers.
CONFLICT OF GOALS BETWEEN MANAGEMENT AND OWNERS AND AGENCY
 In a corporate form of business organization owners
PROBLEM
(stockholders) do not run the activities of the firm. Rather, the
stockholders elect the board of directors, who in turn assign
the management on behalf of the owners.
 So, basically, managers are agents of the owners of the
corporation to maximize the common stockholders’ well-being.
 However, there is a conflict of goals between managers and
owners of a corporation and mangers may act to maximize their
interest instead of maximizing the wealth of owners.
 Managers are interested to maximize their personal wealth, job
security, life style and fringe benefits.
 The natural conflict of interest between stockholders and
managerial interest create agency problems.
 Agency problems are the likelihood that mangers may place their
personal goals ahead of corporate goals. Theoretically, agency problems
are always there as long as mangers are agents of owners.
Conflict … Cont’d
 Corporations (owners) are aware of these agency problems and they
incur some costs as a result of agency. These costs are called agency
cost and include:
1. Monitoring expenditures – are expenditures incurred by
corporations to monitor or control the activities of managers.
1. Example: fees paid by corporations to external auditors.
2. Bonding expenditures – are cost incurred to protect dishonesty of
mangers and other employees of a firm.
 Example: fidelity guarantee insurance premium.
3. Structuring expenditures – expenditures made to make managers
fell sense of ownership to the corporation.
 These include stock options, performance shares, cash bonus etc.
4. Opportunity costs – unlike the previous three, these costs are not
explicit expenditures.
 Opportunity costs are assumed by corporations due to hindrances of
decisions by them as a result of their organizational structure and
hierarchy.
 1.1.5. Markets and their Role in the Economy

Most economies around the world rely

principally upon markets to carry out the
complex task of allocating scarce resources
(land, labor, managerial skills, and capital).
The marketplace is dynamic.
 It determines what goods and services will be
produced and in what quantities through their prices.
Markets also distribute income by rewarding
superior producers with
 increased profits,
 higher wages, and
 other economic benefits
TYPES OF MARKETS
There are essentially three types of markets within
the global economic system.
 factor markets
 product markets
 financial markets
These markets serve different purposes
1) The factor markets allocate factors of production
(land, labor, skills, capital) and distribute income
(wages, rent) to the owners of productive resources.
2) Consuming units use most of their income from
factor markets to purchase goods and services in
the product markets.
Type …. Cont’d
3) The financial markets channel savings to
those individuals and institutions needing
more funds for spending than are provided by
their current incomes.
 Financial markets bring together the buyers
and sellers of debt and equity securities.
THE FINANCIAL MARKETS: CHANNEL FOR SAVINGS AND
INVESTMENT

The financial system is the mechanism

through which loanable funds reach
borrowers.
Through the operation of the financial markets,
money is exchanged for financial claims in the
form of stocks, bonds, and other securities,
thereby transforming savings into investment
so that the economy can grow
businesThe
financial
system is the
mechanism
through loan
Financial … cont’d
able funds
reach
borrowers.
Through the Suppliers of
operation of the funds
Flow of loanable funds (savings)
financial (mainly
markets, money household)
is exchanged for
financial claims Flow of financial services, income and financial claims
in the form of
stocks, bonds,
and other
securities,
thereby
transforming
savings into
investment so
that the
economy can
grow
Financial … cont’d
The financial markets enable
 the exchange of current income for future income
and the transformation of savings into investment
so that production, employment, and income
can grow, and living standards can improve
The suppliers of funds to the financial
system expect to
 recover their original funds as well as earn
additional income as a reward for waiting and
assuming risk
 Primary Market
When firms need to raise capital, they may
choose to sell (float) new securities.
These new issues of stocks, bonds or other
securities typically are marked to the public
by investment bankers in what is called the
primary market.
This is to acquire new capital
Primary market…Cont’d
The two types of primary market issues are:
A public offering- which is an issue of stock
or bonds sold to the general investing public
that can then be traded on the secondary
market
Private placement- which is an issue that is
sold to a few wealthy or institutional
investors generally held to maturity.
Functions of the primary markets

- Origination
- Underwriting
- Distribution
Parties involved in the new issue
Managers to the issue or the lead manager
Registrar to the issue
Underwriters
Bankers
Advertising Agencies
Financial institutions
Government or statutory agencies
 The Secondary Market
The primary market deals with the new issue
of securities.
Outstanding securities are traded in the
secondary market, which is commonly known
as stock market or stock exchange.
In the secondary market the investor can sell
and buy securities
NB: “Growth of the primary market
depends
on the secondary market”
 Functions of the stock exchange
Maintaining active trading
Fixation of prices
Ensuring safe and fair dealing
Aids in financing the industry
Dissemination of information
Performance inducer
Self regulating organization
 Listing of securities
Listing refers to the admission of security of
a company on a recognized stock exchange.
Only listed shares are traded on the stock
exchange.
Listed securities are also known as quoted
securities.
NB: Every stock exchange has unique
listing requirements for the shares to be
listed on the stock exchange.
 Listing Requirements
Listing requirements are the set of
conditions imposed by a given stock
exchange upon companies that want to be
listed on that exchange.
Such conditions sometimes include:
1. Minimum number of shares outstanding
2. Minimum market capitalization
3. Minimum annual income
Listing requirement…Cont’d
For example
 London stock Exchange
- the main market of the London stock exchange
has requirements for a minimum market
capitalization of £700,000, three years of audited
financial statements, minimum public float 25% and
sufficient working capital for at least 12 months
from the date of listing.
NASADAQ Stock Exchange-
- to be listed on the NASADAQ a company must
have issued at least 1.25 million shares of stock
worth at least $70 million and must have earned
more than $11 million over the last three years.
Example… cont’d
New York Stock Exchange
- to be listed on the NYSE a company
must have at least a million shares worth
$100million and must have earned more
than 10 million over the last three years.
Regional Exchanges
and
The Over-The-Counter
Market
 Regional Exchanges
 Regional exchanges typically have the same operating
procedures as the national exchanges in the same countries,
but they differ in
- their listing requirements and
- the geographic distributions of the listed firms
 Regional stock exchanges exist for two main reasons:
1. they provide trading facilities for local companies not
large enough to qualify for listing on one of the national
exchanges. Their listing requirements are typically less
stringent than those of the national exchanges.
2. regional exchanges in some countries list firms that also
list on one of the national exchanges to give local
brokers who are not members of a national exchange
access to these securities
Cont’d
The regional exchanges in the United States
are
 Chicago Stock Exchange
 Pacific Stock Exchange (San Francisco–Los
Angeles)
 Philadelphia Exchange
 Boston Stock Exchange
 Cincinnati Stock Exchange
Over-the-Counter (OTC) Market
includes trading in all stocks not listed on one
of the exchanges.

NB: It can also include trading in listed

stocks, which is referred to as the third
market
The OTC market is not a formal organization
with membership requirements or a specific list
of stocks deemed eligible for trading.
In theory, any security can be traded on the
OTC market as long as a registered
dealer(ነጋደ) willing to buy and sell shares of
the stock
The Third Market
The third market refers to trading of
exchange –listed securities on the OTC
market.
The third market involves dealers and
brokers who trade shares that are listed on
an exchange away from the exchange.
 Fourth Market
The term fourth market describes direct
trading of securities between two parties with
no broker intermediary.
 Foreign Exchange Market
The foreign exchange market :- is the
market where the currency of one country is
exchanged for that of another currency and
where the rate of exchange is determined.
Currency trading is the world’s largest
market
It is also the most liquid.
There is no central market place for the
exchange of currency.
Cont’d
The foreign exchange market is unique because:
1. Its huge trading volume, leading to high
liquidity
2. Its geographic dispersion
3. Its continuous operation, 24 hours a day
4. The variety of factors that affect exchange rates
5. The low margin of relative profit
6. The use of leverage to enhance profit margins
with respect to account size
1.1.6. Financial Assets and their Characteristics

A financial asset is …
a claim against the income or
wealth of a business firm,
household, or unit of government,
 represented usually by a

certificate, receipt, computer

recorded file, or other legal
document, and usually created by
or related to the lending of money.
Creation of Financial Assets
Financial instruments are created in the
economy due to the diverse patterns of
savings and investments among
economic units
Saving-deficit units (business firms &
governments) issue financial
claims/instruments such as stocks and
bonds in order to acquire funds
 this gives rise to the creation of financial

liabilities for the savings-deficit units

Creation … cont’d
Savings-surplus units (mostly
households) provide surplus funds
(savings) in exchange for the financial
claims
 this gives rise to the creation of financial
assets to the savings surplus units
The creation of financial assets/liabilities
eventually lead to wealth creation in the
economy
CHARACTERISTICS OF FINANCIAL ASSETS
Financial assets are sought after because they
promise future returns to their owners and serve
as a store of value (purchasing power).
They do not depreciate like physical goods, and
their physical condition or form is usually not
relevant in determining their market value.
They have little or no value as a commodity and
their cost of transportation and storage is low.
Financial assets are fungible – they can easily be
changed in form and substituted for other
assets.
DIFFERENT KINDS OF FINANCIAL ASSETS
1) Any financial asset that is generally accepted in
payment for purchases of goods and services is
money.
Currency and checking accounts are forms of money.
All financial assets are valued in terms of money, and
flows of funds between lenders and borrowers occur
through the medium of money
2) Equities(ትክክለናነት) represent ownership shares
in a business firm and are claims against the
firm’s profits and against proceeds from the sale
of its assets.
 Common stock and preferred stock are equities.
Different… cont’d
3) Debt securities entitle their holders to a
priority claim over the holders of equities to
the assets and income of an economic unit.
They can be negotiable or nonnegotiable.
 Examples include bonds, notes,(ብር)
accounts payable, and savings deposits.
Different … cont’d
4) Derivatives have a market value that is tied to or
influenced by the value or return on a financial asset.
 Examples: futures contracts, options, and swaps.

In financial terms, a derivative is a financial

instrument or an agreement between two parties-
that has a value determined by the price of
something else called the underlying
It is a financial contract with a value linked to the
expected future price movements of the asset
A derivative is an agreement between two parties
that is contingent on a future outcome of the
underlying
Cont’d
 Derivatives are broadly classified on the basis of the following:
1. The relationship between the underlying (assets) and the
derivative
example: future, forward, options and swaps
2. The type of underlying asset
such as equity derivatives, foreign exchange derivatives,
interest rate derivatives, commodity derivatives or
credit derivatives
3. The market in which they are traded
such as exchange traded or over –the – counter
4. The structure of derivatives
- based on their structure derivatives can be vanilla derivative
or exotic derivatives.
- The vanilla derivatives are simple and more common
where
as the exotic derivatives are more complicated and
specialized.
Cont’d
Derivatives are mostly used by investors in order
to
1. Provide leverage() or gearing(መሰማማት)
2. Speculate(መገመት) and to make profit
3. Hedge(መጠባበቂያ) or mitigate(ማሻሻል) risk in the
underlying,(ከጅምር)
4. Obtain exposure(ማጋለጥ) to underlying where it is
not possible to trade in the underlying
5. Create option ability where the value of the
derivative is linked to a specific condition or
event.
Types of Derivative Market
 Among the many Forwards, Futures, options, swaps, floors and
Caps are the major ones

Assignment I: Make detailed analysis of these derivative

instruments and report your views in connection with:
 Their differences and similarities
 At what level of operation our country is in connection with
derivatives?
 What made to be in the level you mentioned?
 What need to be fulfilled to make the derivatives to operate in
our country?
 How you associate the operation of Ethiopian Commodity
Exchange with types of market and derivative instruments?
Submission date: Next week
 1.1.7. Financial Markets and their
Characteristics

Financial markets can be classified as:

 Money market vs. capital market
 Open market vs. negotiated market
 Primary market vs. secondary market
 Spot market vs. futures, forward, and options

market
Types… cont’d
Money market vs. Capital market
The money market is for short-term (1 year or
less) loans, while the capital market finances
long-term investments by businesses,
governments, and households.
Governments borrow from commercial
banks in the money market, while in the
capital market, insurance companies,
mutual funds, security dealers, and
pension funds supply the funds for
businesses.
Type … cont’d
The money market may be subdivided
into:
Treasury bills market
Market for certificates of deposit (CDs)
Market for bankers’ acceptances
Market for commercial paper
Federal funds
Eurocurrencies market
Type … cont’d
The capital market may be subdivided
into:
Mortgage loans
Tax-exempt (municipal) bonds

Consumer loans

Eurobonds and Euronotes

Corporate stock

Corporate notes and bonds

Type… cont’d
Primary vs. Secondary markets
 Financial capital is raised when new securities are
sold in the primary markets.
 Security trading in the secondary markets then
provides liquidity for the investors.
Company Primary market
Public
Via investment banker

Company secondary market

public
Via stock exchanges
Type … cont’d
In short:
 Money markets involve the trading of
short term debt securities, while capital
markets involve the trading of long-term
debt and equity securities.
 Primary markets involve the original
sale of securities, while secondary
markets involve the continual buying
and selling of issued securities.
Type … cont’d
Open vs. Negotiated market
In open markets, financial instruments are sold to
the highest bidder, and they can be traded as often
as is desirable before they mature.
In negotiated markets, the instruments are sold to
one or a few buyers under private contract.
Spot vs. futures, forward, and options market
In the spot market, assets are traded for immediate
delivery (usually within one or two business days).
Type … cont’d
A futures or forward market is designed to
trade contracts calling for the future delivery
of financial instruments.
Options markets enable contracts that grant
the right to buy or sell certain securities at
specific prices within a certain time to be
traded.
Critical and Urgent Reading Assignment
Issues related with Time Value of Money
including:
Future Value
 Future Value of a Single Amount
 Future Value of an Annuity
 Future Value of Uneven Cash Flows
Present Value
 Present Value of a Single Amount
 Present Value of an Annuity
 Present Value of Uneven Cash Flows
 Present Value of a Perpetuity
 Thank you for your
Attention!!!