Post on 19-Apr-2018
SIXTH E D I T I O N
FREDERIC S. MISHKSNGraduate School of Business, Columbia University
STANLEY G. EAKINSEast Carolina University
PEARSON
•Mr
Boston San Francisco New YorkLondon Toronto Sydney Tokyo Singapore Madrid
Mexico City Munich Paris Cape Town Hong Kong Montreal
Contents on the WebPrefaceAbout the Authors
PART ONE INTRODUCTION
Chapter 1 Why Study Financial Markets and Institutions?PreviewWhy Study Financial Markets?
Debt Markets and Interest RatesThe Stock MarketThe Foreign Exchange Market
Why Study Financial Institutions?Central Banks and the Conduct of Monetary PolicyStructure of the Financial SystemBanks and Other Financial InstitutionsFinancial InnovationManaging Risk in Financial Institutions
Applied Managerial PerspectiveHow We Will Study Financial Markets and Institutions
Exploring the WebCollecting and Graphing Data
Web Exercise
Concluding Remarks
Summary
Key Terms
Questions
Quantitative Problems s
Web Exercises: Working with Financial Market Data
Chapter 2 Overview of the Financial SystemPreviewFunction of Financial MarketsStructure of Financial Markets
Debt and Equity MarketsPrimary and Secondary Markets
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IX
Contents in Detail
Exchanges and Over-the-Counter Markets 21
Money and Capital Markets 22
Internationalization of Financial Markets 22
International Bond Market, Eurobonds, and Eurocurrencies 22
• GLOBAL Are U.S. Capital Markets Losing Their Edge? 23World Stock Markets 24
Function of Financial Intermediaries: Indirect Finance 24
• FOLLOWING THE FINANCIAL NEWS Foreign Stock Market Indexes 25Transaction Costs 25
• GLOBAL The Importance of Financial Intermediaries Relative to Securities Markets:An International Comparison 26Risk Sharing 27
Asymmetric Information: Adverse Selection and Moral Hazard 27
Types of Financial Intermediaries 29
Depository Institutions 29
Contractual Savings Institutions 30
Investment Intermediaries 32
Regulation of the Financial System 33
Increasing Information Available to Investors 33
Ensuring the Soundness of Financial Intermediaries 34
Financial Regulation Abroad 35
Summary 36Key Terms 36Questions 37Web Exercises: The Financial System 37
PART TWO FUNDAMENTALS OF FINANCIAL MARKETS 39
Chapter 3 What Do Interest Rates Mean and What isTheir Role in Valuation? 41Preview 41
Measuring Interest Rates 42
Present Value 42
Four Types of Credit Market Instruments 44
Yield to Maturity 45
• GLOBAL Negative T-Bill Rates? Japan Shows the Way 52
The Distinction Between Real and Nominal Interest Rates , 52
The Distinction Between Interest Rates and Returns ' 55
• MINI-CASE With TIPS, Real Interest Rates Have Become Observable in the United States 5 6Maturity and the Volatility of Bond Returns: Interest-Rate Risk 59
• MINI-CASE Helping Investors Select Desired Interest-Rate Risk 59Reinvestment Risk 60Summary 60
• THE PRACTICING MANAGER Calculating Duration to Measure Interest-Rate Risk 6 1Calculating Duration 62Duration and Interest-Rate Risk 66
Contents in Detail xi
Summary 6 7
Key Terms 6 8Questions 6 8
Quantitative Problems 6 8Web Exercises: Understanding Interest Rates 70
Chapter 4 Why Do Interest Rates Change? 71Preview . 71
Determinants of Asset Demand 71
Wealth 72
Expected Returns 72
Risk 73
Liquidity 75
Summary 75
Supply and Demand in the Bond Market 75
Demand Curve 76
Supply Curve 77
Market Equilibrium 78
Supply and Demand Analysis 79
Changes in Equilibrium Interest Rates 79
Shifts in the Demand for Bonds 80
Shifts in the Supply of Bonds 83
• CASE Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect 8 6• CASE Changes in the Interest Rate Due to a Business Cycle Expansion 8 7• CASE Explaining Low Japanese Interest Rates 8 9• CASE Reading the Wall Street Journal "Credit Markets" Column 9 0• FOLLOWING THE FINANCIAL NEWS The "Credit Markets" Column 9 1• THE PRACTICING MANAGER Profiting from Interest-Rate Forecasts 9 2• FOLLOWING THE FINANCIAL NEWS Forecasting Interest Rates 93Summary 9 4Key Terms 9 5Questions 9 5Quantitative Problems 9 6Web Exercises: Interest Rates ond Inflation 9 7
Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 99Preview • 99
Risk Structure of Interest Rates 99
Default Risk 100
• CASE The Enron Bankruptcy and the Baa-Aaa Spread 103Liquidity 104Income Tax Considerations 104Summary 105
• CASE Effects of the Bush Tax Cut on Bond Interest Rates 106T e r m Structure of Interest Rates 107• FOLLOWING THE FINANCIAL NEWS Yield Curves 107
x i i Contents in Detail
Expectations Theory 109Market Segmentation Theory 113Liquidity Premium Theory 114
• MINI-CASE The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle 118Evidence on the Term Structure 118Summary 119
• CASE Interpreting Yield Curves, 1980-2008 119• THE PRACTICING MANAGER Using the Term Structure to Forecast Interest Rates 120Summary 124Key Terms 124Questions 124Quantitative Problems 125Web Exercises: The Risk and Term Structures of interest Rotes 126
Chapter 6 Are Financial Markets Efficient? 127Preview 127The Efficient Market Hypothesis 128
Rationale Behind the Hypothesis 130Stronger Version of the Efficient Market Hypothesis 131
Evidence on the Efficient Market Hypothesis 131Evidence in Favor of Market Efficiency 131
• MINI-CASE An Exception That Proves the Rule: Ivan Boesky 133• CASE Should Foreign Exchange Rates Follow a Random Walk? 1 3 5
Evidence Against Market Efficiency 135Overview of the Evidence on the Efficient Market Hypothesis 137
• THE PRACTICING MANAGER Practical Guide to Investing in the Stock Market 1 3 8How Valuable Are Published Reports by Investment Advisers? 138
• MINI-CASE Should You Hire an Ape as Your Investment Adviser? 138Should You Be Skeptical of Hot Tips? 139Do Stock Prices Always Rise When There Is Good News? 139Efficient Markets Prescription for the Investor 140
• CASE What Do the Black Monday Crash of 1987 and the Tech Crash of 2000Tell Us About the Efficient Market Hypothesis? 141
Behavioral Finance 142Summary 143Key Terms 1 4 3Questions ' , 1 4 3Quantitative Problems ' 144Web Exercises: The Efficient Market Hypothesis 1 4 4
PART THREE CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY 145
Chapter 7 Structure of Central Banks and the Federal Reserve System 147Preview 147Origins of the Federal Reserve System 147• INSIDE THE FED The Political Genius of the Founders of the Federal Reserve System 148
Contents in Detail x l i l
Structure of the Federal Reserve System 149
Federal Reserve Banks 150
• INSIDE THE FED The Special Role of the Federal Reserve Bank of New York 1 5 1
Member Banks 152
Board of Governors of the Federal Reserve System 153
• INSIDE THE FED The Role of the Research Staff 1 5 4
Federal Open Market Committee (FOMC) 155
The FOMC Meeting 155
• INSIDE THE FED Green, Blue, and Beige: What Do These Colors Mean at the Fed? 1 5 6
Why the Chairman of the Board of Governors Really Runs the Show 156
How Independent Is the Fed? 157
Structure and Independence of the European Central Bank 158
Differences Between the European System of Central Banks
and the Federal Reserve System 159
Governing Council 159
How Independent Is the ECB? 160
Structure and Independence of Other Foreign Central Banks 161
Bank of Canada 161
Bank of England 161
Bank of Japan 162
The Trend Toward Greater Independence 162
Explaining Central Bank Behavior 163
• INSIDE THE FED Federal Reserve Transparency 163
Should the Fed Be Independent? 164
The Case for Independence 164
The Case Against Independence 165
Central Bank Independence and Macroeconomic
Performance Throughout the World 166
Summary 166Key Terms 1 6 7Questions ani Problems 167Web Exercises: The Structure of the Federal Reserve System 168
Chapter 8 Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics 169Preview 169
The Federal Reserve's Balance Sheet 169
Liabilities 170
Assets - I 171
Open Market Operations 171
Discount Lending 172
The Market for Reserves and the Federal Funds Rate 173
Demand and Supply in the Market for Reserves 173
How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate 11A
Tools of Monetary Policy 176
Open Market Operations 177
A Day at the Trading Desk 178
xiv Contents in Detail
Discount Policy . 179
Operation of the Discount Window 179
Lender of Last Resort 180
• INSIDE THE FED Using Discount Policy to Prevent a Financial Panic 182Reserve Requirements 183
Monetary Policy Tools of the European Central Bank 183
Open Market Operations 184
Lending to Banks 184
Reserve Requirements 184
The Price Stability Goal and the Nominal Anchor 185
The Role of a Nominal Anchor 185
The Time-Inconsistency Problem 185
Other Goals of Monetary Policy 186
High Employment 186
Economic Growth 187
Stability of Financial Markets 187
Interest-Rate Stability 188
Stability in Foreign Exchange Markets 188
Should Price Stability Be the Primary Goal of Monetary Policy? 188
Hierarchical Versus Dual Mandates 189
Price Stability as the Primary, Long-Run Goal of Monetary Policy 189
Monetary Targeting 190
Monetary Targeting in the United States, Japan, and Germany 190
• GLOBAL The European Central Bank's Monetary Policy Strategy 1 9 3
Advantages of Monetary Targeting 193
Disadvantages of Monetary Targeting 194
Inflation Targeting 194
Inflation Targeting in New Zealand, Canada, and the United Kingdom 194
Advantages of Inflation Targeting 196
Disadvantages of Inflation Targeting 197
• INSIDE THE FED The New Fed Chairman and Inflation Targeting 199Tactics: Choosing the Policy Instrument 199
Criteria for Choosing the Policy Instrument 202
• THE PRACTICING MANAGER Using a Fed Watcher 2 0 3Summary 2 0 4Key Terms 2 0 5Questions ; 2 0 5Quantitative Problems 2 0 6Web Exercises; Conduct of Monetary Poiicy 2 0 7
PART FOUR FINANCIAL MARKETS 209
Chapter 9 The Money Markets 211Preview 211
The Money Markets Defined 211
Why Do We Need the Money Markets? 212
Money Market Cost Advantages 213
Contents in Detail xv
The Purpose of the Money Markets 214
Who Participates in the Money Markets? 215
U.S. Treasury Department 215
Federal Reserve System 215
Commercial Banks 215
Businesses 216
Investment and Securities Firms 216
Individuals 217
Money Market Instruments 217
Treasury Bills 218
• CASE Discounting the Price of Treasury Securities to Pay the Interest 2 1 8• MINI-CASE Treasury Bill Auctions Go Haywire 2 2 0
Federal Funds 222
Repurchase Agreements 223
Negotiable Certificates of Deposit 224
Commercial Paper 224
Banker's Acceptances 227
Eurodollars 229
• GLOBAL Ironic Birth of the Eurodollar Market 229
Comparing Money Market Securities 230
Interest Rates 230
Liquidity 231
• FOLLOWING THE FINANCIAL NEWS Money Market Rates 2 3 2
How Money Market Securities Are Valued 233
Summary- 234
Key Terms 2 3 4
Questions 2 3 5
Quontitative Problems 2 3 5
Web Exercises: The Money Markets 2 3 6
Chapter 10 The Bond Market 237Preview • 237
Purpose of the Capital Market 237
Capital Market Participants - 238
Capital Market Trading 238
Types of Bonds 239
Treasury Notes and Bonds ; 240
Treasury Bond Interest Rates 240
Treasury Inflation Protected Securities (TIPS) 240
Treasury STRIPS 242
Agency Bonds 242
Municipal Bonds 243
Risk in the Municipal Bond Market 244
Corporate Bonds 244
Characteristics of Corporate Bonds 245
Types of Corporate Bonds 247
xvi Contents in Detail
Financial Guarantees for Bonds 250
Current Yield Calculation .. 250
Current Yield 250
Finding the Value of Coupon Bonds 252
Finding the Price of Semiannual Bonds 252
Investing in Bonds 255
Summary 2 5 6
Key Terms 256
Questions 256
Quantitative Problems 257
Web Exercise: The Bond Market ' 258
Chapter 11 The Stock Market 259Preview 259
Investing in Stocks 259
Common Stock Versus Preferred Stock 260
How Stocks Are Sold 261
Computing the Price of Common Stock 265
The One-Period Valuation Model 265
The Generalized Dividend Valuation Model 266
The Gordon Growth Model 267
Price Earnings Valuation Method 268
How the Market Sets Security Prices 269
Errors in Valuation 270
Problems with Estimating Growth 270
Problems with Estimating Risk 271
Problems with Forecasting Dividends 271
• CASE The September 11 Terrorist Attack, the Enron Scandal, and the Stock Market 272Stock M a r k e t I ndexes 272
• MINI-CASE History of the Dow Jones Industrial Average 273Buying Foreign Stocks 275
Regulation of the Stock Market 275
The Securities and Exchange Commission 275Summary 2 7 6
Key Terms 2 7 7
Questions 2 7 7
Quantitative Problems ' ; 2 7 7
Web Exercises: The Stock Market 2 7 9
Chapter 12 The Mortgage Markets 2siPreview 281
What Are Mortgages? 282
Characteristics of the Residential Mortgage 283
Mortgage Interest Rates 283
• CASE The Discount Point Decision 284Loan Terms 285
Contents in Detail xv i i
Mortgage Loan Amortization . 287• CASE Computing the Payment on Mortgage Loans 288Types of Mortgage Loans 289
Insured and Conventional Mortgages 289Fixed- and Adjustable-Rate Mortgages 290Other Types of Mortgages 290
Mortgage-Lending Institutions 293Loan Servicing 294• E-FINANCE Borrowers Shop the Web for Mortgages 294Secondary Mortgage Market 295Securitization of Mortgages 295
What Is a Mortgage-Backed Security? 296• MINI-CASE Are Fannie Mae and Freddie Mac Getting Too Big for Their Britches? 2 9 6
Types of Pass-Through Securities 297Mortgage-Backed Securities Clearing Corporation 298The Impact of Securitized Mortgages on the Mortgage Market 299Subprime Mortgages 299
Summary 300Key Terms 3 0 1
Questions 3 0 1
Quantitative Problems 302Web Exercises: The Mortgage Markets 303
Chapter 13 The Foreign Exchange Market 305Preview 305Foreign Exchange Market 306
What Are Foreign Exchange Rates? 307Why Are Exchange Rates Important? 307
• FOLLOWING THE FINANCIAL NEWS Foreign Exchange Rates 308How Is Foreign Exchange Traded? 308
Exchange Rates in the Long Run 309Law of One Price 309Theory of Purchasing Power Parity 310Why the Theory of Purchasing Power Parity Cannot Fully Explain
Exchange Rates 311Factors That Affect Exchange Rates in the Long Run 311
Exchange Rates in the Short Run . 313Comparing Expected Returns on Domestic and Foreign Assets 314Interest Parity Condition 316Demand Curve for Domestic Assets 317Supply Curve for Domestic Assets 319Equilibrium in the Foreign Exchange Market 319
Explaining Changes in Exchange Rates 319Shifts in the Demand for Domestic Assets 319
• CASE Changes in the Equilibrium Exchange Rate: Two Examples 324Changes in Interest Rates 324
xvi i i Contents in Detail
Changes in the Money Supply 325
Exchange Rate Overshooting 326
• CASE Why Are Exchange Rates So Volatile? 327• CASE The Dollar and Interest Rates, 1973-2007 3 2 8• CASE The Euro's First Nine Years 329• CASE Reading the Wall Street Journal: The "Currency Trading" Column 330• FOLLOWING THE FINANCIAL NEWS The "Currency Trading" Column 3 3 1• THE PRACTICING MANAGER Profiting from Foreign Exchange Forecasts 332Summory ' 333Key Terms 333Questions 333Quantitative Problems 334Web Exercises: The Foreign Exchange Market 335
Chapter 14 The International Financial System 337Preview 337
Intervention in the Foreign Exchange Market 337
Foreign Exchange Intervention and the Money Supply 338
• INSIDE THE FED A Day at the Federal Reserve Bank of New York's Foreign Exchange Desk 339Unsterilized Intervention 340Sterilized Intervention 341
Balance of Payments 342
Exchange Rate Regimes in the International Financial System 343
• GLOBAL Why the Large U.S. Current Account Deficit Worries Economists 344Fixed Exchange Rate Regimes 344How a Fixed Exchange Rate Regime Works 345
• GLOBAL The Euro's Challenge to the Dollar 345
• GLOBAL Argentina's Currency Board 348
• GLOBAL Dollarization 349• CASE The Foreign Exchange Crisis of September 1992 349• THE PRACTICING MANAGER Profiting from a Foreign Exchange Crisis 3 5 1• CASE Recent Foreign Exchange Crises in Emerging Market Countries:
Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002 352• CASE How Did China Accumulate Over $1 Trillion of International Reserves? 353
Managed Float 354
Capital Controls 355
Controls on Capital Outflows . 355
Controls on Capital Inflows ' ' 355
The Role of the IMF 356
, Should the IMF Be an International Lender of Last Resort? 356
How Should the IMF Operate? 358Summary 359Key Terms 359Questions 360Quoniitative Problems 3 6 1Web Exercises: The International Financial System 3 6 1
Contents in Detail x ix
PART FIVE FUNDAMENTALS OF FINANCIAL INSTITUTIONS 363
Chapter 15 Why Do Financial Institutions Exist? 365Preview 365
Basic Facts About Financial Structure Throughout the World 365
Transaction Costs 369
How Transaction Costs Influence Financial Structure 369
How Financial Intermediaries Reduce Transaction Costs 369
Asymmetric Information: Adverse Selection and Moral Hazard 370
The Lemons Problem: How Adverse Selection Influences Financial Structure 371
Lemons in the Stock and Bond Markets 371
Tools to Help Solve Adverse Selection Problems 372
• CONFLICTS OF INTEREST The Enron Implosion 374
How Moral Hazard Affects the Choice Between Debt and Equity Contracts 376
Moral Hazard in Equity Contracts: The Principal-Agent Problem 377
Tools to Help Solve the Principal-Agent Problem 378
How Moral Hazard Influences Financial Structure in Debt Markets 379
Tools to Help Solve Moral Hazard in Debt Contracts 380
Summary 382
• CASE Financial Development and Economic Growth 3 8 3• CASE Is China a Counter-Example to the Importance of Financial Development? 385
Financial Crises and Aggregate Economic Activity 386
Factors Causing Financial Crises 386
• CASE Financial Crises in the United States 3 8 9• MINI-CASE Case Study of a Financial Crisis: The Great Depression 3 9 1• CASE Financial Crises in Emerging Market Countries: Mexico, 1994—1995;
East Asia, 1997-1998; and Argentina, 2001-2002 3 9 1Summery 3 9 5
Key Terms 3 9 6
Questions 3 9 6
Quantitative Problems 3 9 7
Web Exercises: Why Do Financial Institutions Exist? 3 9 7
Chapter 16 What Should Be Done About Conflicts of Interest?A Central Issue in Business Ethics 399Preview 399
What Are Conflicts of Interest and Why Are They Important? ; 400
Why Do We Care About Conflicts of Interest? 401
Ethics and Conflicts of Interest 401
Types of Conflicts of Interest 401
Underwriting and Research in Investment Banking 401
Auditing and Consulting in Accounting Firms 402
• CONFLICTS OF INTEREST The King, Queen, and Jack of the Internet 4 0 3
• CONFLiaS OF INTEREST Frank Quattrone and Spinning 4 0 4
Credit Assessment and Consulting in Credit-Rating Agencies 404
xx Contents in Detail
• CONFLICTS OF INTEREST The Collapse of Arthur Andersen 405
Universal Banking 405
• MINI-CASE Why Do Issuers of Securities Pay to Have Their Securities Rated? 406Can the Market Limit Exploitation of Conflicts of Interest? 406
• CONFLICTS OF INTEREST Banksters 407What Has Been Done to Remedy Conflicts of Interest? 410
Sarbanes-Oxley Act of 2002 410
Global Legal Settlement of 2002 410
A Framework for Evaluating Policies to Remedy Conflicts of Interest 411
Approaches to Remedying Conflicts of Interest 412
• CASE Evaluating Sarbanes-Oxley and the Global Legal Settlement 414Summary 417Key Terms 417Questions 417Web Exercises: What Should Be Done About Conflicts of Interest? 418
PART SIX THE FINANCIAL INSTITUTIONS INDUSTRY im
Chapter 17 Banking and the Management of Financial Institutions 421Preview 421
The Bank Balance Sheet 421
Liabilities 422
Assets 424
Basic Banking 425
General Principles of Bank Management 428
Liquidity Management and the Role of Reserves 428
Asset Management 431
Liability Management 432
Capital Adequacy Management . 433
• THE PRACTICING MANAGER Strategies for Managing Bank Capital 435
• CASE Did the Capital Crunch Cause a Credit Crunch in the Early 1990s? 436Off-Balance-Sheet Ac t i v i t ies 437
Loan Sales 437
Generation of Fee Income 437
Trading Activities and Risk Management Techniques 438
• CONFLICTS OF INTEREST Barings, Daiwa, Sumitomo, and Allied Irish:Rogue Traders and the Principal-Agent Problem 439
Measuring Bank Performance 440
Bank's Income Statement 440
Measures of Bank Performance 442
Recent Trends in Bank Performance Measures 443
Summary 444
Key Terms 445Questions 445Quantitative Problems 446Web Exercises: Bonking and the Management of Financiai Institutions 447
Contents in Detail xx i
Chapter 18 Commercial Banking Industry: Structure and Competition 449Preview 449
Historical Development of the Banking System 450
Multiple Regulatory Agencies 452
Financial Innovation and the Evolution of the Banking Industry 452
Responses to Changes in Demand Conditions: Interest Rate Volatility 453
Responses to Changes in Supply Conditions: Information Technology 454
• E-FINANCE Will "Clicks" Dominate "Bricks" in the Banking Industry? 4 5 6• E-FINANCE Why Are Scandinavians So Far Ahead of Americans in Using Electronic
Payments and Online Banking? 457• E-FINANCE Are We Headed for a Cashless Society? 458
Avoidance of Existing Regulations 460
• THE PRACTICING MANAGER Profiting from a New Financial Product: A Case Study of Treasury Strips 462Financial Innovation and the Decline of Traditional Banking 464
Structure of the U.S. Commercial Banking Industry 467
Restrictions on Branching 468
Response to Branching Restrictions 469
Bank Consolidation and Nationwide Banking 470
• E-FINANCE Information Technology and Bank Consolidation 4 7 2
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 472
What Will the Structure of the U.S. Banking Industry Look Like in
the Future? 473
Are Bank Consolidation and Nationwide Banking Good Things? 473
Separation of Banking and Other Financial Service Industries 474
Erosion of Glass-Steagall 474
The Gramm-Leach-Bliley Financial Services Modernization Act of 1999:
Repeal of Glass-Steagall 475
Implications for Financial Consolidation 475
Separation of the Banking and Other Financial Services Industries
Throughout the World 475
International Banking 476
Eurodollar Market 477
Structure of U.S. Banking Overseas 477
Foreign Banks in the United States 478
Summary 479Key Terms 480Questions 4 8 0Web Exercises: Commercial Banking Industry: Structure ond Competition / 4 8 1
Chapter 19 Savings Associations and Credit Unions 483Preview 483
Mutual Savings Banks 484
Savings and Loan Associations 485
Mutual Savings Banks and Savings and Loans Compared 485
Savings and Loans in Trouble: The Thrift Crisis 486
Later Stages of the Crisis: Regulatory Forbearance 487
Competitive Equality in Banking Act of 1987 488
Contents in Detail
Political Economy of the Savings and Loan Crisis 489Principal-Agent Problem for Regulators and Politicians 489
• CASE Principal-Agent Problem in Action: Charles Keating and the Lincoln Savings and Loan Scandal 4 9 0
Savings and Loan Bailout: Financial Institutions Reform, Recovery,and Enforcement Act of 1989 491
The Savings and Loan Industry Today 492Number of Institutions 493S&L Size 493S&L Assets 494S&L Liabilities and Net Worth 496Capital 496Profitability and Health 496The Future of the Savings and Loan Industry 497
Credit Unions 499History and Organization 499Sources of Funds 504Uses of Funds 505Advantages and Disadvantages of Credit Unions 505The Future of Credit Unions 506
Summary 5 0 7Key Terms 5 0 8Questions 5 0 8Web Exercises: Savings Associations and Credit Unions 5 0 9
Chapter 20 Banking Regulation 511Preview 511Asymmetric Information and Bank Regulation 511
Government Safety Net: Deposit Insurance and the FDIC 512• GLOBAL The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing? 5 1 4
Restrictions on Asset Holdings and Bank Capital Requirements 515• GLOBAL Basel 2: How Well Will It Work? 5 1 7
Bank Supervision: Chartering and Examination 518Assessment of Risk Management 519Disclosure Requirements 520Consumer Protection 520Restrictions on Competition 520
• E-FINANCE Electronic Banking: New Challenges for Bank Regulation , 521
International Banking Regulation v ' 523
Problems in Regulating International Banking 523Summary 524
The 1980s U.S. Banking Crisis 524Federal Deposit Insurance Corporation Improvement Act of 1991 526Banking Crises Throughout the World 527
Scandinavia 528Latin America 529Russia and Eastern Europe 530
Contents in Detail xx i l i
Japan 531
China 532
East Asia 532
"Dejd Vu All Over Again" 533
Summary 533Key Terms 5 3 4
Questions 5 3 4Quantitative Problems 534Web Exercises: Banking Regulation 5 3 5
Chapter 21 The Mutual Fund Industry 537Preview 537
The Growth of Mutual Funds 537
The First Mutual Funds 538
Benefits of Mutual Funds 538
Ownership of Mutual Funds 539
Mutual Fund Structure 542
Open- Versus Closed-End Funds 542
Organizational Structure 542
• CASE Calculating a Mutual Fund's Net Asset Value 543Investment Objective Classes 544
Equity Funds 544
Bond Funds 545
Hybrid Funds 546
Money Market Funds 546
Index Funds 548
Fee Structure of Investment Funds 549
Regulation of Mutual Funds 550
Hedge Funds 551
• MINI-CASE The Long Term Capital Debacle 553
Conflicts of Interest in the Mutual Fund Industry 554
Sources of Conflicts of Interest 554
• CONFLICTS OF INTEREST Many Mutual Funds Are Caught Ignoring Ethical Standards 555Mutual Fund Abuses 555
• CONFLICTS OF INTEREST SEC Survey Reports Mutual Fund Abuses Widespread 557Government Response to Abuses 557
Summary , 558
Key Terms x ' 558Questions 559Quontitative Problems 559Web Exercises: Investment Banks, Brokerage Firms, and Mutuol Funds 560
Chapter 22 Insurance Companies and Pension Funds 561Preview 561
Insurance Companies 562
Fundamentals of Insurance 563
xxiv Contents in Detail
Adverse Selection and Moral Hazard in Insurance 563
Selling Insurance 564
• MINI-CASE Insurance Agent: The Customer's Ally 565
Growth and Organization of Insurance Companies 565
Types of Insurance 566
Life Insurance 567
Health Insurance 570
Property and Casualty Insurance 572
Insurance Regulation 574
• CONFLICTS OF INTEREST Insurance Behemoth Charged with Conflicts of Interest Violations 5 7 4• THE PRACTICING MANAGER Insurance Management 5 7 5
Screening 575
Risk-Based Premium 576
Restrictive Provisions 576
Prevention of Fraud 577
Cancellation of Insurance 577
Deductibles 577
Coinsurance 577
Limits on the Amount of Insurance 577
Summary 578
Pensions 578
Types of Pensions 578
Defined-Benefit Pension Plans 579
Defined-Contribution Pension Plans 579
Private and Public Pension Plans 580
• MINI-CASE Power to the Pensions 581
Regulation of Pension Plans 584
Employee Retirement Income Security Act 584
Individual Retirement Plans 587
The Future of Pension Funds 587
Summary 5 8 7
Key Terms 5 8 8
Questions 5 8 8
Quantitative Problems 5 8 9
Web Exercises: Insurance Companies and Pension Funds 5 8 9
Chapter 23 Investment Banks, Security Brokers and Dealers,and Venture Capital Firms l 591Preview 591
Investment Banks 592
Background 592
Underwriting Stocks and Bonds 593
• FOLLOWING THE FINANCIAL NEWS New Securities Issues 5 9 6
Equity Sales 598
Mergers and Acquisitions 599
Securities Brokers and Dealers 600
Contents in Detail xxv
Brokerage Services 600
• MINI-CASE Example of Using the Limit-Order Book 6 0 3Securities Dealers 604
Regulation of Securities Firms 604
Relationship Between Securities Firms and Commercial Banks 605
Private Equity Investment 606
Venture Capital Firms 606
Private Equity Buyouts 610
• E-FINANCE Venture Capitalists Lose Focus with Internet Companies 6 1 1
Advantages to Private Equity Buyouts 611
Life Cycle of the Private Equity Buyout 612
Implications of the Private Equity Ownership Structure 612
Summary 6 1 3. Key Terms 6 1 3
Questions 6 1 4Quantitative Problems 6 1 4Web Exercises: Investment Bonks, Security Brokers and Dealers, ond Venture Capital Firms 615
PART SEVEN THE MANAGEMENT OF FINANCIAL INSTITUTIONS 617
Chapter 24 Risk Management in Financial Institutions 619Preview 619
Managing Credit Risk 619
Screening and Monitoring 620
Long-Term Customer Relationships 621
Loan Commitments 622
Collateral 622
Compensating Balances 622
Credit Rationing 623
Managing Interest-Rate Risk 624
Income Gap Analysis 625
Duration Gap Analysis 627
Example of a Nonbanking Financial Institution 631
Some Problems with Income Gap and Duration Gap Analyses 633
• THE PRACTICING MANAGER Strategies for Managing Interest-Rate Risk 6 3 4Summary 6 3 6Key Terms 6 3 6Questions . j 6 3 6Quantitative Problems 6 3 7Web Exercises: Risk Management in Financial Institutions 6 3 9
Chapter 25 Hedging with Financial Derivatives 641Preview 641
Hedging 641
Forward Markets 642
Interest-Rate Forward Contracts 642
xxvi Contents in Detail
• THE PRACTICING MANAGER Hedging Interest-Rate Risk with Forward Contracts 642
Pros and Cons of Forward Contracts 643Financial Futures Markets 644
Financial Futures Contracts 644• FOLLOWING THE FINANCIAL NEWS Financial Futures 645• THE PRACTICING MANAGER Hedging with Financial Futures 6 4 6
Organization of Trading in Financial Futures Markets 648Globalization of Financial Futures Markets 648Explaining the Success of Futures Markets 649
• MINI-CASE The Hunt Brothers and the Silver Crash 6 5 1
• THE PRACTICING MANAGER Hedging Foreign Exchange Risk with Forward and Futures Contracts 6 5 2Hedging Foreign Exchange Risk with Forward Contracts 652Hedging Foreign Exchange Risk with Futures Contracts 653
Stock Index Futures 654Stock Index Futures Contracts 654
• MINI-CASE Program Trading and Portfolio Insurance: Were They to Blamefor the Stock Market Crash of 1987? 654
• FOLLOWING THE FINANCIAL NEWS Stock Index Futures 655• THE PRACTICING MANAGER Hedging with Stock Index Futures 656Options 657
Options Contracts 657Profits and Losses on Option and Futures Contracts 658Factors Affecting the Prices of Option Premiums 661Summary 662
• THE PRACTICING MANAGER Hedging with Futures Options 663Interest-Rate Swaps 664
Interest-Rate Swap Contracts 664• THE PRACTICING MANAGER Hedging with Interest-Rate Swaps 6 6 5
Advantages of Interest-Rate Swaps 666Disadvantages of Interest-Rate Swaps 666Financial Intermediaries in Interest-Rate Swaps 667
Credit Derivatives 667Credit Options 668Credit Swaps 668Credit-Linked Notes 669
• CASE Are Financial Derivatives a Worldwide Time Bomb? 669• CONFLIQS OF INTEREST < The Orange County Bankruptcy 670Summary - / 6 7 1Key Terms 672Questions 672Quantitative Problems 673Web Exercises: Hedging with financial Derivatives 675
Glossary G-l
Index 1-1