part1 INTRODUCTION AND OVERVIEW OF FINANCIAL MARKETS 1
1 Introduction 2
Why Study Financial Markets and Institutions？：Chapter Overview 2
Overview of Financial Markets 4
Primary Markets versus Secondary Markets 4
Money Markets versus Capital Markets 8
Financial Market Regulation 9
Foreign Exchange Markets 10
Overview of Financial Institutions 11
Unique Economic Functions Performed by Financial Institutions 14
Additional Benefits FIs Provide to Suppliers of Funds 17
Economic Functions FIs Provide to the Financial System as a Whole 18
Regulation of Financial Institutions 20
Globalization of Financial Markets and Institutions 21
2 Determinants of Interest Rates 26
Interest Rate Fundamentals：Chapter Overview 26
Time Value of Money and Interest Rates 27
Time Value of Money 27
Present Values 28
Future Values 30
Interest Rates on Securities with a Maturity of Less than One Year 33
Loanable Funds Theory 36
Supply of Loanable Funds 36
Demand for Loanable Funds 38
Equilibrium Interest Rate 40
Factors that Cause the Supply and Demand Curves for Loanable Funds to Shift 40
Movement of Interest Rates Over Time 45
Determinants of Interest Rates for Individual Securities 45
Inflation 45
Real Interest Rates 47
Fisher Effect 47
Default or Credit Risk 48
Liquidity Risk 48
Special Provisions or Covenants 49
Term to Maturity 50
Term Structure of Interest Rates 52
Unbiased Expectations Theory 52
Liquidity Premium Theory 54
Market Segmentation Theory 55
Forecasting Interest Rates 56
3 Interest Rates and Security Valuation 58
Interest Rates as a Determinant of Financial Security Values：Chapter Overview 58
Various Interest Rate Measures 59
Required Rate of Return 60
Expected Rate of Return 60
Required versus Expected Rates of Return：The Role of Efficient Markets 61
Realized Rate of Return 62
Coupon Rate 62
Bond Valuation 63
Bond Valuation Formula Used to Calculate Fair Present Values 63
Bond Valuation Formula Used to Calculate Yield to Maturity 65
Impact of Interest Rate Changes on Security Values 66
Impact of Maturity on Security Values 68
Maturity and Security Prices 68
Maturity and Security Price Sensitivity to Changes in Interest Rates 69
Impact of Coupon Rates on Security Values 70
Coupon Rate and Security Prices 70
Coupon Rate and Security Price Sensitivity to Changes in Interest Rates 70
Duration 71
A Simple Illustration of Duration 73
A General Formula for Duration 74
Features of Duration 78
Economic Meaning of Duration 78
Large Interest Rate Changes and Duration 81
Appendix：Equity Valuation 83
4 The Federal Reserve System，Monetary Policy，and Interest Rates 89
Major Duties and Responsibilities of the Federal Reserve System：Chapter Overview 89
Structure of the Federal Reserve System 90
Federal Reserve Banks 90
Board of Governors of the Federal Reserve System 97
Federal Open Market Committee 98
Balance Sheet of the Federal Reserve 98
Monetary Policy Tools 100
Open Market Operations 102
The Discount Rate 104
Reserve Requirements （Reserve Ratios） 106
The Federal Reserve，the Money Supply，and Interest Rates 109
Effects of Monetary Tools on Various Economic Variables 109
Money Supply versus Interest Rate Targeting 111
International Monetary Policies and Strategies 115
Impact of U.S.Monetary Policy on Foreign Exchange Rates 116
part2 SECURITIES MARKETS 121
5 Money Markets 122
Definition of Money Markets：Chapter Overview 122
Money Markets 123
Money Market Securities 125
Treasury Bills 126
Federal Funds 132
Repurchase Agreements 133
Commercial Paper 136
Negotiable Certificates of Deposit 139
Banker’s Acceptances 141
Comparison of Money Market Securities 142
Money Market Participants 143
The U.S.Treasury 143
The Federal Reserve 144
Commercial Banks 144
Brokers and Dealers 144
Corporations 145
Other Financial Institutions 145
International Aspects of Money Markets 145
Euro Money Markets 145
Euro Money Market Securities 149
6 Bond Markets 153
Definition of Bond Markets：Chapter Overview 153
Bond Market Securities 154
Treasury Notes and Bonds 154
Municipal Bonds 164
Corporate Bonds 171
Bond Ratings 177
Bond Market Indexes 178
Bond Market Participants 179
Comparison of Bond Market Securities 179
International Aspects of Bond Markets 181
Eurobonds，Foreign Bonds，and Brady and Sovereign Bonds 184
Eurobonds 184
Foreign Bonds 185
Brady Bonds and Sovereign Bonds 185
7 Mortgage Markets 189
Mortgages and Mortgage-Backed Securities：Chapter Overview 189
Primary Mortgage Market 191
Mortgage Characteristics 191
Mortgage Amortization 196
Other Types of Mortgages 199
Secondary Mortgage Markets 201
History and Background of Secondary Mortgage Markets 201
Mortgage Sales 202
Securitization of Mortgages 203
Institutional Use of Mortgage Markets 212
International Trends in Securitization 213
Demand by International Investors for U.S.Mortgage-Backed Securities 213
International Mortgage Securitization 214
8 Stock Markets 218
The Stock Markets：Chapter Overview 218
Stock Market Securities 219
Common Stock 220
Preferred Stock 225
Primary and Secondary Stock Markets 226
Primary Markets 226
Secondary Markets 232
Stock Market Indexes 240
Stock Market Participants 244
Other Issues Pertaining to Stock Markets 246
Economic Indicators 246
Market Efficiency 246
Stock Market Regulations 249
International Aspects of Stock Markets 250
Appendix：Event Study Tests 254
9 Foreign Exchange Markets 256
Foreign Exchange Markets and Risk：Chapter Overview 256
Background and History of Foreign Exchange Markets 258
Foreign Exchange Rates and Transactions 258
Foreign Exchange Rates 258
Foreign Exchange Transactions 260
Return and Risk of Foreign Exchange Transactions 262
Role of Financial Institutions in Foreign Exchange Transactions 267
Interaction of Interest Rates，Inflation，and Exchange Rates 273
Purchasing Power Parity 273
Interest Rate Parity 274
Balance of Payment Accounts 275
CurrentAccount 276
Capital Accounts 277
10 Derivative Securities Markets 280
Derivative Securities：Chapter Overview 280
Forwards and Futures 281
Spot Markets 281
Forward Markets 282
Futures Markets 284
Options 291
Call Options 293
Put Options 295
Option Values 296
Option Markets 298
Regulation of Futures and Options Markets 304
Swaps 304
Interest Rate Swaps 305
Currency Swaps 308
Swap Markets 309
Caps，Floors，and Collars 310
Appendix：Black-Scholes Option Pricing Model 313
part3 DEPOSITORY INSTITUTIONS 317
11 Commercial Banks 318
Commercial Banks as a Sector of the Financial Institutions Industry：Chapter Overview 318
Definition of a Commercial Bank 320
Balance Sheets and Recent Trends 320
Assets 320
Liabilities 322
Equity 324
Off-Balance-Sheet Activities 324
Other Fee-Generating Activities 325
Size，Structure，and Composition of the Industry 328
Economies of Scale and Scope 329
Bank Size and Concentration 335
Bank Size and Activities 336
Industry Performance 339
Regulators 340
Federal Deposit Insurance Corporation 340
Office of the Comptroller of the Currency 340
Federal Reserve System 340
State Authorities 341
12 Thrift Institutions 343
Three Categories of Thrift Institutions：Chapter Overview 343
Savings Associations 344
Size，Structure，and Composition of the Industry 344
Balance Sheets and Recent Trends 348
Savings Banks 350
Size，Structure，and Composition of the Industry 350
Balance Sheets and Recent Trends 350
Regulators of Savings Institutions 351
Savings Association and Savings Bank Recent Performance 352
Credit Unions 354
Size，Structure，and Composition of the Industry 354
Balance Sheets and Recent Trends 359
Regulators 362
Industry Performance 362
13 Depository Institutions’ Financial Statements and Analysis 364
Why Evaluate the Performance of Depository Institutions：Chapter Overview 364
Financial Statements of Commercial Banks 366
Balance Sheet Structure 366
Off-Balance-SheetAssets and Liabilities 374
Income Statement 380
Direct Relationship between the Income Statement and the Balance Sheet 382
Financial Statement Analysis Using a Return on Equity Framework 383
Return on Equity and Its Components 384
Return on Assets and Its Components 390
Other Ratios 393
Impact of Market Niche and Bank Size on Financial Statement Analysis 394
Impact of a Bank’s Market Niche 394
Impact of Size on Financial Statement Analysis 395
14 Regulation of Depository Institutions 398
Specialness and Regulation：Chapter Overview 398
Types of Regulations and the Regulators 399
Safety and Soundness Regulation 399
Monetary Policy Regulation 401
Credit Allocation Regulation 401
Consumer Protection Regulation 401
Investor Protection Regulation 402
Entry and Chartering Regulation 402
Regulators 402
Regulation of Product and Geographic Expansion 403
Product Segmentation in the U.S.Depository Institutions Industry 404
Geographic Expansion in the U.S.Depository Institutions Industry 410
History of Bank and Savings Institution Guarantee Funds 414
FDIC 414
The Federal Savings and Loan Insurance Corporation and Its Demise 415
Causes of the Depository Fund Insolvencies 415
Non-U.S.Deposit Insurance Systems 418
Balance Sheet Regulations 418
Regulations on Depository Institution Liquidity 418
Regulations on Capital Adequacy （Leverage） 419
Off-Balance-Sheet Regulations 422
Foreign versus Domestic Regulation of Depository Institutions 424
Product Diversification Activities 424
Global or International Expansion Activities 424
Appendix A：Depository Institutions and Their Regulators 429
Appendix B：Financial Services Modernization Act of 1999：Summary of Provisions 430
Appendix C：Calculating Minimum Required Reserves at U.S.Depository Institutions 434
Appendix D：Calculating Risk-Based Capital Ratios 438
part4 OTHER FINANCIAL INSTITUTIONS 445
15 Insurance Companies 446
Two Categories of Insurance Companies：Chapter Overview 446
Life Insurance Companies 447
Size，Structure，and Composition of the Industry 447
Balance Sheets and Recent Trends 452
Regulation 454
Property-Casualty Insurance Companies 455
Size，Structure，and Composition of the Industry 455
Balance Sheets and Recent Trends 460
Regulation 467
16 Securities Firms and Investment Banks 470
Services Offered by Securities Firms versus Investment Banks：Chapter Overview 470
Size，Structure，and Composition of the Industry 471
Securities Firm and Investment Bank Activity Areas 473
Investing 474
Investment Banking 474
Market Making 478
Trading 479
Cash Management 482
Mergers and Acquisitions 482
Other Service Functions 482
Recent Trends and Balance Sheets 483
Recent Trends 483
Balance Sheet 486
Regulation 487
17 Finance Companies 490
Finance Company Functions：Chapter Overview 490
Size，Structure，and Composition of the Industry 490
Balance Sheets and Recent Trends 494
Assets 494
Liabilities and Equity 499
Regulation 499
18 Mutual Funds 502
Mutual Funds：Chapter Overview 502
Size，Structure，and Composition of the Industry 503
Historical Trends 503
Different Types of Mutual Funds 504
Mutual Fund Prospectuses and Objectives 511
Size and Mutual Fund Performance：The Case of the Magellan Fund 514
Investor Returns from Mutual Fund Ownership 515
Mutual Fund Costs 517
Mutual Fund Share Quotes 520
Balance Sheets and Recent Trends 521
Money Market Funds 521
Long-Term Funds 522
Regulation 523
19 Pension Funds 525
Pension Funds Defined：Chapter Overview 525
Size，Structure，and Composition of the Industry 526
Insured versus Noninsured Pension Funds 526
Defined Benefit versus Defined Contribution Pension Funds 528
Private Pension Funds 529
Public Pension Funds 537
Financial Asset Investments and Recent Trends 538
Private Pension Funds 538
Public Pension Funds 539
Regulation of Pension Funds 540
part5 RISK MANAGEMENT IN FINANCIAL INSTITUTIONS 545
20Types of Risks Incurred by Financial Institutions 546
Why Financial Institutions Need to ManageRisk：Chapter Overview 546
Credit Risk 547
Liquidity Risk 550
Interest Rate Risk 550
The Federal Reserve and Interest Rate Risk 550
Maturity Mismatching and Interest Rate Risk 551
Market Risk 554
Off-Balance-Sheet Risk 554
Foreign Exchange Risk 555
Country or Sovereign Risk 557
Technology and Operational Risk 557
Insolvency Risk 560
Interaction Among Risks 560
21 Managing Risk on the BalanceSheet Ⅰ：Credit Risk 564
Credit Risk Management：Chapter Overview 564
Credit Analysis 568
Real Estate Lending 568
Consumer （Individual） and Small-Business Lending 571
Mid-Market Commercial and Industrial Lending 571
Large Commercial and Industrial Lending 578
Calculating the Return on a Loan 582
Return on Assets （ROA） 584
RAROC Models 586
Appendix：Loan Portfolio Risk and Management 589
22 Managing Risk on the Balance SheetⅡ：Liquidity Risk 593
Liquidity Risk Management：Chapter Overview 593
Causes of Liquidity Risk 594
Liquidity Risk and Depository Institutions 595
Liability Side Liquidity Risk 595
Asset Side Liquidity Risk 599
Measuring a Bank’s Liquidity Exposure 599
Liquidity Risk，Unexpected Deposit Drains，and Bank Runs 603
Bank Runs，the Discount Window，and Deposit Insurance 605
Liquidity Risk and Insurance Companies 609
Life Insurance Companies 609
Property-Casualty Insurance Companies 609
Guarantee Programs for Life and Property-Casualty Insurance Companies 610
Liquidity Risk and Mutual Funds 611
23 Managing Risk on the Balance Sheet Ⅲ：Interest Rate and Insolvency Risk 614
Interest Rate and Insolvency Risk Management：Chapter Overview 614
Interest Rate Risk Measurement and Management 616
Repricing Model 616
Duration Model 623
Insolvency Risk Management 629
Capital and Insolvency Risk 630
24 Managing Risk with Derivative Securities 640
Derivative Securities Used to Manage Risk：Chapter Overview 640
Forward and Futures Contracts 641
Hedging with Forward Contracts 642
Hedging with Futures Contracts 643
Options 648
Basic Features of Options 648
Actual Interest Rate Options 652
Hedging with Options 654
Swaps 654
Interest Rate Swaps 655
Currency Swaps 658
Credit Risk Concerns with Swaps 660
Comparison of Hedging Methods 661
Writing versus Buying Options 661
Futures versus Options Hedging 662
Swaps versus Forwards，Futures，and Options 663
25 Loan Sales and Asset Securitization 667
Why Financial Institutions Securitize Assets：Chapter Overview 667
Loan Sales 668
Types of Loan Sales Contracts 669
Bank Loan Sale Market 672
Secondary Market for Less Developed Country Debt 675
Factors Encouraging Future Loan Sales Growth 675
Factors Deterring Future Loan Sales Growth 676
Loan Securitization 677
Pass-Through Security 677
Collateralized Mortgage Obligation 683
Mortgage-Backed Bond 686
Securitization of Other Assets 688
Can All Assets Be Securitized？ 689
Glossary 693
Appendix 703
References 711
Index 713