PART ⅠOverview of the Financial Environment 1
Chapter 1 Role of Financial Markets and Institutions 2
Overview of Financial Markets 2
Money versttsCapitalMarkets 3
Primary versus Secondary Markets 3
Organized versus Over-the-Counter Markets 3
Securities Traded in Financial Markets 3
Money Market Securities 3
Capital Market Securities 4
Derivative Securities 5
Valuation of Securities in Financial Markets 6
Market Pricing ofSecurities 6
MarketEfficiency 8
Financial Market Regulation 8
Disclosure 8
Other Regulations 9
Financial Market Globalization 9
Role of the Foreign Exchange Market 9
Foreign Exchange Rates 10
Role of Financial Institutions in Financial Markets 10
Role of Depository Institutions 11
Role ofNondepositoryfinancial Institutions 13
Comparison of Roles among Financial Institutions 18
Overview of Financial Institutions 19
Competition between Financial Institutions 19
Consolidation of Financial Institutions 20
Participation in Financial Markets 24
Global Expansion by Financial Institutions 27
Summary 27
Questions and Applications 28
Chapter 2 Determination of Interest Rates 30
Loanable Funds Theory 30
Household Demand for Loanable Funds 31
Business Demand for Loanable Funds 31
Government Demandfor Loanable Funds 33
Foreign Demand for Loanable Funds 33
Aggregate Demandfor Loanable Funds 34
Supply of Loanable Funds 34
Equilibrium Interest Rate 36
Economic Forces That Affect Interest Rates 37
Impact of Economic Growth on Interest Rates 38
Impact of Inflation on Interest Rates 39
Impact ofthe Money Supply on Interest Rates 41
Impact of the Budget Deficit on Interest Rates 42
Impact of Foreign Flows of Funds on Interest Rates 44
Summary of Forces That Affect Interest Rates 46
Evaluation of Interest Rates over Time 46
Forecasting Interest Rates 47
Summary 49
Questions and Applications 50
Problems 52
Chapter 3 Structure of Interest Rates 53
Characteristics of Debt Securities That Cause Their Yields to Vary 53
Credit (Default) Risk 54
Liquidity 56
Tax Status 56
Term to Maturity 57
Special Provisions 58
Explaining Actual Yield Difierentials 59
Yield Differentials of Money Market Securities 59
Yield Differentials of Capital Market Securities 60
Estimating the Appropriate Yield 61
A Closer Look at the Term Structure 62
Pure Expectations Theory 63
Liquidity Premium Theory 68
Segmented Markets Theory 70
Research on Term Structure Theories 72
Integrating the Theories of the Term Structure 72
Uses of the TemStructure 73
Impact of Debt Management on Term Structure 75
Impact of September 11 on the Term Structure 77
Historical Review of the Term Structure 77
International Structure of Interest Rates 79
Summary 80
Questions and Applications 81
Problems 82
Integ rative Problem:Interest Rate Forecasts and Investment Decisions 83
PART ⅡThe Fed and Monetary Policy 85
Chapter 4 Functions of the Fed 86
Organization of the Fed 86
Federal Reserve District Banks 87
Member Banks 87
Board of Governors 88
Federal Open Market Committee(FOMC) 89
Advisory Committees 90
Integration of Federal Reserve Components 90
Monetary Policy Tools 91
Open Market Operations 91
Adjusting the Discount Rate 95
Adjusting the Reserve Requirement Ratio 96
Comparison of Monetary Policy Tools 98
Impact of Technical Factors on Funds 99
Fed Control of the Money Supply 99
Limitations of Controlling Money Supply 100
Monetary Control Act of 1980 102
Global Monetary Policy 103
A Single Euro Zone Monetary Policy 103
Global Central Bank Coordination 104
Summary 104
Questions and Applications 105
Chapter 5 Monetary Theory and Policy 107
Monetary Theory 107
Pure Keynesian Theory 107
Quantity Theory and the Monetarist Approach 111
Theory of Rational Expectations 112
Which Theory is Correct? 114
Tradeoff Faced by the Fed 114
Impact of Other Forces on the Tradeoff 115
Economic Indicators Monitored by the Fed 119
Indicators of Economic Growth 119
Indicators of Inflation 120
How the Fed Uses Indicators 120
Lags in Monetary Policy 121
Assessing the Impact of Monetary Policy 121
Forecasting Money Supply Movements 122
Forecasting the Impact of Monetary Policy 126
Integrating Monetary and Fiscal Policies 127
History 128
Monetizing the Debt 129
Market Assessment of Integrated Policies 131
Global Effects of Monetary Policy 131
Impact of the Dollar 132
Impact of Global Economic Conditions 132
Transmission of Interest Rates 132
Fed Policy during the Asian Crisis 133
Summary 133
Questions and Applications 134
Integrative Problem:Fed Watching 136
PART ⅢDebt Security Markets 139
Chapter 6 Money Markets 140
Money Market Securities 140
Treasury Bills 141
Commercial Paper 144
Negotiable Certificates of Deposit(NCDs) 146
Repurchase Agreements 146
Federal Funds 147
Banker's Acceptances 148
Institutional Use of Money Markets 150
Valuation of Money Market Securities 151
Explaining Money Market Price Movements 152
Indicators of Future Money Market Security Prices 153
Risk of Money Market Securities 153
Measuring Risk 154
Interaction among Money Market Yields 155
Globalization of Money Markets 155
Eurodollar Deposits and Euronotes 156
Euro-Commercial Paper 156
Performance of Foreign Money Market Securities 157
Summary 158
Questions and Applications 159
Problems 160
Chapter 7 Bond Markets 162
Background on Bonds 162
Bond Yields 162
Treasury and Federal Agency Bonds 163
Treasury Bond Auction 163
Trading Treasury Bonds 164
Treasury Bond Quotations 165
Stripped Treasury Bonds 166
Inflation-Indexed Treasury Bonds 166
Brady Bonds 166
Federal Agency Bonds 167
Municipal Bonds 167
Trading and Quotations 168
Corporate Bonds 168
Private Placements of Corporate Bonds 169
Characteristics of Corporate Bonds 169
Trading Corporate Bonds 171
Corporate Bond Quotations 171
Junk Bonds 172
How Corporate Bonds Facilitate Restructuring 175
Institutional Use of Bond Markets 176
Globalization of Bond Markets 177
Eurobond Market 178
Tax Effects 179
Summary 179
Questions and Applications 180
Chapter 8 Bond Valuation and Risk 182
Bond Valuation Process 182
Bond Valuation with a Present Value Table 183
Impact of the Discount Rate on Bond Valuation 184
Impact of the Timing of Payments on Bond Valuation 184
Valuation of Bonds with Semiannual Payments 184
Use of Annuity Tables for Valuation 186
Relationships Between Coupon Rate,Required Return,and Bond Price 186
Implications for Financial Institutions 188
Explaining Bond Price Movements 189
Factors That Affct the Risk-Free Rate 189
Factors That Affectthe Credit(Default) Risk Premium 191
Summary of Factors Affecting Bond Prices 193
Sensitivity of Bond Prices to Interest Rate Movements 194
Bond Price Elasticity 195
Duration 197
Bond Investment Strategies Used by Investors 199
Matching Strategy 199
Laddered Strategy 199
Barbell Strategy 200
Interest Rate Strategy 200
Return and Risk of International Bonds 200
Influence of Foreign Interest Rate Movements 201
Influence of Credit Risk 201
Influence of Exchange Rate Fluctuations 201
Intemational Bond Diversification 202
Summary 203
Questions and Applications 203
Problems 205
APPENDIX 8:Forecasting Bond Prices and Yields 207
Forecasting Bond Portfolio Values 209
Forecasting Bond Portfolio Returns 210
Chapter 9 Mortgage Markets 216
Background on Mortgages 216
Residential Mortgage Characteristics 217
Insured versus Conventional Mortgages 218
Fixed-Rate versus Adjustable-Rate Mortgages 218
Mortgage Maturities 219
Creative Mortgage Financing 221
Graduated-PaymentMortgage(GPM) 222
Growing-Equity Mortgage 222
Second Mortgage 222
Shared-Appreciation Mortgage 222
Activities in the Mortgage Market 223
How the Secondary Market Facilitates Mortgage Activities 223
Unbundling of Mortgage Activities 223
Institutional Use of Mortgage Markets 224
Valuation of Mortgages 226
Factors ThatAffect the Risk-Free Interest Rate 227
Factors That Affect the Risk Premium 228
Summary of Factors Affecting Mortgage Prices 228
Indicators of Changes in Mortgages Prices 229
Risk from Investing in Mortgages 230
Interest Rate Risk 230
Prepayment Risk 231
Credit Risk 231
Measuring Risk 232
Use of Mortgage-Backed Securities 233
Ginnie Mae Mortgage-Backed Securities 234
Fannie Mae Mortgage-Backed Securities 234
Publicly Issued Pass-Through Securities(PIPs) 235
Participation Certificates(PC)s 235
Collateralized Mortgage Obligations(CMOs) 235
Mortgage-Backed Securities for Small Investors 236
Globalization of Mortgage Markets 237
Summary 237
Questions and Applications 238
Integrative Problem:Asset Allocation 239
PART ⅣEquity Markets 241
Chapter 10 Stock Offerings and Investor Monitoring 242
Background on Stock 242
Ownership and Voting Rights 242
Preferred Stock 242
Issuer Participation in Stock Markets 243
Initial Public Ofierings 244
Process of Going Public 244
Underwriter Efforts to Ensure Price Stability 245
Timing of IPOs 247
Initial Returns of IPOs 248
Long-Term Performance Following IPOs 249
Secondary Stock Offerings 250
Shelf-Registration 251
Stock Exchanges 251
Organized Exchanges 251
Over-the-Counter Market 253
Consolidation of Stock Exchanges 254
Late Trading Provided by Exchanges 254
Stock Quotations Provided by Exchanges 255
Stock Index Quotations 257
Investor Participation in the Secondary Market 258
How Investor Decisions Affect the Stock Price 259
Types of Investors 260
Monitoring by Investors 262
Shareholder Activism 262
The Corporate Monitoring Role 263
Stock Repurchases 264
Market for Corporate Control 264
Barriers to Corporate Control 265
Globalization of Stock Markets 266
Foreign Stock Offerings in the United States 266
International Placement Process 267
Global Stock Exchanges 267
Emerging Stock Markets 268
Methods Used to Invest in Foreign Stocks 269
Summary 270
Questions and Applications 270
Chapter 11 Stock Valuation and Risk 272
Stock Valuation Methods 272
Price-Earnings (PE)Method 272
Dividend Discount Model 273
Adjusting the Dividend Discount Model 275
Determining the Required Rate of Return to Value Stocks 277
Capital Asset Pricing Model 277
Arbitrage Pricing Model 279
Factors That Affect Stock Prices 279
Economic Factors 279
Market-Related Factors 281
Firm-Specific Factors 282
Integration of Factors Affecting Stock Prices 283
Role of Analysts in Valuing Stocks 285
Conflicts of Interest 285
Impact of Disclosure Regulations 285
Unbiased Analyst Rating Services 286
Stock Risk 286
Measures ofRisk 287
Applying Value at Risk 290
Methods of Determining the Maximum Expected Loss 290
Deriving the Maximum Dollar Loss 291
Common Adjustments to the Value-at-Risk Applications 292
Forecasting Stock Price Volatility and Beta 293
Methods of Forecasting Stock Price Volatility 293
Forecasting a Stock Portfolio's Volatility 294
Forecasting a Stock Portfolio's Beta 294
Stock Performance Measurement 295
Sharpe Index 295
TreynorIndex 295
Stock Market Efficiency 296
Forms of Efficiency 296
Tests of the Efficient Market Hypothesis 297
Foreign Stock Valuation,Performance,and Efficiency 299
Valuation of Foreign Stocks 299
Measuring Performance from Investing in Foreign Stocks 299
Performance from Global Diversification 300
International Market Efficiency 302
Summary 302
Questions and Applications 303
Problems 304
APPENDIX 11A:Stock Valuation:Lessons from Enron's Demise 306
Chapter 12 Market Microstructure and Strategies 313
Stock Market Transactions 313
Placing an Order 313
Margin Trading 314
Short Selling 316
Investing in Stock Indexes 317
How Trades are Executed 319
Floor Brokers 319
Specialists and Market-Makers 319
Electronic Communication Networks(ECNs) 320
Program Trading 323
Regulation of Stock Trading 324
Circuit Breakers 324
Securities and Exchange Commission (SEC) 324
How Barriers to International Stock Trading Have Decreased 327
Reduction in Transaction Costs 327
Reduction in Information Costs 327
Reduction in Exchange Rate Risk 328
Summary 328
Questions and Applications 328
Problems 330
Integrative Problem:Stock Market Analysis 331
PART ⅤDerivative Security Markets 333
Chapter 13 Financial Futures Markets 334
Background on Financial Futures 334
Steps Involved in Trading Futures 335
Purpose of Trading Financial Futures 336
Interpreting Financial Futures Tables 336
Valuation of Financial Futures 338
Impact of the Opportunity Costs 338
Explaining Price Movements of Bond Futures Contracts 338
Speculating with Interest Rate Futures 340
Impact of Leverage 340
Closing Out the Futures Position 341
Hedging with Interest Rate Futures 342
Using Interest Rate Futures to Create a Short Hedge 343
Using Interest Rate Futures to Create a Long Hedge 345
Hedging Net Exposure 346
Bond Index Futures 346
Stock Index Futures 347
Valuing Stock Index Futures Contracts 348
Speculating with Stock Index Futures 349
Hedging with Stock Index Futures 349
Dynamic Asset Allocation with Stock Index Futures 351
Prices of Stock Index Futures versus Stocks 352
Arbitrage with Stock Index Futures 352
Circuit Breakers on Stock Index Futures 353
Risk of Trading Futures Contracts 354
Market Risk 354
Basis Risk 354
Liquidity Risk 355
Credit Risk 355
Prepayment Risk 355
Operational Risk 355
Regulation in the Futures Markets 356
Institutional Use of Futures Markets 356
Globalization of Futures Markets 357
Non-U.S.Participation in U.S.Futures Contracts 357
Foreign Stock Index Futures 357
Currency Futures Contracts 358
Summary 359
Questions and Applications 359
Problems 361
Chapter 14 Options Markets 362
Background on Options 362
Markets Used to Trde Options 363
How Option TradesAre Executed 364
Types of Orders 365
Stock Option Quotations 365
Speculating with Stock Options 366
Speculating with Call Options 366
Speculating with Put Options 368
Determinants of Stock Option Premiums 370
Determinants of Call Option Premiums 370
Determinants of Put Option Premiums 371
Explaining Change In Option Premiums 373
Indicators Monitored by Participants in the Options Market 374
Hedging with Stock Options 375
Hedging with Call Options 375
Hedging with Put Options 375
Using Options to Measure a Stock's Risk 377
Stock Index Options 377
Hedging with Stock Index Options 378
Dynamic Asset Allocation with Stock Index Options 378
Using Index Options to Measure the Market's Risk 379
Options on Futures Contracts 381
Speculating with Options on Futures 381
Hedging with Options on Futures 384
Hedging with Options on Interest Rate Futures 384
Hedging with Options on Stock Index Futures 386
Institutional Use of Options Markets 387
Globalization of Options Markets 388
Currency Options Contracts 388
Summary 389
Questions and Applications 389
Problems 391
APPENDIX 14:Option Valuation 393
Chapter 15 Interest Rate Derivative Markets 401
Background 401
Participation by Financial Institutions 403
Types of Interest Rate Swaps 404
Plain Vanilla Swaps 405
Forward Swaps 405
Callable Swaps 407
Putable Swaps 408
Extendable Swaps 408
Zero-Coupon-for-Floating Swaps 409
Rate-Capped Swaps 409
Equity Swaps 410
Other Types of Swaps 411
Risk of Interest Rate Swaps 412
Basis Risk 412
Credit Risk 413
Sovereign Risk 413
Pricing Interest Rate Swaps 414
Prevailing Market Interest Rates 414
Availability of Counterparties 414
Credit and Sovereign Risk 414
Factors Affecting the Performance of Interest Rate Swaps 414
Indicators Monitored by Participants in the Swap Market 415
Interest Rate Caps,Floors,and Collars 416
Interest Rate Caps 416
Interest Rate Floors 417
Interest Rate Collars 417
Globalization of Swap Markets 419
Currency Swaps 420
Risk of Currency Swaps 422
Summary 422
Questions and Applications 422
Problems 423
Chapter 16 Foreign Exchange Derivative Markets 425
Background on Foreign Exchange Markets 425
Institutional Use of Foreign Exchange Markets 426
Exchange Rate Quotations 427
Types of Exchange Rate Systems 427
Factors Affecting Exchange Rates 430
Differential Inflation Rates 431
Diffrential Interest Rates 431
Central Bank Intervention 432
Indirect Intervention 433
Foreign Exchange Contracts 434
Movements in Exchange Rates 434
Forecasting Exchange Rates 434
Technical Forecasting 435
Fundamental Forecasting 436
Market-Based Forecasting 437
Mixed Forecasting 437
Forecasting Exchange Rate Volatility 438
Speculation in Foreign Exchange Markets 440
Foreign Exchange Derivatives 440
Forward Contracts 441
Currency Futures Contracts 442
Currency Swaps 442
Currency Options Contracts 442
Use of Foreign Exchange Derivatives for Speculating 444
International Arbitrage 446
Locational Arbitrage 446
Covered Interest Arbitrage 447
Explaining Price Movements of Foreign Exchange Derivatives 449
Indicators of Foreign Exchange Derivative Prices 449
Summary 450
Questions and Applications 451
Problems 452
APPENDIX 16A:Impact of the Asian Crisis on Foreign Exchange Markets and Other Financial Markets 453
APPENDIX 16B:Currency Option Pricing 463
Integrative Problem:Choosing among Derivative Securities 467