Part I The Financial System 1
Chapter 1 An Overview of Financial Markets and Institutions 3
Chapter Preview 4
Learning Objectives 4
1.1 The Financial System 4
1.2 Financial Markets and Direct Financing 7
Do You Understand? 10
People & Events: A Brief Examination of the Causes and Effects of the Global Financial Crisis of 2007 and 2008 11
1.3 Types of Financial Markets 12
1.4 The Money Markets 14
1.5 The Capital Markets 15
Do You Understand? 17
1.6 Financial Intermediaries and Indirect Financing 17
Do You Understand? 22
1.7 Types of Financial Intermediaries 23
Do You Understand? 27
1.8 The Risks Financial Institutions Manage 28
1.9 Regulation of the Financial System 29
People & Events: Systemically Risky Banks: What is the Solution? 33
1.10 Ethics and the Financial System 33
Do You Understand? 35
Summary of Learning Objectives 35
Key Terms 36
Questions and Problems 36
Chapter 2 The Federal Reserve and Its Powers 38
Chapter Preview 39
Learning Objectives 39
2.1 Origins of the Federal Reserve System 39
People & Events: Banking before 1933, Banking from 1933 to 1980, and Banking in the Modern Era 43
2.2 The Current Structure of the Fed 44
2.3 Monetary Powers of the Board of Governors 47
2.4 The Fed’s Regulatory Powers 47
2.5 Independence of the Fed 51
Do You Understand? 53
2.6 The Fed’s Balance Sheet 53
2.7 The Fed’s Role in Check Clearing and the Growth of Electronic Payments 59
Learning by Doing 2.1: Computing a Bank’s Excess Reserve Position 60
2.8 Federal Reserve Tools of Monetary Policy 61
People & Events: The Challenges of Fed Chair Janet Yellen 62
Learning by Doing 2.2: Calculating a Bank’s Reserve Position 66
Summary of Learning Objectives 69
Key Terms 69
Questions and Problems 69
Chapter 3 The Fed and Interest Rates 71
Chapter Preview 72
Learning Objectives 72
3.1 Federal Reserve Control of the Money Supply 72
3.2 The Fed’s Influence on Interest Rates 75
3.3 The Treasury Department and Fiscal Policy 79
Do You Understand? 81
3.4 Goals of Monetary Policy 82
People & Events: The Fed as Lender of Last Resort During the Financial Crisis 87
3.5 The Fed and the Economy 88
People & Events: Black Monday 91
3.6 Complications of Monetary Policy 91
3.7 Anatomy of a Financial Crisis 93
People & Events: Good Work If You Can Get It: Executive Bonuses During Bailouts? 100
Do You Understand? 101
Summary of Learning Objectives 102
Key Terms 102
Questions and Problems 102
Part II How Interest Rates are Determined 105
Chapter 4 The Level of Interest Rates 107
Chapter Preview 108
Learning Objectives 108
4.1 What are Interest Rates? 108
4.2 The Real Rate of Interest 109
4.3 Loanable Funds Theory of Interest 111
Do You Understand? 114
4.4 Price Expectations and Interest Rates 114
4.5 A Restatement of the Fisher Equation 116
People & Events: What Is the Actual Inflation Rate? 117
Do You Understand? 121
People & Events: Estimating the Expected Rate of Inflation from TIPS 122
4.6 Forecasting Interest Rates 122
4.7 Interest Rates and Currency Values 124
Summary of Learning Objectives 125
Key Terms 126
Questions and Problems 126
Chapter 5 Bond Prices and Interest Rate Risk 127
Chapter Preview 128
Learning Objectives 128
5.1 The Time Value of Money 128
Do You Understand? 130
5.2 Bond Pricing 131
People & Events: Bond Market Liquidity and the Volcker Rule 132
Learning by Doing 5.1: Calculating the Price of a Bond Using a Financial Calculator 135
5.3 Bond Yields 136
Learning by Doing 5.2: Calculating the Yield‐to‐Maturity on a Bond 137
Do You Understand? 140
5.4 Important Bond Pricing Relationships 140
5.5 Interest Rate Risk and Duration 144
Learning by Doing 5.3: Calculating the Duration of a Bond 146
People & Events: Betting the Farm on Interest Rates and Losing 155
Do You Understand? 156
Summary of Learning Objectives 156
Key Terms 157
Questions and Problems 157
Chapter 6 The Structure of Interest Rates 159
Chapter Preview 160
Learning Objectives 160
6.1 The Term Structure of Interest Rates 160
Learning by Doing 6.1: Using the Term Structure Formula to Calculate Implied Forward Rates 165
Do You Understand? 171
People & Events: More on Forecasting Future Interest Rates 172
6.2 Default Risk 172
6.3 Tax Treatment 176
People & Events: The Credit‐Rating Club 177
Do You Understand? 180
6.4 Marketability 180
6.5 Options on Debt Securities 180
6.6 Behavior of Interest Rates over the Business Cycle 183
Do You Understand? 185
Summary of Learning Objectives 185
Key Terms 186
Questions and Problems 186
Part III Financial Markets 189
Chapter 7 Money Markets 191
Chapter Preview 192
Learning Objectives 192
7.1 How the Money Markets Work 192
7.2 Economic Role of the Money Markets 193
7.3 Features of Money Market Instruments 194
7.4 Treasury Bills 194
Learning by Doing 7.1: Calculating the Discount Yield 199
Learning by Doing 7.2: Calculating the Bond Equivalent Yield 199
Do You Understand? 200
7.5 Federal Agency Securities 201
7.6 Federal Funds 203
7.7 Other Major Money Market Instruments 205
People & Events: Lehman Brothers’ “Creative” Accounting: Repos 105 and 108 207
7.8 Money Market Participants 211
7.9 The Impact of the 2007–2008 Financial Crisis on the Money Markets 213
People & Events: How Breaking the Buck (Almost) Broke the Commercial Paper Market 216
Do You Understand? 217
Summary of Learning Objectives 218
Key Terms 219
Questions and Problems 219
Chapter 8 Bond Markets 220
Chapter Preview 221
Learning Objectives 221
8.1 Functions of the Capital Markets 221
8.2 The U.S. Government and Agency Securities 223
People & Events: What Do Negative Yields on TIPS Tell Us? 226
Do You Understand? 227
8.3 State and Local Government Bonds 227
People & Events: Build America Bonds Keep Municipal Finance Going During the Crisis 232
8.4 Corporate Bonds 232
Do You Understand? 237
8.5 Financial Guarantees 237
8.6 Securitized Credit Instruments 238
8.7 Capital Market Regulators 240
8.8 Bond Markets Around the World are Increasingly Linked 241
8.9 The Impact of the 2007–2008 Financial Crisis on the Bond Markets 242
Do You Understand? 244
Summary of Learning Objectives 244
Key Terms 245
Questions and Problems 245
Chapter 9 Mortgage Markets and Mortgage‐Backed Securities 247
Chapter Preview 248
Learning Objectives 248
9.1 The Unique Nature of Mortgage Markets 249
9.2 Types of Mortgages 249
9.3 Mortgage Qualifying 257
Learning by Doing 9.1: Determining How Much Home You Can Buy 259
Do You Understand? 260
9.4 Mortgage‐Backed Securities 261
9.5 Mortgage Prepayment Risk and Other MBS 265
Do You Understand? 270
9.6 Participants in the Mortgage Markets 271
People & Events: The Rise and Fall of Fannie and Freddie 273
Do You Understand? 274
9.7 Relationship Between Mortgage Markets and the Capital Markets 275
Summary of Learning Objectives 276
Key Terms 277
Questions and Problems 278
Chapter 10 Equity Markets 279
Chapter Preview 280
Learning Objectives 280
10.1 What are Equity Securities? 280
10.2 Equity Markets 282
People & Events: The Retail Brokerage Industry 287
10.3 Equity Trading 287
10.4 Global Stock Markets 291
10.5 Large-Scale and High Frequency Trading 292
People & Events: High Speed Trading and the Demise of Knight Capital Group in 45 Minutes 293
10.6 Regulation of Equity Markets 294
Do You Understand? 294
10.7 Stock Market Indexes 295
People & Events: Circuit Breakers, Black Monday, and the Flash Crash 296
Summary of Learning Objectives 297
Key Terms 298
Questions and Problems 299
Chapter 11 Derivatives Markets 300
Chapter Preview 301
Learning Objectives 301
11.1 The Nature of Derivative Securities 301
11.2 Forward Markets 302
11.3 Futures Markets 304
Do You Understand? 311
11.4 Uses of the Financial Futures Markets 311
Learning by Doing 11.1: Hedging Risk in a Stock Portfolio 313
11.5 Risks in the Futures Markets 318
Do You Understand? 319
11.6 Options Markets 319
Do You Understand? 325
11.7 Swap Markets 326
People & Events: Swap Market Regulation 329
Summary of Learning Objectives 330
Key Terms 331
Questions and Problems 331
Chapter 12 International Markets 332
Chapter Preview 333
Learning Objectives 333
12.1 The Difficulties of International Trade 333
12.2 Exchange Rates 334
12.3 Balance of Payments 337
12.4 Foreign Exchange Markets 341
12.5 Spot and Forward Transactions 343
Learning by Doing 12.1: Using Forward Contracts to Hedge Exchange Rate Risks 343
People & Events: The Big Mac Test of Purchasing Power Parity 345
12.6 Capital Flows and Exchange Rates 346
Do You Understand? 349
People & Events: The Greek Crisis and Lessons for the U.S. 350
12.7 Government Intervention in Foreign Exchange Markets 351
Learning by Doing 12.2: Using Purchasing Power Parity to Determine the Expected Exchange Rate 353
12.8 Financing International Trade 354
Do You Understand? 355
12.9 International Money and Capital Markets 355
12.10 The Globalization of Financial Markets 358
Summary of Learning Objectives 360
Key Terms 360
Questions and Problems 361
Part IV Commercial Banking 363
Chapter 13 Commercial Bank Operations 365
Chapter Preview 366
Learning Objectives 366
13.1 An Overview of the Banking Industry 366
13.2 Balance Sheet for a Commercial Bank 369
13.3 The Source of Bank Funds 370
Do You Understand? 375
13.4 Bank Uses of Funds: Bank Investments and Cash Assets 376
13.5 Bank Uses of Funds: Loans and Leases 378
13.6 Loan Pricing 381
13.7 Analysis of Loan Credit Risk 384
People & Events: What’s Your Score? 385
Do You Understand? 386
13.8 Fee‐Based Services 386
13.9 Off‐Balance‐Sheet Banking 387
Do You Understand? 391
13.10 Bank Earnings 392
13.11 Bank Performance 396
Do You Understand? 397
Summary of Learning Objectives 398
Key Terms 398
Questions and Problems 399
Chapter 14 International Banking 400
Chapter Preview 401
Learning Objectives 401
14.1 Development of International Banking 401
14.2 Regulation of Overseas Banking Activities 404
14.3 Delivery of Overseas Banking Services 406
Do You Understand? 409
14.4 International Lending 409
People & Events: The LIBOR Scandal 411
Do You Understand? 416
14.5 Foreign Banks in the United States 416
14.6 Future Directions of International Banking 420
Summary of Learning Objectives 420
Key Terms 421
Questions and Problems 421
Chapter 15 Regulation of Financial Institutions 422
Chapter Preview 423
Learning Objectives 423
15.1 Reasons for Regulation 423
15.2 Bank Failures and Regulation 426
People & Events: WaMu and the Destructive “Power of Yes” 431
15.3 Safety and Soundness Regulation: Deposit Insurance 432
Do You Understand? 434
15.4 Deposit Insurance Issues 435
Do You Understand? 438
15.5 Safety and Soundness Regulation: Capital Requirements 439
Do You Understand? 447
15.6 Bank Examinations 447
15.7 Structure and Competition Regulations 450
15.8 Consumer Protection Regulations 452
People & Events: Excerpts from “What are the FDIC’s primary new responsibilities under the new law?” 454
15.9 Bank Regulators 456
Do You Understand? 458
Summary of Learning Objectives 459
Key Terms 459
Questions and Problems 460
Part V Financial Institutions 463
Chapter 16 Thrift Institutions and Finance Companies 465
Chapter Preview 466
Learning Objectives 466
16.1 Historical Development of Savings Institutions 467
16.2 Operations of Savings Institutions 470
Do You Understand? 478
16.3 Credit Unions 478
People & Events: Demographic Change Brings Opportunity 479
16.4 Thrift Institutions Around the Globe 484
People & Events: Commercial Banks Versus Credit Unions 485
Do You Understand? 486
16.5 Finance Companies 486
People & Events: GE Divests Much of Its Finance Company Business 488
Do You Understand? 494
Summary of Learning Objectives 494
Key Terms 495
Questions and Problems 495
Chapter 17 Insurance Companies and Pension Funds 496
Chapter Preview 497
Learning Objectives 497
17.1 Insurance 497
People & Events: 9/11 and Katrina: Insurance Coverage Disputes 499
17.2 The Insurance Industry 501
People & Events: The Rise, Fall, and Return of American International Group (AIG) 503
Do You Understand? 508
17.3 Life and Health Insurance Products 508
Learning by Doing 17.1: Calculating Policyholders’ Surplus 514
Do You Understand? 515
17.4 Property and Liability Insurance Products 515
Learning by Doing 17.2: Measuring Insurance Company Profitability with the Combined Ratio 518
Do You Understand? 519
17.5 Pensions 519
Do You Understand? 524
Summary of Learning Objectives 524
Key Terms 525
Questions and Problems 526
Chapter 18 Investment Banking 527
Chapter Preview 528
Learning Objectives 528
18.1 The Relationship Between Commercial and Investment Banking 528
18.2 Primary Services of an Investment Bank 533
People & Events: Where, Oh, Where Have All the Investment Banks Gone? 534
Do You Understand? 543
18.3 Private Equity 543
Learning by Doing 18.1: Evaluating a Venture Capital Investment 546
Do You Understand? 548
Summary of Learning Objectives 548
Key Terms 549
Questions and Problems 549
Chapter 19 Investment Companies 551
Chapter Preview 552
Learning Objectives 552
19.1 Investment Companies 552
19.2 Open‐End Mutual Funds 553
Learning by Doing 19.1: Calculating Net Asset Value 554
People & Events: Money Market Mutual Funds Breaking the Buck 563
19.3 Closed‐End Mutual Funds 566
19.4 Exchange‐Traded Funds 567
Do You Understand? 572
19.5 Hedge Funds 572
People & Events: Hedge Funds and the Dodd‐Frank Wall Street Reform and Consumer Protection Act 573
Do You Understand? 576
19.6 Real Estate Investment Trusts 576
Summary of Learning Objectives 578
Key Terms 579
Questions and Problems 579
Chapter 20 Risk Management in Financial Institutions 580
Chapter Preview 581
Learning Objectives 581
20.1 The Dilemma: Profitability Versus Safety 581
20.2 Liquidity Management 583
Do You Understand? 586
People & Events: Operational Risk 587
20.3 Managing Credit Risk 587
People & Events: Counterparty Controversy: AIG and Its Risky Risk Management 591
Do You Understand? 593
20.4 Measuring and Assessing Interest Rate Risk 593
20.5 Hedging Interest Rate Risk 602
Learning by Doing 20.1: Measuring Interest Rate Risk 608
Do You Understand? 611
Summary of Learning Objectives 611
Key Terms 612
Questions and Problems 612
Glossary 613
Index 637
