FinancialMarkets andInstitutionsA Modern Perspective

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Stephen A. RossFranco Modigliani Professor of Financeand EconomicsSloan School of ManagementMassachusetts Institute of TechnologyConsulting Editor

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FinancialMarkets andInstitutionsA Modern Perspective

Anthony SaundersStern School of BusinessNew York University

Marcia Millon CornettSouthern Illinois University

Boston Burr Ridge, IL Dubuque, IA Madison, WINew York San Francisco St. Louis

Bangkok Bogotá Caracas Lisbon London Madrid Mexico CityMilan New Delhi Seoul Singapore Sydney Taipei Toronto

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FINANCIAL MARKETS AND INSTITUTIONSPublished by McGraw-Hill/Irwin, an imprint of The McGraw-Hill Companies, Inc. 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

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ISBN 0-07-234892-5

Vice president/Editor-in-chief: Michael W. JuniorDevelopmental editor: Sarah PearsonMarketing manager:Senior project manager: Susan TrentacostiProduction supervisor: Melonie SalvatiCoordinator freelance design:Supplement coordinator: Cathy TepperMedia technology producer: Barb BlockCover design: tbdInterior design: tbdCompositor: GAC IndianapolisTypeface: 10.5/12 Times RomanPrinter: Von Hoffmann Press, Inc.

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To my father, Myer Saunders (1919–1998).

TONY SAUNDERS

To Galen

MARCIA MILLON CORNETT

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ANTHONY SAUNDERS

Anthony Saunders is the John M. Schiff Professor of Finance

and Chair of the Department of Finance at the Stern School

of Business at New York University. Professor Saunders re-

ceived his Ph.D. from the London

School of Economics and has

taught both undergraduate

and graduate level courses at

NYU since 1978. Through-

out his academic career, his

teaching and research have

specialized in financial institu-

tions and international banking.

He has served as a visiting professor

all over the world, including INSEAD, the Stockholm School

of Economics, and the University of Melbourne. He is cur-

rently on the Executive Committee of the Salomon Center for

the Study of Financial Institutions, NYU.

Professor Saunders holds positions on the Board of Aca-

demic Consultants of the Federal Reserve Board of Gover-

nors as well as the Council of Research Advisors for the

Federal National Mortgage Association. In addition, Dr.

Saunders has acted as a visiting scholar at the comptroller of

the Currency and at the Federal Monetary Fund. He is the ed-

itor of the Journal of Banking and Finance and the Journal of

Financial Markets, Instruments and Institutions, as well as

the associate editor of eight other journals, including Finan-

cial Management and the Journal of Money, Credit and

Banking. His research has been published in all of the major

money and banking journals and in several books. He has just

published a book on Financial Institutions Management: A

Modern Perspective with McGraw-Hill/Irwin.

MARCIA MILLON CORNETT

Marcia Millon Cornett is a Professor of Finance at Southern

Illinois University at Carbondale. She received her B.S. de-

gree in Economics from Knox College in Galesburg, Illinois,

and her M.B.A. and Ph.D. degrees in Finance from Indiana

University in Bloomington, Indiana. Dr. Cornett has written

and published several articles in the areas of bank perfor-

mance, bank regulation, corporate finance, and investments.

Articles authored by Dr. Cornett have appeared in such aca-

demic journals as the Journal of Finance, the Journal of

Money, Credit, and Banking, the Journal of Financial Eco-

nomics, Financial Management, and the Journal of Banking

and Finance. She served as an Associate Editor of Financial

Management and is currently an Associ-

ate Editor for the Multinational Fi-

nance Journal. Dr. Cornett is

currently a member of the

Board of Directors and the

Finance Committee of the

Southern Illinois University

Credit Union. Dr. Cornett has

also taught at the University of

Colorado, Boston College, and

Southern Methodist University. She is

a member of the Financial Management Association, the

American Finance Association, and the Western Finance

Association.

About the Authors

viii

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he 1990s was characterized as a period in which financial markets in the UnitedStates boomed. The Dow Jones Industrial Average rose from a level of 2,800 inJanuary 1990 to more than 11,000 by the end of the decade; this compared to amove from 100 at its inception in 1906 to 2,800 thirty-four years later. While

security values in U.S. financial markets rose dramatically, financial markets in South-east Asia, South America, and Russia plummeted. For example, on July 2, 1997, theThai baht fell nearly 50 percent in value relative to the U.S. dollar. Countries suchas Russia, Thailand, and South Korea required an international bailout by the Inter-national Monetary Fund to prevent a complete collapse of their financial marketsand their economies. Nevertheless, Indonesia had to declare a moratorium on someof its debt repayments, while Russia defaulted on payments on its short-term govern-ment bonds.

Meanwhile, the financial services industry is approaching a full historical cycle.Originally the banking industry operated as a full-service industry, performing directlyor indirectly all financial services (commercial banking, investment banking, stock in-vesting, insurance provision, etc.). In the early 1930s, the economic and industrial col-lapse resulted in the separation of some of these activities. In the 1970s and 1980s,new, relatively unregulated financial services industries sprang up (e.g., mutual funds,brokerage funds, etc.) that separated the financial service functions even further. Now,at the turn of the century, regulatory barriers, via the Financial Services ModernizationAct of 1999, technological innovation, and financial innovation has resulted in changessuch that a full set of financial services may again be offered by a single financialinstitution (FI) such as Citigroup. Not only are the boundaries between traditionalindustry sectors weakening but competition is becoming global in nature as theGermans, French, and other Europeans enter into U.S. financial service markets, andvice versa.

As the economic and competitive environments change, attention to profit and,more than ever, risk becomes increasingly important. This book offers a unique analy-sis of the risks faced by investors and savers interacting through both financial institu-tions and financial markets, as well as strategies that can be adopted for controlling andmanaging these risks. Special emphasis is also put on new areas of operations infinancial markets and institutions, such as asset securitization, off-balance-sheet activ-ities, and globalization of financial services.

While maintaining a risk measurement and management framework, FinancialMarkets and Institutions: A Modern Perspective provides a broader application ofthis important perspective. This book recognizes that domestic and foreign financial

Preface

ix

T

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markets are increasingly connected and that financial intermediaries are evolvingtowards a single financial services industry. The analytical rigor is mathematically ac-cessible to all levels of students, undergraduate and graduate, and is balanced by acomprehensive discussion of the unique environment within which financial marketsand institutions operate. Important practical tools such as how to issue and trade fi-nancial securities or how to analyze financial statements and loan applications will armstudents with skills necessary to understand and manage financial market and institu-tion risks in this dynamic environment. While descriptive concepts, so important to fi-nancial management (financial market securities, regulation, industry trends, industrycharacteristics, etc.) are included in the book, ample analytical techniques are also in-cluded as practical tools to help students to understand the operation of modern finan-cial markets and institutions.

Intended AudienceFinancial Markets and Institutions: A Modern Perspective is aimed at the first coursein financial markets and institutions at both the undergraduate and MBA levels. Whiletopics covered in this book are found in more advanced textbooks on financial marketsand institutions, the explanations and illustrations are aimed at those with little or nopractical or academic experience beyond the introductory level in financial courses. Inmost chapters, the main relationships are presented using figures, graphs, and simpleexamples. The more complicated details and technical problems related to in-chapterdiscussion are provided in appendixes to the chapters.

OrganizationSince our focus is on return and risk and the sources of that return and risk in domes-tic and foreign financial markets and institutions, this book relates ways in which amodern financial manager, saver, and investor can expand return with a managed levelof risk to achieve the best, or most favorable, return-risk outcome.

The book is divided into five major sections. Part One provides an introduction tothe text and an overview of financial markets and institutions. Chapter 1 defines andintroduces the various domestic and foreign financial markets and describes the specialfunctions of FIs. This chapter also takes an analytical look at how financial marketsand institutions benefit today’s economy. In Chapter 2, we provide an in-depth lookat interest rates. We first review the concept of time value of money. We then lookat factors that determine interest rate levels, as well as their past, present, and expectedfuture movements. Chapter 3 then applies these interest rates to security valuation.In Chapter 4, we describe the Federal Reserve System and how monetary policy im-plemented by the Federal Reserve affects interest rates and, ultimately, the overalleconomy.

Part Two of the text presents an overview of the domestic securities markets. Wedescribe each securities market, its participants, the securities traded in each, the trad-ing process, and how changes in interest rates, inflation, and foreign exchange ratesimpact the FI managers’ decisions to hedge risk. These chapters cover the money mar-kets (Chapter 5), bond markets (Chapter 6), mortgage markets (Chapter 7), stock mar-kets (Chapter 8), foreign exchange markets (Chapter 9), and derivative securitiesmarkets (Chapter 10).

Part Three of the text summarizes the operations of depository institutions. Chap-ter 11 describes the key characteristics and recent trends in the commercial bankingsector. Chapter 12 does the same for the thrift institution sector. Chapter 13 describesthe financial statements of a typical depository institution and the ratios used to ana-lyze those statements. This chapter also analyzes actual financial statements for repre-sentative financial institutions. Chapter 14 provides a comprehensive look at the

x Preface

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regulations under which these financial institutions operate and, particularly, at the ef-fect of recent changes in regulation.

Part Four of the text provides an overview describing the key characteristics andregulatory features of the other major sectors of the U.S. financial services industry.We discuss insurance institutions in Chapter 15, securities firms and investment banksin Chapter 16, finance companies in Chapter 17, mutual fund firms in Chapter 18, andpension funds in Chapter 19.

Part Five concludes the text by examining the risks facing a modern FI and FImanagers, and the various strategies for managing these risks. In Chapter 20, we pre-view the risk measurement and management chapters that follow with an overview ofthe risks facing a modern FI. We divide the chapters on risk measurement and man-agement along two lines: measuring and managing risks on the balance sheet, andmanaging risks off the balance sheet. In Chapter 21, we begin the on-balance-sheet riskmeasurement and management section by looking at credit risk on individual loans andbonds and how these risks adversely impact an FI’s profits and value. The chapter alsodiscusses the lending process, including loans made to small households and small,medium-sized, and large corporations. Chapter 22 covers liquidity risk in financial in-stitutions. This chapter includes a detailed analysis of ways in which FIs can insulatethemselves from liquidity risk, and the key role deposit insurance and other guaranteeschemes play in reducing liquidity risk.

In Chapter 23, we investigate the net interest margin as a source of profitabilityand risk, with a focus on the effects of interest rate risk and the mismatching of assetand liability maturities on FI risk exposure. At the core of FI risk insulation is the sizeand adequacy of the owner’s capital stake, which is also a focus of this chapter.

The management of risk off the balance sheet is examined in Chapter 24. Thechapter highlights various new markets and instruments that have emerged to allow FIsto better manage three important types of risk: interest rate risk, foreign exchange risk,and credit risk. These markets and instruments and their strategic use by FIs includeforwards and futures, options, and swaps.

Finally, Chapter 25 explores ways of removing credit risk from the loan portfoliothrough asset sales and securitization.

Walk-ThroughMain Features

The following special features have been integrated throughout the text to encouragestudent interaction and to aid them in absorbing the material.

• Chapter-opening outlines offer students a snapshot view of what they can expectto learn from each chapter’s discussion.

Preface xi

Reserve System,Monetary Policy, and Interest Rates

Major Duties andResponsibilities of theFederal Reserve System:Chapter Overview

Structure of the FederalReserve System

Federal ReserveBanks

Board of Governors ofthe Federal ReserveSystem

Federal Open MarketCommittee

Balance Sheet of theFederal Reserve

Monetary Policy Tools

Open MarketOperations

The Discount Rate

ReserveRequirements(Reserve Ratios)

The Federal Reserve, theMoney Supply, andInterest Rates

Effects of Monetary

Chapter Navigator

1. What are the major functions of the Federal Reserve System?

2. What is the structure of the Federal Reserve System?

3. What are the monetary policy tools used by the Federal Reserve?

4. How do monetary policy changes affect key economic variables?

5. How do U.S. monetary policy initiatives affect foreign exchange rates?

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• Chapter Navigators list the chapter topics in order, providing numbers that cor-respond with the section in which they can be found in the chapter.

xii Preface

Monetary Policy ToolsIn the previous section of this chapter, we referred briefly to tools or instru-

ments that the Federal Reserve uses to implement its monetary policy. These in-cluded open market operations, the discount rate, and reserve requirements.

Regardless of the tool the Federal Reserve uses to implement monetary policy, the ma-jor link by which monetary policy impacts the macroeconomy occurs through the Fed-eral Reserve influencing the market for bank reserves (required and excess reservesheld as depository institution reserves balances in accounts at Federal Reserve Banksplus vault cash on hand of commercial banks). Specifically, the Federal Reserve’s

7. The minimum daily average reserves that a bank must maintain are computed as a percentage ofthe daily average net transaction accounts held by the bank over the two-week computation period, calledthe reserve computation period. Transaction accounts include all deposits on which an account holder maymake withdrawals (for example, demand deposits, NOW accounts, and share draft accounts—offered by

3

• Bold key terms and a marginal glossary emphasize the main terms and conceptsthroughout the chapter.

• Pertinent website addresses are also referenced in the margins throughout eachchapter providing additional resources to aid in the learning process.

Open Market OperationsWhen a targeted monetary aggregate (M1, M2, etc.—see definition below) or interestrate level is determined by the FOMC, it is forwarded to the Federal Reserve BoardTrading Desk at the Federal Reserve Bank of New York (FRBNY) through a state-ment called the policy directive. The manager of the Trading Desk uses the policy di-rective to instruct traders on the amount of open market purchases or sales to transact.Open market operations are the Federal Reserves’ purchases or sales of securities inthe U.S. Treasury securities market. This is an over-the-counter market in whichtraders are linked to each other electronically (see Chapter 5).

Open market operations are particularly important because they are the primarydeterminant of changes in bank excess reserves in the banking system and thus directlyimpact the size of the money supply and/or the level of interest rates (e.g., the fedfunds rate). When the Federal Reserve purchases securities, it pays for the securities byeither writing a check on itself or directly transferring funds (by wire transfer) into theseller’s account. Either way, the Fed credits the reserve deposit account of the bankthat sells it (the Fed) the securities. This transaction increases the bank’s excess reservelevels. When the Fed sells securities, it either collects checks received as payment orreceives wire transfers of funds from these agents (such as banks) using funds from

www.ny.frb.org/

Federal Reserve BoardTrading DeskUnit of the Federal ReserveBank of New York throughwhich open market operationsare conducted.

policy directiveStatement sent to the FederalReserve Board Trading Deskfrom the FOMC that specifiesthe money supply target.

• “Do You Understand?” boxes allow students to test themselves on the main con-cepts within each major chapter section.

banks (reserve account) deposits at the Fed.

Example 4–1 Purchases of Securities by the Federal Reserve

Suppose the FOMC instructs the FRBNY Trading Desk to purchase $500 million ofTreasury securities. Traders at the FRBNY call primary government securities dealersof major commercial and investment banks (such as Goldman Sachs and Chase)9 whoprovide a list of securities they have available for sale, including the denomination,maturity, and the price on each security. FRBNY traders then seek to purchase the tar-get number of securities (at the desired maturities and lowest possible price) until theyhave purchased the $500 million. The FRBNY then notifies its government bond de-partment to receive and pay the sellers for the securities it has purchased. The securi-ties dealer sellers (such as banks) in turn deposit these payments in their accounts heldat their local Federal Reserve Bank. As a result of these purchases, the Treasury secu-rities account balance of the Federal Reserve System is increased by $500 million andthe total reserve accounts maintained by these banks and dealers at the Fed is increasedby $500 million. We illustrate these changes to the Federal Reserve’s balance sheet inTable 4–6. In addition, there is also an impact on commercial bank balance sheets. To-tal reserves (assets) of commercial banks will increase by $500 million due to the pur-chase of securities by the Fed, and demand deposits (liabilities) of the securities dealers(those who sold the securities) at their banks will increase by $500 million.10 We alsoshow the changes to commercial banks’ balance sheets in Table 4–6.

Note the Federal Reserve’s purchase of Treasury securities has increased the totalsupply of bank reserves in the financial system. This in turn increases the ability of

• In-chapter examples provide numerical demonstrations of the analytical materialdescribed in many chapters.

money supply.

Gold and Foreign Exchange and Treasury Currency. The Federal Reserve holdsTreasury gold certificates that are redeemable at the U.S. Treasury for gold. The Fedalso holds small amounts of Treasury-issued coinage and foreign-denominated assets

to assist in foreign currency transactions or currency swap agreementswith the central banks of other nations.

Loans to Domestic Banks. As mentioned earlier, in a liquidity emer-gency, depository institutions in need of additional funds can borrow atthe Federal Reserve’s discount window (discussed in detail below). Theinterest rate or discount rate charged on these loans is often lower thanother interest rates in the short-term money markets (see Chapter 5). Toprevent excessive borrowing from the discount window, the Fed dis-courages borrowing unless a bank is in serious liquidity need (seeChapters 14 and 22). As a result, (discount) loans to domestic banks arenormally a relatively small portion of the Fed’s total assets.8

Do You Understand?

1. What the main functions of FederalReserve Banks are?

2. What the main responsibilities ofthe Federal Reserve Board are?

3. How the FOMC implementsmonetary policy?

4. What the main assets and liabilitiesin the Federal Reserve System are?

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• “In the News . . .” boxes demonstrate the application of chapter material to real,current events.

Preface xiii

Alan Greenspan,

U.S. Federal Re-

serve Chairman,

said yesterday he

expected “a lot of prob-

lems” to emerge in the

global financial payments

system because of the Year

2000 computer problem.

The Fed had already or-

dered the printing of extra

banknotes for the next year

is we are going to run into a

lot of problems. And as a

consequence we are doing

a great deal of planning on

for banknotes between July

and the end of 1999. In

July, the Fed estimated it

had $460 billion in bank-

notes in circulation with an

additional $153 billion in its

vaults, a total of $613 bil-

lion. As part of the Fed’s

contingency planning, it had

ordered increased printing

of currency for the fiscal

year starting in October

U.S. Prints Cashto Cope withDemands ofMillennium

Bomb

In the NIn the News4–1

• End-of-chapter problems. At least 20 problems per chapter are written for variedlevels of difficulty.

SummaryThis chapter described the Federal Reserve System in the United States. The FederalReserve is the central bank charged with conducting monetary policy, supervising andregulating depository institutions, maintaining the stability of the financial system, andproviding specific financial services to the U.S. government, the public, and financialinstitutions. We reviewed the structure under which the Fed provides these functions,the monetary policy tools it uses, and the impact of monetary policy changes on creditavailability, interest rates, money supply, security prices, and foreign exchange rates.

1. Describe the functions performed by Federal ReserveBanks.

2. Define the discount window and the discount rate.3. Describe the structure of the Board of Governors of the

Federal Reserve System.4. What are the primary responsibilities of the Federal

Reserve Board?5. What are the primary responsibilities of the Federal

Open Market Committee?6. What are the major liabilities of the Federal Reserve

System? Describe each.7. What are the major assets of the Federal Reserve Sys-

tem? Describe each.8. What are the tools used by the Federal Reserve to im-

plement monetary policy? 9. Suppose the Federal Reserve instructs the Trading Desk

to purchase $1 billion of securities. Show the result ofthis transaction on the balance sheets of the Federal Re-serve System and commercial banks.

10. Suppose the Federal Reserve instructs the Trading Deskto sell $850 million of securities. Show the result of thistransaction on the balance sheets of the Federal ReserveSystem and commercial banks.

11. Explain how a decrease in the discount rate affectscredit availability and the money supply.

12. Why does the Federal Reserve rarely use the discountrate to implement its monetary policy?

13. What is the difference between an adjustment credit, aseasonal credit, and an extended credit discount win-dow loan?

14. Bank Three currently has $600 million in transactiondeposits on its balance sheet. The Federal Reserve has

currently set the reserve requirement at 10 percent oftransaction deposits.a. If the Federal Reserve decreases the reserve re-

quirement to 8 percent, show the balance sheet ofBank Three and the Federal Reserve System justbefore and after the full effect of the reserve re-quirement change. Assume Bank Three withdrawsall excess reserves and gives out loans, and thatborrowers eventually return all of these funds toBank Three in the form of transaction deposits.

b. Redo part (a) using a 12 percent reserve requirement.15. National Bank currently has $500 million in transaction

deposits on its balance sheet. The current reserve re-quirement is 10 percent, but the Federal Reserve is de-creasing this requirement to 8 percent.a. Show the balance sheet of the Federal Reserve and

National Bank if National Bank converts all excessreserves to loans, but borrowers return only 50 per-cent of these funds to National Bank as transactiondeposits.

b. Show the balance sheet of the Federal Reserve andNational Bank if National Bank converts 75 percentof its excess reserves to loans and borrowers return60 percent of these funds to National Bank as trans-action deposits.

16. Which of the monetary tools available to the FederalReserve is most often used? Why?

17. Describe how expansionary activities conducted by theFederal Reserve impact credit availability, the moneysupply, interest rates, and security prices. Do the samefor contractionary activities.

Questions

Supplements• The Wall Street Journal Edition. Through a unique arrangement with Dow Jones,

McGraw-Hill/Irwin is able to offer your students a 10-week subscription to TheWall Street Journal as part of the purchase price of the WSJ Edition text. The WSJwill keep students up to date on the world of finance. (ISBN 007239708X)

• The Instructor’s Manual, prepared by Tim Manuel of the University of Montana,includes detailed chapter contents, additional examples for use in the classroom,

sau48925_FM.qxd 8/9/00 9:27 AM Page xiii

and complete solutions to end-of-chapter question and problem materials. (ISBN0072397047)

• Also prepared by Tim Manuel, the Test Bank includes nearly 1,000 additionalproblems to be used for test material. (ISBN 0072397055)

• Our Brownstone Diploma Testing System offers the test items for FinancialMarkets and Institutions on computer disk. This program makes it possible to cre-ate tests based on chapter, type of questions, and difficulty level. It allows instruc-tors to combine their own questions with test items created by the Test Bankauthor. This system can be used to edit existing questions and create several dif-ferent versions of each test. The program accepts graphics, allows passwordprotection of saved tests, and may be used on a computer network. (ISBN0072397063)

• William Lepley, University of Wisconsin–Green Bay, has written a Study Guidethat speaks directly to the student. It provides a conceptual outline and applica-tions that include definitional and quantitative problems for each chapter. Detailedsolutions explain how answers were derived. (ISBN 0072397039)

• The PowerPoint Presentation, prepared by Joseph Ogden of the State Universityof New York–Buffalo, includes full-color slides featuring lecture notes, figures,and tables. Found only on the book’s website, the slides can be easily downloadedand edited for a specific course.

• The Instructor’s CD-ROM provides the instructor with one resource for all sup-plementary material, including the Instructor’s Manual, Test Bank, and Power-point. (ISBN 0072397071)

• The Saunders/Cornett Custom Crafted Website is found at www.mhhe.com/sc1e. In addition to information on the book and its features, the site also includesdownloadable Powerpoint slides and Excel Spreadsheet examples and a samplerchapter from both the text and the Study Guide.

• PAGEOUT: THE COURSE WEBSITE DEVELOPMENT CENTER ANDPAGEOUT LITE

www.pageout.net

This Web page generation software, free to adopters, is designed to help professorsjust beginning to explore website options. In just a few minutes, even a novicecomputer user can have a course website.

Simply type your material into the template provided and PageOut Liteinstantly converts it to HTML—a universal Web language. Next, choose yourfavorite of three easy-to-navigate designs and your Web homepage is created,complete with online syllabus, lecture notes, and bookmarks. You can even in-clude a separate instructor page and an assignment page.

Anthony Saunders

Marcia Millon Cornett

xiv Preface

sau48925_FM.qxd 8/9/00 9:27 AM Page xiv

Preface ix

p a r t 1 INTRODUCTION AND OVERVIEWOF FINANCIAL MARKETS 1

1 Introduction 2

2 Determinants of Interest Rates 00

3 Interest Rates and Security Valuation 00

4 The Federal Reserve System, MonetaryPolicy, and Interest Rates 00

p a r t 2 SECURITIES MARKETS 121

5 Money Markets 122

6 Bond Markets 153

7 Mortgage Markets 000

8 Stock Markets 000

9 Foreign Exchange Markets 000

10 Derivative Securities Markets 000

p a r t 3 DEPOSITORY INSTITUTIONS 000

11 Commercial Banks 000

12 Thrift Institutions 000

13 Depository Institutions’ FinancialStatements and Analysis 000

14 Regulation of Depository Institutions 000

p a r t 4 OTHER FINANCIALINSTITUTIONS 000

15 Insurance Companies 000

16 Securities Firms and Investment Banks 000

17 Finance Companies 000

18 Mutual Funds 000

19 Pension Funds 000

p a r t 5 RISK MANAGEMENT INFINANCIAL INSTITUTIONS 000

20 Types of Risks Incurred by FinancialInstitutions 000

21 Managing Risk on the Balance Sheet I:Credit Risk 000

22 Managing Risk on the Balance Sheet II:Liquidity Risk 000

23 Managing Risk on the Balance Sheet III:Interest Rate and Insolvency Risk 000

24 Managing Risk with Derivative Securities 000

25 Loan Sales and Asset Securitization 000

Glossary 000

Appendix 000

References 000

Index 000

Contents in Brief

xv

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p a r t 1 INTRODUCTION AND OVERVIEWOF FINANCIAL MARKETS 1

1 Introduction 2Why Study Financial Markets andInstitutions?: Chapter Overview 0

Overview of Financial Markets 0Primary Markets versus Secondary

Markets 0Money Markets versus Capital Markets 0Financial Market Regulation 0Foreign Exchange Markets 0

Overview of Financial Institutions 0Unique Economic Functions Performed by

Financial Institutions 0Additional Benefits FIs Provide to

Suppliers of Funds 0Economic Functions FIs Provide to the

Financial System as a Whole 0Regulation of Financial Institutions 0

Globalization of Financial Markets andInstitutions 0

2 Determinants of Interest Rates 00Interest Rate Fundamentals:Chapter Overview 00

Time Value of Money and Interest Rates 00Time Value of Money 00Present Values 00Future Values 00Interest Rates on Securities with a Maturity

of Less than One Year 00

Loanable Funds Theory 00Supply of Loanable Funds 00Demand for Loanable Funds 00Equilibrium Interest Rate 00

Factors that Cause the Supply and DemandCurves for Loanable Funds to Shift 00

Movement of Interest Rates Over Time 00

Determinants of Interest Rates for IndividualSecurities 00

Inflation 00Real Interest Rates 00Fisher Effect 00Default or Credit Risk 00Liquidity Risk 00Special Provisions or Covenants 00Term to Maturity 00

Term Structure of Interest Rates 00Unbiased Expectations Theory 00Liquidity Premium Theory 00Market Segmentation Theory 00

Forecasting Interest Rates 00

3 Interest Rates and Security Valuation 00Interest Rates as a Determinant of FinancialSecurity Values: Chapter Overview 00

Various Interest Rate Measures 00Required Rate of Return 00Expected Rate of Return 00Required versus Expected Rates of Return:

The Role of Efficient Markets 00Realized Rate of Return 00Coupon Rate 00

Bond Valuation 00Bond Valuation Formula Used to Calculate

Fair Present Values 00Bond Valuation Formula Used to Calculate

Yield to Maturity 00

Impact of Interest Rate Changes on SecurityValues 00

Contents

xvii

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Impact of Maturity on Security Values 00Maturity and Security Price 00Maturity and Security Price Sensitivity to

Changes in Interest Rates 00

Impact of Coupon Rates on Security Values 00

Coupon Rate and Security Prices 00Coupon Rate and Security Price Sensitivity

to Changes in Interest Rates 00

Duration 00A Simple Illustration of Duration 00A General Formula for Duration 00Features of Duration 00Economic Meaning of Duration 00Large Interest Rate Changes and

Duration 00

Appendix: Equity Valuation 00

4 The Federal Reserve System,Monetary Policy, and Interest Rates 000Major Duties and Responsibilities ofthe Federal Reserve System:Chapter Overview 000

Structure of the Federal Reserve System 000

Federal Reserve Banks 000Board of Governors of the Federal Reserve

System 000Federal Open Market Committee 000Balance Sheet of the Federal Reserve 000

Monetary Policy Tools 000Tools of Monetary Policy 000

The Federal Reserve, the Money Supply,and Interest Rates 000

Effects of Monetary Tools on VariousEconomic Variables 000

Money Supply versus Interest RateTargeting 000

International Monetary Policies andStrategies 000

Impact of U.S. Monetary Policy on ForeignExchange Rates 000

p a r t 2 SECURITIES MARKETS 121

5 Money Markets 122Definition of Money Markets:Chapter Overview 122

Money Markets 123

Money Market Securities 125Treasury Bills 126Federal Funds 132Repurchase Agreements 133Commercial Paper 136

Negotiable Certificates of Deposit 139Banker’s Acceptances 141Comparison of Money Market

Securities 142

Money Market Participants 143The U.S. Treasury 143The Federal Reserve 144Commercial Banks 144Brokers and Dealers 144Corporations 145Other Financial Institutions 145

International Aspects of Money Markets 145

Euro Money Markets 145Euro Money Market Securities 149

6 Bond Markets 153Definition of Bond Markets:Chapter Overview 153

Bond Market Securities 154Treasury Notes and Bonds 154Municipal Bonds 164Corporate Bonds 171Bond Ratings 177Bond Market Indexes 178

Bond Market Participants 179

Comparison of Bond Market Securities 179

International Aspects of Bond Markets 181

Eurobonds, Foreign Bonds, and Brady andSovereign Bonds 184

Eurobonds 184Foreign Bonds 185Brady Bonds and Sovereign Bonds 185

7 Mortgage Markets 000Mortgages and Mortgage-Backed Securities:Chapter Overview 000

Primary Mortgage Market 000Mortgage Characteristics 000Mortgage Amortization 000Other Types of Mortgages 000

Secondary Mortgage Markets 000History and Background of Secondary

Mortgage Markets 000Mortgage Sales 000Securitization of Mortgages 000

Institutional Use of Mortgage Markets 000

International Trends in Securitization 000Demand by International Investors for U.S.

Mortgage-Backed Securities 000International Mortgage Securities 000

8 Stock Markets 000The Stock Markets: Chapter Overview 000

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Stock Market Securities 000Common Stock 000Preferred Stock 000

Primary and Secondary Stock Markets 000Primary Markets 000Secondary Markets 000Stock Market Indexes 000

Stock Market Participants 000

Other Issues Pertaining to Stock Markets 000

Economic Indicators 000Market Efficiency 000Stock Market Regulations 000

International Aspects of Stock Markets 000

Appendix: Event Study Tests 000

9 Foreign Exchange Markets 000Foreign Exchange Markets and Risk:Chapter Overview 000

Background and History of ForeignExchange Markets 000

Foreign Exchange Rates and Transactions 000

Foreign Exchange Rates 000Foreign Exchange Transactions 000Return and Risk of Foreign Exchange

Transactions 000Role of Financial Institutions in Foreign

Exchange Transactions 000

Interaction of Interest Rates, Inflation, andForeign Exchange Rates 000

Purchasing Power Parity 000Interest Rate Parity 000

Balance of Payment Accounts 000Current Account 000Capital Accounts 000

10 Derivative Securities Markets 000Derivative Securities: Chapter Overview 000

Forwards and Futures 000Spot Markets 000Forward Markets 000Futures Markets 000

Options 000Call Options 000Put Options 000Option Values 000Option Markets 000

Regulation of Futures and Options Markets 000

Swaps 000Interest Rate Swaps 000

Currency Swaps 000Swap Markets 000

Caps, Floors, and Collars 000

Appendix: Black-Scholes Option PricingModel 000

p a r t 3 DEPOSITORY INSTITUTIONS 000

11 Commercial Banks 000Commercial Banks as a Sector ofthe Financial Institutions Industry:Chapter Overview 000

Definition of a Commercial Bank 000

Balance Sheets and Recent Trends 000Assets 000Liabilities 000Equity 000Off-Balance-Sheet Activities 000Other Fee-Generating Activities 000

Size, Structure, and Composition ofthe Industry 000

Economies of Scale and Scope 000Bank Size and Concentration 000Bank Size and Activities 000

Industry Performance 000

Regulators 000Federal Deposit Insurance

Corporation 000Office of the Comptroller of the

Currency 000Federal Reserve System 000State Authorities 000

12 Thrift Institutions 000Three Categories of Thrift Institutions:Chapter Overview 000

Savings Associations 000Size, Structure, and Composition of the

Industry 000Balance Sheets and Recent Trends 000

Savings Banks 000Size, Structure, and Composition of the

Industry 000Balance Sheets and Recent Trends 000

Regulators of Savings Institutions 000

Savings Association and Savings BankRecent Performance 000

Credit Unions 000Size, Structure, and Composition of the

Industry 000Balance Sheets and Recent Trends 000Regulators 000Industry Performance 000

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13 Depository Institutions’ FinancialStatements and Analysis 000Why Evaluate Performance of DepositoryInstitutions: Chapter Overview 000

Financial Statements of Commercial Banks 000

Balance Sheet Structure 000Off-Balance-Sheet Assets and

Liabilities 000Income Statement 000Direct Relationship between the Income

Statement and the Balance Sheet 000

Financial Statement Analysis Using a Returnon Equity Framework 000

Return on Equity and Its Components 000Return on Assets and Its Components 000Other Ratios 000

Impact of Market Niche and Bank Size onFinancial Statement Analysis 000

Impact of a Bank’s Market Niche 000Impact of Size on Financial Statement

Analysis 000

14 Regulation of DepositoryInstitutions 000Specialness and Regulation:Chapter Overview 000

Types of Regulations and the Regulators 000

Safety and Soundness Regulation 000Monetary Policy Regulation 000Credit Allocation Regulation 000Consumer Protection Regulation 000Investor Protection Regulation 000Entry and Chartering Regulation 000Regulators 000

Regulation of Product and GeographicExpansion 000

Product Segmentation in the U.S.Depository Institutions Industry 000

Geographic Expansion in the U.S.Depository Institutions Industry 000

History of Bank and Savings InstitutionGuarantee Funds 000

FDIC 000The Federal Savings and Loan Insurance

Corporation and Its Demise 000Causes of the Depository Fund

Insolvencies 000Non U.S. Deposit Insurance

Systems 000

Balance Sheet Regulations 000Regulations on Depository Institution

Liquidity 000Regulations on Capital Adequacy

(Leverage) 000

Off-Balance-Sheet Regulations 000

Foreign versus Domestic Regulation ofDepository Institutions 000

Product Diversification Activities 000Global or International Expansion

Activities 000

Appendix A: Depository Institutions andTheir Regulators 000

Appendix B: Financial ServicesModernization Act of 1999: Summary ofProvisions 000

Appendix C: Calculating MinimumRequired Reserves at U.S. DepositoryInstitutions 000

Appendix D: Calculating Risk-BasedCapital Ratios 000

p a r t 4 OTHER FINANCIALINSTITUTIONS 000

15 Insurance Companies 000Two Categories of Insurance Companies:Chapter Overview 000

Life Insurance Companies 000Size, Structure, and Composition of the

Industry 000Balance Sheets and Recent Trends 000Regulation 000

Property-Casualty Insurance Companies 000

Size, Structure, and Composition of theIndustry 000

Balance Sheets and Recent Trends 000Regulation 000

16 Securities Firms and InvestmentBanks 000Services Offered by Securities Firms versusInvestment Banks: Chapter Overview 000

Size, Structure, and Composition of theIndustry 000

Securities Firm and Investment BankActivity Areas 000

Investing 000Investment Banking 000Market Making 000Trading 000Cash Management 000Mergers and Acquisitions 000Other Service Functions 000

Recent Trends and Balance Sheets 000Recent Trends 000Balance Sheet 000

Regulation 000

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17 Finance Companies 000Finance Company Functions:Chapter Overview 000

Size, Structure, and Composition of theIndustry 000

Balance Sheets and Recent Trends 000Assets 000Liabilities and Equity 000

Regulation 000

18 Mutual Funds 000Mutual Funds: Chapter Overview 000

Size, Structure, and Composition of theIndustry 000

Historical Trends 000Different Types of Mutual Funds 000Mutual Fund Prospectuses and

Objectives 000Size and Mutual Fund Performance:

The Case of the Magellan Fund 000Investor Returns from Mutual Fund

Ownership 000Mutual Fund Costs 000Mutual Fund Share Quotes 000

Balance Sheets and Recent Trends 000Money Market Funds 000Long-Term Funds 000

Regulation 000

19 Pension Funds 000Pension Funds Defined: Chapter Overview 000

Size, Structure, and Composition of theIndustry 000

Insured versus Noninsured Pension Funds 000

Defined Benefit versus DefinedContribution Pension Funds 000

Private Pension Funds 000Public Pension Funds 000

Financial Asset Investments and RecentTrends 000

Private Pension Funds 000Public Pension Funds 000

Regulation of Pension Funds 000

p a r t 5 RISK MANAGEMENT INFINANCIAL INSTITUTIONS 000

20 Types of Risks Incurred by FinancialInstitutions 000Why Financial Institutions Need to ManageRisk: Chapter Overview 000

Credit Risk 000

Liquidity Risk 000

Interest Rate Risk 000The Federal Reserve and Interest

Rate Risk 000Maturity Mismatching and Interest

Rate Risk 000

Market Risk 000

Off-Balance-Sheet Risk 000

Foreign Exchange Risk 000

Country or Sovereign Risk 000

Technology and Operational Risk 000

Insolvency Risk 000

Interaction Among Risks 000

21 Managing Risk on the BalanceSheet I: Credit Risk 000Credit Risk Management: Chapter Overview 000

Credit Analysis 000Real Estate Lending 000Consumer (Individual) and Small-Business

Lending 000Mid-Market Commercial and Industrial

Lending 000Large Commercial and Industrial

Lending 000

Calculating the Return on a Loan 000Return on Assets (ROA) 000RAROC Models 000

Appendix: Loan Portfolio Risk andManagement 000

22 Managing Risk on the BalanceSheet II: Liquidity Risk 000Liquidity Risk Management:Chapter Overview 000

Causes of Liquidity Risk 000

Liquidity Risk and Depository Institutions 000

Liability Side Liquidity Risk 000Asset Side Liquidity Risk 000Measuring a Bank’s Liquidity

Exposure 000Liquidity Risk, Unexpected Deposit Drains,

and Bank Runs 000Bank Runs, the Discount Window, and

Deposit Insurance 000

Liquidity Risk and Insurance Companies 000

Life Insurance Companies 000Property-Casualty Insurance

Companies 000Guarantee Programs for Life and Property-

Casualty Insurance Companies 000

Contents xxi

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Liquidity Risk and Mutual Funds 000

23 Managing Risk on the BalanceSheet III: Interest Rate andInsolvency Risk 000Interest Rate and Insolvency RiskManagement: Chapter Overview 000

Interest Rate Risk Measurement andManagement 000

Repricing Model 000Duration Model 000

Insolvency Risk Management 000Capital and Insolvency Risk 000

24 Managing Risk with DerivativeSecurities 000Derivative Securities Used to Manage Risk:Chapter Overview 000

Forward and Futures Contracts 000Hedging with Forward Contracts 000Hedging with Futures Contracts 000

Options 000Basic Features of Options 000Actual Interest Rate Options 000Hedging with Options 000

Swaps 000Interest Rate Swaps 000Currency Swaps 000Credit Risk Concerns with Swaps 000

Comparison of Hedging Methods 000Writing versus Buying Options 000

Futures versus Options Hedging 000Swaps versus Forwards, Futures, and

Options 000

25 Loan Sales and Asset Securitization 000Why Financial Institutions Securitize Assets:Chapter Overview 000

Loan Sales 000Types of Loan Sales Contracts 000Bank Loan Sale Market 000Secondary Market for Less Developed

Country Debt 000Factors Encouraging Future Loan Sales

Growth 000Factors Deterring Future Loan Sales

Growth 000

Loan Securitization 000Pass-Through Security 000Collateralized Mortgage Obligation 000Mortgage-Backed Bond 000

Securitization of Other Assets 000

Can All Assets Be Securitized? 000

Glossary 000

Appendix 000

References 000

Index 000

xxii Contents

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