PART TWO FUNDAMENTALS OF FINANCIAL MARKETS
Chapter 3 What Do Interest Rates Mean, and What Is Their
Role in Valuation? 77
PREVIEW 77
Measuring Interest Rates 78
Present Value 78
Four Types of Credit Market Instruments 80
Yield to Maturity 81
GLOBAL Negative Interest Rates? Japan First, Then the United States, Then Europe 87
The Distinction Between Real and Nominal Interest Rates 88
MINI-CASE Seeing the Difference Between Real and Nominal in Practice: Australian eTIBs 90
The Distinction Between Interest Rates and Returns 91
Maturity and the Volatility of Bond Returns: InterestRate Risk 94
Reinvestment Risk 95
Summary 95
THE PRACTICING MANAGER Calculating Duration to Measure Interest-Rate Risk 96
Calculating Duration 97
Duration and Interest-Rate Risk 100
SUMMARY 102
KEY TERMS 102 QUESTIONS 103
QUANTITATIVE PROBLEMS 103
WEB EXERCISE 104
Chapter 4 Why Do Interest Rates Change? 105
PREVIEW 105
Determinants of Asset Demand 106
Wealth 106
Expected Returns 106
Risk 107
Liquidity 109
Theory of Portfolio Choice 109
Supply and Demand in the Bond Market 109
Demand Curve 110
Supply Curve 111
Market Equilibrium 112
Supply-and-Demand Analysis 113
Changes in Equilibrium Interest Rates 113
Shifts in the Demand for Bonds 114
Shifts in the Supply of Bonds 117
CASE Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect 119
CASE Changes in the Interest Rate Due to a Business Cycle Expansion 121
CASE Explaining the Low Interest Rates in Europe, Japan, and the United
States Before 2022 122
THE PRACTICING MANAGER Profiting from Interest-Rate Forecasts 123
FOLLOWING THE FINANCIAL NEWS Forecasting
Interest Rates 125
SUMMARY 125
KEY TERMS 125
QUESTIONS 125
QUANTITATIVE PROBLEMS 126
WEB EXERCISES 127
WEB APPENDICES 127
Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 128
PREVIEW 128
Risk Structure of Interest Rates 129
Default Risk 129
Liquidity 132
CASE The Coronavirus Pandemic and the Baa–
Treasury Spread 132
Income Tax Considerations 133
Summary 134
CASE Effects of the Trump Tax Cuts on Bond
Interest Rates 135
Term Structure of Interest Rates 136
FOLLOWING THE FINANCIAL NEWS Yield Curves 137
Expectations Theory 137
Market Segmentation Theory 141
Liquidity Premium Theory 142
Evidence on the Term Structure 145
MINI-CASE The Yield Curve as a Forecasting Tool for Inflation and the
Business Cycle 147
Summary 147
CASE Interpreting Yield Curves, 1980–2022 148
THE PRACTICING MANAGER Using the Term
Structure to Forecast Interest Rates 149
SUMMARY 152
KEY TERMS 152
QUESTIONS 152
QUANTITATIVE PROBLEMS
153
WEB EXERCISES 154
Chapter 6 Are Financial Markets Efficient? 155
PREVIEW 155
The Efficient Market Hypothesis 156
Rationale Behind the Hypothesis 158
Evidence on the Efficient Market Hypothesis 159
Evidence in Favor of Market Efficiency 159
MINI-CASE An Exception That Proves the Rule: Raj Rajaratnam and Galleon 160
CASE Should Foreign Exchange Rates Follow a Random Walk? 162
Evidence Against Market Efficiency 163
Overview of the Evidence on the Efficient Market Hypothesis 165
THE PRACTICING MANAGER Practical Guide to Investing in the Stock Market 165
How Valuable Are Published Reports by Investment Advisers? 165
MINI-CASE Should You Hire an Ape as Your Investment Adviser? 166
Should You Be Skeptical of Hot Tips? 166
Do Stock Prices Always Rise When There Is Good News? 167 Efficient Markets Prescription for the Investor 167
Why the Efficient Market Hypothesis Does Not Imply That Financial Markets Are Efficient 168 CASE What Do Stock Market Crashes Tell Us About the
PREVIEW 173
Basic Facts About Financial Structure Throughout the World 174
Transaction Costs 177
How Transaction Costs Influence Financial Structure 177
How Financial Intermediaries Reduce Transaction Costs 177
Asymmetric Information: Adverse Selection and Moral Hazard 178
The Lemons Problem: How Adverse Selection Influences
Financial Structure 179
Lemons in the Stock and Bond Markets 180
Tools to Help Solve Adverse Selection Problems 180 MINI-CASE The Enron Implosion 182
How Moral Hazard Affects the Choice Between Debt and Equity Contracts 185
Moral Hazard in Equity Contracts: The Principal–Agent Problem 185
Tools to Help Solve the Principal–Agent Problem 186
How Moral Hazard Influences Financial Structure in Debt Markets 188
Tools to Help Solve Moral Hazard in Debt Contracts 188
Summary 190
CASE Financial Development and Economic Growth 192
MINI-CASE The Tyranny of Collateral 193
CASE Is China a Counter-Example to the Importance of Financial Development? 194
Conflicts of Interest 195
What Are Conflicts of Interest, and Why Do We Care? 195
Why Do Conflicts of Interest Arise? 195
CONFLICTS OF INTEREST The Demise of Arthur Andersen 197
CONFLICTS OF INTEREST Credit-Rating Agencies and the 2007–2009
Financial Crisis 198
What Has Been Done to Remedy Conflicts of Interest? 198
MINI-CASE Has Sarbanes-Oxley Led to a Decline in U.S. Capital Markets? 200
SUMMARY 200
KEY TERMS 201
QUESTIONS 201
QUANTITATIVE PROBLEMS 202
WEB EXERCISES 203
Chapter 8 Why Do Financial Crises Occur, and Why Are They So Damaging to the Economy? 204
PREVIEW 204
What Is a Financial Crisis? 205
Agency Theory and the Definition of a Financial Crisis 205
Dynamics of Financial Crises 205
Stage One: Initial Phase 205
Stage Two: Banking Crisis 208
Stage Three: Debt Deflation 209
CASE The Mother of All Financial Crises: The Great Depression 209
Stock Market Crash 209
Bank Panics 209
Continuing Decline in Stock Prices 210
Debt Deflation 211
International Dimensions 211
CASE The Global Financial Crisis of 2007–2009 212
Causes of the 2007–2009 Financial Crisis 212
MINI-CASE Collateralized Debt Obligations (CDOs) 213
Effects of the 2007–2009 Financial Crisis 214
INSIDE THE FED Was the Fed to Blame for the Housing Price Bubble? 215
GLOBAL The European Sovereign Debt Crisis 218
Height of the 2007–2009 Financial Crisis 219
CASE Could Covid Have Led to a Financial Crisis?
220
SUMMARY 221
KEY TERMS 222
QUESTIONS 222
WEB EXERCISE 223
WEB REFERENCES 223
PART FOUR CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY
Chapter 9 Central Banks 224
PREVIEW 224
Origins of the Central Banking System 225
Variations in the Functions and Structures of Central Banks 225
GLOBAL Who Should Own Central Banks? 226
The European Central Bank, the Euro System, and the European System of Central Banks 226
Decision-Making Bodies of the ECB 227
GLOBAL The Importance of the Bundesbank Within the ECB 230
How Monetary Policy Is Conducted Within the ECB 231
GLOBAL Are Non-Euro Central Banks Constrained by Membership of the EU? 232
The Federal Reserve System 232
Difference Between the ECB and the Fed 233
The Bank of England 234
GLOBAL Brexit and the BoE 235
Structure of Central Banks of Larger Economies 235
The Bank of Canada 235
The Bank of Japan 236
The People’s Bank of China 237
Structure and Independence of Central Banks of Emerging Market Economies 238
Central Banks Independence 238
The Case for Independence 239
The Case Against Independence 239
The Trend Toward Greater Independence 239
SUMMARY 240
KEY TERMS 241
QUESTIONS AND PROBLEMS 241
WEB EXERCISES 241
Chapter 10 Conduct of Monetary Policy 242
PREVIEW 242
How Fed Actions Affect Reserves in the Banking System 243
Open Market Operations 243
Discount Lending 244
The Market for Reserves and the Federal Funds Rate 245
Demand and Supply in the Market for Reserves 245
How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate 247
CASE How the Federal Reserve’s Operating Procedures Limit Fluctuations
in the Federal Funds Rate 251
Conventional Monetary Policy Tools 252
Open Market Operations 252
INSIDE THE FED A Day at the Trading Desk 253
Discount Policy and the Lender of Last Resort 253
Reserve Requirements 256
Interest on Excess Reserves 256
Nonconventional Monetary Policy Tools and
Quantitative Easing 256
Liquidity Provision 257
INSIDE THE FED Fed Lending Facilities During the Global Financial and Covid Crises 258
Large-Scale Asset Purchases 259
Quantitative Easing Versus Credit Easing 260
Forward Guidance 261
Deposits
Interest on Excess Reserves 265
Reserve Requirements 265
The Price Stability Goal and the Nominal Anchor 265
The Role of a Nominal Anchor 266
The Time-Inconsistency Problem 266
Other Goals of Monetary Policy 267
High Employment and Output Stability 267
Economic Growth 268
Stability of Financial Markets 268
Interest-Rate Stability 268
Stability in Foreign Exchange Markets 269
Should Price Stability Be the Primary Goal of Monetary Policy? 269
Hierarchical Versus Dual Mandates 269
Price Stability as the Primary, Long-Run Goal of Monetary Policy 270
Inflation Targeting 271
Advantages of Inflation Targeting 271
INSIDE THE FED Ben Bernanke and the Federal Reserve’s Adoption of Inflation Targeting 272
INSIDE THE FED The Fed’s New Monetary Policy Strategy: Average
Inflation Targeting 273
Disadvantages of Inflation Targeting 273
Should Central Banks Respond to Asset-Price Bubbles?
Lessons from the Global Financial Crisis 274 Two Types of Asset-Price Bubbles 275
The Debate over Whether Central Banks Should Try to Pop Bubbles 276 THE PRACTICING MANAGER Using a Fed Watcher 279 SUMMARY 280
PART FIVE FINANCIAL MARKETS
Chapter 11 The Money Markets 284
PREVIEW 284
The Money Markets Defined 285
Why Do We Need the Money Markets? 285
Money Market Cost Advantages 286
The Purpose of the Money Markets 287
MINI-CASE Covid and Prime Money Market Fund
Withdrawals 288
Who Participates in the Money Markets? 288
U.S. Treasury Department 288
Federal Reserve System 289
Commercial Banks 289
Businesses 290
Investment and Securities Firms 290
Individuals 290
Money Market Instruments 291
Treasury Bills 291
CASE Discounting the Price of Treasury Securities to Pay the Interest 291
MINI-CASE Treasury Bill Auctions Go Haywire 294
Federal Funds 295
Repurchase Agreements 296
Negotiable Certificates of Deposit 297
Commercial Paper 298
Acceptances
Chapter 12 The Bond Market 307
PREVIEW 307
Purpose of the Capital Market 308
Capital Market Participants 308
Capital Market Trading 309
Types of Bonds 309
Treasury Notes and Bonds 309
Treasury Bond Interest Rates 310
Treasury Inflation-Protected Securities (TIPS) 312
Treasury STRIPS 312
Agency Bonds 312
CASE The 2007–2009 Financial Crisis and the Bailout of Fannie Mae and Freddie Mac 313
Municipal Bonds 314
Risk in the Municipal Bond Market 316
Corporate Bonds 316
Characteristics of Corporate Bonds 317
Types of Corporate Bonds 319
Financial Guarantees for Bonds 322
Oversight of the Bond Markets 323
Current Yield Calculation 323
Current Yield 324
Finding the Value of Coupon Bonds 325
Finding the Price of Semiannual Bonds 326
Investing in Bonds 328
SUMMARY 329
KEY TERMS 330
QUESTIONS 330
QUANTITATIVE PROBLEMS 330
Chapter 13 The Stock Market 332
PREVIEW 332
Investing in Stocks 333
Common Stock Versus Preferred Stock 333
How Stocks Are Sold 334
Computing the Price of Common Stock 338
The One-Period Valuation Model 338
The Generalized Dividend Valuation Model 339
The Gordon Growth Model 340
Price Earnings Valuation Method 341
How the Market Sets Security Prices 342
Errors in Valuation 343
Problems with Estimating Growth 343
Problems with Estimating Risk 344
Problems with Forecasting Dividends 344
MINI-CASE Covid Impact on Stock Markets 345
Stock Market Indexes 345
MINI-CASE History of the Dow Jones Industrial Average 346
Buying Foreign Stocks 347
Regulation
Chapter 14 The Mortgage Markets 353
PREVIEW 353
What Are Mortgages? 354
Characteristics of the Residential Mortgage 355
Mortgage Interest Rates 355
CASE The Discount Point Decision 356
Loan Terms 358
Mortgage Loan Amortization 359
Types of Mortgage Loans 360
Insured and Conventional Mortgages 360
Fixed- and Adjustable-Rate Mortgages 361
Other Types of Mortgages 361
Mortgage-Lending Institutions 363
Loan Servicing 364
E-FINANCE Borrowers Shop the Web for Mortgages 365
Secondary Mortgage Market 365
Securitization of Mortgages 366
What Is a Mortgage-Backed Security? 366
Types of Pass-Through Securities 368
Subprime Mortgages and CDOs 369
The Real Estate Bubble 370
MINI-CASE Has Covid Led to a Housing Price Bubble? 371
SUMMARY 371
KEY TERMS 371 QUESTIONS 372 QUANTITATIVE PROBLEMS 372
Chapter 15 The Foreign Exchange Market 374 PREVIEW 374
Foreign Exchange Market 375
What Are Foreign Exchange Rates? 375
Why Are Exchange Rates Important? 375
FOLLOWING THE FINANCIAL NEWS Foreign Exchange Rates 376
How Is Foreign Exchange Traded? 376 Exchange Rates in the Long Run 377
Law of One Price 377
Theory of Purchasing Power Parity 378
Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates 378
Factors That Affect Exchange Rates in the Long Run 380
Exchange Rates in the Short Run: A Supply and Demand Analysis 381
Supply Curve for Domestic Assets 382
Demand Curve for Domestic Assets 383
Equilibrium in the Foreign Exchange Market 383
Explaining Changes in Exchange Rates 383
Shifts in the Demand for Domestic Assets 384
Recap: Factors That Change the Exchange Rate 387
CASE Effect of Changes in Interest Rates on the Equilibrium Exchange Rate 389
CASE Brexit and the British Pound 390
THE PRACTICING MANAGER
Profiting from Foreign Exchange Forecasts 391
SUMMARY 392
KEY TERMS 392
QUESTIONS 393
QUANTITATIVE PROBLEMS 393
WEB EXERCISES 394
Chapter 15 Appendix: The Interest Parity Condition 395
Comparing Expected Returns on Domestic and Foreign Assets 395
Interest Parity Condition 397
Chapter 16 The International Financial System 399
PREVIEW 399
Intervention in the Foreign Exchange Market 400
Foreign Exchange Intervention and Reserves in the Banking System 400
GLOBAL Variation in Central Banks’ Activism and Method of Intervention on Foreign Exchange Markets 401
Unsterilized Intervention 402
Sterilized Intervention 402
Balance of Payments 403
GLOBAL Rising Current Account Deficits in the EU 405
Exchange Rate Regimes in the International
Financial System 405
Fixed Exchange Rate Regimes 405
How a Fixed Exchange Rate Regime Works 406
The Policy Trilemma 408
Monetary Unions 409
GLOBAL Will the Euro Survive? 410
Currency Boards and Dollarization 410
Speculative Attacks 410
GLOBAL Argentina’s Currency Board 411
Managed Float 411
GLOBAL Dollarization 412
CASE The Foreign Exchange Crisis of September 1992 412
THE
PRACTICING
MANAGER
Profiting from a Foreign Exchange Crisis 414
CASE How Did China Accumulate Over $3 Trillion of International Reserves? 415
Capital Controls 415
Controls on Capital Outflows 415
Controls on Capital Inflows 416
The Role of the IMF 416
Should the IMF Be an International Lender of Last Resort? 417
SUMMARY 417 KEY TERMS 418 QUESTIONS 418 QUANTITATIVE PROBLEMS 419 WEB EXERCISE 419 PART SIX THE
Chapter 17 Banking and the Management of Financial Institutions 420
PREVIEW 420
The Bank Balance Sheet 421
Liabilities 421
Assets 423
Basic Banking 424
General Principles of Bank Management 427
Liquidity Management and the Role of Reserves 427
Asset Management 430
Liability Management 431
Capital Adequacy Management 432
THE PRACTICING MANAGER Strategies for Managing Bank Capital 434
CASE How a Capital Crunch Caused a Credit Crunch During the
Global Financial Crisis 435
Off-Balance-Sheet Activities 435
Loan Sales 436
Generation of Fee Income 436
Trading Activities and Risk Management Techniques
436
CONFLICTS OF INTEREST Barings, Daiwa, Sumitomo, Société Générale, and JPMorgan Chase: Rogue Traders and the Principal–Agent Problem 437
Measuring Bank Performance 438
Bank’s Income Statement 438
Measures of Bank Performance 440
Recent Trends in Bank Performance Measures 441
SUMMARY 443
KEY TERMS 444
QUESTIONS 444
QUANTITATIVE PROBLEMS 444
Chapter 18 Financial Regulation 446
PREVIEW 446
Asymmetric Information as a Rationale for Financial Regulation 447
Government Safety Net 447
GLOBAL The Spread of Government Deposit
Insurance
Throughout the World: Is This a Good Thing? 449
Types of Financial Regulation 452
Restrictions on Asset Holdings 452
Capital Requirements 453
Prompt Corrective Action 454
Financial Supervision: Chartering and Examination 454
GLOBAL Where Is the Basel Accord Heading in a Post–Global Financial Crisis World? 455
Assessment of Risk Management 456
Disclosure Requirements 457
Consumer Protection 458
MINI-CASE Mark-to-Market Accounting and the Global Financial Crisis 459
Restrictions on Competition 459
MINI-CASE The Global Financial Crisis and Consumer Protection Regulation 460
Macroprudential Versus Microprudential Supervision 461
E-FINANCE Electronic Banking: New Challenges for Bank Regulation 461
Summary 462
GLOBAL International Financial Regulation 463
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 466
Dodd-Frank 466
Too-Big-to-Fail and Future Regulation 467 What Can Be Done About the Too-Big-to-Fail Problem? 467 Other Issues for Future Regulation 468 SUMMARY 469
PREVIEW 472
Historical Development of the Banking System 473
Multiple Regulatory Agencies 475
Financial Innovation and the Growth of the Shadow Banking System 475
Responses to Changes in Demand Conditions:
Interest Rate Volatility 476
Responses to Changes in Supply Conditions:
Information Technology 477
E-FINANCE Will Fintech Disrupt the Conventional Banking Sector? 479
E-FINANCE Why Are Scandinavians So Far Ahead of Americans in Using Electronic Payments and Online Banking? 480
E-FINANCE Sweden: The Leading Cashless Society 481
Securitization and the Shadow Banking System 482
Avoidance of Existing Regulations 484
MINI-CASE Bruce Bent and the Money Market
Mutual Fund Panic of 2008 486
THE PRACTICING MANAGER Profiting from a New Financial Product:
A Case Study of Treasury Strips 486
Financial Innovation and the Decline of Traditional Banking 488
Structure of the U.S. Banking Industry 491
Restrictions on Branching 492
Response to Branching Restrictions 493
Bank Consolidation and Nationwide Banking 494
E-FINANCE Information Technology and Bank
Consolidation 496
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 496
What Will the Structure of the U.S. Banking Industry Look Like in the Future? 497
Are Bank Consolidation and Nationwide Banking
Good Things? 497
Separation of the Banking and Other Financial Service Industries 498
Erosion of Glass-Steagall 498
The Gramm-Leach-Bliley Financial Services
Modernization Act of 1999:
Repeal of Glass-Steagall 499
Implications for Financial Consolidation 499
MINI-CASE The Global Financial Crisis and the Demise of Large, Free-Standing
Investment Banks 500
Separation of Banking and Other Financial Services
Industries Throughout the World 500
Thrift Industry 501
Savings and Loan Associations 501
Mutual Savings Banks 501
Credit Unions 502
International Banking 502
Eurodollar Market 503
Structure of U.S. Banking Overseas 503
Foreign Banks in the United States 504
SUMMARY 505
KEY TERMS 506
QUESTIONS 506
Chapter 20 The Mutual Fund Industry 507
PREVIEW 507
The Growth of Mutual Funds 508
The First Mutual Funds 508
Benefits of Mutual Funds 508
Ownership of Mutual Funds 509
Mutual Fund Structure 511
Open- Versus Closed-End Funds 511
CASE Calculating a Mutual Fund’s Net Asset Value 512
Organizational Structure 513
Investment Objective Classes 514
Equity Funds 514
Bond Funds 515
Hybrid Funds 516
Money Market Funds 516
Index Funds 518
Fee Structure of Investment Funds 519
Regulation of Mutual Funds 520
Hedge Funds 521
MINI-CASE The Long Term Capital Debacle 523
Conflicts of Interest in the Mutual Fund Industry 523
Sources of Conflicts of Interest 524
Mutual Fund Abuses 524
CONFLICTS OF INTEREST Many Mutual Funds Are Caught Ignoring
Ethical Standards 525
Government Response to Abuses 526
CONFLICTS OF INTEREST SEC Survey Reports
Mutual Fund Abuses Widespread 526
SUMMARY 527
KEY TERMS 528
QUESTIONS 528
QUANTITATIVE PROBLEMS 528
544
545
546
546
547
Defined-Benefit Pension Plans 550
Defined-Contribution Pension Plans 550
Private and Public Pension Plans 551
MINI-CASE Power to the Pensions 552
Regulation of Pension Plans 555
Employee Retirement Income Security Act 555
Individual Retirement Plans 557
The Future of Pension Funds 558
SUMMARY 558
KEY TERMS 558
QUESTIONS 559 QUANTITATIVE PROBLEMS 559
Chapter 22 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms 561
PREVIEW 561
Investment Banks 562 Background 562
Underwriting Stocks and Bonds 563
Equity Sales 567
Mergers and Acquisitions 568
MINI-CASE Twitter Uses Poison Pills to Drive Hard
Bargain with Musk 569
Securities Brokers and Dealers 570
Brokerage Services 570
MINI-CASE Example of Using the Limit-Order Book 571
Securities Dealers 573
Regulation of Securities Firms 573
Relationship Between Securities Firms and Commercial Banks 575
Private Equity Investment 575
Venture Capital Firms 575
Private Equity Buyouts 579
Advantages to Private Equity Buyouts 579
Life Cycle of the Private Equity Buyout 580
SUMMARY 580
KEY TERMS 581
QUESTIONS 581
QUANTITATIVE PROBLEMS 582
PART SEVEN THE MANAGEMENT OF FINANCIAL INSTITUTIONS
Chapter 23 Risk Management in Financial Institutions 584
PREVIEW 584
Managing Credit Risk 585
Screening and Monitoring 585
Long-Term Customer Relationships 586
Loan Commitments 587
Collateral 587
Compensating Balances 588
Credit Rationing 588
Managing Interest-Rate Risk 589
SUMMARY 590
KEY TERMS 591
QUESTIONS 591
QUANTITATIVE PROBLEMS 592
WEB EXERCISES 593
PART SEVEN THE MANAGEMENT OF FINANCIAL INSTITUTIONS
Chapter 23 Risk Management in Financial Institutions 594
PREVIEW 594
Managing Credit Risk 595
Screening and Monitoring 595
Long-Term Customer Relationships 596
Loan Commitments 597
Collateral 597
Compensating Balances 598
Credit Rationing 598
Managing Interest-Rate Risk 599
Income Gap Analysis 600
Duration Gap Analysis 602
Example of a Nonbanking Financial Institution 607
Some Problems with Income Gap and Duration Gap Analyses 609
THE PRACTICING MANAGER Strategies for Managing Interest-Rate Risk 610
SUMMARY 611
KEY TERMS 611
QUESTIONS 611
QUANTITATIVE PROBLEMS 612
WEB EXERCISES 614
Chapter 24 Hedging with Financial Derivatives 615
PREVIEW 615
Hedging 616
Forward Markets 616
THE PRACTICING MANAGER Hedging InterestRate Risk with Forward Contracts 616
Interest-Rate Forward Contracts 616
Pros and Cons of Forward Contracts 617
Financial Futures Markets 618
Financial Futures Contracts 618
FOLLOWING THE FINANCIAL NEWS Financial Futures 619
THE PRACTICING MANAGER Hedging with Financial Futures 620
Organization of Trading in Financial Futures Markets 622
Globalization of Financial Futures Markets 622
Explaining the Success of Futures Markets 623
MINI-CASE The Hunt Brothers and the Silver Crash 625
Interest-Rate Swaps 627
HE PRACTICING MANAGER Hedging Foreign
Exchange Risk with Forward and Futures Contracts 626
Hedging Foreign Exchange Risk with Forward Contracts 626
Hedging Foreign Exchange Risk with Futures Contracts 627
Stock Index Futures 627
Stock Index Futures Contracts 628
FOLLOWING THE
FINANCIAL NEWS Stock Index
Futures 628
THE PRACTICING MANAGER Hedging with Stock Index Futures 629
Options 630
Option Contracts 630
Profits and Losses on Option and Futures Contracts 631
Factors Affecting the Prices of Option Premiums 634
Summary 635
THE PRACTICING MANAGER Hedging with Futures Options 635
Interest-Rate Swaps 637
Interest-Rate Swap Contracts 637
THE PRACTICING MANAGER Hedging with Interest-Rate Swaps 638
Advantages of Interest-Rate Swaps 639
Disadvantages of Interest-Rate Swaps 639
Financial Intermediaries in Interest-Rate Swaps 640
Credit Derivatives 640
Credit Options 641
Credit Swaps 641
Credit-Linked Notes 642
CASE Lessons from the Global Financial Crisis: When Are Financial Derivatives Likely to Be a Worldwide Time Bomb? 642 SUMMARY 644 KEY TERMS 644 QUESTIONS 645
WEB APPENDICES 647
Glossary 649
Index 667
What’s New in the Ninth Edition
In addition to the expected updating of all data whenever possible, there is major new material in every part of the text. New Material on Financial Markets and Institutions In light of ongoing research and changes in financial markets and institutions, we have added the following material to keep the text current: • A new section on hedge funds (Chapter 2) • An updated Mini-Case box on negative interest
rates in the United States, Europe, and Japan (Chapter 3) • An updated case on explaining low interest rates in Europe, Japan, and the United States (Chapter 4) • A new Mini-Case box on the tyranny of collateral (Chapter 7)
• A new chapter on major central banks around the world, their origins, structure, and functions (Chapter 9) • A new section describing securitization and the shadow banking system (Chapter 19) New Material on Monetary Policy In the aftermath of the global financial crisis, there have been major changes in the way central banks conduct monetary policy. This has involved the following new material. • A new Global box on the importance of the Bundesbank within the ECB (Chapter 9) • A new Global box on whether non-Euro Central Banks are limited by their EU membership (Chapter 9) • A new section on how Federal Reserve actions affect reserves in the banking system (Chapter 10) • An updated section on forward guidance (Chapter 10) • A new section on the policy tool, negative interest rates on bank deposits at central banks (Chapter 10) Appendices on the Web The Web site for this book, www.pearsonglobaleditions.com/Mishkin, has
allowed us to retain and add new material for the book by posting content online. The appendices include: Chapter 4: Models of Asset Pricing Chapter 4: Applying the Asset Market Approach to a Commodity Market: The Case of Gold Chapter 4: Loanable Funds Framework Chapter 4: Supply and Demand in the Market for Money: The Liquidity Preference Framework Chapter 18: Banking Crises Throughout the World Chapter 24: More on Hedging with Financial Derivatives Instructors can either use these appendices in class to supplement the material in the textbook or recommend them to students who want to expand their knowledge of the financial markets and institutions field. Hallmarks
Although this text has undergone a major revision, it retains the basic hallmarks that make it the bestselling textbook on financial markets and institutions. The ninth edition of Financial Markets and Institutions is a practical introduction to the workings of today’s financial markets and institutions. Moving beyond the descriptions and definitions provided by other textbooks in the field, Financial Markets and Institutions encourages students to understand the connection between the theoretical concepts and
their real-world applications. By enhancing students’ analytical abilities and concrete problem-solving skills, this textbook prepares students for successful careers in the financial services industry or successful interactions with financial institutions, whatever their jobs. To prepare students for their future careers, Financial Markets and Institutions provides the following features: • A unifying analytic framework that uses a few basic principles to organize students’ thinking. These principles include: Asymmetric information (agency) problems Conflicts of interest Transaction costs Supply and demand Asset market equilibrium Efficient markets
Measurement and management of risk • “The Practicing Manager” sections include nearly 20 hands-on applications that emphasize the financial practitioner’s approach to financial markets and institutions. • A careful step-by-step development of models enables students to master the material more easily. • A high degree of flexibility allows professors to teach the course in the manner they prefer. • International perspectives are completely integrated throughout the text. • “Following the Financial News” is a feature that encourages the
reading of a financial newspaper. • Numerous cases increase students’ interest by applying theory to real-world data and examples. • The text focuses on the impact of electronic (computer and telecommunications) technology on the financial system. The text makes extensive use of the Internet with Web exercises, Web sources for charts and tables, and Web references in the margins. It also features special “E-Finance” boxes that explain how changes in technology have affected financial markets and institutions. Flexibility There are as many ways to teach financial markets and institutions as there are instructors. Thus, there is a great need to make a textbook flexible in order to satisfy the diverse needs of instructors, and that has been a primary objective in writing this book. This textbook achieves this flexibility in the following ways: • Core chapters provide the basic analysis used throughout the book, and other chapters or sections of chapters can be assigned or omitted according to instructor preferences. For example, Chapter 2 introduces the financial system and basic concepts such as transaction costs, adverse selection, and moral hazard. After covering Chapter
2, an instructor can decide to teach a more detailed treatment of financial structure and financial crises using chapters in Part 3 of the text, or cover specific chapters on financial markets or financial institutions in Parts 4 or 5 of the text, or the instructor can skip these chapters and take any of a number of different paths.
Chapter 1 Why Study Financial Markets and Institutions?
On the evening news you have just heard that the bond market has been booming. Does this mean that interest rates will fall so that it is easier for you to finance the purchase of a new computer system for your small retail business? Will the economy improve in the future so that it is a good time to build a new building or add to the one you are in? Should you try to raise funds by issuing stocks or bonds or instead go to the bank for a loan? If you import goods from abroad, should you be concerned that
they will become more expensive? This book provides answers to these questions by examining how financial markets (such as those for bonds, stocks, and foreign exchange) and financial institutions (banks, insurance companies, mutual funds, and other institutions) work. Financial markets and institutions not only affect your everyday life but also involve huge flows of funds—trillions of dollars—throughout our economy, which in turn affect business profits, the production of goods and services, and even the economic well-being of countries other than the United States. What happens to financial markets and institutions is of great concern to politicians and can even have a major impact on elections. The study of financial markets and institutions will reward you with an understanding of many exciting issues. In this chapter we provide a road map of the book by outlining these exciting issues and exploring why they are worth studying.
Why Study Financial Markets?
Parts 2 and 5 of this book focus on financial markets, markets in which funds are transferred from people who have an excess of available funds to people who have a shortage. Financial markets, such as bond and stock markets, are crucial to promot- ing greater economic efficiency by channeling funds from people who do not have a productive use for them to those who do. Indeed, well-functioning financial markets are a key factor in producing high economic growth, and poorly performing financial markets are one reason that many countries in the world remain desperately poor. Activities in financial markets also have direct effects on personal wealth, the behav- ior of businesses and consumers, and the cyclical performance of the economy.
Debt Markets and Interest Rates
A security (also called a financial instrument) is a claim on the issuer’s future income or assets (any financial claim or piece of property that is subject to owner- ship). A bond is a debt security that promises to make payments periodically for a specified period
of time. 1 Debt markets, also often referred to generically as the bond market, are especially important to economic activity because they enable cor- porations and governments to borrow in order to finance their activities; the bond market is also where interest rates are determined. An interest rate is the cost of borrowing or the price paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year). Many types of interest rates are found in the econ- omy—mortgage interest rates, car loan rates, and interest rates on many types of bonds. Interest rates are important on a number of levels. On a personal level, high interest rates could deter you from buying a house or a car because the cost of financing it would be high. Conversely, high interest rates could encourage you to save because you can earn more interest income by putting aside some of your earn- ings as savings. On a more general level, interest rates have an impact on the overall health of the economy because they affect not only consumers’ willingness to spend or save but also businesses’ investment decisions. High interest rates, for example, might cause a corporation to postpone building a new
plant that would provide more jobs. Because changes in interest rates have important effects on individuals, finan- cial institutions, businesses, and the overall economy, it is important to explain fluctuations in interest rates that have been substantial over the past 35 years. For example, the interest rate on three-month Treasury bills peaked at over 16% in 1981. This interest rate fell to 3% in late 1992 and 1993 and then rose to above 5% in the mid- to late 1990s. It then fell below 1% in 2004 and rose to 5% by 2007, only to fall close to zero from 2008 to 2021. Starting in 2022, the three-month Treasury bill rate started to rise, climbing to well above zero. Find the Full Original Textbook (PDF) in the link
