Financial Markets
and Institutions
SEVENTH EDITION


The Prentice Hall Series in Finance
Alexander/Sharpe/Bailey

Geisst

Fundamentals of Investments

Megginson

Investment Banking in the Financial
System

Andersen

Corporate Finance Theory

Melvin

Global Derivatives: A Strategic Risk
Management Perspective

Bear/Moldonado-Bear

Gitman

International Money and Finance

Principles of Managerial Finance*
Principles of Managerial Finance––
Brief Edition*

Mishkin/Eakins
Financial Markets and Institutions

Free Markets, Finance, Ethics, and Law

Moffett

Gitman/Joehnk
Berk/DeMarzo

Fundamentals of Investing*

Corporate Finance*
Corporate Finance: The Core*

Cases in International Finance

Moffett/Stonehill/Eiteman

Gitman/Madura
Introduction to Finance

Fundamentals of Multinational Finance


Bierman/Smidt
The Capital Budgeting Decision:
Economic Analysis of Investment Projects

Bodie/Merton/Cleeton

Nofsinger

Guthrie/Lemon
Mathematics of Interest Rates and Finance

Ogden/Jen/O’Connor

Haugen

Financial Economics

Click/Coval
The Theory and Practice of International
Financial Management

Copeland/Weston/Shastri

The Inefficient Stock Market: What Pays
Off and Why
Modern Investment Theory
The New Finance: Overreaction,
Complexity, and Uniqueness

Holden


Financial Theory and Corporate Policy

Cornwall/Vang/Hartman
Entrepreneurial Financial Management

Cox/Rubinstein
Options Markets

Dorfman
Introduction to Risk Management and
Insurance

Dietrich
Financial Services and Financial
Institutions: Value Creation in Theory
and Practice

Dufey/Giddy
Cases in International Finance

Excel Modeling and Estimation in the
Fundamentals of Corporate Finance
Excel Modeling and Estimation in the
Fundamentals of Investments
Excel Modeling and Estimation in
Investments
Excel Modeling and Estimation in
Corporate Finance


Hughes/MacDonald
International Banking: Text and Cases

Hull
Fundamentals of Futures and Options
Markets
Options, Futures, and Other Derivatives
Risk Management and Financial
Institutions

Keown

Eakins

Advanced Corporate Finance

Pennacchi
Theory of Asset Pricing

Rejda
Principles of Risk Management and
Insurance

Schoenebeck
Interpreting and Analyzing Financial
Statements

Scott/ Martin/ Petty/Keown/Thatcher
Cases in Finance


Seiler
Performing Financial Studies: A
Methodological Cookbook

Shapiro
Capital Budgeting and Investment
Analysis

Sharpe/Alexander/Bailey
Investments

Solnik/McLeavey

Personal Finance: Turning Money into
Wealth

Finance in .learn

Psychology of Investing

Global Investments

Stretcher/Michael

Eiteman/Stonehill/Moffett
Multinational Business Finance

Emery/Finnerty/Stowe
Corporate Financial Management


Keown/Martin/Petty/Scott
Financial Management: Principles and
Applications
Foundations of Finance: The Logic and
Practice of Financial Management

Cases in Financial Management

Titman/Martin
Valuation: The Art and Science of
Corporate Investment Decisions

Fabozzi
Bond Markets, Analysis and Strategies

Trivoli

Kim/Nofsinger
Corporate Governance

Fabozzi/Modigliani
Capital Markets: Institutions and
Instruments

Fabozzi/Modigliani/Jones/Ferri
Foundations of Financial Markets and
Institutions

Personal Portfolio Management:
Fundamentals and Strategies


Levy/Post
Van Horne

Investments

May/May/Andrew
Effective Writing: A Handbook for Finance
People

Financial Management and Policy
Financial Market Rates and Flows

Van Horne/Wachowicz
Fundamentals of Financial Management

Madura

Finkler
Financial Management for Public, Health,
and Not-for-Profit Organizations

Francis/Ibbotson
Investments: A Global Perspective

Personal Finance

Vaughn
Financial Planning for the Entrepreneur


Marthinsen
Risk Takers: Uses and Abuses of Financial
Derivatives

Weston/Mitchel/Mulherin
Takeovers, Restructuring, and Corporate
Governance

McDonald

Fraser/Ormiston
Understanding Financial Statements

*denotes

Derivatives Markets
Fundamentals of Derivatives Markets

titles

Winger/Frasca
Personal Fikance

Log onto www.myfinancelab.com to learn more


Financial Markets
and Institutions
SEVENTH EDITION


Frederic S. Mishkin
Graduate School of Business, Columbia University

Stanley G. Eakins
East Carolina University

Prentice Hall
Boston Columbus Indianapolis New York San Francisco Upper Saddle River
Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montréal Toronto
Delhi Mexico City São Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo


Editorial Director: Sally Yagan
Editor in Chief: Donna Battista
Acquisitions Editor: Noel Kamm Seibert
Editorial Project Manager: Melissa Pellerano
Director of Marketing: Patrice Jones
Full-Service Project Management/Composition:
GEX Publishing Services
Managing Editor: Nancy Fenton
Senior Production Project Manager: Nancy Freihofer
Text Permissions Project Supervisor: Michael Joyce
Permissions Researcher: Jill Dougan
Senior Manufacturing Buyer: Carol Melville
Text Designer: GEX Publishing Services

Cover Designer: Jonathan Boylan
Cover Images: © Dorling Kindersley;
Petrol/Westend61 GmbH/Alamy; Kevin
Foy/Alamy; JLImages/Alamy; Martin

Preston/Shutterstock Images; paokun/Shutterstock
Images; Tupungato/Shutterstock Images;
HenryHo/Shutterstock Images
Media Producer: Nicole Sackin
Supplements Editor: Alison Eudsen
Printer/Binder: R.R. Donnelley, Willard
Cover Printer: Lehigh Phoenix
Text Font: 10/12 ITCCentury Light

Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate page within text.
Microsoft® and Windows® are registered trademarks of the Microsoft Corporation in the U.S.A. and other
countries. Screen shots and icons reprinted with permission from the Microsoft Corporation. This book is not
sponsored or endorsed by or affiliated with the Microsoft Corporation.
Copyright © 2012, 2009, 2006 Pearson Education, Inc. All rights reserved. Manufactured in the United States
of America. This publication is protected by Copyright, and permission should be obtained from the publisher
prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means,
electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this
work, please submit a written request to Pearson Education, Inc., Rights and Contracts Department, 501
Boylston Street, Suite 900, Boston, MA 02116, fax your request to 617 671-3447, or e-mail at http://www.
pearsoned.com/legal/permission.htm
Many of the designations by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the
designations have been printed in initial caps or all caps.
Library of Congress Cataloging-in-Publication Data
Mishkin, Frederic S.
Financial markets and institutions / Frederic S. Mishkin, Stanley G.
Eakins. -- 7th ed.
p. cm. -- (The Prentice Hall series in finance)
Includes index.
ISBN 978-0-13-213683-9 (0-13-213683-x)
1. Financial institutions--United States. 2. Money--United States. 3.

Money market--United States. 4. Banks and banking--United States. I.
Eakins, Stanley G. II. Title. III. Series.
HG181.M558 2012
332.10973--dc22
2010048490
10 9 8 7 6 5 4 3 2 1

ISBN 10: 0-13-213683-X
ISBN 13: 978-0-13-213683-9


To My Dad
—F. S. M.
To My Wife, Laurie
—S. G. E.


This page intentionally left blank


Contents in Brief

PART ONE
1
2

PART TWO
3
4
5

6

PART THREE
7
8

PART FOUR
9
10

PART FIVE
11
12
13
14
15
16

PART SIX
17
18
19
20
21
22

Contents in Detail
Contents on the Web
Preface
About the Authors


ix
xxvii
xxix
xxxix

INTRODUCTION

1

Why Study Financial Markets and Institutions?
Overview of the Financial System

1
15

FUNDAMENTALS OF FINANCIAL MARKETS

36

What Do Interest Rates Mean and What Is Their Role in Valuation?
Why Do Interest Rates Change?
How Do Risk and Term Structure Affect Interest Rates?
Are Financial Markets Efficient?

36
64
89
116


FUNDAMENTALS OF FINANCIAL INSTITUTIONS
Why Do Financial Institutions Exist?
Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?

134
134
163

CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY 191
Central Banks and the Federal Reserve System
Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics

FINANCIAL MARKETS
The Money Markets
The Bond Market
The Stock Market
The Mortgage Markets
The Foreign Exchange Market
The International Financial System

THE FINANCIAL INSTITUTIONS INDUSTRY
Banking and the Management of Financial Institutions
Financial Regulation
Banking Industry: Structure and Competition
The Mutual Fund Industry
Insurance Companies and Pension Funds
Investment Banks, Security Brokers and Dealers, and Venture Capital Firms

191
214


254
254
279
302
323
344
374

398
398
425
454
489
513
543

vii


viii

Contents in Brief

PART SEVEN
23
24

THE MANAGEMENT OF FINANCIAL INSTITUTIONS
Risk Management in Financial Institutions

Hedging with Financial Derivatives

568
590

Glossary

G-1

Index

CHAPTERS ON THE WEB
25
26

568

Savings Associations and Credit Unions
Finance Companies

I-1


Contents in Detail
Contents on the Web
Preface
About the Authors

PART ONE


xxvii
xxix
xxxix

INTRODUCTION

Chapter 1 Why Study Financial Markets and Institutions?
Preview
Why Study Financial Markets?
Debt Markets and Interest Rates
The Stock Market
The Foreign Exchange Market
Why Study Financial Institutions?
Structure of the Financial System
Financial Crises
Central Banks and the Conduct of Monetary Policy
The International Financial System
Banks and Other Financial Institutions
Financial Innovation
Managing Risk in Financial Institutions
Applied Managerial Perspective
How We Will Study Financial Markets and Institutions
Exploring the Web
Collecting and Graphing Data
Web Exercise
Concluding Remarks
Summary
Key Terms
Questions
Quantitative Problems

Web Exercises

Chapter 2 Overview of the Financial System
Preview
Function of Financial Markets
Structure of Financial Markets
Debt and Equity Markets
Primary and Secondary Markets
Exchanges and Over-the-Counter Markets
Money and Capital Markets

1
1
2
2
3
4
6
6
6
6
7
7
7
7
8
8
9
9
10

12
12
13
13
14
14
15
15
16
18
18
18
19
20

ix


x

Contents in Detail
Internationalization of Financial Markets
International Bond Market, Eurobonds, and Eurocurrencies
■ GLOBAL Are U.S. Capital Markets Losing Their Edge?
World Stock Markets
Function of Financial Intermediaries: Indirect Finance
Transaction Costs
■ FOLLOWING THE FINANCIAL NEWS Foreign Stock Market Indexes
■ GLOBAL The Importance of Financial Intermediaries Relative to
Securities Markets: An International Comparison

Risk Sharing
Asymmetric Information: Adverse Selection and Moral Hazard
Types of Financial Intermediaries
Depository Institutions
Contractual Savings Institutions
Investment Intermediaries
Regulation of the Financial System
Increasing Information Available to Investors
Ensuring the Soundness of Financial Intermediaries
Financial Regulation Abroad
Summary
Key Terms
Questions
Web Exercises

PART TWO

20
20
21
22
22
22
23
24
25
25
27
28
29

29
30
30
32
33
33
34
34
35

FUNDAMENTALS OF FINANCIAL MARKETS

Chapter 3 What Do Interest Rates Mean and What Is Their
Role in Valuation?
Preview
Measuring Interest Rates
Present Value
Four Types of Credit Market Instruments
Yield to Maturity
■ GLOBAL Negative T-Bill Rates? It Can Happen
The Distinction Between Real and Nominal Interest Rates
The Distinction Between Interest Rates and Returns
■ MINI-CASE With TIPS, Real Interest Rates Have Become Observable
in the United States
Maturity and the Volatility of Bond Returns: Interest-Rate Risk
Reinvestment Risk
■ MINI-CASE Helping Investors Select Desired Interest-Rate Risk
Summary
■ THE PRACTICING MANAGER Calculating Duration to Measure
Interest-Rate Risk

Calculating Duration
Duration and Interest-Rate Risk
Summary
Key Terms
Questions

36
36
37
37
39
40
47
48
50
51
53
54
54
55
55
56
60
61
62
62


Contents in Detail


Chapter 4

xi

Quantitative Problems
Web Exercises

62
63

Why Do Interest Rates Change?

64

Preview
Determinants of Asset Demand
Wealth
Expected Returns
Risk
Liquidity
Summary
Supply and Demand in the Bond Market
Demand Curve
Supply Curve
Market Equilibrium
Supply-and-Demand Analysis
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds
Shifts in the Supply of Bonds
■ CASE Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect

■ CASE Changes in the Interest Rate Due to a Business Cycle Expansion
■ CASE Explaining Low Japanese Interest Rates
■ CASE Reading the Wall Street Journal “Credit Markets” Column
■ FOLLOWING THE FINANCIAL NEWS The “Credit Markets” Column
■ THE PRACTICING MANAGER Profiting from Interest-Rate Forecasts
■ FOLLOWING THE FINANCIAL NEWS Forecasting Interest Rates
Summary
Key Terms
Questions
Quantitative Problems
Web Exercises
Web Appendices

64
64
65
65
66
67
68
68
69
69
70
71
72
72
75
78
79

81
82
83
84
85
85
86
86
87
87
88

Chapter 5 How Do Risk and Term Structure Affect Interest Rates?

89

Preview
89
Risk Structure of Interest Rates
89
Default Risk
90
■ CASE The Subprime Collapse and the Baa-Treasury Spread
93
Liquidity
93
Income Tax Considerations
94
Summary
95

■ CASE Effects of the Bush Tax Cut and Its Possible Repeal on Bond Interest Rates 96
Term Structure of Interest Rates
96
■ FOLLOWING THE FINANCIAL NEWS Yield Curves
97
Expectations Theory
98
Market Segmentation Theory
102
Liquidity Premium Theory
103


xii

Contents in Detail
Evidence on the Term Structure
Summary
■ MINI-CASE The Yield Curve as a Forecasting Tool for Inflation and
the Business Cycle
■ CASE Interpreting Yield Curves, 1980–2010
■ THE PRACTICING MANAGER Using the Term Structure to Forecast
Interest Rates
Summary
Key Terms
Questions
Quantitative Problems
Web Exercises

Chapter 6 Are Financial Markets Efficient?


106
107
108
108
110
112
113
113
114
115
116

Preview
116
The Efficient Market Hypothesis
117
Rationale Behind the Hypothesis
119
Stronger Version of the Efficient Market Hypothesis
120
Evidence on the Efficient Market Hypothesis
120
Evidence in Favor of Market Efficiency
120
■ MINI-CASE An Exception That Proves the Rule: Ivan Boesky
122
■ CASE Should Foreign Exchange Rates Follow a Random Walk?
124
Evidence Against Market Efficiency

124
Overview of the Evidence on the Efficient Market Hypothesis
126
■ THE PRACTICING MANAGER Practical Guide to Investing in the Stock Market 127
How Valuable Are Published Reports by Investment Advisers?
127
■ MINI-CASE Should You Hire an Ape as Your Investment Adviser?
127
Should You Be Skeptical of Hot Tips?
128
Do Stock Prices Always Rise When There Is Good News?
128
Efficient Markets Prescription for the Investor
129
■ CASE What Do the Black Monday Crash of 1987 and the Tech Crash
of 2000 Tell Us About the Efficient Market Hypothesis?
130
Behavioral Finance
131
Summary
132
Key Terms
132
Questions
132
Quantitative Problems
133
Web Exercises
133


PART THREE
Chapter 7

FUNDAMENTALS OF FINANCIAL INSTITUTIONS
Why Do Financial Institutions Exist?

134

Preview
Basic Facts About Financial Structure Throughout the World
Transaction Costs
How Transaction Costs Influence Financial Structure
How Financial Intermediaries Reduce Transaction Costs
Asymmetric Information: Adverse Selection and Moral Hazard

134
134
138
138
138
139


Contents in Detail

Chapter 8

xiii

The Lemons Problem: How Adverse Selection Influences Financial Structure

Lemons in the Stock and Bond Markets
Tools to Help Solve Adverse Selection Problems
■ MINI-CASE The Enron Implosion
How Moral Hazard Affects the Choice Between Debt and Equity Contracts
Moral Hazard in Equity Contracts: The Principal–Agent Problem
Tools to Help Solve the Principal–Agent Problem
How Moral Hazard Influences Financial Structure in Debt Markets
Tools to Help Solve Moral Hazard in Debt Contracts
Summary
■ CASE Financial Development and Economic Growth
■ MINI-CASE Should We Kill All the Lawyers?
■ CASE Is China a Counter-Example to the Importance of
Financial Development?
Conflicts of Interest
What Are Conflicts of Interest and Why Do We Care?
Why Do Conflicts of Interest Arise?
■ MINI-CASE The Demise of Arthur Andersen
■ MINI-CASE Credit Rating Agencies and the 2007–2009 Financial Crisis
What Has Been Done to Remedy Conflicts of Interest?
■ MINI-CASE Has Sarbanes-Oxley Led to a Decline in U.S. Capital Markets?
Summary
Key Terms
Questions
Quantitative Problems
Web Exercises

154
154
155
155

157
158
158
160
160
161
161
162
162

Why Do Financial Crises Occur and Why Are
They So Damaging to the Economy?

163

Preview
Asymmetric Information and Financial Crises
Agency Theory and the Definition of a Financial Crisis
Dynamics of Financial Crises in Advanced Economies
Stage One: Initiation of Financial Crisis
Stage Two: Banking Crisis
Stage Three: Debt Deflation
■ CASE The Mother of All Financial Crises: The Great Depression
■ CASE The 2007–2009 Financial Crisis
Causes of the 2007–2009 Financial Crisis
Effects of the 2007–2009 Financial Crisis
■ INSIDE THE FED Was the Fed to Blame for the Housing Price Bubble?
■ GLOBAL Ireland and the 2007–2009 Financial Crisis
Height of the 2007–2009 Financial Crisis and the Decline of
Aggregate Demand

Dynamics of Financial Crises in Emerging Market Economies
Stage One: Initiation of Financial Crisis
Stage Two: Currency Crisis
Stage Three: Full-Fledged Financial Crisis

140
140
141
143
145
145
146
148
149
151
152
153

163
164
164
164
164
167
168
169
171
171
172
174

177
178
178
178
181
182


xiv

Contents in Detail
■ CASE Financial Crises in Mexico, 1994–1995; East Asia, 1997–1998;
and Argentina, 2001–2002
■ GLOBAL The Perversion of the Financial Liberalization/Globalization Process:
Chaebols and the South Korean Crisis
Summary
Key Terms
Questions
Web Exercises
Web References

184
185
188
189
189
190
190

PART FOUR CENTRAL BANKING AND THE CONDUCT OF

MONETARY POLICY
Chapter 9 Central Banks and the Federal Reserve System
Preview
Origins of the Federal Reserve System
■ INSIDE THE FED The Political Genius of the Founders of the
Federal Reserve System
Structure of the Federal Reserve System
Federal Reserve Banks
■ INSIDE THE FED The Special Role of the Federal Reserve Bank of New York
Member Banks
Board of Governors of the Federal Reserve System
■ INSIDE THE FED The Role of the Research Staff
Federal Open Market Committee (FOMC)
The FOMC Meeting
■ INSIDE THE FED Green, Blue, Teal, and Beige: What Do These Colors
Mean at the Fed?
Why the Chairman of the Board of Governors Really Runs the Show
■ INSIDE THE FED How Bernanke’s Style Differs from Greenspan’s
How Independent Is the Fed?
Structure and Independence of the European Central Bank
Differences Between the European System of Central Banks and
the Federal Reserve System
Governing Council
How Independent Is the ECB?
Structure and Independence of Other Foreign Central Banks
Bank of Canada
Bank of England
Bank of Japan
The Trend Toward Greater Independence
Explaining Central Bank Behavior

Should the Fed Be Independent?
The Case for Independence
■ INSIDE THE FED The Evolution of the Fed’s Communication Strategy
The Case Against Independence
Central Bank Independence and Macroeconomic Performance
Throughout the World

191
191
192
192
193
194
195
196
197
198
198
199
200
200
201
202
203
204
204
205
206
206
206

207
207
207
208
208
209
210
211


Contents in Detail

Chapter 10

xv

Summary
Key Terms
Questions and Problems
Web Exercises

212
212
212
213

Conduct of Monetary Policy: Tools, Goals, Strategy,
and Tactics

214


Preview
The Federal Reserve’s Balance Sheet
Liabilities
Assets
Open Market Operations
Discount Lending
The Market for Reserves and the Federal Funds Rate
Demand and Supply in the Market for Reserves
How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate
■ INSIDE THE FED Why Does the Fed Need to Pay Interest on Reserves?
■ CASE How the Federal Reserve’s Operating Procedures Limit Fluctuations
in the Federal Funds Rate
Tools of Monetary Policy
Open Market Operations
A Day at the Trading Desk
Discount Policy
Operation of the Discount Window
Lender of Last Resort
Reserve Requirements
■ INSIDE THE FED Federal Reserve Lender-of-Last-Resort Facilities During
the 2007–2009 Financial Crisis
Monetary Policy Tools of the European Central Bank
Open Market Operations
Lending to Banks
Reserve Requirements
The Price Stability Goal and the Nominal Anchor
The Role of a Nominal Anchor
The Time-Inconsistency Problem
Other Goals of Monetary Policy

High Employment
Economic Growth
Stability of Financial Markets
Interest-Rate Stability
Stability in Foreign Exchange Markets
Should Price Stability Be the Primary Goal of Monetary Policy?
Hierarchical vs. Dual Mandates
Price Stability as the Primary, Long-Run Goal of Monetary Policy
Inflation Targeting
Inflation Targeting in New Zealand, Canada, and the United Kingdom
Advantages of Inflation Targeting

214
214
215
216
216
217
217
218
219
220
223
224
224
225
226
226
227
228

229
230
231
231
231
232
232
232
233
233
234
234
234
235
235
235
236
237
237
238


xvi

Contents in Detail
■ GLOBAL The European Central Bank’s Monetary Policy Strategy
Disadvantages of Inflation Targeting
■ INSIDE THE FED Chairman Bernanke and Inflation Targeting
Central Banks’ Response to Asset-Price Bubbles: Lessons from
the 2007–2009 Financial Crisis

Two Types of Asset-Price Bubbles
Should Central Banks Respond to Bubbles?
Should Monetary Policy Try to Prick Asset-Price Bubbles?
Are Other Types of Policy Responses Appropriate?
Tactics: Choosing the Policy Instrument
Criteria for Choosing the Policy Instrument
■ THE PRACTICING MANAGER Using a Fed Watcher
Summary
Key Terms
Questions
Quantitative Problems
Web Exercises
Web Appendices

PART FIVE
Chapter 11

240
240
242
243
243
244
244
245
246
248
249
250
251

251
252
252
253

FINANCIAL MARKETS
The Money Markets

254

Preview
The Money Markets Defined
Why Do We Need the Money Markets?
Money Market Cost Advantages
The Purpose of the Money Markets
Who Participates in the Money Markets?
U.S. Treasury Department
Federal Reserve System
Commercial Banks
Businesses
Investment and Securities Firms
Individuals
Money Market Instruments
Treasury Bills
■ CASE Discounting the Price of Treasury Securities to Pay the Interest
■ MINI-CASE Treasury Bill Auctions Go Haywire
Federal Funds
Repurchase Agreements
Negotiable Certificates of Deposit
Commercial Paper

Banker’s Acceptances
Eurodollars
■ GLOBAL Ironic Birth of the Eurodollar Market
Comparing Money Market Securities
Interest Rates

254
255
255
256
257
258
258
258
258
259
260
260
260
261
261
264
264
266
267
268
271
271
272
273

273


Contents in Detail

Chapter 12

Chapter 13

xvii

Liquidity
How Money Market Securities Are Valued
■ FOLLOWING THE FINANCIAL NEWS Money Market Rates
Summary
Key Terms
Questions
Quantitative Problems
Web Exercises

274
274
274
276
277
277
277
278

The Bond Market


279

Preview
Purpose of the Capital Market
Capital Market Participants
Capital Market Trading
Types of Bonds
Treasury Notes and Bonds
Treasury Bond Interest Rates
Treasury Inflation-Protected Securities (TIPS)
Treasury STRIPS
Agency Bonds
■ CASE The 2007–2009 Financial Crisis and the Bailout of Fannie Mae
and Freddie Mac
Municipal Bonds
Risk in the Municipal Bond Market
Corporate Bonds
Characteristics of Corporate Bonds
Types of Corporate Bonds
Financial Guarantees for Bonds
Current Yield Calculation
Current Yield
Finding the Value of Coupon Bonds
Finding the Price of Semiannual Bonds
Investing in Bonds
Summary
Key Terms
Questions
Quantitative Problems

Web Exercises

279
279
280
280
281
282
282
282
283
284
284
286
288
288
289
290
293
294
294
295
296
298
299
300
300
300
301


The Stock Market

302

Preview
Investing in Stocks
Common Stock vs. Preferred Stock
How Stocks Are Sold
Computing the Price of Common Stock
The One-Period Valuation Model
The Generalized Dividend Valuation Model

302
302
303
304
307
308
309


xviii

Contents in Detail

Chapter 14

The Gordon Growth Model
Price Earnings Valuation Method
How the Market Sets Security Prices

Errors in Valuation
Problems with Estimating Growth
Problems with Estimating Risk
Problems with Forecasting Dividends
■ CASE The 2007–2009 Financial Crisis and the Stock Market
■ CASE The September 11 Terrorist Attack, the Enron Scandal, and
the Stock Market
Stock Market Indexes
■ MINI-CASE History of the Dow Jones Industrial Average
Buying Foreign Stocks
Regulation of the Stock Market
The Securities and Exchange Commission
Summary
Key Terms
Questions
Quantitative Problems
Web Exercises

309
311
311
313
313
314
314
314

The Mortgage Markets

323


Preview
What Are Mortgages?
Characteristics of the Residential Mortgage
Mortgage Interest Rates
■ CASE The Discount Point Decision
Loan Terms
Mortgage Loan Amortization
Types of Mortgage Loans
Insured and Conventional Mortgages
Fixed- and Adjustable-Rate Mortgages
Other Types of Mortgages
Mortgage-Lending Institutions
Loan Servicing
■ E-FINANCE Borrowers Shop the Web for Mortgages
Secondary Mortgage Market
Securitization of Mortgages
What Is a Mortgage-Backed Security?
Types of Pass-Through Securities
Subprime Mortgages and CDOs
The Real Estate Bubble
Summary
Key Terms
Questions
Quantitative Problems
Web Exercises

323
324
325

325
326
327
329
330
330
330
331
333
334
335
335
336
336
337
338
339
340
340
341
341
343

315
316
318
318
319
319
320

320
321
321
322


Contents in Detail

Chapter 15

The Foreign Exchange Market

344

Preview
Foreign Exchange Market
What Are Foreign Exchange Rates?
Why Are Exchange Rates Important?
■ FOLLOWING THE FINANCIAL NEWS Foreign Exchange Rates
How Is Foreign Exchange Traded?
Exchange Rates in the Long Run
Law of One Price
Theory of Purchasing Power Parity
Why the Theory of Purchasing Power Parity Cannot Fully Explain
Exchange Rates
Factors That Affect Exchange Rates in the Long Run
Exchange Rates in the Short Run: A Supply and Demand Analysis
Supply Curve for Domestic Assets
Demand Curve for Domestic Assets
Equilibrium in the Foreign Exchange Market

Explaining Changes in Exchange Rates
Shifts in the Demand for Domestic Assets
Recap: Factors That Change the Exchange Rate
■ CASE Changes in the Equilibrium Exchange Rate: An Example
■ CASE Why Are Exchange Rates So Volatile?
■ CASE The Dollar and Interest Rates
■ CASE The Subprime Crisis and the Dollar
■ CASE Reading the Wall Street Journal: The “Currency Trading” Column
■ FOLLOWING THE FINANCIAL NEWS The “Currency Trading” Column
■ THE PRACTICING MANAGER Profiting from Foreign Exchange Forecasts
Summary
Key Terms
Questions
Quantitative Problems
Web Exercises

344
345
346
346
347
348
348
348
349

Chapter 15 Appendix The Interest Parity Condition

Chapter 16


xix

350
351
352
353
353
354
355
355
358
360
362
362
364
365
366
366
367
368
368
368
369
370

Comparing Expected Returns on Domestic and Foreign Assets
Interest Parity Condition

370
372


The International Financial System

374

Preview
Intervention in the Foreign Exchange Market
Foreign Exchange Intervention and the Money Supply
■ INSIDE THE FED A Day at the Federal Reserve Bank of New York’s Foreign
Exchange Desk
Unsterilized Intervention
Sterilized Intervention
Balance of Payments
■ GLOBAL Why the Large U.S. Current Account Deficit Worries Economists

374
374
374
376
377
377
379
380


xx

Contents in Detail
Exchange Rate Regimes in the International Financial System
Fixed Exchange Rate Regimes

How a Fixed Exchange Rate Regime Works
■ GLOBAL The Euro’s Challenge to the Dollar
■ GLOBAL Argentina’s Currency Board
■ GLOBAL Dollarization
■ CASE The Foreign Exchange Crisis of September 1992
■ THE PRACTICING MANAGER Profiting from a Foreign Exchange Crisis
■ CASE Recent Foreign Exchange Crises in Emerging Market Countries:
Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002
■ CASE How Did China Accumulate Over $2 Trillion of International Reserves?
Managed Float
Capital Controls
Controls on Capital Outflows
Controls on Capital Inflows
The Role of the IMF
Should the IMF Be an International Lender of Last Resort?
How Should the IMF Operate?
Summary
Key Terms
Questions
Quantitative Problems
Web Exercises
Web Appendices

PART SIX
Chapter 17

380
381
381
383

384
385
386
387
388
389
390
391
391
391
392
392
393
395
395
396
396
397
397

THE FINANCIAL INSTITUTIONS INDUSTRY
Banking and the Management of Financial Institutions

398

Preview
The Bank Balance Sheet
Liabilities
Assets
Basic Banking

General Principles of Bank Management
Liquidity Management and the Role of Reserves
Asset Management
Liability Management
Capital Adequacy Management
■ THE PRACTICING MANAGER Strategies for Managing Bank Capital
■ CASE How a Capital Crunch Caused a Credit Crunch in 2008
Off-Balance-Sheet Activities
Loan Sales
Generation of Fee Income
Trading Activities and Risk Management Techniques
■ CONFLICTS OF INTEREST Barings, Daiwa, Sumitomo, and Societé Generale:
Rogue Traders and the Principal–Agent Problem
Measuring Bank Performance
Bank’s Income Statement

398
399
399
401
403
405
406
408
409
410
412
413
414
414

414
415
416
417
417


Contents in Detail

Chapter 18

Chapter 19

xxi

Measures of Bank Performance
Recent Trends in Bank Performance Measures
Summary
Key Terms
Questions
Quantitative Problems
Web Exercises

419
420
422
422
422
423
424


Financial Regulation

425

Preview
Asymmetric Information and Financial Regulation
Government Safety Net
■ GLOBAL The Spread of Government Deposit Insurance Throughout
the World: Is This a Good Thing?
Restrictions on Asset Holdings
Capital Requirements
Prompt Corrective Action
■ GLOBAL Whither the Basel Accord?
Financial Supervision: Chartering and Examination
Assessment of Risk Management
Disclosure Requirements
Consumer Protection
Restrictions on Competition
■ MINI-CASE Mark-to-Market Accounting and the 2007–2009 Financial Crisis
■ MINI-CASE The 2007–2009 Financial Crisis and Consumer Protection
Regulation
Summary
■ E-FINANCE Electronic Banking: New Challenges for Bank Regulation
■ GLOBAL International Financial Regulation
The 1980s Savings and Loan and Banking Crisis
Federal Deposit Insurance Corporation Improvement Act of 1991
Banking Crises Throughout the World in Recent Years
“Déjà Vu All Over Again”
The Dodd-Frank Bill and Future Regulation

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
Future Regulation
Summary
Key Terms
Questions
Quantitative Problems
Web Exercises
Web Appendices

425
425
425

438
438
439
440
443
444
445
447
448
448
449
451
451
451
452
453
453


Banking Industry: Structure and Competition

454

Preview
Historical Development of the Banking System
Multiple Regulatory Agencies

454
454
456

427
430
430
431
432
433
434
435
436
436
437


xxii

Contents in Detail


Chapter 20

Financial Innovation and the Growth of the Shadow Banking System
Responses to Changes in Demand Conditions: Interest Rate Volatility
Responses to Changes in Supply Conditions: Information Technology
■ E-FINANCE Will “Clicks” Dominate “Bricks” in the Banking Industry?
■ E-FINANCE Why Are Scandinavians So Far Ahead of Americans in
Using Electronic Payments and Online Banking?
■ E-FINANCE Are We Headed for a Cashless Society?
Avoidance of Existing Regulations
■ MINI-CASE Bruce Bent and the Money Market Mutual Fund Panic of 2008
■ THE PRACTICING MANAGER Profiting from a New Financial Product:
A Case Study of Treasury Strips
Financial Innovation and the Decline of Traditional Banking
Structure of the U.S. Commercial Banking Industry
Restrictions on Branching
Response to Branching Restrictions
Bank Consolidation and Nationwide Banking
■ E-FINANCE Information Technology and Bank Consolidation
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
What Will the Structure of the U.S. Banking Industry Look Like in the Future?
Are Bank Consolidation and Nationwide Banking Good Things?
Separation of the Banking and Other Financial Service Industries
Erosion of Glass-Steagall
The Gramm-Leach-Bliley Financial Services Modernization Act of 1999:
Repeal of Glass-Steagall
Implications for Financial Consolidation
Separation of Banking and Other Financial Services Industries
Throughout the World
■ MINI-CASE The 2007-2009 Financial Crisis and the Demise of Large,

Free-Standing Investment Banks
Thrift Industry: Regulation and Structure
Savings and Loan Associations
Mutual Savings Banks
Credit Unions
International Banking
Eurodollar Market
Structure of U.S. Banking Overseas
Foreign Banks in the United States
Summary
Key Terms
Questions
Web Exercises

457
458
459
461

481
482
482
483
483
483
484
485
485
486
487

487
488

The Mutual Fund Industry

489

Preview
The Growth of Mutual Funds
The First Mutual Funds
Benefits of Mutual Funds
Ownership of Mutual Funds

489
489
490
490
491

462
463
465
467
467
469
473
474
474
475
477

477
478
478
479
480
480
480
481


Contents in Detail

Chapter 21

xxiii

Mutual Fund Structure
Open- Versus Closed-End Funds
Organizational Structure
■ CASE Calculating a Mutual Fund’s Net Asset Value
Investment Objective Classes
Equity Funds
Bond Funds
Hybrid Funds
Money Market Funds
Index Funds
Fee Structure of Investment Funds
Regulation of Mutual Funds
Hedge Funds
■ MINI-CASE The Long Term Capital Debacle

Conflicts of Interest in the Mutual Fund Industry
■ CONFLICTS OF INTEREST Many Mutual Funds Are Caught
Ignoring Ethical Standards
Sources of Conflicts of Interest
Mutual Fund Abuses
■ CONFLICTS OF INTEREST SEC Survey Reports Mutual Fund
Abuses Widespread
Government Response to Abuses
Summary
Key Terms
Questions
Quantitative Problems
Web Exercises

494
494
494
495
497
497
498
498
499
500
501
502
503
505
506


509
509
510
510
511
511
512

Insurance Companies and Pension Funds

513

Preview
Insurance Companies
Fundamentals of Insurance
Adverse Selection and Moral Hazard in Insurance
Selling Insurance
■ MINI-CASE Insurance Agent: The Customer’s Ally
Growth and Organization of Insurance Companies
Types of Insurance
Life Insurance
Health Insurance
Property and Casualty Insurance
Insurance Regulation
■ CONFLICTS OF INTEREST Insurance Behemoth Charged with
Conflicts of Interest Violations
■ THE PRACTICING MANAGER Insurance Management
Screening
Risk-Based Premium
Restrictive Provisions

Prevention of Fraud

513
514
515
515
516
517
517
518
518
522
524
525

507
506
507

526
526
527
527
528
528


xxiv

Contents in Detail


Chapter 22

528
528
529
529
529
529
530
531

Cancellation of Insurance
Deductibles
Coinsurance
Limits on the Amount of Insurance
Summary
Credit Default Swaps
■ CONFLICTS OF INTEREST The AIG Blowup
Pensions
■ CONFLICTS OF INTEREST The Subprime Financial Crisis and
the Monoline Insurers
Types of Pensions
Defined-Benefit Pension Plans
Defined-Contribution Pension Plans
Private and Public Pension Plans
■ MINI-CASE Power to the Pensions
Regulation of Pension Plans
Employee Retirement Income Security Act
Individual Retirement Plans

The Future of Pension Funds
Summary
Key Terms
Questions
Quantitative Problems
Web Exercises

531
532
532
532
533
534
537
537
539
540
540
541
541
541
542

Investment Banks, Security Brokers and Dealers,
and Venture Capital Firms

543

Preview
Investment Banks

Background
Underwriting Stocks and Bonds
■ FOLLOWING THE FINANCIAL NEWS New Securities Issues
Equity Sales
Mergers and Acquisitions
Securities Brokers and Dealers
Brokerage Services
Securities Dealers
■ MINI-CASE Example of Using the Limit-Order Book
Regulation of Securities Firms
Relationship Between Securities Firms and Commercial Banks
Private Equity Investment
Venture Capital Firms
Private Equity Buyouts
Advantages to Private Equity Buyouts
■ E-FINANCE Venture Capitalists Lose Focus with Internet Companies
Life Cycle of the Private Equity Buyout

543
544
544
545
548
550
551
552
553
555
556
556

558
558
558
562
563
563
564