Financial markets and institutions 12th edition jeff madura

Part 1: Overview of the financial environment 1. Role of financial markets and institutions 2. Determination of interest rates 3. Structure of interest rates Part 2: The Fed and monetary policy 4. Functions of the Fed 5. Monetary policy Part 3: Debt security markets 6. Money markets 7. Bond markets 8. Bond valuation and risk 9. Mortage markets Part 4: Equity markets 10. Stock offerings and investor monitoring 11. Stock valuation and risk 12. Market microstructure and strategies Part 5: Derivative security markets 13. Financial futures markets 14. Option markets 15. Swap markets 16. Foreign exchange derivative markets Part 6: Commercial banking 17. Commercial bank operations 18. Bank regulation 19: Bank management 20. Bank performance Part 7: Nonbank operations 21. Thrift operations 22. Finance company operations 23. Mutual fund operations 24. Securities operations 25. Insurance operations 26. Pension fund operations

Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Want to turn your C into an A? Obviously, right? But the right way to go about it isn’t always so obvious Go digital to get the grades MindTap’s customizable study tools and eTextbook give you everything you need all in one place Engage with your course content, enjoy the flexibility of studying anytime and anywhere, stay connected to assignment due dates and instructor notifications with the MindTap Mobile app and most of all…EARN BETTER GRADES TO GET STARTED VISIT WWW.CENGAGE.COM/STUDENTS/MINDTAP Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Financial Markets and Institutions Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 )LQDQFLDO0DUNHWV DQG,QVWLWXWLRQV WK(GLWLRQ -HII0DGXUD
Florida Atlantic University Australia • Brazil • Mexico • Singapore • United Kingdom • United States Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Financial Markets and Institutions, 12th Edition Jeff Madura SVP, General Manager for Social Sciences, Humanities & Business: Erin Joyner Executive Product Director: Mike Schenk Sr Product Team Manager: Joe Sabatino Project Manager: Julie Dierig Developer: Stacey Lutkoski, MPS Product Assistant: Denisse A Zavala-Rosales © 2018, 2015 Cengage Learning ALL RIGHTS RESERVED No part of this work covered by the copyright herein may be reproduced or distributed in any form or by any means, except as permitted by U.S copyright law, without the prior written permission of the copyright owner For product information and technology assistance, contact us at Cengage Learning Customer & Sales Support, 1-800-354-9706 For permission to use material from this text or product, submit all requests online at www.cengage.com/permissions Further permissions questions can be emailed to permissionrequest@cengage.com Marketing Manager: Emily McLellan Marketing Coordinator: Hillary Johns Except where otherwise noted, all content is © Cengage Learning Content Project Manager: Nadia Saloom Library of Congress Control Number: 2016945877 Media Developer: Mark Hopkinson Student Edition ISBN: 978-1-337-09974-5 Manufacturing Planner: Kevin Kluck Marketing Communications Manager: Sarah Greber Production Service: Lumina Datamatics, Inc Sr Art Director: Michele Kunkler Internal & Cover Designer: Tippy McIntosh Intellectual Property: Analyst: Brittani Morgan Project Manager: Erika Mugavin Cover Image: iStockphoto.com/MACIEJ NOSKOWSKI Design Images: Global Aspects icon: T-Kot/ Shutterstock.com Financial Reform icon: AshDesign/ Shutterstock.com LooseLeaf Edition ISBN: 978-1-337-26987-2 Cengage Learning 20 Channel Center Street Boston, MA 02210 USA Cengage Learning is a leading provider of customized learning solutions with employees residing in nearly 40 different countries and sales in more than 125 countries around the world Find your local representative at www.cengage.com Cengage Learning products are represented in Canada by Nelson Education, Ltd To learn more about Cengage Learning Solutions, visit www.cengage.com Purchase any of our products at your local college store or at our preferred online store www.cengagebrain.com Printed in Canada Print Number: 01 Print Year: 2016 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 This text is dedicated to Best Friends Animal Sanctuary in Kanab, Utah, for its commitment to, compassion for, and care of more than 1,500 animals, many of which were previously homeless Best Friends has recently taken the initiative to help animal shelters across the country Most of the royalties the author receives from this text are invested in a fund that will ultimately be donated to Best Friends During the 2012–2015 period, this fund donated $275,000 to support a new healthcare facility for Best Friends, and to sponsor a Public Broadcasting Service (PBS) documentary on the efforts of Best Friends to help animal shelters throughout the United States This fund has also donated more than $100,000 to other animal care societies, including Friends of Greyhounds (Fort Lauderdale, FL), Florida Humane Society (Pompano Beach, FL), Greyhound Pets of America in Central Florida (Melbourne, FL), Tri-County Humane Society (Boca Raton, FL), and Doris Day Animal League (Washington, D.C.) Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Brief Contents PART 1: Overview of the Financial Environment Role of Financial Markets and Institutions Determination of Interest Rates 27 Structure of Interest Rates 47 PART 2: The Fed and Monetary Policy 77 Functions of the Fed 79 Monetary Policy 101 PART 3: Debt Security Markets 131 Money Markets 133 Bond Markets 159 Bond Valuation and Risk 185 Mortgage Markets 219 PART 4: Equity Markets 247 10 Stock Offerings and Investor Monitoring 249 11 Stock Valuation and Risk 285 12 Market Microstructure and Strategies 325 PART 5: Derivative Security Markets 351 13 Financial Futures Markets 353 14 Option Markets 377 15 Swap Markets 415 16 Foreign Exchange Derivative Markets 445 PART 6: Commercial Banking 479 17 Commercial Bank Operations 481 18 Bank Regulation 503 19 Bank Management 533 20 Bank Performance 563 PART 7: Nonbank Operations 583 21 Thrift Operations 585 22 Finance Company Operations 607 23 Mutual Fund Operations 619 24 Securities Operations 651 25 Insurance Operations 679 26 Pension Fund Operations 703 Appendix A: Comprehensive Project 727 Appendix B: Using Excel to Conduct Analyses Glossary 741 Index 753 737 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 vii Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Index A loans supporting leveraged buyouts, 490 real estate loans, 491–492 AAA-rated notes, 537 regulation of, 507 Accounting single borrower, 507 fraud prevention, 323–324 Bank management, 533–556 governance of See Governance of Bank market structure, 481–482 accounting Bank of America, 13, 323, 433, 671 irregularities, 273 Bank performance, 563–574 at Lehman Brothers, 323–324 assessing, 567–570 regulation of, 510 return on assets, 570–574 Adjustable-rate mortgages (ARM), 223–224 B Bank proprietary trading, limits on, at savings institutions, 595–596 Back-end load, 625 525–526 Adjusted dividend discount model, 288–289 Bailout Act, 21, 149 Bank regulation, 503–527 limitations, 289 Bailout of financial institutions, 239 regulatory structure, 503–504 Adverse selection problem, 680 Balance sheet of savings institutions, Bank sources of funds, 482–488 Affordable Care Act of 2010 (ACA), 691–692 588–589 bank capital, 486–487 AIG, government rescue of, 695 Balloon payment, 489 bonds issued by bank, 486 Allstate Insurance, 15, 689 Balloon payment mortgages, 225 borrowing from federal reserve banks, Amazon.com, 261 Bank capital, 486–487 485 America Online, 261 Bank goals, strategy, and governance, distribution of, 487–488 American call options, 413–414 533–535 Eurodollar borrowings, 486 American depository receipts (ADRs), aligning managerial compensation with federal funds purchased, 485 278–279 bank goals, 533–534 money market deposit accounts, 484 American International Group (AIG), 436, bank strategy, 534 repurchase agreements, 486 695 governance by the board of directors, savings deposits, 484 American put options, 414 534–535 time deposits, 484 American Stock Exchange, 378 other forms of governance, 535 transaction deposits, 483 American-style stock options, 377 Bank governance by board of directors, Bank strategy, 534 Amortization schedule, 222 534–535 Banker’s acceptances, 143–144 Amortizing fixed-rate mortgages, 222–223 inside vs outside directors, 535 steps, 143–144 Analysts Bank holding companies (BHCs), 504, 673 Banking Act of 1933, 507 role of, 272–273 Bank Insurance Fund (BIF), 505, 586 Banks in aggregate stock exchange rules, 272–273 Bank investment in securities, regulation of, interest income and expenses, 567–568 Annuity plans, 684 507 net income, 568 Antitakeover amendments, 276 Bank loans, 488–492 noninterest income and expenses, 568–569 Apple, 250 business loans, 488–489 Barbell strategy, 201 Appropriate yield, estimating, 53–54 community, 507 Barings PLC, 389–390 consumer loans, 491 Arbitrage with stock index futures, 367–368 Barings Bank, 658 foreign loans, 507 Arbitrageurs, 367 Basel Committee on Banking Supervision, Arthur Andersen’s audit, 322 highly leveraged transactions, 490 511, 512 Ask quote, 15, 325 loan participations, 489 Basel I Accord (1988), 511 753 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Asset allocation funds, 631 Asset management of life insurance companies, 687–688 Asset stripping, 656 Asymmetric information, 9, 266 At the money, 377 Auction-rate securities, 180–181 Auditing, 317–318 754 Index Basel II framework, 512 accounting for operational risk, 512 revising measurement of credit risk, 511–512 Basel III framework, 512 BBB-rated notes, 537 Bear Stearns, 21, 92, 234, 519, 658, 669–671 government assistance, 670–671 Bearer bonds, 159 Behavioral finance, Beige Book, 83 Bernard Madoff, 639 Best-efforts agreement, 169, 652 Beta of a stock, 301 beta of a stock portfolio, 301 Bid quote, 15, 325 Binomial pricing model, 407–410 to price call options, 407–409 to price put options, 409 put-call parity, 410 Black-Scholes option-pricing model, 410–413 deriving implied volatility, 412–413 European call options, 411 to price a European call option, 412 put-call parity, 412 Black-Scholes partial differential equation, 410–411 BNP Paribus, 322 Board of directors compensation, 318 independent audit committee, 318 Board of Governors of Federal Reserve, 80–82 Bond(s), 5–6, 159–181 bearer, 159 corporate, 168–177 federal agency, 164–165 inflation indexed, 164 institutional participation in bond markets, 160 international, 202–206 issued by bank, 486 junk, 171–172 municipal, 165–168 registered, 159 savings, 164 stripped treasury, 163–164 treasure and federal agency, 162–165 yields, 160–161 Bond Buyer Index, 357 Bond convexity, 200–201 Bond insurance, 692–693 Bond interest rate strategy, 202 Bond investment strategies, 201–202 barbell strategy, 201 interest rate strategy, 202 Bond laddered strategy, 201 Bond markets, globalization of, 177–179 Eurobond market, 179 government debt markets, 177–178 Bond matching strategy, 201 Bond mutual fund categories, 627 high-yield (junk) bond funds, 630 income funds, 630 international and global bond funds, 630–631 maturity classifications, 631 tax-free funds, 630 Bond mutual funds, valuation of, 645 Bond offerings, facilitating, 653–654 advising, 654 distribution of, 654 origination, 653–654 private placements, 654 underwriting bonds, 654 Bond portfolio performance of pension funds, 716–717 change in risk-free rate, 716 change in risk premium, 716 change in management abilities, 716–717 Bond portfolio returns, forecasting, 217–218 Bond portfolio values, forecasting, 216–217 Bond price, and interest rate movements, 195–201 bond price elasticity, 196–197 coupon rate, and required return, 197 duration, 197–201 Bond price elasticity, 196–197 and coupon rate, 197 influence of maturity, 197 Bond price movements, affecting bond prices explaining, 190–195 and financial institutions, 194–195 risk-free rate, 190–192 Bond valuation process, 185–190 coupon rate, required return, and bond price, 188–190 credit (default) risk premium, 192–193 discount rate, 186 timing of payments, 186–187 with semiannual payments, 187–188 Bond yields, 160–161 forecasting, 214–216 investor’s perspective, 161 issuer’s perspective, 160–161 Bookbuilding, 257–259 Borrowed funds, Borrower’s credit history, 221 Borrower’s equity invested, 221 Borrower’s income level, 221 Bretton Woods era, 447 Bridge loan, 656 Broker, 15 Brokerage services by securities firms, 656 management of customer accounts, 657 online orders, 656 Bullet loan, 489 Business demand for loanable funds, 28–29 Business finance companies, 607 Business insurance, 692 C California Public Employees Retirement System (CALPERS), 274, 705 Call option, 377 speculating with, 385–387 Call option premiums call option’s time to maturity, 382 determinants of, 380–382 influence of market price, 381 stock’s volatility, 381–382 Call premium, 174 Call provision, 174 Callable CDs, 484 Callable swap, 422 CAMELS rating system, 514–517, 586 asset quality, 515–516 capital adequacy, 514–515 earnings, 516 limitations, 516–517 liquidity, 516 management, 516 sensitivity, 516 Capital appreciation funds, 629 Capital asset pricing model (CAPM), 289 application, 290–291 estimating firm’s beta, 290 estimating market risk premium, 290 Capital (equity) maintained by banks, 510 Capital market securities, 5–7 Capital of a savings institution, 587 Capital ratio, 514 Captive finance subsidiaries (CFS), 608 Carve out, 655 Cash flow factors that affect, 563–565 factors that affect insurance companies, 695–696 savings institutions, 591–592 securities firm, 664–665 Cash flow underwriting, 690 Cash management bills, 134 Central bank intervention in exchange rates, 452–454 direct intervention, 452–453 during Asian crisis, 453 during Greek crisis, 454 during peso crisis, 453 during Russian crisis, 453–454 indirect intervention, 453 Certificate of deposit, 484 Charles Schwab, 326, 334 Chattel mortgage bond, 175 Chicago Board of Trade (CBOT), 354, 378 Chicago Board Options Exchange (CBOE), 354, 356, 378 Chicago Mercantile Exchange (CME), 354, 355 Circuit breakers on stock or stock indexes, 342, 368 Citicorp, 509, 523 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Index Citigroup, 13 Closed-end funds, 639–640 CME Group, 354 CNA Insurance, 15 Coca-Cola Company, 168 Coincident economic indicators, 102 Collateral on CDS contracts, 433 Collateralized debt obligation (CDO), 230 Collateralized loan obligations (CLOs), 537 Collateralized mortgages obligations (CMOs), 230–231 Commercial bank(s), 13–14 background, 481–482 balance sheet, 495–496 bank market structure, 481–482 factors that affect cash flow, 563–565 impact of credit crisis, 566 required rate of return, 565–566 valuation of, 563–566 Commercial paper, 137–140 backing commercial paper, 138–139 credit risk during credit crisis, 137–138 denomination, 137 estimating yield, 139 placement, 138 rate over time, 139–140 ratings, 138 yield curve, 139 Commission brokers, 266, 355 Commission on Public Trust and Private Enterprise, 318 Commodity Futures Trading Commission (CFTC), 354, 368 Common stock, 254 Competition, impact of consolidation on, 19 Comptroller of the Currency, 80, 504, 514, 525 Consumer Financial Protection Bureau, 22, 82, 525, 599 Consumer Protection Act, 21 Consumer Price Index, 103 Conventional mortgages, 221–222 Convertible bond, 175 Corporate bond(s), 168–177 bond collateral, 174-175 bond ratings, 170–171 call provisions, 174 characteristics, 173–175 convertibility, 175 credit risk, 170 finance restructuring, 175–176 low- and zero-coupon bonds, 175 protective covenants, 174 secondary market for, 172–173 sinking-fund provision, 174 variable-rate bonds, 175 Corporate bond offerings, 169 private placement, 170 public offering, 169 timing, 169 Corporate bonds finance restructuring, 175–176 finance a leveraged buyout, 175–176 revise capital structure, 176 Corporate control antitakeover amendments, 276 barriers to the market, 276–277 golden parachutes, 277 LBOs to achieve, 276 market for, 275–277 poison pills, 276–277 role of the market, 319 Corporate finance, Corporate finance needs, accommodating, Cost of carry, 364 Counterparties, availability for pricing interest rate swaps, 428 Coupon rate, required return, and bond price, 188–190 Covered call, 390–391 Covered call options, hedging with, 390–391 Covered interest arbitrage, 461–463 Creative accounting, problems with, 317 Credit, Credit crisis Fannie Mae and Freddie Mac, 232–234 for financial institutions, 20–22 government assistance to Bear Stearns, 670–671 government response, 21–22 impact on securities firms, 668–674 insurance companies during, 694–695 international systemic risk, 236 and Lehman Brothers, 671–673 and regulatory reform, 673–674 systematic risk during, 20–21, 235–236 Credit crisis for financial institutions, 20–22 Credit crisis impact on CDS market, 434–436 AIG’s financial problems, 436 insufficient margins, 435 Lehman Brothers’ failure, 435–436 mortgage defaults, 434–435 Credit crisis of 2008–2009, 598–599 Credit crunch, 108 Credit (default) risk, 47–49, 226 accuracy of credit ratings, 48–49 credit rating agencies, 49 rating agencies, 48 Credit (default) risk premium changes over time, 192 factors that affect, 192–193 impact of debt maturity, 192–193 issuer-specific characteristics on credit risk, 193 Credit default swap contracts, 497–498 Credit default swaps (CDS), 432– collateral on contracts, 433 755 contracts affect debtor-creditor negotiations, 434 development of CDS market, 434 as form of mortgage insurance, 693 impact of credit crisis, 434–436 payments on, 433–434 reform of CDS contracts, 436–437 regulation of, 509–510 secondary market for contracts, 433 Credit Ratings, Office of, 49 Credit rating agencies, role of, 318–319 Credit risk, 192 determining collateral, 548 determining loan rate, 548 following Lehman Brothers’ default, 148–149 for finance companies, 615 impact of change, 148–149 insurance against, 166–167 for insurance companies, 694 of interest rate swaps, 426–427 international integration, 205 managing, 547–550 measuring, 547–548 of municipal bonds, 165–167 ratings of municipal bonds, 166 reducing, 549–550 risk exposure, 593–594 risk premiums among money market securities, 149–150 for savings institutions, 593–594 for securities firms, 667 swap credit crisis, 427 trade-off between risk and return, 548–549 of trading futures contracts, 370 Credit unions, 14, 600–603 advantages and disadvantages, 600–601 deposit insurance for, 601 exposure to risk, 602–603 ownership of, 600 regulatory assessment of, 601 sources of funds, 601–602 uses of funds, 602 Creditworthiness, measuring, 221 Cross-exchange rates, 446–447 Crowding-out effect, 38 Currency call option, 400 Currency futures contracts, 372, 457 Currency options boundaries, 468–469 contracts, 400–401, 458 lower bounds, 468–469 pricing models, 469–471 upper bounds, 469 Currency put option, 400–401 pricing according to put-call parity, 470–471 Currency swaps, 437–440, 457–458 to hedge bond payments, 438–439 risk of currency swaps, 439–440 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 756 Index D Dark pools, 334–335 Day traders, 354 Dealers, 15 Debentures, 175 Debt-for-equity swap, 176 Debt securities, long-term See Long-term debt securities Debt security yields credit (default) risk, 47–49 liquidity, 49–50 tax status, 50–51 term to maturity, 51–52 why they vary, 47–52 Debtor-creditor negotiations, CDS contracts affect, 434 Defensive market operations, 88 Deficit units, Defined-benefit pension plans, 703–704 Defined-contribution pension plans, 704 Demand curve, 28 Demand deposit account, 483 Demand for loanable funds, 27 Demand-pull inflation, 103 Deposit insurance, 505–506 credit unions, 601 insurance limits, 505 risk-based deposit premiums, 505 Deposit Insurance Fund, 505–506 Depository institutions, role of, 13–14 Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980, 89, 506 Derivative securities, trading of under Financial Reform Act of 2010, 526 Development of the CDS market, 434 Differential inflation rates, 451–452 Differential interest rates, 452 Direct access broker, 334 Direct exchange rate, 446 Direct purchases, 278 Direct lease loan, 489 Direct placement of stock, 653 Dirty float, 447 Discount bonds, 188 Discount brokerage firms, 656 Discount rate, 91 Discount rate on bond valuation, 186 Distorted financial statements, 264 Distribution of bank sources of funds, 487–488 Distributions to mutual fund shareholders, 621 Dividend discount model, 287–288 adjusted dividend discount model, 288–289 free cash flow model, 289 limitations, 288 with PE ratio for valuing firms, 287–288 Dividend yield (Yld), 269 Dollar, impact of, 122 Dow Jones Industrial Average (DJIA), 270 Dual banking system, 503 Duration gap, 541 Duration of a bond on present value basis, 197–198 bond convexity, 200–201 duration of a portfolio, 198 estimation errors using modified duration, 199–200 modified duration (DUR*), 199 Dynamic asset allocation with stock index futures, 367 Dynamic asset allocation with stock index options, 394 Dynamic market operations, 88 Dynegy, 323 E E*Trade, 326, 379 Economic growth, monitoring indicators, 101–102 index of economic indicators, 102 Economies of scale, 481 Effective yield, 153–154 Efficient market, Efficient market hypothesis test of, 307–308 test of semistrong-form, 307 test of strong-form, 308 test of weak-form, 307 Electronic bond networks, 172–173 Electronic communication networks (ECNs), 333–335 Electronic transactions, 483 Emergency Economic Stabilization Act of 2008, 21, 149, 239, 505, 523 Emerging stock markets, 277–278 Employee Retirement Income Security Act (ERISA), 707 Enron Corporation, 10, 11, 273, 400, 510, 569, 638 Enron Online, 319 Enron scandal, 319–323 Arthur Andersen’s audit, 322 financial statement manipulation, 321–322 letter to its shareholders, 319–320 management motives, 320–321 market for corporate control, 323 monitoring by creditors, 323 oversight by investment analysts, 322–323 stock valuation, 320 Equilibrium interest rate, 33–35 algebraic presentation, 33–34 graphic presentation, 34–35 Equity REITs, 643–644 Equity securities, 4, Equity swaps, 425–426 Estimating the forward premium, 457 ETFs and stock indexes asset allocation with stock index options, 394 hedging with, 393–394 measure market’s risk with index options, 394–395 Eurobond market, 179 Euro-commercial paper, 152–153 Eurodollar(s), 152, 486 loans, 493 securities, 152 Eurodollar certificates of deposit, 152 Eurodollar floating rate CDs (FRCDs), 152 Euronotes, 152 European Central Bank (ECB), 95, 449 European Debt Crisis, 205–206 European-style stock options, 377 Eurozone, 448 Eurozone crisis, 449 Eurozone monetary policy 95–96, 449 Excessive commission, 264 Exchange rate(s) central bank intervention, 452–454 differential inflation rates, 451–452 differential interest rates, 452 factors affecting, 451–454 forecasting, 454–456 rate fluctuations, 203–204 technical forecasting, 455 Exchange rate quotations, 446–447 cross-exchange rates, 446–447 forward rate, 446 Exchange rate risk international operations, 555–556 securities firms, 667 Exchange rate systems, 447–448 Exchange traded funds (ETFs), 392, 640–641 popular ETFs, 641 short sales of, 641 Exchange-traded notes, 180 Executive compensation, 399–400 Exercise price, 377, 458 Expenses incurred by mutual fund shareholders, 623–625 12b-1 fees, 625 Exposure of futures market to systemic risk, 371 Extendable swap, 423–424 Extended trading sessions, 268 term asset-backed security loan facility (TALF), 93 F Factors, finance companies acting as for accounts receivable, 611 Failing banks, funding closure of, 517 Fair value accounting, 515 Fed, controls money supply, 83–91 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Index Fed’s lending during credit crisis, 92–94 facilities created by Fed, 92 Fed’s loan rate, adjusting, 91 Fed’s response to oil shocks, 121 Fed’s Trading Desk, 86–88 control of M1 vs M2, 87 dynamic vs defensive market operations, 88 Fed purchase of securities, 86 Fed sale of securities, 87 Fed trading of repurchase agreements, 87 technical factors, 87–88 Federal Advisory Council, 82 Federal agency bonds, 162–165 Federal Deposit Insurance Corporation (FDIC), 504 Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991, 505 Federal funds, 142–143 Federal funds market, 14 Federal funds rate, 142, 485 Federal funds sold, 493 Federal Home Loan Mortgage Association (FHLMA or Freddie Mac), 165, 229, 230, 232–234, 237 Federal Housing Administration (FHA), 221–222 Federal Housing Finance Agency, 525 Federal National Mortgage Association (FNMA or Fannie Mae), 165, 229, 230, 232–234, 237 Federal Open Market Committee (FOMC), 82, 83, 84, 85, 86, 119 Federal Reserve, 504 actions, 21 borrowing from banks, 485 Board of Governors, 80–82 components, integration of, 82 member banks, 80 Vice Chairman for Supervision, 81 Federal Reserve Act, 79 Federal Reserve District Banks, 80 Federal Reserve System (Fed), 79 advisory committees, 82 consumer financial protection bureau, 82 Federal Open Market Committee (FOMC), 82 integration of Federal Reserve components, 82 organizational structure of, 79 overview, 79 Fidelity, 173 Finance company, 14 business finance companies, 607 captive finance subsidiaries, 608 consumer finance companies, 607 credit risk, 615 exposure to risk, 615 factors that affect cash flow, 613 interaction with other financial institutions, 611–612 interest rate risk, 615 liquidity risk, 615 regulation of, 608–609 required rate of return, 614–615 types of, 607–609 valuation, 612–615 Finance company cash flows, 613 change in industry conditions, 613 change in management abilities, 613 change in risk-free interest rates, 613 economic growth, 613 Finance company funds business loans and leasing, 610–611 consumer loans, 610 interaction with other financial institutions, 611–612 real estate loans, 611 uses of funds, 611 Finance company operations, 607–616 Financial Accounting Standards Board (FASB), 317 Financial conglomerate, structure of, 18–19 Financial corporations’ funds, 609–611 bonds, 609–610 capital, 610 commercial paper, 609 deposits, 609 loans from banks, 609 uses of funds, 610–611 Financial futures, 353–356 contract, 353 institutional trading, 355 markets, 353–354 purpose of trading, 354–355 trading process, 355–356 trading requirements, 356 Financial institutions, 13–20, 418–419 consolidation of, 18–20 credit crisis, 20–22 global consolidation, 19–20 importance of, 17–18 Internet facilitates, 17 participation in swap markets, 418–419 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), 597 Financial leverage on securities firms’ exposure to risk, 667–668 Financial management, Financial market, 3–5 facilitate bank’s strategy, 534 participation of securities firms, 660–661 securities traded in, 5–12 Financial Reform Act of 2010, 21–22, 49, 81, 82, 170, 195, 240, 427, 436, 505, 514, 524–527, 588, 608, 673–674 Consumer Financial Protection Bureau, 525 financial stability oversight council, 524–525 757 limits on bank proprietary trading, 525–526 mortgage origination, 524 orderly liquidation, 525 sales of mortgage-backed securities, 524 trading of derivative securities, 526 Financial Services Modernization Act of 1999, 525, 663 Financial Stability Oversight Council, 22, 195, 240, 371, 524–525, 599, 639, 674 Financing for corporations, 656 Firm commitment, 169 First mortgage bond, 175 Fiscal policy, response to monetary policy, 116–117 Fisher effect, 36–37 Fitch Investors Service, 138, 166 Cs to assess quality of loans, 515–516 Fixed assets, 493 Fixed rate mortgages, 222–223 Flash crash, 337–338 Flipping shares, 261 Floor brokers, 266, 331 Floor traders, 355 Flotation costs of stock, 653 FOMC Statement, 119 Forecasting bond portfolio returns, 217–218 Forecasting bond portfolio values, 216–217 Forecasting bond prices, 213–214 Forecasting bond yields, 214–216 Forecasting exchange rates, 454–456 fundamental forecasting, 455 market-based forecasting, 455–456 mixed forecasting, 456 technical forecasting, 455 Forecasting interest rates, 41–42 Foreign exchange derivatives, 445, 456–460 currency futures contracts, 457 currency options contracts, 458 currency swaps, 457–458 for hedging, 458 forward contracts, 456–457 for speculating, 458–460 Foreign exchange market, 12, 445–451 abandoning Euro, 449 Eurozone arrangement , 448–449 exchange rate quotations, 446–447 exchange rate systems, 447–448 institutional use, 445–446 virtual currencies, 449–451 Foreign interest rate movements, influence of, 203 Foreign stock index futures, 371–372 Foreign stocks, valuation and performance, 308–310 diversification among emerging stock markets, 310 dividend discount model, 308 global diversification, 309–310 international market efficiency, 309 investing in foreign stocks, 309 price-earnings method, 308 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 758 Index Foreign stocks investment American depository receipts, 278–279 direct purchases, 278 international exchange-traded funds, 279 international mutual funds, 279 methods, 278–279 Forex derivatives, 445 Forward contracts, 456–457 on currencies, 497 Forward market, 456 Forward rate, 57, 446 Forward swap, 420–422 Free cash flow model, 289 limitations, 289 Freely floating system, 447 Front-end load, 625 Full-service brokerage firms, 656 Fundamental analysis, 285 Fundamental forecasting of exchange rates, 455 Funds, 488–496 bank loans, 488–492 cash, 488 diversifying among, 645–646 Eurodollar loans, 493 federal funds sold, 493 fixed assets, 493 investment in securities, 492–493 life insurance operations, 685–687 proprietary trading, 493–494 repurchase agreements, 493 sources of for banks, 487–488 summary, 494–496 uses of by banks, 488–496 Futures contracts, non-U.S participation in, 371 Futures exchanges, 353–354 Futures market electronic trading, 355–356 over-the-counter trading, 354 G Gap analysis, 539–540 Gap ratio, 539 Garn-St Germain Act, 506 General Electric, 177 General Electric Capital Corporation (GECC), 608 General obligation bonds, 165 Generally accepted accounting principles (GAAP), 317 Gibson Greetings, Inc., 418 Global Bank Regulations, 527 Global central bank coordination, 96 global monetary policy during credit crisis, 96 Global Crossing, 400 Global crowding out, 123 Global diversification, performance from, 309–310 Global economic conditions, impact of, 122 Global monetary policy, 95–96, 122–124 crisis in Greece, 123–124 Eurozone monetary policy, 95–96 global central bank coordination, 96 impact of global economic conditions, 122 impact of the Euro, 95–96 impact of the dollar, 122 transmission of interest rates, 122–123 Globalization of bond markets, 177–179 Globalization of futures markets, 371–372 currency futures contracts, 372 foreign stock index futures, 371–372 non-U.S participation in U.S futures contracts, 371 Globalization of money markets, 150–154 Eurodollar securities, 152–153 foreign money market securities, performance of, 153–154 international interbank market, 153 Globalization of options markets, 400–401 currency options contracts, 400–401 Globalization of stock markets, 277–279 characteristics across stock markets, 278 emerging stock markets, 277–278 methods to invest in foreign stocks, 278–279 privatization, 277 Globalization of swap markets, 437–440 currency swaps, 437–440 Globex, 355–356 Going public, 257 allocation of IPO shares, 259 bookbuilding, 257–259 developing a prospectus, 257 pricing, 257–259 transaction costs, 259 Golden parachute, 277 Goldman Sachs, 21, 508, 519, 652, 673 Google, 261–262 Google’s IPO, 261–262 auction process, 262 estimating stock’s value, 261–262 results of Google’s Dutch auction, 262 Governance of accounting, 317–319 auditing, 317–318 board of directors, 318 credit rating agencies, 318–319 market for corporate control, 319 Governance of mutual funds, 625–626 Government debt markets, Greek debt crisis, 177–178 Government National Mortgage Association (GNMA/Ginnie Mae), 229 Government rescue of failing banks, 517–522 argument against, 518 argument for, 518 failure of Lehman, 520–521 rescue of AIG, 521–522 rescue of Bear Stearns, 519–520 Graduated-payment mortgage (GPM), 224 Gramm-Leach Bliley Act, 508 Greece, on European Monetary Policy, 123–124 Gross domestic product (GDP), 101 Gross interest expenses, 568 Gross interest income, 567 Group life policy, 683 Growing equity mortgage, 225 Growth and income funds, 629 Growth funds, 627, 629 H Health care insurance, 691–692 Health maintenance organizations (HMOs), 691 Hedge funds, 635–639 expert networks, 637 fees, 636 Madoff fund scandal, 639 pursuit of information, 637 Regulation Fair Disclosure, 637 regulatory reform of, 639 short selling by, 637–639 use of financial leverage, 636 Hedgers, 355 Hedging interest rate risk, 542–544 swaps, 416–417 Hedging with foreign exchange derivatives, 458 Hedging with interest rate futures, 360–363 cross-hedging, 362 hedging net exposures, 363 short hedge, 361–362 trade-off from using a short hedge, 362–363 using to create a long hedge, 363 Hedging with options on interest rate futures, 397–398 Hedging with options on stock index futures, 398–399 determining degree of the hedge, 398 selling call options to cover cost of put options, 399 Hedging with stock index futures, 365–367 proportion of portfolio to hedge, 366–367 test of suitability, 366 Hedging with stock index options, 393–394 dynamic asset allocation, 394 hedging with long-term options, 394 Highly leveraged transactions (HLTs), 490 High-yield mutual funds, 171 High-yield (or junk bond) funds, 630 Holding period return, 161 Holiday effect, 307 Hurdle rate, 29 I IBM, 177, 270, 498 Immunize a portfolio, 198 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Index Impact lag of monetary policy, 111 Impact of inflation on interest rates, 36–37 Fisher effect, 36–37 Impact on financial markets, 118–121 Fed’s communication to financial markets, 119–121 Implementation lag of monetary policy, 111 In the money, 377 Income before taxes of banks, 569 Income funds, 629 Indenture, 173 Independent brokers, 266 Index arbitrage, 367 Index funds, 629–630 Index options to measure market’s risk, using, 394–395 Indirect exchange rate, 446 Inflation monitoring, 103 producer and consumer price indexes, 103 Inflation-indexed Treasury bonds, 164 Informal line of credit, 489 Information costs, reduction in, 346 Initial margin, 327 Initial public offering (IPO), 257–265 abuses in the IPO market, 263–264 Facebook IPO, 262–263 flipping shares, 261 going public, 257–259 Google’s IPO, 261–262 initial returns on, 260–261 long-term performance, 264–265 Sarbanes-Oxley Act, 273 timing, 260 underwriter efforts to ensure price stability, 259–260 Installment loans, 491 Institutional investors, 16 Institutional Shareholder Services (ISS), 274 Institutional trading of futures contracts, 355 Insurance companies, 15 assessment system, 681 capital, 682 cash flow factors that affect, 695–696 change in economic conditions, 696 change in industry conditions, 696 change in management abilities, 696 change in payouts, 696 change in risk-free interest rate, 696 credit risk, 694 exposure during credit crisis, 694–695 exposure to risk, 694–695 factors that affect cash flows, 695–696 factors that affect required rate of return by investors, 696 failed insurance companies, 682 federal insurance office, 682 financial services offered, 682 indicators of liquidity, 697–698 indicators of profitability, 698 indicators of value and performance, 697–698 interest rate risk, 694 international insurance regulations, 682 liquidity risk, 694 market risk, 694 regulation of, 681–682 valuation of, 695–698 Insurance operations, 679–698 setting insurance premiums, 679–681 Insurance premiums, setting, 679–681 Insurance Regulatory Information System (IRIS), 681 Insurance services, regulation of, 509 Insured mortgage, 221–222 Integrated bank management, 551–555 application, 552–555 Integration, 309 Interactive Brokers, 334 Interest rate(s) equilibrium, 33–35 factors that affect, 35–41 forecasting, 41–42 impact of budget deficit on, 38–39 impact of economic growth on, 35–36 impact of foreign funds on, 39–40 impact of inflation on, 36–37 impact of monetary policy on, 37–38 international structure, 66–67 open market operations in response to economy, 84 Interest rate caps, 429–430, 547 Interest rate collars, 431–432 Interest rate floors, 430–431 Interest rate futures, 353 Interest rate futures contracts, 357–363 closing out futures position, 360 hedging with, 360–363 impact of leverage, 360 savings institutions, 596 speculating in, 358–360 valuing, 357–358 Interest rate parity, 461 Interest rate risk, 150, 190, 227–228 duration measurement, 540–541 finance companies, 615 insurance companies, 694 international, 547 managing, 537–547 measuring, 150 methods to assess, 538–542 methods to reduce, 544–547 regression analysis, 541–542 savings institutions, 594–595 securities firms, 667 whether to hedge, 542–544 Interest rate strategy, 202 Interest rate swap, 415 availability of counterparties, 428 basis risk, 426 759 callable swaps, 422 contracts, 497 credit and sovereign risk, 428 credit risk, 426 equity swaps, 425–426 extendable swap, 423–424 forward swaps, 420–422 performance of, 428 plain vanilla swaps, 420 prevailing market interest rates, 427 pricing, 427–428 putable swap, 422–423 rate-capped swaps, 424–425 risks of, 426–427 savings institutions, 596 sovereign risk, 427 tax advantage swaps, 426 types, 419–427 zero-coupon-for-floating swaps, 424 Interest-inelastic, 30 Interest-only (IO) tranche, 230 Internal ratings-based (IRB) approach, 512 International and global bond funds, 629 International arbitrage, 460–463 covered interest arbitrage, 461–463 locational arbitrage, 460–461 triangular arbitrage, 461 International banking, 498–499 credit risk, 204 exchange rate risk, 204 global competition in foreign countries, 498–499 International bond diversification, 204–205 International expansion, 498 International exposure, 499 International bonds, valuation and risk, 202–206 and credit risk, 203 diversification, 204–205 exchange rate fluctuations, 203–204 and foreign interest rate movements, 203 International exchange-traded funds (ETFs), 279 International interbank market, 153 International interest rate risk, 547 International market efficiency, 309 International mutual funds (IMFs), 279 International operations, managing risk of, 555–556 exchange rate risk, 555–556 settlement risk, 556 International Securities Exchange, 378 International stocks, trading, 345–346 reduction in exchange rate risk, 346 reduction in information costs, 346 reduction in transaction costs, 345–346 Investing in foreign stocks, measuring performance, 309 Investment analysts, oversight in Enron scandal, 322–323 Investment banks, 15 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 760 Index Investment-grade bonds, 48 Investment-grade securities, 492 Investment needs, accommodating, 4–5 Investors, IPO market abuses in, 263–264 distorted financial statements, 264 excessive commissions, 264 laddering, 263 spinning, 263 Issue costs of stock, 653 J JPMorgan Chase, 92, 172, 234, 323, 436, 481, 519, 526, 534, 599, 669–670 January effect, 293 Junk bonds, 171–172 risk premium, 171 K Krispy Kreme, 638 KSR call options, 381, 382 L Laddered strategy, 201 Laddering, 263 Lagging economic indicators, 102 Leading economic indicators, 102 Lehman Brothers, 11, 21, 93, 138, 148, 192, 234, 273, 435, 520–522, 638, 658, 671, 695 accounting fraud, 323–324 Letter of credit (L/C), 143 Leveraged buyout (LBO), 175–176 to achieve corporate control, 276 Liberty Mutual, 15 LIBOR See London Interbank Offer Rate Life insurance, 682 term insurance, 683 types of, 683–684 universal life insurance, 684 variable life insurance, 684 whole life insurance, 683 Life insurance operations, 682–689 asset management, 687–688 corporate securities, 686 government securities, 685–686 interaction with other financial institutions, 688–689 mortgages, 686 ownership, 683 policy loans, 687 real estate, 687 sources of funds, 684–685 uses of funds, 685–687 Limit order, 173, 325 Limitations of option compensation, 399–400 Liquidity, debt security yields, 49–50 managing, 536–537 Liquidity preference theory, 60 Liquidity premium theory, 59–61 forward rate of liquidity premium, 60–61 Liquidity risk for finance companies, 615 for insurance companies, 694 for savings institutions, 592–593 of trading futures contracts, 369–370 Load fund, 624 Loan commitment, 497 Loan loss provision of banks, 569 Loan participation, 489 Loanable funds aggregate demand for, 31 business demand for, 28–29 demand for, 27, 29 equilibrium interest rate, 33–35 foreign demand for, 30–31 government demand for, 30 household demand for, 28 supply of, 31–33 Loanable funds theory, 27–35 Locals, 355 Locational arbitrage, 460–461 London Interbank Offer Rate (LIBOR), 152, 175, 420, 537, 686 LIBOR Scandal, 153 London International Financial Futures Exchange (LIFFE), 372 Long hedge, 363 Long-term debt securities auction-rate securities, 180–181 exchange-traded notes, 180 other types, 179–181 structured notes, 179–180 Long-term equity anticipations (LEAPs), 392 Long-term performance following IPOs, 264–265 Low-coupon bonds, 175 M M1, 87 M2, 87 Maintenance margin, 327 Managed health care plans, 691 Management of Bank Capital, 554–555 Management of loans, 536 Management of money market funds, 634–635 Management of money market securities, 536 Management of mutual funds, 622–623 interaction with other financial institutions, 622–623 use of financial markets, 623 Management of pension fund portfolio risk, 714–715 Managing liquidity, 536–537 Managing market risk, 550–551 Margin account, 327 Margin call, 327 Margin requirements, 326 Margin trading, 326–328 impact on returns, 327–328 margin calls, 327 Market-based forecasting of exchange rates, 455–456 use of forward rate, 455–456 use of spot rate, 455 Market makers, 331–332 Market microstructure, 325–346 Market order, 173, 325 Market related factors affect stock prices, 293 investor sentiment, 293 January effect, 293 Market risk for insurance companies, 694 managing, 550–551 measuring, 551 to reduce, 551 for securities firms, 666 of trading futures contracts, 369 Matched funding of pension plans, 715 Matching strategy, 201 Maturity matching, 544 Maturity classifications of bond mutual funds, 631 MBIA, 166 MCI, 317 Measuring market risk, 551 bank revisions of, 551 bank’s market risk and interest rate risk, 551 Member banks, 80 Merger-conversion, 586 Merrill Lynch, 21, 508, 652, 671 Microsoft, 250, 261 Mixed forecasting of exchange rates, 456 Modified duration, 199 Monetary policy, 101 correcting a weak economy, 115 impact of credit crunch, 108 impact on interest rates, 104–105 implementing monetary policy, 103–112 lagged effects of, 111–112 mechanics of, 101–103 monetary policy effects, 117–122 monitoring indicators of economic growth, 101–102 monitoring indicators of inflation, 103 response to fiscal policy, 116–117 restrictive policy effects, 110–111 stimulative policy effects, 103–107 target for federal funds rate, 105 trade-off in, 112–117 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Index Monetary policy shifts over time, 115 improving weak economy in 2001–2003, 115 improving weak economy in 2008–2015, 115 reducing inflation in 2004–2007, 115 Money market(s) foreign money market securities, 153–154 institutional use of, 144–146 international interbank market, 153 Money market deposit account (MMDA), 87, 484, 506 Money market funds, 632– asset composition of, 632–634 closed-end funds, 639–640 exchange-traded funds, 640–641 management of, 634–635 other types, 639–644 private equity funds, 642–643 real estate investment trusts, 643–644 risk of, 634 venture capital funds, 642 Money market mutual funds, 15, 506 Money market securities, 5, 133–150 banker’s acceptances, 143–144 commercial paper, 137–140 Federal funds, 142–143 interest rate risk, 150 negotiable certificates of deposit, 140–141 performance of, 153–154 repurchase agreements, 141–142 treasury bills, 134–137 valuation of, 146–150 yield differentials of, 52 Money policy, loose, 111, 113 Money supply growth adjusting Fed’s loan rate, 91 Fed controls, 83–91 Fed operations affect interest rates, 88–89 growth, tightening, 87 loosening of, 86 open market operations, 83–86 role of the Fed’s Trading Desk, 86–88 Moody’s Investors Service, 48, 138, 166, 177, 231, 318 Moral hazard problem, 505, 680–681 Morgan Stanley, 21, 330, 433, 508, 652, 673 Mortgage(s), 6, 219–228 adjustable-rate (ARM), 223–224 amortizing fixed-rate, 222–223 balloon-payment, 225 classifications, 221–222 credit risk, 226–227 facilitate flow of funds, 219–220 fixed rate, 222 graduated-payment (GPM), 224 growing equity, 225 insured vs conventional, 221–222 interest rate risk, 227–228 prepayment risk, 228 prime vs subprime, 221 residential, 222–225 second, 225 shared-appreciation, 225 valuation of, 225–228 See also Residential mortgages Mortgage-backed securities (MBS), 228 collateralized mortgage obligations, 230–231 fair value, 231 FHLMA participation certificates, 229–230 FNMA, 229 GNMA, 229 private label pass-through securities, 229 ratings to assess value, 231 securitization process, 228 types, 229–231 valuation, 231 Mortgage credit crisis, 231–240 conclusion about blame, 238–239 credit rating agencies, 236–237 Fannie Mae and Freddie Mac, 232–234 financial institutions that insured MBS, 238 financial institutions that packaged MBS, 237 Financial Reform Act, 240 government bailout of financial institutions, 239 government programs, 239 institutional investors that purchased MBS, 237 mortgage originators, 236 speculators of credit default swaps, 238 systemic risk, 235–236 Mortgage insurance, 693 Mortgage markets, 219–240 facilitate flow of funds, 219–220 institutional use, 219–220 Mortgage pipeline, 227–228 Mortgage REITS, 643–644 Multifund funds, 630 Multinational finance companies, 616 Municipal Bond Index (MBI) futures, 357 Municipal bonds, 165 credit risk of, 165–167 junk bonds, 171–172 ratings, 166 tax advantages, 167 trading and quotations of, 167 variable-rate municipal bonds, 167 yields offered, 167–168 Mutual fund(s), 14–15, 619 distributions to shareholders, 621 expenses incurred by shareholders, 623–625 governance of, 625–626 management of, 622–623 performance from diversifying among funds, 645–646 performance, 644–646 pricing shares of, 620–621 761 ratings, 646 research on, 646 valuation of bond mutual funds, 645 valuation of stock mutual funds, 644–645 regulation of, 621–622 Mutual fund categories, 626–632 asset allocation funds, 631 bond mutual fund categories, 630–631 stock mutual fund categories, 627–630 Mutual fund operations, 609–634 Mutual fund prospectus, information contained in, 622 Mutual fund shareholders, expenses, 623–625 sales charge, 624–625 12b-1 fee, 625 Mutual savings institutions, 585 Mutual-to-stock conversions, 585 N Naked shorting, 330 National Association of Insurance Commissioners (NAIC), 681 National Association of Securities Dealers Automatic Quotations (Nasdaq), 268, 271, 318, 331, 378 National Association of Securities Dealer’s Trade Reporting and Compliance Engine (TRACE), 172 National Credit Union Administration (NCUA), 601 National Credit Union Association, 525 National Credit Union Share Insurance Fund (NCUSIF), 601 National income, 101 Negotiable certificates of deposit (NCDs), 140–141 placement, 140 premium, 141 yield, 140–141 Negotiable order of withdrawal (NOW) account, 483 Net asset value (NAV), 620 Net financing cost, 364 Net interest income, 568 Netscape, 261 New York State Government Retirement Fund, 706 New York Stock Exchange (NYSE), 266, 270, 318, 327, 331 Euronext, 266 New York Stock Exchange Indexes, 270 Nikkei (Japanese) stock index, 389 No-load fund, 624 Noise traders, 331 Nondepository financial institutions, role of, 14–15 Noninterest income and expenses of banks, 568–569 Note issuance facility (NIF), 497 Notional principal value, 415 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 762 Index O Off-balance sheet activities, 496–498 credit default swap contracts, 497–498 forward contracts on currencies, 497 interest rate swap contracts, 497 loan commitments, 497 standby letters of credit, 497 Off-balance sheet transactions, regulation of, 509–510 Office of Credit Ratings, 49 OneChicago, 368 Open Market Desk, 86 Open market operations, 83 economic presentations, 84 FOMC decisions, 84–85 FOMC statement, 85 minutes of FOMC meeting, 86 pre-meeting economic reports, 83 Operational risk of trading futures contracts, 370 Option(s), 377–380 comparison of options and futures, 378 how executed, 379 institutional use of, 380 listing requirements, 378 markets used to trade, 378–379 options clearing corporation, 379 regulation of options trading, 379 stock option quotations, 379–380 types of orders, 379 Option compensation, limitations, backdating options, 399–400 Option pricing, to derive stock’s volatility, 383 Option valuation, 407–414 Options Clearing Corporation (OCC), 379 Options market, 377–401 globalization See Globalization of options markets Options on futures contracts, 395–399 hedging with options on interest rate futures, 397–398 hedging with options on stock index futures, 398–399 speculating with, 395–397 Oracle Corporation, 251 Orange County, California, 418 Order, stop-loss and stop-buy, 326 Organized exchanges, 266–267 listing requirements, 267 Origination stage of stock offering, 651–652 Out of the money, 377 Over-the-counter market (OTC), 267–268 Nasdaq, 268 OTC Bulletin Board, 268 Pink Sheets, 268 Ownership and voting rights, 254–255 P Participation certificates (PCs), 229 Pass-through securities, 228 Payments on a credit default swap, 433–434 Pegged exchange rate system, 447–448 Penny stocks, 268 Pension Benefit Guaranty Corporation (PBGC), 707–708 Pension fund(s), 15 asset allocation of, 713–714 bond portfolio performance, 716–717 defined-benefit vs defined-contribution plans, 703–705 participation in financial markets, 705–706 pension portfolio managers, performance of, 717–718 performance, 715–718 performance evaluation, 717 regulations, 706–709 stock portfolio performance, 716 Pension fund management, 713–715 management of portfolio risk, 714–715 matched versus projective funding strategies, 715 Pension Protection Act of 2006, 709 Philadelphia Stock Exchange, 378 Plain vanilla swaps, 420 Poison pills, 276–277 Portfolio insurance, 336 Portland Pension Fund, 390 Position traders, 354 Power of governance, limited, 275 PowerShares QQQ (Cube), 641 Preemptive rights (first priority), 265 Preferred habitat theory, 62 Preferred provider organizations (PPOs), 691 Preferred stock, 255 Pre-market session, 268 Prepayment risk mortgages, 228 trading futures contracts, 370 Prevailing market interest rates, 427 Price-earnings (PE) method, 285–286 different valuations, 285–286 limitations, 286 Priceline.com, 261 Pricing models of currency options, application of, 469–471 Pricing shares of the mutual fund, 620–621 Primary credit, 91 Primary credit lending rate, 91, 484 Primary market, 4, 253 Primary vs secondary markets, 4–5 Prime mortgages, 221 Prime rate, 489 Principal-only (PO) tranche, 230 Private equity, 249–253 financing by venture capital funds, 249–251 Private equity funds, 642–643 financing by, 251–252 Private pension plans, 706–709 Private placement of stock, 653 Privatization of stock markets, 277 Procter & Gamble, 418 Producer Price Index, 103 Program trading, 335–336 impact on stock volatility, 337–339 Projective funding of pension plans, 715 Property and casualty insurance, 689–691 cash flow underwriting, 690 property and casualty reinsurance, 691 use of funds, 690–691 Proposals to focus on inflation, 117 Proprietary trading, 493–494, 525–526 Proprietary trading by securities firms, 658 Barings Bank, 658 Bear Stearns, 658 Lehman Brothers, 658 Société Général, 658 underlying cause of investment problems, 658 Prospectus, 169, 257, 652 Protective covenants, 174, 488 Public equity, 253–257 ownership and voting rights, 254–255 participation in stock markets, 255 preferred stock, 255 Public pension funds, 703 Publicly traded companies accounting irregularities, 273 limited power of governance, 275 monitoring, 272–275 role of analysts, 272–273 Sarbanes-Oxley Act, 273 shareholder activism, 274–275 Purchasing power parity (PPP), 451 Pure expectations theory, 55–59 algebraic presentation, 57–59 impact of decline in interest rates, 55–56 impact of increase in interest rates, 55 Put option, 377 hedging with, 392 hedging with LEAPs, 392 speculating with, 388–389 Put option premiums determinants of, 382–383 influence of market price, 382 influence of put option’s time to maturity, 383 influence of stock’s volatility, 382–383 Putable swap, 422–423 Q Quote, bid and ask, 325 R Rate-capped swaps, 424–425 Real estate investment trust (REIT), 643–644 Real interest rate, 37 Recognition lag of monetary policy, 111 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Index Reduce interest rate risk maturity matching, 544 methods, 544–547 using floating-rate loans, 544 using interest rate caps, 547 using interest rate futures contracts, 544–545 using interest rate swaps, 545–547 Reducing credit risk, 549–550 industry diversification of loans, 549 international diversification of loans, 549–550 revising loan portfolio in response to economic conditions, 550 selling loans, 550 Reform of CDS contracts, 436–437 Registered bonds, 159 Registration statement, 652 Regulation Fair Disclosure (FD), 344, 663 Regulation of bank loans regulation of foreign loans, 507 regulation of highly leveraged transactions, 507 regulation of loans to a single borrower, 507 regulation of loans to community, 507 Regulation of bank operations, 504–510 regulation of accounting process, 510 regulation of bank loans, 507 regulation of deposit insurance, 504–506 regulation of deposits, 506 regulation of insurance services, 509 regulation of investments in securities, 507 regulation of off-balance sheet transactions, 509–510 regulation of securities services, 507–508 Regulation of capital, 510–514 Basel I Accord, 511 Basel II framework, 511–512 Basel III framework, 512 stress tests, 513–514 VaR to determine capital requirements, 512–513 Regulation of credit default swaps, 509–510 Regulation of deposits, 506 Depository Institutions Deregulation and Monetary Control Act (DIDMCA), 506 Garn-St Germain Act, 506 Interstate Banking Act, 506 Regulation of mutual funds, 621–622 Regulation of savings institutions, 586–587 deposit insurance, 586 deregulation of services, 586 regulatory assessment of, 586–587 Regulation SHO, 330 Regulators monitor banks, 514–517 CAMELS ratings, 514–517 corrective action by regulators, 517 funding the closure of failing banks, 517 Regulatory reform, conversion of securities firms to BHCs, 673 Financial Reform Act of 2010, 673–674 impact of credit crisis, 673–674 Regulatory structure of banks, 503–504 regulation of ownership, 504 regulators, 504 Reigle-Neal Interstate Banking and Branching Efficiency Act, 506 Repurchase agreements, 89, 143–145, 479–480, 487 estimating yield, 145 impact of credit crisis, 143–145 placement, 143 Required rate of return insurance companies, 696 savings institutions, 592 securities firms, 665–666 Required rate of return by investors, 565–566 change in risk premium, 565–566 change in risk-free rate, 565 Required rate of return on stocks, 289–291 Required return, coupon rate, and bond price, 188–190 Reserve requirement ratio adjusting, 89–90 impact on money growth, 89–90 Reset rate, 180 Residential mortgages, 222–225 adjustable-rate mortgages, 223–224 amortizing fixed-rate mortgages, 222–223 balloon-payment mortgages, 225 fixed-rate mortgages, 222–223 graduated-payment mortgages, 224 growing-equity mortgages, 225 second mortgages, 225 shared appreciation mortgages, 225 types of, 222–225 See also Mortgages Resolution Trust Corporation (RTC), 597 Return on assets (ROA), 570 evaluation of, 570–574 Return on equity (ROE), 555 Return on stocks capital asset pricing model (CAPM), 289–291 required rate, 289–291 Revenue bonds, 165 Reverse leveraged buyout (reverse LBO), 276 Reverse repo, 141 Revolving credit loan, 489 Risk-adjusted stock performance, 304– Sharpe index, 305 Treynor index, 305–306 Risk-free rate, 190–192 budget deficit, 192 economic growth, 191 inflationary expectations, 190–191 money supply growth, 191–192 Risk management, Riskless hedge, 410 763 S S&P 100, 394 S&P 500 index, 363, 364, 365, 366 Sarbanes-Oxley (SOX) Act of 2002, 11, 273, 323, 510, 535 cost of being public, 273 Savings Association Insurance Fund (SAIF), 505, 586 Savings bonds, 164 Savings deposits, 484 Savings institution(s), 14, 585 adjustable-rate mortgages, 595–596 borrowed funds, 587 capital, 587 Consumer Financial Protection Bureau, 599 credit crisis of 2008–2009, 598–599 credit risk, 593–594 crisis in late 1980s, 597 deposits, 587 exposure to crises, 597–600 exposure to risk, 592–595 factors that affect cash flow, 591–592 factors that affect required rate of return, 592 Financial Stability Oversight Council, 599 interest rate futures contracts, 596 interest rate risk, 594–595 interest rate swaps, 596 liquidity risk, 592–593 mortgage origination, 599 with other financial institutions, 589 ownership of, 585–586 participation in financial markets, 589–590 provisions of FIRREA, 597 reform in response to the credit crisis, 599–600 regulation of, 586–587 sales of mortgage-backed securities, 599 sources of funds, 587 trading of derivative securities, 599–600 valuation of, 591–592 Savings institution funds balance sheet, 588–589 cash, 587 consumer and commercial loans, 588 mortgage-backed securities, 588 mortgages, 587–588 with other financial institutions, 589 other securities, 588 other uses, 588 participation in financial markets, 589–590 Second mortgages, 225 Secondary credit, 91 Secondary market, CDS contracts, 433 corporate bonds, 172–173 trading online, 173 types of orders, 173 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 764 Index Secondary stock offerings, 265–266 shelf registration, 265–266 Securities, capital market, 5–7 corporate and municipal bonds, 492 derivative, money market, mortgage-backed, 6–7, 492–493 treasury and agency, 492 uncertainty surrounding, 9–10 valuation of, 8–10 Securities Act of 1933, 343 Securities and Exchange Commission (SEC), 10, 49, 169, 237, 253, 257, 296, 317, 330, 379, 427, 436, 508, 525, 621, 652 key divisions, 343–344 oversight of corporate disclosure, 344 oversight of insider trading, 344–345 structure, 343 trading halts, 342–343 Securities Exchange Act of 1934, 10, 342 Securities firm(s), 15 advising corporations, 655–656 credit risk, 667 exchange rate risk, 667 expanding functions internationally, 661–662 exposure to risk, 666–668 facilitating bond offerings, 653–654 facilitating stock offerings, 6651–653 factors that affect cash flow, 664–665 factors that affect required rate of return, 665 financial leverage on exposure to risk, 667–668 Financial Services Modernization Act, 663 financing for corporations, 656 growth of international joint ventures, 661 growth of international securities transactions, 661–662 impact of credit crisis, 668–674 interaction with other financial institutions, 659–660 interest rate risk, 667 market risk, 666 operating mutual funds, 657 participation in financial markets, 660–661 proprietary trading, 658 providing brokerage services, 656–657 Regulation FD, 663 regulation of analyst ratings, 663–664 regulation of IPO market, 664 regulation of, 662–664 securitizing mortgages, 655 stock exchange regulations, 662 valuation of, 664–666 Securities Investor Protection Corporation (SIPC), 662 Securities operations, 651–674 Securities regulations, 10–11 Securities services Financial Services Modernization Act, 508 regulation of, 507–508 Securitization, 228, 536–537 Securitizing mortgages, 655 Segmented markets theory, 61–62 implications, 62 limitation of theory, 62 Semistrong-form efficiency, of stock market, 306 Settlement risk in international operations, 556 Shared appreciation mortgage, 225 Shareholder activism, 274 communication with firm, 274 proxy contest, 274–275 shareholder lawsuits, 275 Sharpe index, 305 Shelf registration, 265–266 Short hedge, 361–362 Short interest ratio, 329 Short selling, 328–330 concerns about, 330 measuring the short position, 329 restrictions on, 330 stop-buy order to offset, 329 Singapore International Monetary Exchange (SIMEX), 389 Single stock futures, 368–369 Sinking-fund provision, 174 Smithsonian Agreement, 447 Société Général, 658 Sovereign risk, 428 Special-purpose entities (SPEs), 321 Specialists, 267 Specialty funds, 629 Speculating, use of swaps, 418 Speculating in interest rate futures, 358–360 closing out the futures position, 360 impact of leverage, 360 payoffs from, 359–360 Speculating in stock index futures, 365 Speculating with foreign exchange derivatives, 458–460 with currency futures, 459 with currency options, 460 Speculating with options on futures, 395–397 decline in interest rates, 395–396 increase in interest rates, 396–397 Speculation, from excessive risk, 389–390 Speculators, 354 Spinning, 263, 664 Spread, 15 Spread on stock transactions, 332–333 competition, 332 inventory costs, 332 order costs, 332 risk, 333 volume, 332 Standard & Poor’s (S&P) 500 index, 363, 364, 365, 366 Standard & Poor’s Corporation, 48 Standard & Poor’s Depository Receipt (SPDR or Spider), 641 Standard & Poor’s Investors Service, 166 Standby letter of credit (SLC), 497 State Farm Group, 15, 689 Steelco, 385–386, 388 Stock(s), stop-buy order, 326 stop-loss order, 326 Stock exchanges, 266–272 extended trading sessions, 268 organized exchanges, 266–267 over-the-counter market, 267–268 private, 271–272 stock index quotations, 270–271 stock quotations provided by Exchanges, 268–270 Stock exchange regulations, 662 insurance on cash and securities, 662 Stock index futures, 353, 363–368 arbitrage, 367–368 circuit breakers on, 368 dynamic asset allocation with, 367 hedging with, 365–367 speculating in, 365 valuing, 364–365 Stock index option, 392 Stock index quotations, 270 Dow Jones Industrial Average, 270 Nasdaq Stock Indexes, 271 New York Stock Exchange Indexes, 270–271 Standard & Poor’s 500, 270 Wilshire 5000 Total Market Index, 270 Stock market(s) emerging, diversification among, 310 globalization, 277–279 globalization See Globalization of stock markets investor decisions affect stock prices, 255–256 investor reliance on information, 256–257 Stock market efficiency, 306–308 semistrong-form, 306 strong-form, 306–307 tests of efficient market hypothesis, 307–308 weak-form, 306 Stock market transactions, 325–327 margin trading, 326–328 placing an order, 325–326 short selling, 328–330 Stock mutual fund categories, 627–630 capital appreciation funds, 629 growth and income funds, 629 growth funds, 627, 629 index funds, 629–630 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 Index international and global funds, 629 multifund funds, 630 specialty funds, 629 Stock mutual funds, valuation of, 644 change in management abilities, 645 change in market conditions, 644 change in sector conditions, 644 Stock offerings, 249–279 advising, 653 distribution of stock, 652–653 facilitating, 651–653 origination, 651–652 private placements, 653 and repurchases, 265–266 secondary stock offerings, 265–266 shelf registration, 265–266 stock repurchases, 266 underwriting, 652 Stock option(s) hedging with, 390 hedging with covered call options, 390–391 hedging with put options, 392 speculating with, 385–391 speculating with call options, 385–387 speculating with put options, 388–389 excessive risk from speculation, 389–390 Stock option premiums changes in, 384–385 indicators monitored by participants, 384–385 determinants, 380–385 determinants of call option premiums, 380–382 option pricing to derive stock’s volatility, 383–384 put option premiums, 382–383 Stock option quotations, 379–380 Stock portfolio performance of pension funds, 716 change in management abilities, 716 change in market conditions, 716 Stock prices acquisitions and divestitures, 294 changes in dividend policy, 293–294 earnings surprises, 294 economic factors, 291–293 expectations, 294 factors that affect, 291–297 firm-specific factors, 293–294 impact of economic growth, 291 impact of interest rates, 291–292 impact of the dollar’s exchange rate value, 292–293 integration of factors that affect, 294–295 market related factors, 293 Stock quotations provided by Exchanges closing price quotations, 270 dividend, 269 dividend yield, 269 52-week price range, 269 price-earnings ratio, 270 symbol, 269 volume, 270 Stock repurchases, 266 Stock risk, 297–304 beta of a stock, 301 forecasting price volatility, 299 value at risk, 301–304 volatility of portfolio, 299–301 volatility of stock, 298–301 Stock trading, regulation of, 342–345 circuit breakers, 342 Stock transactions, how executed, 331–335 electronic communication networks (ECNs), 333–335 floor brokers, 331 interaction between direct access brokers and ECNs, 334–335 market-makers, 331–332 program trading, 335–336 spread on, 332–333 Stock valuation methods, 308 dividend discount model, 308 price-earnings method, 308 Stop-buy order, 326 Stop-loss order, 326 Strike price, 377 Stripped Treasury bonds, 163–164 STRIPS (Separate Trading of Registered Interest and Principal of Securities), 163–164 Strong-form efficiency, of stock market, 306–307 Structured notes, risk of, 180 Subordinated debentures, 175 Subprime mortgages, 221 SunTrust Banks, 13 Supply curve, 31 Supply of loanable funds, 31–33 aggregate supply of funds, 33 effects of the Fed, 33 Surplus units, Swap markets, 415–440 participation by financial institutions, 418–419 use of swaps for hedging, 416–417 use of swaps for speculating, 418 use of swaps to accommodate financing, 417–418 Swap options (swapoptions), 422 Syndicate, 259 Systematic risk, 289 of bond price movements, 195 T Tax advantages of municipal bonds, 167 Tax-free funds, 630 Tax status 765 computing equivalent before-tax yield, 51 of debt security yields, 50–51 term to maturity, 51–52 TD Ameritrade, 326 Technical analysis, 285 Technical forecasting of exchange rates, 455 Term insurance, 683 Term loan, 488 Term structure, 55–67 forecasting interest rates, 64 forecasting recessions, 64–65 integrating theories, 63–64 interest rates, 51 international structure of interest rates, 66–67 liquidity premium theory, 59–61 making financing decisions, 65 making investment decisions, 65 pure expectations theory, 55–59 research on 63 segmented markets theory, 61–62 yield curve, 65–66 Theory of rational expectations, 109 Thrift institutions, 14 Thrift Institutions Advisory Council, 82 Thrift operations, 573–591 Time deposits, 484 certificates of deposit, 484 negotiable certificates of deposit, 484 Time-series models of forecasting exchange rates, 455 Timing of IPOs, 260 Timing of payments on bond valuation, 186–187 Trade-off between credit risk and return, 548–549 expected return and risk of subprime mortgage loans, 549 Trade-off in monetary policy, 112–117 forces on the trade-off, 113–114 shifts in monetary policy, 115 Trading and quotations of municipal bonds, 167 Trading Desk, 86–88 Trading futures, 354–356 how orders are executed, 356 type of orders, 356 Trading futures contracts risk, 369–371 basic risk, 369 credit risk, 370 exposure to systemic risk, 371 liquidity risks, 369–370 market risk, 369 operational risk, 370 prepayment risk, 370 Trading halts, 342–343 Trading Treasury bonds, online, 162–163 Transaction deposits, 483 Transmission of interest rates, 122–123 Traveler’s Insurance Group, 15, 509 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 766 Index Treasury and federal agency bonds, 162 federal agency bonds, 164–165 inflation-indexed Treasury bonds, 164 savings bonds, 164 stripped Treasury bonds, 163–164 trading Treasury bonds, 162–163 Treasury bond auctions, 162 Treasury bills, 134–137 auction, 136–137 credit risk, 134 estimating discount, 136 estimating yield, 135–136 investors, 134 liquidity, 135 pricing, 135 Treasury Direct program, 163 Treynor index, 305–306 Triangular arbitrage, 461 Troubled Asset Relief Program (TARP), 239, 523 12b-1 fees, 625 Tyco, 273 U U.S Commodities Futures Trading Commission, 525 Underwrite, 15 Underwriter efforts to ensure price lockup, 260 overallotment option, 259–206 Underwriting syndicate, 652 United Technologies Corporation, 177 Universal life insurance, 684 Uptick rule, 330 Usury laws, 491 V Valuation of finance company, factors that affect required rate of return, 614–615 impact of behavioral finance on, impact of information on, 8–9 impact of Internet on, Valuation of money market securities, 146–150 changes in credit risk, 148–150 Value at risk, 301–304 adjusting investment horizon desired, 304 adjusting length of historical period, 304 deriving maximum dollar loss, 303 historical returns, 303 limitations of value-at-risk method, 304 standard deviation, 303 stock portfolio, 304 using beta, 303 Value-at-risk (VaR) model to determine capital requirements, 512–514 limitations, 513 regulatory stress tests during credit crisis, 513–514 Value line, 290 Vanguard, 173 Variable life insurance, 684 Variable-rate bonds, 175 Variable-rate municipal bonds, 167 Venture capital funds exit strategy, 250–251 financing by, 249–251 performance, 251 Veterans Administration (VA), 22 Volatility index (VIX), 299 Volcker Paul, 494, 520 W Wall Street Reform Act, 21 Weak-form efficiency, of stock market, 306 Weekend effect, 307 Whole life insurance, 683 Wilshire 5000 Total Market Index, 267 Working capital loan, 488 WorldCom, 10, 273, 317, 638 Y Yahoo!, 261 Yield curve, 51, 55 Yield differentials explaining, 52–53 of capital market securities, 52–53 of money market securities, 52 Yield to maturity, 160 Yields of municipal bonds, 167–168 Z Zero-coupon bonds, 175 Zero-coupon-for-floating swaps, 424 Zikard Company, 269, 270 Zyco, 368, 369 Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203 This is an electronic version of the print textbook Due to electronic rights restrictions, some third party content may be suppressed Editorial review has deemed that any suppressed content does not materially affect the overall learning experience The publisher reserves the right to remove content from this title at any time if subsequent rights restrictions require it For valuable information on pricing, previous editions, changes to current editions, and alternate formats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for materials in your areas of interest ,PSRUWDQW1RWLFH0HGLDFRQWHQWUHIHUHQFHGZLWKLQWKHSURGXFWGHVFULSWLRQRUWKHSURGXFW WH[WPD\QRWEHDYDLODEOHLQWKHH%RRNYHUVLRQ Copyright 2018 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part WCN 02-200-203