(BQ) Part 2 book Financial markets and institutions has contents The stock market, the mortgage markets, the foreign exchange market, the international financial system, banking and the management of financial institutions, financial regulation, the mutual fund industry,...and other contents.
Chapter 13 The Stock Market Preview In the last chapter we identified the capital they had returned to record highs before falling markets as the place where long-term securities back to 1997 levels in 2009 Since then the mar- trade We then examined the bond market and kets have fully recovered and reached record highs discussed how bond prices are established In this In this chapter we look at how this important mar- chapter we continue our investigation of the capital ket works markets by taking a close look at the stock market We begin by discussing the markets where The market for stocks is undoubtedly the one that stocks trade We then examine the fundamental receives the most attention and scrutiny Great theories that underlie the valuation of stocks These fortunes are made and lost as investors attempt to theories are critical to an understanding of the anticipate the market’s ups and downs We have forces that cause the value of stocks to rise and fall witnessed an unprecedented period of volatility over minute by minute and day by day We will learn that the last decade Stock indexes hit record highs in determining a value for a common stock is very dif- the late 1990s, largely led by technology compa- ficult and that it is this difficulty that leads to so nies, and then fell precipitously in 2000 By 2007 much volatility in the stock markets 297 298 Part 5 Financial Markets Investing in Stocks A share of stock in a firm represents ownership A stockholder owns a percentage interest in a firm, consistent with the percentage of outstanding stock held Investors can earn a return from stock in one of two ways Either the price of the stock rises over time or the firm pays the stockholder dividends Frequently, investors earn a return from both sources Stock is riskier than bonds because stockholders have a lower priority than bondholders when the firm is in trouble, dividends are less assured, and stock price increases are not guaranteed Despite these risks, it is possible to make a great deal of money by investing in stock, whereas that is very unlikely by investing in bonds Another distinction between stock and bonds is that stock does not mature Ownership of stock gives the stockholder certain rights regarding the firm One is the right of a residual claimant: Stockholders have a claim on all assets and income left over after all other claimants have been satisfied If nothing is left over, they get nothing As noted, however, it is possible to get rich as a stockholder if the firm does well Most stockholders have the right to vote for directors and on certain issues, such as amendments to the corporate charter and whether new shares should be issued Notice that the stock certificate shown in Figure 13.1 does not list a maturity date, face value, or an interest rate, which were indicated on the bond shown in Chapter 12 Common Stock vs Preferred Stock There are two types of stock, common and preferred A share of common stock in a firm represents an ownership interest in that firm Common stockholders vote, receive dividends, and hope that the price of their stock will rise There are various Figure 13.1 Sapir Consolidated Airlines Stock chapter 13 The Stock Market 299 classes of common stock, usually denoted type A, type B, and so on Unfortunately, the type does not have any meaning that is standard across all companies The differences among the types usually involve either the distribution of dividends or voting rights It is important for an investor in stocks to know exactly what rights go along with the shares of stock being contemplated Preferred stock is a form of equity from a legal and tax standpoint However, it differs from common stock in several important ways First, because preferred stockholders receive a fixed dividend that never changes, a share of preferred stock is as much like a bond as it is like common stock Second, because the dividend does not change, the price of preferred stock is relatively stable Third, preferred stockholders not usually vote unless the firm has failed to pay the promised dividend Finally, preferred stockholders hold a claim on assets that has priority over the claims of common shareholders but after that of creditors such as bondholders Less than 25% of new equity issues are preferred stock, and only about 5% of all capital is raised using preferred stock This may be because preferred dividends are not tax-deductible to the firm like bond interest payments Consequently, issuing preferred stock usually costs the firm more than issuing debt, even though it shares many of the characteristics of a bond How Stocks Are Sold Literally billions of shares of stock are sold each business day in the United States The orderly flow of information, stock ownership, and funds through the stock markets is a critical feature of well-developed and efficient markets This efficiency encourages investors to buy stocks and to provide equity capital to businesses with valuable growth opportunities We traditionally discuss stocks as trading on either an organized exchange or over the counter Recently, this distinction is blurring as electronic trading grows in both volume and influence Go Online Find listed companies, member information, real-time market indices, and current stock quotes at www.nyse.com Organized Securities Exchanges Historically, the New York Stock Exchange (NYSE) has been the best known of the organized exchanges The NYSE first began trading in 1792, when 24 brokers began trading a few stocks on Wall Street The NYSE is still the world’s largest and most liquid equities exchange The traditional definition of an organized exchange is that there is a specified location where buyers and sellers meet on a regular basis to trade securities using an open-outcry auction model As more sophisticated technology has been adapted to securities trading, this model is becoming less frequently used The NYSE currently advertises itself as a hybrid market that combines aspects of electronic trading and traditional auctionmarket trading In March of 2006, the NYSE merged with Archipelago, an electronic communication network (ECN) firm On April 4, 2007, the NYSE Euronext was created by the combination of the NYSE Group and Euronext N.V NYSE Euronext completed acquisition of the American stock exchange in 2009 There are also major organized stock exchanges around the world The most active exchange in the world is the Nikkei in Tokyo Other major exchanges include the London Stock Exchange in England, the DAX in Germany, and the Toronto Stock Exchange in Canada To have a stock listed for trading on one of the organized exchanges, a firm must file an application and meet certain criteria set by the exchange designed to enhance trading For example, the NYSE encourages only the largest firms to list so that transaction volume will be high There are several ways to meet the minimum 300 Part 5 Financial Markets listing requirements Generally, the firm must have substantial earnings and market value (greater than $10 million per year and $100 million market value) Over 8,000 companies around the world list their shares on the NYSE Euronext The average firm on the exchange has a market value of $19.6 billion On October 28, 1998, the NYSE volume topped billion shares for the first time.1 By 2013, daily volume was usually in excess of billion shares with billion shares being traded on peak days Regional exchanges, such as the Philadelphia, are even easier to list on Some firms choose to list on more than one exchange, believing that more exposure will increase the demand for their stock and hence its price Many firms also believe that there is a certain amount of prestige in being listed on one of the major exchanges They may even include this fact in their advertising There is little conclusive research to support this belief, however Microsoft, for example, is not listed on any organized exchange, yet its stock had a total market value of over $250 billion in 2013 Over-the-Counter Markets If Microsoft’s stock is not traded on any of the organized stock exchanges, where does it sell its stock? Securities not listed on one of the exchanges trade in the over-the-counter (OTC) market This market is not organized in the sense of having a building where trading takes place Instead, trading occurs over sophisticated telecommunications networks One such network is called the National Association of Securities Dealers Automated Quotation System (NASDAQ) This system, introduced in 1971, provides current bid and ask prices on about 3,000 actively traded securities Dealers “make a market” in these stocks by buying for inventory when investors want to sell and selling from inventory when investors want to buy These dealers provide small stocks with the liquidity that is essential to their acceptance in the market Total volume on the NASDAQ is usually slightly lower than on the NYSE; however, NASDAQ volume has been growing and occasionally exceeds NYSE volume Not all publicly traded stocks list on one of the organized exchanges or on NASDAQ Securities that trade very infrequently or trade primarily in one region of the country are usually handled by the regional offices of various brokerage houses These offices often maintain small inventories of regionally popular securities Dealers that make a market for stocks that trade in low volume are very important to the success of the over-the-counter market Without these dealers standing ready to buy or sell shares, investors would be reluctant to buy shares of stock in regional or unknown firms, and it would be very difficult for start-up firms to raise needed capital Recall from Chapter that the more liquid an asset is, the greater the quantity demanded By providing liquidity intervention, dealers increase demand for thinly traded securities Organized vs Over-the-Counter Trading There is a significant difference between how organized and OTC exchanges operate Organized exchanges are characterized as auction markets that use floor traders who specialize in particular stocks These specialists oversee and facilitate trading in a group of stocks Floor traders, representing various brokerage firms with buy and sell orders, meet at the trading post on the exchange and learn about current bid and ask prices These quotes are called out loud In about 90% of trades, the specialist matches buyers with sellers In the other 10%, the specialists may intervene by taking ownership of the stock themselves or by selling stock from inventory It is the specialist’s duty to maintain an orderly market in the stock even if that means buying stock in a declining market NYSE Fact Book, www.nyse.com chapter 13 The Stock Market 301 About one of four orders on the New York Stock Exchange is filled by floor traders personally approaching the specialist on the exchange The other three-quarters of trades are executed by the SuperDOT system (Super Designated Order Turnaround system) The SuperDOT is an electronic order routing system that transmits orders directly to the specialist who trades in a stock This allows for much faster communication of trades than is possible using floor traders SuperDOT is for trades under 100,000 shares and gives priority to trades of under 2,100 shares About 75% of orders to buy or sell on the NYSE are executed using this system Whereas organized exchanges have specialists who facilitate trading, over-thecounter markets have market makers Rather than trade stocks in an auction format, they trade on an electronic network where bid and ask prices are set by the market makers There are usually multiple market makers for any particular stock They each enter their bid and ask quotes Once this is done, they are obligated to buy or sell at least 1,000 securities at that price Once a trade has been executed, they may enter a new bid and ask quote Market makers are important to the economy in that they assure there is continuous liquidity for every stock, even those with little transaction volume Market makers are compensated by the spread between the bid price (the price they pay for stocks) and ask price (the price they sell the stocks for) They also receive commissions on trades Although NASDAQ, the NYSE, and the other exchanges are heavily regulated, they are still public for-profit businesses They have shareholders, directors, and officers who are interested in market share and generating profits This means that the NYSE is vigorously competing with NASDAQ for the high-volume stocks that generate the big fees For example, the NYSE has been trying to entice Microsoft to leave the NASDAQ and list with them for many years Electronic Communications Networks (ECNs) ECNs have been challenging both NASDAQ and the organized exchanges for business in recent years An ECN is an electronic network that brings together major brokerages and traders so that they can trade among themselves and bypass the middleman ECNs have a number of advantages that have led to their rapid growth • Transparency: All unfilled orders are available for review by ECN traders This provides valuable information about supply and demand that traders can use to set their strategy Although some exchanges make this information available, it is not always as current or complete as what the ECN provides • Cost reduction: Because the middleman and the commission are cut out of the deal, transaction costs can be lower for trades executed over an ECN The spread is usually reduced and sometimes eliminated • Faster execution: Since ECNs are fully automated, trades are matched and confirmed faster than can be done when there is human involvement For many traders this is not of great significance, but for those trying to trade on small price fluctuations, this is critical • After-hours trading: Prior to the advent of ECNs only institutional traders had access to trading securities after the exchanges had closed for the day Many news reports and information become available after the major exchanges have closed, and small investors were locked out of trading on this data Since ECNs never close, trading can continue around the clock Along with the advantages of ECNs there are disadvantages The primary one is that they work well only for stocks with substantial volume Since ECNs require there to be a seller to match against each buyer and vice versa, thinly traded stocks may 302 Part 5 Financial Markets go long intervals without trading One of the largest ECNs is Instinet It is mainly for institutional traders Instinet also owns Island, which is for active individual trades The major exchanges are fighting the ECNs by expanding their own automatic trading systems For example, the NYSE recently announced changes to its own Direct1 order routing system and merged with Archipelago to give it an established place in this market Although the NYSE still dominates the American stock market in terms of share and dollar volume, its live auction format may not survive technological challenges for many more years Exchange Traded Funds Exchange traded funds (ETFs) have become the latest market innovation to capture investor interest They were first introduced in 1990 and by 2010 nearly 1,000 separate ETFs were being traded In their simplest form, ETFs are formed when a basket of securities is purchased and a stock is created based on this basket that is traded on an exchange The makeup and structure are continuing to evolve, but ETFs share the following features: They are listed and traded as individual stocks on a stock exchange They are indexed rather than actively managed Their value is based on the underlying net asset value of the stocks held in the index basket The exact content of the basket is public so that intraday arbitrage keeps the ETF price close to the implied value In many ways ETFs resemble stock index mutual funds in that they track the performance of some index, such as the S&P 500 or the Dow Jones Industrial Average They differ in that ETFs trade like stocks, so they allow for limit orders, short sales, stop-loss orders, and the ability to buy on margin ETFs tend to have lower management fees than comparable index mutual funds For example, the Vanguard extended market ETF reports an expense ratio of 08% compared to an expense ratio of 25% for its extended market index mutual fund Another advantage of ETFs is that they usually have no minimum investment amount, whereas mutual funds often require $3,000–$5,000 minimums The primary disadvantage of ETFs is that since they trade like stocks, investors have to pay a broker commission each time they buy or sale shares This provides a cost disadvantage compared to mutual funds for those who want to frequently invest small amounts, such as through a 401K ETFs feature some of the more exotic names found in finance, including Vipers, Diamonds, Spiders, and Qubes These names are derived from the index that is tracked or the name of the issuing firm For example, Diamonds are indexed to the Dow Jones Industrial Average, Spiders track the S&P 500, and Qubes follow the NASDAQ (ticker symbol QQQQ) Vipers are Vanguard’s ETFs The list of available indexes that can be tracked by purchasing ETFs is rapidly expanding to include virtually every sector, commodity, and investment style (value, growth, capitalization, etc.) Their popularity is likely to increase as more investors learn about how they can be effectively used as a low-cost way to help diversify a portfolio Computing the Price of Common Stock One basic principle of finance is that the value of any investment is found by computing the value today of all cash flows the investment will generate over its life For example, a commercial building will sell for a price that reflects the net cash flows (rents – expenses) it is projected to have over its useful life Similarly, we value chapter 13 The Stock Market 303 common stock as the value in today’s dollars of all future cash flows The cash flows a stockholder may earn from stock are dividends, the sales price, or both To develop the theory of stock valuation, we begin with the simplest possible scenario This assumes that you buy the stock, hold it for one period to get a dividend, then sell the stock We call this the one-period valuation model The One-Period Valuation Model Go Online Access http://stockcharts com/freecharts/historical for detailed stock quotes, charts, and historical stock data Suppose that you have some extra money to invest for one year After a year you will need to sell your investment to pay tuition After watching Wall Street Week on TV you decide that you want to buy Intel Corp stock You call your broker and find that Intel is currently selling for $50 per share and pays $0.16 per year in dividends The analyst on Wall Street Week predicts that the stock will be selling for $60 in one year Should you buy this stock? To answer this question you need to determine whether the current price accurately reflects the analyst’s forecast To value the stock today, you need to find the present discounted value of the expected cash flows (future payments) using the formula in Equation of Chapter in which the discount factor used to discount the cash flows is the required return on investments in equity The cash flows consist of one dividend payment plus a final sales price, which, when discounted back to the present, leads to the following equation that computes the current price of the stock P0 = where Div1 P1 + (1) (1 + ke) (1 + ke) P0 the current price of the stock The zero subscript refers to time period zero, or the present Div1 the dividend paid at the end of year ke the required return on investments in equity P1 the price at the end of the first period This is the assumed sales price of the stock EXAMPLE 13.1 Stock Valuation: One-Period Model Find the value of the Intel stock given the figures reported above You will need to know the required return on equity to find the present value of the cash flows Since a stock is more risky than a bond, you will require a higher return than that offered in the bond market Assume that after careful consideration you decide that you would be satisfied to earn 12% on the investment Solution Putting the numbers into Equation yields the following: P0 = 16 $60 + = $.14 + $53.57 = $53.71 + 0.12 + 0.12 Based on your analysis, you find that the stock is worth $53.71 Since the stock is currently available for $50 per share, you would choose to buy it Why is the stock selling for less than $53.71? It may be because other investors place a different risk on the cash flows or estimate the cash flows to be less than you 304 Part 5 Financial Markets The Generalized Dividend Valuation Model The one-period dividend valuation model can be extended to any number of periods The concept remains the same The value of stock is the present value of all future cash flows The only cash flows that an investor will receive are dividends and a final sales price when the stock is ultimately sold The generalized formula for stock can be written as in Equation P0 = D1 + (1 + ke) D2 (1 + ke) + g + Dn Pn (2) n + (1 + ke) (1 + ke)n If you were to attempt to use Equation to find the value of a share of stock, you would soon realize that you must first estimate the value the stock will have at some point in the future before you can estimate its value today In other words, you must find Pn in order to find P0 However, if Pn is far in the future, it will not affect P0 For example, the present value of a share of stock that sells for $50 seventy-five years from now using a 12% discount rate is just one cent [$50>(1.1275) = $0.01] This means that the current value of a share of stock can be found as simply the present value of the future dividend stream The generalized dividend model is rewritten in Equation without the final sales price ∞ Dt P0 = a t (3) t = (1 + ke) Consider the implications of Equation for a moment The generalized dividend model says that the price of stock is determined only by the present value of the dividends and that nothing else matters Many stocks not pay dividends, so how is it that these stocks have value? Buyers of the stock expect that the firm will pay dividends someday Most of the time a firm institutes dividends as soon as it has completed the rapid growth phase of its life cycle The stock price increases as the time approaches for the dividend stream to begin The generalized dividend valuation model requires that we compute the present value of an infinite stream of dividends, a process that could be difficult, to say the least Therefore, simplified models have been developed to make the calculations easier One such model is the Gordon growth model, which assumes constant dividend growth The Gordon Growth Model Many firms strive to increase their dividends at a constant rate each year Equation rewrites Equation to reflect this constant growth in dividends P0 = D0 * (1 + g)1 (1 + ke) + D0 * (1 + g)2 (1 + ke) + g + D0 * (1 + g) ∞ (4) (1 + ke) ∞ where D0 the most recent dividend paid g the expected constant growth rate in dividends ke the required return on an investment in equity chapter 13 The Stock Market 305 Equation has been simplified using algebra to obtain Equation 5.2 P0 = D0 * (1 + g) D1 = (5) (ke - g) (ke - g) This model is useful for finding the value of stock, given a few assumptions: Dividends are assumed to continue growing at a constant rate forever Actually, as long as they are expected to grow at a constant rate for an extended period of time (even if not forever), the model should yield reasonable results This is because errors about distant cash flows become small when discounted to the present The growth rate is assumed to be less than the required return on equity, ke Myron Gordon, in his development of the model, demonstrated that this is a reasonable assumption In theory, if the growth rate were faster than the rate demanded by holders of the firm’s equity, in the long run the firm would grow impossibly large EXAMPLE 13.2 Stock Valuation: Gordon Growth Model Find the current market price of Coca-Cola stock assuming dividends grow at a constant rate of 10.95%, D 0 = $1.00, and the required return is 13% Solution P0 = D0 * (1 + g) ke - g P0 = $1.00 * (1.1095) 13 - 1095 P0 = $1.1095 = $54.12 0.0205 Coca-Cola stock should sell for $54.12 if the assumptions regarding the constant growth rate and required return are correct To generate Equation from Equation 4, first multiply both sides of Equation by (1 + ke)>(1 + g) and subtract Equation from the result This yields P0 * (1 + ke) (1 + g) - P = D0 - D0 * (1 + g) ∞ (1 + ke) ∞ Assuming that ke is greater than g, the term on the far right will approach zero and can be dropped Thus, after factoring P0 out of the left side, Next, simplify by combining terms to P0 * c P0 * P0 = + ke + g - d = D0 (1 + ke) - (1 + g) (1 + g) D0 * (1 + g) ke - g = = D0 D1 ke - g 306 Part 5 Financial Markets Price Earnings Valuation Method Theoretically, the best method of stock valuation is the dividend valuation approach Sometimes, however, it is difficult to apply If a firm is not paying dividends or has a very erratic growth rate, the results may not be satisfactory Other approaches to stock valuation are sometimes applied Among the more popular is the price/earnings multiple The price earnings ratio (PE) is a widely watched measure of how much the market is willing to pay for $1 of earnings from a firm A high PE has two interpretations A higher-than-average PE may mean that the market expects earnings to rise in the future This would return the PE to a more normal level A high PE may alternatively indicate that the market feels the firm’s earnings are very low risk and is therefore willing to pay a premium for them The PE ratio can be used to estimate the value of a firm’s stock Note that algebraically the product of the PE ratio times expected earnings is the firm’s stock price P * E = P (6) E Firms in the same industry are expected to have similar PE ratios in the long run The value of a firm’s stock can be found by multiplying the average industry PE times the expected earnings per share EXAMPLE 13.3 Stock Valuation: PE Ratio Approach The average industry PE ratio for restaurants similar to Applebee’s, a pub restaurant chain, is 23 What is the current price of Applebee’s if earnings per share are projected to be $1.13? Solution Using Equation and the data given we find: P0 = P>E * E P0 = 23 * $1.13 = $26 The PE ratio approach is especially useful for valuing privately held firms and firms that not pay dividends The weakness of the PE approach to valuation is that by using an industry average PE ratio, firm-specific factors that might contribute to a long-term PE ratio above or below the average are ignored in the analysis A skilled analyst will adjust the PE ratio up or down to reflect unique characteristics of a firm when estimating its stock price Index Mahathir Mohamad, 385 Main refinancing operations, 227 Malaysia, 385 Managed care, 518 Managed float regimes (dirty float), 374, 380, 384 Management of expectations, 226–27 Managerial expertise, 485 Managers, 359 Mandate-consistent inflation, 236 Marché Terme International de France, 590 Marginal lending facility, 228 Marginal lending rate, 228 Margin credit, 548 Margin requirements, 190, 592 Marine insurance, 513 Mark (German currency), 375, 381, 383 Marked to market, 592–93, 602 Market See Stock markets Market-clearing price, 71 Market efficiency See Efficient market hypothesis Market equilibrium in bond markets, 70, 71–72 defined, 71 for reserves, 210–11, 211f, 212 Market fundamentals, 128 Market makers, 301, 549, 611 Market order, 547 Market rate, 291t Market rates, 320 Market segmentation theory, 96, 101–2 Market timing, 503 Market value, 61 Mark-to-market accounting, 429, 430 Martin, William McChesney, Jr., 189n, 192, 196n MasterCharge (MasterCard), 454 Matched sale–purchase transaction (reverse repo), 218 Mattel, 544 Maturity, 18, 291t See also Term to maturity; Yield to maturity Maturity bucket approach, 569–70 Maturity date, 37 Maximum acceptable price, 547 MBIA, 525 McCain, John, 437n McCarran-Ferguson Act (1945), 521 McFadden Act (1927), 435t, 468, 471 McKinney, Stewart, 422 Mean reversion, 124 Mean-reverting interest rates, 101n Medicaid, 518 Medicare, 518 Mergers of banks, 190, 191, 472, 474, 480 defined, 545 policies on, 284 Mergers and acquisitions market, 545–46 Merrill Lynch, 159, 179, 255, 270, 278, 461–62, 475, 493, 539, 540, 546, 548, 550, 552 Mexico, 314, 386–87 Micro hedge, 589 Microprudential supervision, 431 Microsoft, 300, 301, 467, 553 Excel, 10, 12f MidAmerica Commodity Exchange, 590 Milken, Michael, 287, 457–58, 545–46 Miller, Merton, 596 Minimum acceptable price, 547 Ministry of Finance, Japan, 203 Moffat, Robert, 120 Mondex, 457 Monetary base, 207, 207n, 209 Monetary liabilities, 207 See also Liabilities Monetary policy, 206–49 bubbles and, 241 central banks and, 7, 183, 200–203 defined, easing of, 191 European Central Bank and, 200–201, 227–28, 233, 235, 378 Federal Reserve banks and, 188 Federal Reserve System and, 7, 183, 189–90, 194–99, 233, 262 fiscal policy and, 197 future, 372n goals of, 201, 203, 228–34, 242 impacts of, 175 inflation and, 196–97, 202 policy trilemma, 377, 378f risk taking and, 240–41 tightening of, 191 Monetary Policy Report to the Congress, 195 Monetary policy tools conventional, 217–21 federal funds rate affected by, 212–15 nonconventional, 221–27 open market operations as, 217–18 Monetary unions, 377–79 Money, See also Money supply electronic money, 433, 456–57 high-powered, 224 at the money, 600 in the money, 600, 602 out of the money, 600, 602 smart, 130 Money center banks, 255, 263, 403, 539 Money market deposit accounts (MMDAs), 392–93 Money Market Investor Funding Facility (MMIFF), 223 Money market mutual funds (MMMFs), 27t, 28t, 493–95 checks, 30, 460, 493 I-15 defined, 30 development of, 458 distribution of assets, 495f features of, 138, 460, 464 net assets of, 494f panic of 2008, 461 shares, 30 Money markets, 250–72 cost advantages, 252–53 defined, 20, 251 need for, 251–52 participants, 254–56, 256t purpose of, 253–54 sample rates, 253, 253t Money market securities, 256–68 See also Commercial paper; Eurodollars; Repurchase agreements; U.S Treasury bills banker’s acceptances, 267 characteristics of, 20, 250, 251 commercial banks and, 255 comparing, 268–70 federal funds, 260–61 interest rates on, 268–69, 269f liquidity of, 269 negotiable certificates of deposit, 263, 264f secondary markets for, 253, 269–70, 270t value calculations for, 270 Money supply control of, 199n foreign exchange interventions and, 368–70 impacts on, 207–10 open market operations and, 191 Monitoring credit risk management and, 563–64 of financial information, 146 of restrictive covenants, 564 Monoline insurance companies, 525–26 Montgomery Securities, 540 Moody’s Investor Service, 141, 157 bond ratings, 90, 90t, 286, 286t Moral hazard credit risk management and, 563 in debt contracts, 147–50 defined, 25, 139, 145 in equity contracts, 145–46, 147 examples of, 283, 410 financial crises and, 165, 167, 220, 386–87 financial intermediaries and, 25–26, 147 financial structure and, 145–51 government safety nets and, 421–22 insurance and, 25n, 510–11, 521 principal-agent problem, 145–46 regulation and, 30–31 tools for solving, 148–50, 323 I-16 Index Morgan Guaranty Trust Company, 82 Morgan Stanley, 156, 159, 450, 475, 533, 539 Morningstar, 507 Mortgage-backed securities as collateral, 176 defined, 172, 331 purchases of, 224–25 underwriting, 173 Mortgage bankers, 319 Mortgage Bankers Association, 334 Mortgage bonds, 285 Mortgage brokers, 319 Mortgage interest rates, 320–22, 324–26 discount points and, 320–22, 322t loan terms and, 320 market rates, 320 for mortgages and long-term Treasury rates, 321f Mortgage-lending institutions, 319, 327–30, 329f Mortgage markets, 318–38 characteristics of, 318 financial innovation in, 172 Great Depression and, 319–20, 330 online, 330 principal-agent problem in, 172–73, 320 secondary, 320, 324, 330–31 share held by mortgage-lending institutions, 328, 329f Mortgage pass-throughs defined, 331 Freddie Mac, 333 Ginnie Mae, 332–33 private pass-throughs, 333 Mortgage pools and trusts, 331–32 mortgages held by, 328, 329f value of, 332f Mortgages See also Subprime mortgage crisis; Subprime mortgage loans adjustable-rate, 325–26, 328t, 334, 452–53 amortization of, 324, 325t amortized, 319 balloon loans, 319–20 banks and, 319, 320, 328–31 borrower distribution, 319t borrower qualification, 323–24 closing for, 320–21 collateral for, 322–23 conventional, 325, 328t defaults on, 169, 172, 176, 323, 327, 335 defined, 319 down payments and, 323 fixed-rate, 41–42, 325–26 graduated-payment, 326, 328t growing-equity mortgages, 326–27, 328t held by federal agencies, 328, 329f history of, 319–20 insured, 325, 328t, 330 interest-rate risk and, 567–68 jumbo, 333 life insurance companies and, 516–18, 517f loan proceeds, 323 loan servicing, 328–29 loan terms for, 320, 322–24 originate-to-distribute model, 172, 320 piggyback, 174, 323, 327 refinance, 326 residential, 320–24 reverse annuity, 327, 328t second, 323, 327, 328t securitized, 331, 335 teaser loans, 334 types of, 325–27, 328t underwater, 176 uninsured, 331 variable-rate, 452, 567–68 Municipal bonds, 280–82, 282f, 492 defined, 280 interest rates and, 88, 92–95, 94f, 281 risk and, 281–82 taxes and, 92–95, 94f, 280–82 Mutual Benefit Life, 518 Mutual fund industry, 483–507 abuses, 501–4 conflicts of interest in, 501–4 Mutual funds, 27t, 28t benefits of, 484–85 bond funds, 492–93, 492f capital appreciation, 492 closed-end, 488, 555 cost advantages, 485 deferred-load funds, 496 defined, 30, 138, 488 equity funds, 490–92 fee structure of, 496–97 4:00 p.m valuation rule, 504 for 401(k) plans, 487, 488f growth of, 484 hedge funds, 498–500, 499f hybrid funds, 493–96 independent directors of, 498, 504 index funds, 495–96 interest-rate risk of, 54 investment objective classes, 490–93, 491f load funds, 496 net asset value, 489–90 no-load, 128, 496 open-end, 488–89 organizational structure of, 489–90, 491f origins of, 484 ownership of, 485, 487, 487f performance of, 119–20 regulation of, 497–98 retirement, 487 shareholders, 30, 138, 489, 497–98, 501–3 structure of, 488–90 total net assets, number of funds and accounts, 485, 486t–487t trading in foreign stock markets, 22 Mutual insurance companies, 512–13 Mutual savings banks, 27t, 28–29, 476–77 N Named-peril policies, 520 NASDAQ (National Association of Securities Dealers Automated Quotation System), 19, 129, 300, 301, 302, 314, 549 Nasdaq Composite, 23, 312 National Banking Act (1863), 319, 450 National banks, 188, 427, 450 National Bureau of Economic Research, 56 National Central Banks (NCBs), 200–201 National Credit Union Administration (NCUA), 31t, 477 National Credit Union Share Insurance Fund (NCUSIF), 33, 477 National debt, funding of, 253–54, 256, 274, 275 National principal, 605 National Steel, 533 NationsBank, 472, 540 Nationwide banking, 469–73 Natural rate of output, 231 Natural rate of unemployment, 231, 232, 233 Navy Federal Credit Union, 477 Negative interest rates, 47, 81–82, 222, 222n Negotiable certificates of deposit (CDs), 263, 264f, 400n Net asset value (NAV), 489–90 Netherlands, 475 Net income, 412–13 Net interest margin (NIM), 413, 568 Net receipts, 372 Netscape, 553 Net stable funding ratio (NSFR), 433 Net worth adverse selection and, 144 calculation of, 570n debt contracts and, 148–49 decline in, 169 defined, 144 duration gap analysis and, 570–76, 570n The New Finance (Haugen), 308 New York Futures Exchange, 590 New York Stock Exchange (NYSE), 19, 159, 187, 299–302, 549 Index Direct + order routing system, 302 listings on, 21, 299–300 on program trading, 596 New Zealand, 203, 233, 234, 237 Nikkei 225, 590 Nikkei 300 Average, 22 Nikkei stock exchange, 299, 409 NINJA loans, 324, 432 Nippon Ginko (Bank of Japan), 203, 237 No Doc loans, 324, 432 No-load mutual funds, 128, 496 Nominal anchor, 229, 234 Nominal interest rates, 46–50, 49f, 49n, 64, 222, 222n See also Interest rates real interest rates and, 356–58, 357f Nonbank corporations, 264 Nonbanking financial institution, 574–75 Nonbank loans, 134, 134f Nonborrowed reserves (NBR), 212, 242–43, 242f, 243f Noncompetitive bidding, 259 Nonconventional monetary policy tools, 221–27 Noninterest expenses, banks, 412 Noninterest income, banks, 410–11 Nontransaction deposits, 393–94 Northern Rock, 177 Note issuance facilities (NIFs), 408 Notional principal, 605, 608 Now accounts, 392, 397 NYSE composite, 312 NYSE Euronext, 299–300 O Obama, Barack, 95, 432 Off-balance-sheet activities defined, 407, 424 fee income from, 408 loan sales, 407–8 risk management and, 408–9 trading activities, 408–10 Office of Federal Housing Enterprise Oversight (OFHEO), 279 Office of the Comptroller of the Currency, 31t, 32, 179n, 427, 450, 451, 474, 476 Office of Thrift Supervision, 476 Official reserve transactions balance, 373 Offshore deposits, 478, 478n Ohio Life Insurance and Trust Company, 168 100-Share Index (London), 22 One-period valuation model, 303 Online banking, 454–55 Online mortgage market, 330 Online research, 9–10 Open-end mutual funds, 488–89 Open interest, 590 Open market operations bonds and, 209 defensive, 217 defined, 188, 209 dynamic, 217 European Central Bank and, 227–28 Federal Reserve banks and, 187, 188, 189, 191 Federal Reserve System and, 209–10 as monetary policy tool, 217–18 money supply and, 191 open market desk, 187 response to, 212–13, 213f temporary, 217–18 Open-outcry auction model, 299 Open-peril policies, 520 Operating expenses, banks, 393, 411–12 Operating income, banks, 410–11, 412 Operating instrument, 241 See also Policy instruments Opportunity cost, 253, 402 Options, 598–605 credit options, 609 defined, 598 futures contract compared to, 599–602, 604 premium, 598, 602–4 profits and losses on, 599–602, 601f regulation of, 599 sellers and buyers of, 598 stock options, 285, 598 term to expiration, 598, 603 types of, 598 Organization for Economic Cooperation and Development, 424 Organized exchanges, 19, 275, 299–300 Organized securities exchanges, 275, 299–301 Originate-to-distribute model, 172, 320 Osaka Securities Exchange, 590 Other things being equal (ceteris paribus), 69, 78 Outright operation, 218 Overconfidence, 130 Overdraft privileges, 408 Overfunded pension plans, 527 Overnight cash rate, 227 Overregulation, 445 Oversubscribed issue, 543 Over-the-counter exchanges, 275 Over-the-counter (OTC) markets, 19–20, 300–301 Over-the-counter securities exchanges, 275 Overvalued exchange rate, 376f P Paid-in-capital, 555 Panama, 380 Paper loss, 53 Parmalat, 142 I-17 Participation certificates (PCs), 333 Par value, 39, 275, 289, 291t Pass-throughs mortgage, 331, 332–33 private, 333 Patient Protection and Affordable Care Act (2010), 519 Paul, Ron, 195 Payable on demand accounts, 393 Payoff method, 420, 422 Pecking order hypothesis, 144 Pension Benefit Guarantee Corporation (PBGC) (Penny Benny), 533–34, 534f Pension fund manager, 529 Pension funds, 27t, 28t defined, 29 future of, 535 investment in, 508 life insurance companies and, 516 as money market participants, 256 prudent man rule and, 555 Pension plans, 526–35 defined, 526 defined-benefit, 527, 527n defined-contribution, 485, 527–28 failures during Great Depression, 532 fully funded, 527 overfunded, 527 power of, 529 private, 528, 528f public, 528–32 regulation of, 532–35 Social Security, 529–32, 530f, 531f taxes and, 530, 532 types of, 527–32 underfunded, 527 Pension Protection Act (2006), 534 Pension Reform Act (1978), 534 Perfect substitutes, 97, 109 Performance measurement, banks, 410–15 income statements, 410–12, 411t trends in, 413–15, 414t Perpetuities (consols), 44–45 Peseta, Spanish, 382 Peso/dollar exchange rate, 379 Piggyback mortgages, 174, 323, 327 Piper, 520 Placid Oil Company, 593 Plain vanilla swap, 605 Points, 320–22, 322t Policy instruments, 241–45 criteria for choosing, 243–45 Policy interest rate See Federal funds rate Policy trilemma, 377, 378f Political business cycle, 196–97 Portfolio balance effect, 372n Portfolio insurance, 596 I-18 Index Portfolios, 24, 58–59, 61 See also Theory of portfolio choice duration of, 58–59, 61 management costs, 128 Portugal, 177, 178, 386 Positive feedback loop, 130 Potential output, 231 Pound, British, 381–83, 381f “The Practicing Manager” cases, “Predicting the Future” problems, Preferred habitat theory, 102n Preferred stock, 298–99 Preferred stockholders, 299 Premium, bonds selling at, 292 Premiums insurance, 509, 513, 515–16, 515t, 522 options, 598, 602–4 risk premium, 89, 90, 92, 93 Prepayment risk, 331 Present value (present discounted value), 37–38, 46 Price earnings ratio (PE), 306 Price earnings valuation method, 306 Prices See also Asset prices; Bond prices; Stock prices domestic, 341 efficient market hypothesis and, 115–22, 121n, 125 housing, 158, 172, 174–76, 175f, 238 market setting securities, 307–8 Price stability defined, 228 as monetary policy goal, 201, 203, 228–29, 232, 233–34 Primary credit, 219 Primary credit facility, 219, 219n Primary Dealer Credit Facility (PDCF), 223 Primary dealers, 209, 218 Primary markets, 18–19, 538 Prime rate, 264, 265f Principal (funds), 37 Principal-agent problem defined, 145 examples of, 408–10 in mortgage markets, 172–73, 320 tools for solving, 146–47 Principals (stockholders), 145 Privacy concerns, 433, 455, 457 Private equity buyouts, 557–58 Private equity investment, 552–56 Private mortgage insurance (PMI), 323 Private pass-throughs (PIPs), 333 Private pension plans, 528, 528f Private placement, 543–44 Probability, of defaults, 173, 563 Problem banks, 427 Productivity, foreign exchange rates and, 346, 346n Profits, banks, 410–13 Program trading, 596 Property and casualty insurance, 513, 519–20 Property insurance, 519 Property rights, 152, 153 Proprietary trading, 443 Prospectus, 541 Prudential Insurance Company, 82, 512 Prudential supervision, 425, 427 Prudent man rule, 555 Public Accounting Return and Investor Protection Act See SarbanesOxley Act Public Company Accounting Oversight Board (PCAOB), 159, 429 Public interest view, 198 Public pension plans, 528–32 Purchase and assumption method, 420, 422, 438 Purchasing power parity (PPP), 343–45, 344f Pure arbitrage, 118 Putnam Investments, 502 Put option, 599–600, 602–3 Q Quantitative easing (QE), 224–26 Qubes, 302 Quotas, 346 Qwest, 157 R Raines, Franklin, 279 Rajaratnam, Raj, 120 Random walk defined, 120 of foreign exchange rates, 122 of stock prices, 120–22, 121n Rate of capital gain, 51–52, 55–56 Rate of return on bonds, 36, 50–61, 52t calculating, 50–53 on coupon bonds, 50–52, 52t, 53n defined, 50 interest rates and, 36, 50–61 Rate-sensitive assets and liabilities, 567–68 Reagan, Ronald, 195, 596 Real (Brazilian currency), 340 Real estate bubble, 334–35 Real estate mortgage investment conduits (REMICs), 333 Real exchange rate, 344 Real interest rates, 47–50, 49f, 259 after-tax, 49n ex ante and ex post, 47 loans and, 48–49, 49n nominal interest rates and, 356–58, 357f Real terms, 48 Recession causes of, 178, 328, 334 Great, 6, 179 impacts of, 73, 81, 107, 164, 314, 379 Reciprocal regional compacts, 470 Redemption fee, 496, 504 Redlining, 429–30 Refinancing operations, 227, 228 Regional securities market, 300 Registered bonds, 283 Registration statement, 541 Regulation, 21, 30–33, 418–47 See also Deregulation adverse selection and, 30–31 asset holdings restrictions and, 423–24 asymmetric information and, 30, 315, 419–34 banking crisis and, 427–38 of capital requirements, 424–25, 444 of commercial banks, 255, 263, 450–51 competition restrictions and, 430–31 consumer protection and, 429–30, 432, 442 disclosure requirements and, 428–29 electronic banking and, 431, 433 federal agencies, 31t of financial derivatives, 288, 443, 611 of financial futures markets, 590 of financial information, 30–32, 141–42, 146–47, 153 financial innovation for avoiding, 459–61 financial supervision and, 425, 427 of financial systems, 6, 30–33, 136, 418 future, 443–45 government safety nets and, 167, 279, 419–23 of insurance companies, 521 macroprudential regulation, 240–41 macroprudential supervision, 431–33 major legislation, 435t–436t, 551 microprudential supervision, 431 moral hazard and, 30–31 multiple regulatory agencies, 451 of mutual funds, 497–98 of options, 599 in other countries, 33, 434 overregulation, 445 of pension plans, 532–35 prompt corrective action, 425 purpose of, 30 reforms, 438, 439, 451 risk management and, 428 of securities firms, 550–51 of stock market, 314–15 systemic risk, 442 of thrifts, 476–77 types of, 32–33 Regulation B, 429 Regulation K, 479 Index Regulation Q, 33, 263, 438, 459–60, 464–65, 493 Regulation Z, 432 Regulatory agencies, 31t Regulatory arbitrage, 425 Regulatory forbearance, 534 Reinsurance, 520 Reinvestment risk, 53–54, 462 Relative price levels, 345–46 Renminbi (Chinese currency), 383 Repurchase agreements (repos), 261–62 defined, 176, 217, 394 interest rates on, 262 use of, 262 Required reserve ratio, 208, 394 Required reserves, 208, 211, 394 Required returns, 309, 309t Research conflicts of interest, investment banks and, 155–56 online, 9–10 Reserve accounts, 329 Reserve aggregates, 242–43 Reserve Bank of New Zealand, 233 Reserve currency, 375 Reserve Primary Fund, 495 Reserve requirements for banks, 252, 252n, 261, 459 on checkable deposits, 221, 221n defined, 210, 394 of European Central Bank, 228 of Federal Reserve, 189, 199, 210, 221, 261 response to, 214, 215f taxes and, 459 Reserves (bank assets) defined, 394 liquidity management and, 399–402 secondary, 395 Reserves (Federal Reserve deposits) borrowed, 208–9, 212 defined, 208 demand curve for, 210–11, 211f excess, 208, 211 federal funds rate and, 210–15, 243, 243f, 261 interest rates on, 211, 214–15, 215f, 221 market equilibrium for, 210–11, 211f, 212 nonborrowed, 212 required, 208, 211, 394 Reserves market, supply and demand analysis of, 242–43, 242f, 243f Residential mortgages, 320–24 See also Mortgages Residual claimants, 18, 298 Resolution authority, 442 Restrictive covenants, 427 collateral and, 149–50 on corporate bonds, 283–84 debt contracts and, 149–50 defined, 136–37, 283 financial information and, 150 monitoring and enforcement of, 564 Restrictive provisions, insurance companies, 522–23 Retailization, 500 Retirement mutual funds, 487 Return (rate of return), 36, 50–61 See also Rate of return Return on assets (ROA), 404–5, 412–13, 414t, 415 Return on equity (ROE), 405, 413–15, 414t Revaluation, of currencies, 376 Revenue bonds, 281, 282f Reverse annuity mortgages (RAMs), 327, 328t Reverse repo (matched sale-purchase transaction), 218 Reverse transactions, 227–28 Revolving underwriting facilities (RUFs), 408 Riegle-Neal Interstate Banking and Branching Efficiency Act (1994), 423, 436t, 471–72, 474 Riksban of Sweden, 202 Risk See also Credit risk; Default risk; Interest-rate risk asset demand and, 65, 66–68, 69t bond demand curve and, 74t, 75 defined, 24, 65 municipal bonds and, 281–82 prepayment risk, 331 reinvestment risk, 53–54, 462 U.S Treasury bills and, 258–59 Risk-averse individuals, 67, 326, 509 Risk-based insurance premiums, 522 Risk class, 522 Risk management Federal Reserve System and, 428 in financial institutions, 8, 167, 562–82 off-balance-sheet activities and, 408–9 regulation and, 428 Risk preferer or risk lover, 67 Risk premium, 89, 90, 92, 93 Risk sharing, 24 Risk structure of interest rates, 87, 88–95 Risk taking banks and, 465–66 financial crises and, 167, 385–86, 423, 466 lender of last resort and, 387 monetary policy and, 240–41 Risky assets, 24, 32, 68, 75 Robertson Stephens & Co., 540 Rolls-Royce PLC, 478 Roosevelt, Franklin Delano, 169–70 Royal Bank of Canada, 454 Russia, 229, 387 See also Soviet Union I-19 S Sallie Mae (Student Loan Marketing Association), 278–79 Salomon Brothers, 461–62 Salomon Smith Barney, 82, 159, 259, 260, 474, 550 San Francisco Chronicle, 126 Sapir Consolidated Airlines stock, 298f Sarbanes-Oxley Act (2002), 21, 158–59, 160, 429, 436t, 557 Savers, 73 Savings accounts, 393 Savings and loan associations (S&Ls), 27t, 28t, 320 bailouts, 424, 438 crisis of 1980s, 437–38, 437n defined, 28–29 interest rates and, 327, 567 regulation and structure of, 476 Savings deposits, 28, 252f Scam artists, 126, 330 Scandinavians, 455–56 SCAP See Supervisory Capital Assessment Program Scotland, 484 Screening credit risk management and, 563–64 by insurance companies, 522 Sears, 454 Seasonal credit, 219 Seasonal credit facility, 219n Seasoned issues, 541 Secondary credit, 219 Secondary credit facility, 219n Secondary loan participation, 407 Secondary markets, 18–19 in capital market trading, 275 defined, 18, 251, 538 for money market securities, 253, 269–70, 270t organization of, 19 Secondary mortgage markets, 320, 324, 330–31 Secondary reserves, 395 Second Bank of the United States, 184, 449–50 Second mortgages, 323, 327, 328t Secured bonds, 285 Secured debt, 136 Secured loans, 565 Securities See also Mortgage-backed securities; specific securities advertising, 542 advice on, 540–41 as assets, 395 best efforts agreement, 543 default risk of, 395 defined, 2, 16 easy access to, 136 I-20 Index Securities (continued) efficient market hypothesis and, 116–17 financial intermediaries compared to, 24 fully subscribed issue, 543 government securities, 208 hybrid, 462 insider trading and, 32 intrinsic value of, 128 investment-grade, 90 long-term, 269, 274, 277, 328 market setting prices for, 307–8 oversubscribed issue, 543 pricing, 19, 32, 540–41 primary markets for, 18–19, 538 private placement, 543–44 public offering process, 540–44, 544f secondary markets for, 18–19, 538 short-term, 20, 250, 251, 257, 274 state and local government, 395 term security, 263 undersubscribed issue, 543 underwriting, 19 unexploited profit opportunities and, 118–19 Securities Act (1933), 31, 314, 429, 435t, 497, 541, 551 Securities Acts Amendment (1975), 548 Securities and Exchange Commission (SEC), 30, 31t, 461 disclosure requirements and, 429, 497, 504 divisions in, 315 functions of, 31–32, 141, 142, 314–15, 474, 550, 599 investigations by, 157 reforms and, 158 registration with, 263, 541, 551 rules and requirements, 497, 498, 500, 501–4 Sarbanes-Oxley Act and, 159 Securities brokers, 302, 496, 538, 546, 546n Securities dealers, 538, 546, 546n, 549–50 Securities Exchange Act (1934), 314, 435t, 497, 541, 551 Securities firms commercial banks relationship with, 32, 552 regulation of, 550–51 Securities Investor Protection Corporation (SIPC), 548, 551 Securities orders, 547–48 Securities Protection Corporation Act (1970), 551 Securitization, 172, 331, 458, 465 See also Mortgage-backed securities Securitized mortgages, 331, 335 Security First Network Bank, 454 Seed investing, 556 Seigniorage, 380 Self-Employed Individuals Tax Retirement Act (1962), 534 Semiannual bonds, 290–92 Semistrong-form efficiency test, 121n Separate Trading of Registered Interest and Principal Securities (STRIPS), 278, 461–63, 463t September 11 terrorist attack, 310–11, 520 Sequoia Capital, 557 Series I savings bond, 50 Service transactions, 372 Settlement price, 592 Shadow banking system, 176–77, 431, 451 Shareholders, mutual funds, 30, 138, 489, 497–98, 501–3 Shares, 28, 29, 30 Shell operations, 479 Shiller, Robert, 124 Short position, 584, 586 Short sales, 130, 302, 547–48 Short-term debt instruments, 18, 53 Short-term interest rates, 10, 95, 97, 100, 101n, 102, 224–25 Short-term securities, 20, 250, 251, 257, 274 Silver market, 593 Simple interest rate, 37–38, 41 Simple loans, 37, 39, 40–41 Simple present value, 37–38 SIMPLE retirement plans, 534–35 Singapore, 478 Singapore Exchange, 23, 409 Sinking fund, 284 Small Business Protection Act (1996), 534 Small-denomination time deposits, 393 Small-firm effect, 123 Smart card, 456, 457 Smart money, 130 Snake, 375 Social contagion, 130 Social Security, 529–32, 530f, 531f Société Générale, 410 Soros, George, 383 Sources of funds, 27–28, 27t, 392, 403 See also Liabilities South Korea, 314 Sovereign debt crisis, 177, 178 Soviet Union, 154, 268 S&P 500 Index, 23 Spain, 177, 178, 234 Spanish peseta, 382 Special purpose vehicle (SPV), 173 Speculative attacks, on currencies, 380, 382 Speculative bubble, 130 Speculative-grade bonds, 91, 286–87 Spiders, 302 Spinning, 156 Spitzer, Eliot, 159, 504 Spot exchange rate, 341, 342, 347, 364 Spot rates, 109, 594n Spot transactions, 341 Spread, 546 See also Credit spreads SPV See Special purpose vehicle Standard and Poor’s Corporation, 141, 157, 177 bond ratings, 90, 90t, 286, 286t S&P 500 Index, 124, 302, 312, 595–96 Standard deviation, 66–67 Standing lending facility, 219 Staples, 553 Starbucks, 553 State and local government securities, 395 State and national municipal (muni) bonds, 492 State banking and insurance commissions, 31t, 32 State banks, 427, 450 State-owned banks, 153, 154 Sterilized foreign exchange interventions, 370, 371–72, 372n Stern, Edward J., 503 Stewart, Martha, 547 Stock company, 512 Stock funds, 490–92 Stockholders bondholders vs., 283, 293, 298, 299 common, 298 insiders, 32 preferred, 299 principals, 145 rights of, 18, 298–99 Stock index futures contracts, 595–98 Stock market crashes, See also Great Depression of 1929, 31, 169, 484 of 1987 (Black Monday), 3, 129, 387, 547, 596 of 2008, 179 of 2009, 310 efficient market hypothesis and, 129 Tech crash of 2000, Stock market indexes, 311–13 Stock market risk, 595 Stock markets, 297–317 anomalies and, 123, 123n business investment decisions and, defined, 3–4 financial crisis of 2007-2009 and, 310 in financial system, foreign, 22, 23 lemons problem and, 140 overreaction of, 124 Index practical guide to investing in, 125–28 price volatility, 3–4, 4f, 124, 297 regulation of, 314–15 September 11 terrorist attack and, 310–11 Stock options, 285, 598 Stock prices See also Stock valuation advice on, 540–41 computing, 302–6 convertible bonds and, 284–85 efficient market hypothesis and, 120–22, 121n, 124, 125 financial crisis of 2007-2009 and, 176–77, 177f, 310 fluctuations in, 309–10 for foreign stock markets, 22 good news and, 127 during Great Depression, 170–71, 170f January effect and, 123 overvalued, 130 publicly available information on, 120 random walk behavior of, 120–22, 121n required returns and, 309, 309t securities orders and, 547–48 technical analysis and, 121–22 volatility, 3–4, 4f, 124, 297 Stocks See also Common stocks; Initial public offerings of assets, 72 buy and hold strategy for, 128 defined, 3, 17 dividends, 298–99, 304, 309, 314 foreign, 314 hot tips on, 126–27 investing in, 298–302 issued, 293f mean reversion and, 124 preferred vs common, 298–99 sale of, 299–302 Sapir Consolidated Airlines stock, 298f underwriting, 540–44 valuation of, 297 Stock valuation, 302–6 See also Stock prices errors in, 308–11 estimating growth and, 308, 309t estimating risk and, 309 forecasting dividends and, 309 generalized dividend model, 304 Gordon growth model, 304–5, 308, 310–11 market and, 307–8 one-period valuation model, 303 price earnings valuation method, 306 Stop loss order, 302, 547 Stored-value card, 456, 457 Strait Times index, 23 Strategic income bonds, 492 Stress testing, 409, 428 Strike price, 598 STRIPS, 278, 461–63, 463t Strong-form efficiency test, 121n Structural unemployment, 231 Structured credit products, 172, 173 Structured investment vehicles (SIVs), 407 Student Loan Marketing Association (Sallie Mae), 278–79 Subordinated debentures, 285 Subprime mortgage crisis bailout of Fannie Mae and Freddie Mac and, 279–80 financial crisis of 2007-2009 and, 6, 91, 158, 164, 174–76, 266, 279–80, 310, 334, 475 monoline insurance and, 526 Subprime mortgage loans, 333–35, 432 credit-rating agencies and, 334, 526 defined, 172, 333 Federal Reserve System on, 432 Sumitomo Corporation, 410 Sun Microsystems, 553 SuperDOT system (Super Designated Order Turnaround system), 301 Superregional banks, 470 Supervisory Capital Assessment Program (SCAP), 179n Supply, excess, 71 Supply and demand analysis asset market approach, 72, 72n, 347 in bond markets, 68–72, 72n, 117 Bush tax cut, 94–95 forecasting interest rates, 82–83 of foreign exchange rates, 342, 347–49, 375 of reserves market, 242–43, 242f, 243f Supply curve for bonds, 70–71, 70f, 70n, 76–78, 76t, 77f business cycle expansion and, 77, 80–81, 80f defined, 70 for domestic assets, 347–48 expected inflation and, 77 government budget and, 77–78 investment profitability and, 77 shifts in, 72, 76–78, 76t, 77f Supply-side economics, 231 Survivorship benefits, 515 Swap lines, 223 Swaps See also Credit default swaps; Interest-rate swaps credit swaps, 609–10 currency swap, 605 defined, 605 plain vanilla swap, 605 Swaptions, 605 Sweden, 202, 203, 234, 382, 456 Sweep account, 460–61 Switzerland, 203, 444, 475 I-21 Syndicate, 542 Systemically important financial institutions (SIFIs), 442, 443 Systemic financial institutions, 442 Systemic risk regulation, 442 T T-accounts, 209–10, 368, 370, 396–98 Tails, 520 Takedowns, 555 Takeovers, 545 Target financing rate, 227 Tariffs, 346 Taxes Bush tax cut, 94–95 capital gain, 127n debt contracts and, 147n dividends and, 147n, 513 havens, 479 interest rates and, 49n, 92–95, 94f January effect and, 123 municipal bonds and, 92–95, 94f, 280–82 pension plans and, 530, 532 profits after, 412 reserve requirements and, 459 second mortgage deductions, 327 tariffs, 346 Treasury bonds and, 93n Tax Reform Act (1986), 534 Taylor, John, 175 Taylor rule, 175 TCBY, 553 Teal book, 193 Teaser loans, 334 Tech crash of 2000, Technical analysis, stock prices and, 121–22 Tech stock bubble, 167, 238–40 Temporary Guarantee Program, 495 Temporary open market operations, 217–18 Tender offer, 545 Term Asset-Backed Securities Loan Facility (TALF), 223 Term Auction Facility (TAF), 222, 223 Term life insurance, 514–15 Term Securities Lending Facility (TSLF), 223 Term security, 263 Term structure of interest rates, 95–111 defined, 87 evidence on, 105–7 expectations theory and, 96, 97–101, 101n, 103f forecasting interest rates and, 108–11 liquidity premium theory and, 96–97, 102–7, 103f, 106f market segmentation theory and, 96, 101–2 yield curves and, 95–96, 100–107, 106f I-22 Index Term to expiration, 598, 603 Term to maturity bonds and, 54–55, 87, 95 coupon bond and, 45, 55 duration and, 55–57 Terrorism Risk Insurance Act (2002), 520 Texaco, 529 Theory of bureaucratic behavior, 198–99 Theory of efficient capital markets, 116 See also Efficient market hypothesis Theory of portfolio choice assets and, 68, 347–48, 352 defined, 68 Theory of purchasing power parity (PPP), 343–45, 344f Third World debt crisis, 385–86, 412 Thrift institutions (thrifts), 28 See also Credit Unions; Mutual savings banks; Savings and loan associations deposit insurance in, 476–77 deregulation of, 438 market share of, 463, 464f as mortgage-lending institution, 327–28 regulation and structure of, 476–77 Tightening of monetary policy, 191 Time deposits, 28, 393 Time-inconsistency problem, 229–30 TIPS (Treasury Inflation Protection Securities), 50, 278 Title insurance, 323 Title search, 323 Tokyo Stock Exchange, 590 Tombstones, 542 Too big to fail problem, 220, 422–23, 443–44 Toronto Stock Exchange, 299 Total return funds, 492 Toyota, 467, 533 Trade, international, 477–79 Trade balance, 372 Trade barriers, 346 Trading activities, by banks, 408–10 Trading Activities Manual, 428 Tranches, 173, 333 Transaction costs defined, 23 economies of scale and, 23, 138 financial intermediaries and, 23–24, 137–38 financial structure and, 137 Transparency, 194, 199, 234, 301, 504 Travelers Companies, 311 Travelers Group, 474 Treasury Inflation Protection Securities (TIPS), 50, 278 Treasury Investment Growth Fund (TIGRs), 278 Truth in Lending Act, 429, 432 Twain, Mark, 457 12b-1 fees, 496 Two-handed interventions, 194 Tyco International, 146 U UBS Warburg, 159 Uncertainty, during financial crises, 168 Unconditional commitments, 226–27 Underfunded pension plans, 527 Undersubscribed issue, 543 Undervaluation of yuan, 383 Underwater mortgages, 176 Underwriters global debt and equity issues, 542t insurance, 511–12 Underwriting, 542–43 defined, 19 investment banks and, 155–56, 540–44 mortgage-backed securities, 173 stocks and bonds, 540–44 Unemployment, 230–31, 232, 233 Unexploited profit opportunities, 118–19, 129–30 Unilateral transfers, 372–73 Uninsured mortgages, 331 United Health Group, 311 United Kingdom, 177, 202, 234 banking industry in, 467, 472 foreign exchange crisis and, 381–83 purchasing power parity and, 344, 344f universal banking in, 475 United States (U.S.) banking overseas, 478–79 capital markets, 21, 160 claims on foreign wealth, 373, 373n debt default, 259 foreign banks in, 479–80 funding of national debt, 253–54, 256, 274, 275 Universal banking, 475 Universal life insurance, 515–16 Unsecured bonds, 285 Unsecured debt, 136 Unsterilized foreign exchange interventions, 370–71, 370n, 371f U.S Congress budget negotiations, 89 Federal Reserve System and, 184–85, 195–99 lobbying in, 279 U.S Department of Agriculture, 590 U.S Department of Labor, 533, 555 U.S dollar See also Eurodollars; Foreign exchange rates break the buck, 266 deposits denominated in dollars, 342 euro and, 5, 363–65, 364n exchange rates, 5–6, 5f, 232, 339, 379 financial crisis of 2007-2009 and, 358 gold and, 375 interest rates and, 356–58, 357f international bond market and, 20–21 as reserve currency, 375 yuan and, 383–84 Used-car market, 139–40, 142–43 Uses of funds, 27t, 28, 82, 394, 397 See also Assets U.S Flow of Funds report, 35 U.S government and agency securities, 395 U.S government bonds over-the-counter trading of, 19–20 yield curves for, 108f U.S Supreme Court, 473, 532 U.S Treasury Exchange Stabilization Fund, 369 Federal Reserve System and, 197, 217 foreign exchange interventions by, 369 liabilities of, 207, 207n long-term rates, 321f as money market participant, 255 regulation reforms and, 438, 439, 451 requirements of, 179n role of, 178, 421, 525 Series I savings bond, 50 STRIPS, 278, 461–63, 463t Temporary Guarantee Program, 495 TIPS, 50, 278 U.S Treasury bills (T-bills), 256–60 auctions, 257–60, 257t interest rates on, 2–3, 47, 48, 49f, 79f, 80, 81f, 252f, 259, 260f, 261, 262f, 277, 277f, 452 issues of, 255, 256–57 liquidity of, 68 national debt funded with, 253–54, 256 risk and, 258–59 U.S Treasury bonds, 275–79 credit spreads, 171f default-free, 88–90, 91 default risk and, 88–91, 276, 276n defined, 2n forward contracts, 584–85 futures contracts, 586–88, 591–92, 599–602, 601f interest rates on, 50, 92–95, 94f, 276–78, 277f liquidity of, 92 purchase of, 197, 197n taxes and, 93n U.S Treasury notes, 275–76 U.S Treasury securities See also U.S Treasury bills; U.S Treasury bonds; U.S Treasury notes discounting, 257–58 involvement in, 187, 224, 358 maturity differences among, 275, 276t yield curves for, 95, 96 Index V Value-at-risk (VaR) calculations, 409, 428 Value Line, 141 Value Line Survey, 123n Vanguard ETFs, 302 Vanguard Group, 54, 496 Vanguard S&P 500 index fund, 489, 495 Variable-rate bonds, 285 Variable-rate mortgages, 452, 567–68 Vault cash, 208, 394 Venture capital firms, 552–56 asymmetric information and, 553–54 functions of, 147, 538 industry description, 552–53 investments, 553t, 556, 557 operation of, 555–56 origins of, 554–55 profitability of, 556 structure of, 555 Vesting, 532 Veterans Administration (VA), 278, 325 Vipers, 302 Virtual bank, 454–55 Visa, 454 Volcker, Paul A., 192, 196n, 443 Volcker Rule, 443, 444 Voting rights, of stockholders, 18, 298–99 W Wall Street Journal, 495 Dow Jones Industrial Average and, 311 financial futures contracts in, 590 on forecasting foreign exchange rates, 359 on forecasting interest rates, 83 “Heard on the Street,” 125 “Investment Dartboard,” 119, 126 Morgan Stanley memo in, 156 on yield curves for Treasury securities, 95 Wall Street Week, 303 Warehousing funds, 253, 274 Washington Public Power Supply System, 281 Weak-form efficiency test, 121n Wealth asset demand and, 65, 65n, 69t bond demand curve and, 73, 74t U.S claims on foreign, 373, 373n Web See Internet Webvan, 557 Welch, Jack, 558 Wells Fargo, 255, 455 Wharton Econometric Forecasting Associates, 83 Whole life insurance, 508, 515 Wholesale markets, 251 Wingspan, 455 Wolfe, Tom, 539 World Bank, 374–75, 379, 421 WorldCom, 142, 157 World equity funds, 492 I-23 World Trade Organization (WTO), 375 Writer, 598 Y Yen (Japanese currency), 343, 344, 359, 478n Yield curves defined, 95 fluctuation of, 577 forecasting inflation and business cycle with, 107 interpreting, 107–8 inverted, 95, 100–101 shapes of, 95 term structure of interest rates and, 95–96, 100–107, 106f for U.S government bonds, 108f for U.S Treasury securities, 95, 96 Yield to maturity, 36, 40–46 bond prices and, 46 coupon bonds, 42–45, 43t defined, 40, 291t discount bonds, 45–46 fixed-payment loan, 41–42 simple loans, 40–41 Yuan (Chinese currency), 340, 383–84 Z Zero-coupon bonds See Discount bonds Zero-lower-bound problem, 222 This page intentionally left blank Bridging the Gap: Applying Theory to Practice Financial Markets and Institutions’s rich chapter features— including The Practicing Manager, Cases, General Interest Boxes, and Following the Financial News—enable students to both understand and apply core concepts This compelling pedagogy, combined with the authors’ experience as practitioners, rounds out the text’s applied managerial perspective The Practicing Manager CHAPTER Calculating Duration to Measure Interest-Rate Risk CHAPTER Profiting from Interest-Rate Forecasts CHAPTER Using the Term Structure to Forecast Interest Rates CHAPTER Practical Guide to Investing in the Stock Market CHAPTER 10 Using a Fed Watcher CHAPTER 15 Profiting from Foreign Exchange Forecasts CHAPTER 16 Profiting from a Foreign Exchange Crisis CHAPTER 17 Strategies for Managing Bank Capital CHAPTER 19 Profiting from a New Financial Product: A Case Study of Treasury Strips CHAPTER 21 Insurance Management CHAPTER 23 Strategies for Managing Interest-Rate Risk CHAPTER 24 Hedging Interest-Rate Risk with Forward Contracts Hedging with Financial Futures Hedging Foreign Exchange Risk with Forward and Futures Contracts Hedging with Stock Index Futures Hedging with Futures Options Hedging with Interest-Rate Swaps Cases CHAPTER Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect Changes in the Interest Rate Due to a Business Cycle Expansion Explaining Low Japanese Interest Rates CHAPTER The Global Financial Collapse and the Baa Treasury Spread Effects of the Bush Tax Cut and the Obama Tax Increase on Bond Interest Rates Interpreting Yield Curves, 1980–2013 CHAPTER Should Foreign Exchange Rates Follow a Random Walk? What Do the Stock Market Crashes Tell Us About the Efficient Market Hypothesis? CHAPTER Financial Development and Economic Growth Is China a Counter-Example to the Importance of Financial Development? CHAPTER The Mother of All Financial Crises: The Great Depression The Global Financial Crisis of 2007–2009 CHAPTER 10 How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate CHAPTER 11 Discounting the Price of Treasury Securities to Pay the Interest CHAPTER 12 The 2007–2009 Financial Crisis and the Bailout of Fannie Mae and Freddie Mac CHAPTER 13 The 2007–2009 Financial Crisis and the Stock Market The September 11 Terrorist Attack, the Enron Scandal, and the Stock Market CHAPTER 14 The Discount Point Decision CHAPTER 15 Effect of Changes in Interest Rates on the Equilibrium Exchange Rate Why Are Exchange Rates So Volatile? The Dollar and Interest Rates The Global Financial Crisis and the Dollar CHAPTER 16 The Foreign Exchange Crisis of September 1992 How Did China Accumulate Over $3 Trillion of International Reserves? CHAPTER 17 How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis CHAPTER 20 Calculating a Mutual Fund’s Net Asset Value CHAPTER 24 Lessons from the Global Financial Crisis: When Are Financial Derivatives Likely to Be a Worldwide Time Bomb? General Interest Boxes CHAPTER Global: Are U.S Capital Markets Losing Their Edge? Global: The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison CHAPTER Global: Negative T-Bill Rates? It Can Happen Mini-Case: With TIPS, Real Interest Rates Have Become Observable in the United States Mini-Case: Helping Investors Select Desired Interest-Rate Risk CHAPTER Mini-Case: The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle CHAPTER Mini-Case: An Exception That Proves the Rule: Raj Rajaratnam and Galleon Mini-Case: Should You Hire an Ape as Your Investment Adviser? CHAPTER Mini-Case: The Enron Implosion Mini-Case: Should We Kill All the Lawyers? Mini-Case: The Demise of Arthur Andersen Mini-Case: Credit Rating Agencies and the 2007–2009 Financial Crisis Mini-Case: Has Sarbanes-Oxley Led to a Decline in U.S Capital Markets? CHAPTER Mini-Case: Collateralized Debt Obligations (CDOs) Inside the Fed: Was the Fed to Blame for the Housing Price Bubble? Global: The European Sovereign Debt Crisis CHAPTER Inside the Fed: The Political Genius of the Founders of the Federal Reserve System Inside the Fed: The Special Role of the Federal Reserve Bank of New York Inside the Fed: The Role of the Research Staff Inside the Fed: The FOMC Meeting Inside the Fed: Green, Blue, Teal and Beige: What Do These Colors Mean at the Fed? Inside the Fed: How Bernanke’s Style Differs from Greenspan’s Inside the Fed: The Evolution of the Fed’s Communication Strategy CHAPTER 10 Inside the Fed: A Day at the Trading Desk Inside the Fed: Fed Lending Facilities During the Global Financial Crisis Global: The European Central Bank’s Monetary Policy Strategy Inside the Fed: Ben Bernanke and the Federal Reserve Adoption of Inflation Targeting CHAPTER 11 Mini-Case: Treasury Bill Auctions Go Haywire Global: Ironic Birth of the Eurodollar Market CHAPTER 13 Mini-Case: History of the Dow Jones Industrial Average CHAPTER 14 E-Finance: Borrowers Shop the Web for Mortgages CHAPTER 16 Inside the Fed: A Day at the Federal Reserve Bank of New York’s Foreign Exchange Desk Global: Why the Large U.S Current Account Deficit Worries Economists Mini-Case: Will the Euro Survive? Global: Argentina’s Currency Board Global: Dollarization CHAPTER 17 Conflicts of Interest: Barings, Daiwa, Sumitomo, Société Générale, and J.P Morgan Chase: Rogue Traders and the Principal–Agent Problem CHAPTER 18 Global: The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing? Global: Where is the Basel Accord Heading After the Global Financial Crisis? Mini-Case: Mark-to-Market Accounting and the Global Financial Crisis Mini-Case: The Global Financial Crisis and Consumer Protection Regulation E-Finance: Electronic Banking: New Challenges for Bank Regulation Global: International Financial Regulation CHAPTER 19 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? Mini-Case: Bruce Bent and the Money Market Mutual Fund Panic of 2008 E-Finance: Information Technology and Bank Consolidation Mini-Case: The Global Financial Crisis and the Demise of Large, Free-Standing Investment Banks CHAPTER 20 Mini-Case: The Long Term Capital Debacle Conflicts of Interest: Many Mutual Funds Are Caught Ignoring Ethical Standards Conflicts of Interest: SEC Survey Reports Mutual Fund Abuses Widespread CHAPTER 21 Mini-Case: Insurance Agent: The Customer’s Ally Conflicts of Interest: The AIG Blowup Conflicts of Interest: The Subprime Financial Crisis and the Monoline Insurers Mini-Case: Power to the Pensions CHAPTER 22 Mini-Case: Example of Using the Limit-Order Book E-Finance: Venture Capitalists Lose Focus with Internet Companies CHAPTER 24 Mini-Case: The Hunt Brothers and the Silver Crash Mini-Case: Program Trading and Portfolio Insurance: Were They to Blame for the Stock Market Crash of 1987? Following the Financial News CHAPTER Foreign Stock Market Indexes CHAPTER Forecasting Interest Rates CHAPTER Yield Curves CHAPTER 15 Foreign Exchange Rates CHAPTER 24 Financial Futures Stock Index Futures This page intentionally left blank Guide to Commonly Used Symbols Symbol Page Where Introduced Term Δ 59 change in a variable π e 47 expected inflation σ 66 standard deviation Bd 71 demand for bonds s 71 supply of bonds C 43 yearly coupon payment D 68 demand curve 57 duration B DUR DURGAP 572 duration gap E 346 exchange (spot) rate (E et+1 − Et)/Et 364 expected appreciation of domestic currency EM 405 equity multiplier GAP 568 income gap i 37 interest rate (yield to maturity) Symbol Page Where Introduced Term iD 363 interest rate on dollar assets F 363 ir 47 real interest rate Pt 51 price of a security at time t R 51 return i interest rate on foreign assets R D 364 expected return on dollar deposits R F 364 expected return on foreign deposits ROA 405 return on assets ROE 405 return on equity RSA 569 rate-sensitive assets RSL 569 rate-sensitive liabilities S 70 supply curve ... 920 .83 78.75 129 , 921 .24 24 128 ,040 .25 999.59 906.95 92. 66 127 ,947. 62 60 124 ,25 6.74 999.59 880.15 119.43 124 ,137.31 120 115,365.63 999.59 817.17 1 82. 41 115,183 .22 180 101,786 .23 999.59 720 .99 27 8.60... 13 .2 S tock Prices for a Security with D 0 $2. 00, g 5%, and Required Returns as Listed Required Return (%) Price ($) 10 42. 00 11 35.00 12 30.00 13 26 .25 14 23 .33 15 21 .00 310 Part 5 Financial. .. 6.53 Commercial building 2, 223 16.90 1 52 1.16 Farm Source: http://www.federalreserve.gov/econresdata/releases/mortoutstand/current.htm 320 Part 5 Financial Markets As part of the recovery program