An introduction to financial markets and institutions burton, maureen SRG

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An Introduction to Financial Markets and Institutions Second Edition Maureen Burton U Reynold Nesiba U Bruce Brown ROUTLEDGE Routledge Taylor & Francis Group LONDON AND NEW YORK With much love to my grandchildren, Luke and Lucy Paddock, Madison Zehntner, and any grandchildren still to come! —Maureen Burton To Nina, Byron, and Yuka—a lot to be thankful for —Bruce Brown First published 2010 by M.E Sharpe Published 2015 by Routledge Park Square, Milton Park, Abingdon, Oxon OX14 4RN 711 Third Avenue, New York, NY 10017, USA Routledge is an imprint of the Taylor & Francis Group, an informa business Copyright © 2010 Taylor & Francis All rights reserved No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers Notices No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use of operation of any methods, products, instructions or ideas contained in the material herein Practitioners and researchers must always rely on their own experience and knowledge in evaluating and using any information, methods, compounds, or experiments described herein In using such information or methods they should be mindful of their own safety and the safety of others, including parties for whom they have a professional responsibility Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe Library of Congress Cataloging-in-Publication Data Proudly sourced and uploaded by [StormRG] Burton, Maureen Kickass Torrents | TPB | ET | h33t An introduction to fi nancial markets and institutions / Maureen Burton, Reynold Nesiba, Bruce Brown—2nd ed p cm ISBN 978- 0-7656-2276-1 (pbk : alk paper) Finance Financial institutions Capital market I Nesiba, Reynold F (Reynold Frank), 1966– II Brown, Bruce, 1960– III Title HG173.B873 2009 332—dc22 ISBN 13: 9780765622761 (pbk) 2009021361 Brief Contents Part Introduction 10 Monetary Policy 209 Part Financial Markets 237 Introduction and Overview Money: A Unique Financial Instrument Financial Markets, Instruments, and Market Makers An Introduction to Financial Intermediaries and Risk Part Financial Prices 23 45 67 11 The Money Markets 239 12 The Corporate and Government Bond Markets 267 13 The Stock Market 297 14 The Mortgage Market 329 89 Interest Rates and Bond Prices 91 The Structure of Interest Rates 113 Part Financial Institutions 353 15 Commercial Banking 355 16 Savings Associations and Credit Unions 379 Market Efficiency and the Flow of Funds Among Sectors 137 How Exchange Rates Are Determined 17 Regulation of the Financial System 403 157 18 Insurance Companies 431 19 Pension Plans and Finance Companies 453 Part The International Financial System 185 The Overseer: The Federal Reserve System 187 20 Securities Firms, Mutual Funds, and Financial Conglomerates 477 Part Managing Financial Risk 505 21 Financial Instability and Strains on the Financial System 507 22 Risk Assessment and Management 531 23 Forward, Futures, and Options Agreements 561 24 Asset-Backed Securities, Interest Rate Agreements, and Currency Swaps 589 iv Brief Contents Part The International Financial System 613 25 The International Financial System 615 26 Monetary Policy in a Globalized Financial System 637 Detailed Contents Preface xix Part Introduction Chapter Introduction and Overview What This Book Is About Economic and Financial Analysis of an Ever-Changing System Finance in Our Daily Lives Introducing the Financial System More on Financial Intermediaries Depository Institutions and Other Types of Intermediaries 11 The Federal Reserve System 12 The Role of Policy: Changing Views 14 Chapter Money: A Unique Financial Instrument 23 Conceptualization: A Key Building Block 24 Defining Money 24 A Closer Look: Money, Exchange, and Economic Development 25 The Monetary Aggregates and Domestic Nonfinancial Debt 26 The Economy and the Aggregates 29 A Closer Look: The Ongoing Evolution of the Payments System 30 Looking Back: Staying Ahead of the Counterfeiter 33 The Demand for and Supply of Money 33 The Demand for Money 33 The Supply of Money 36 Money, Interest Rates, and the Economy 37 Chapter Financial Markets, Instruments, and Market Makers 45 Game Talk 46 Introducing Financial Markets 46 Major Financial Market Instruments 48 Money Market Instruments 48 A Closer Look: Money and Other Financial Claims 49 U.S Treasury Bills 50 Negotiable Certificates of Deposit (CDs) 51 v Commercial Paper 51 Bankers’ Acceptances 51 Repurchase Agreements 53 Federal (Fed) Funds 53 Eurodollars 53 Capital Market Instruments 54 Stocks 55 Mortgages 55 Corporate Bonds 56 U.S Government Securities 56 U.S Government Agency Securities 56 State and Local Government Bonds (Municipals) 57 The Role of Market Makers 57 Why Market Makers Make Markets 59 Market Making and Liquidity 59 Substitutability, Market Making, and Market Integration 61 Chapter An Introduction to Financial Intermediaries and Risk 67 Are All Financial Intermediaries More or Less Alike? 68 Common Characteristics 68 A Closer Look: FIs as Firms 69 Types of Risks Faced by All FIs 71 Credit or Default Risk 71 Interest Rate Risk 72 Liquidity Risk 73 Exchange Rate Risk 73 A Guide to FIs 74 Deposit-Type FIs 74 Commercial Banks 74 Savings Associations 76 Credit Unions 77 Contractual-Type FIs 78 Investment-Type FIs 79 Finance Company-Type FIs 80 Pulling Things Together 80 vi Detailed Contents Part Financial Prices Chapter Interest Rates and Bond Prices 91 The Present versus the Future 92 The Time Value of Money 92 Compounding and Discounting 92 Compounding: Future Values 92 Discounting: Present Values 94 Interest Rates, Bond Prices, and Present Values 95 Fluctuations in Interest Rates and Managing a Bond Portfolio 97 The Determinants of Interest Rates 97 Changes in the Demand for Loanable Funds 99 Changes in the Supply of Funds 99 Inflation and Interest Rates 102 A Closer Look: Interest Rates: Which Theory Is Correct? Reconciling Stocks and Flows 103 Cracking the Code: Calculating the Inflation Rate 106 The Cyclical Movement of Interest Rates 107 Chapter The Structure of Interest Rates 113 From One Interest Rate to Many 114 The Role of Term to Maturity in Interest Rate Differentials 114 The Yield Curve 114 The Expectations Theory 116 Determining Interest Rate Expectations 121 Tying the Determinants of Expectations to the Changing Shape and Level of Yield Curves 122 Some Necessary Modifications to the Expectations Theory 124 A Closer Look: The Segmented Market Hypothesis 126 The Role of Credit Risk and Taxes in Interest Rate Differentials 127 Credit Risk 127 Taxability 128 Chapter Market Efficiency and the Flow of Funds Among Sectors 137 “Stock Prices Rise over 28 Percent While Bond Prices Rise over Percent” 138 How Expected Rates of Return Affect the Prices of Stocks and Bonds 138 A Closer Look: The Benefits of Diversification 139 Stocks 141 Bonds 141 Detailed Contents vii The Formation of Price Expectations 144 The Efficient Markets Hypothesis: Rational Expectations Applied to Financial Markets 146 A Closer Look: Implications of the Efficient Markets Hypothesis 148 The Flow of Funds Among Sectors 150 Looking Back: The Historical Pattern of Surplus and Deficit Centers 152 Pulling It All Together 152 Chapter How Exchange Rates Are Determined 157 The More Things Change, the More Things Stay the Same 158 Defining Exchange Rates 158 Cracking the Code: How Movements in the Exchange Rate Affect the Dollar Price of Foreign Goods 159 Cracking the Code: Finding the Yen / Euro Exchange Rate 161 Determining Exchange Rates 161 The Demand for Dollars in the Foreign Exchange Market 161 Cracking the Code: The Cost of a Bushel of U.S Wheat in Japan 163 The Supply of Dollars in the Foreign Exchange Market 163 Cracking the Code: The Foreign Exchange Market 165 Changes in Supply and Demand and How They Affect the Exchange Rate 165 Exchange Rates in the Long Run: The Theory of Purchasing Power Parity 168 A Closer Look: The Big Mac Index and Purchasing Power Parity 170 Choosing Among Domestic and Foreign Financial Instruments: The Theory of Interest Rate Parity 172 Looking Back: The Causes and Consequences of Dollar Exchange Rate Movements Since 1980 174 Defining the Balance of Payments and Its Influence on the Exchange Rate, the Financial System, and the U.S Economy 176 The Current Account 176 The Capital Account 177 The Balance of Payments and the Exchange Rate 178 Part The International Financial System Chapter The Overseer: The Federal Reserve System 187 Unraveling the Fed’s Mystique 188 Organizational Structure of the System 188 A Closer Look: The Board of Governors 189 Federal Reserve Banks 190 viii Detailed Contents Federal Open Market Committee (FOMC) 191 The Fed’s Functions 193 Formulation and Implementation of Monetary Policy 193 Supervision and Regulation of the Financial System 194 Facilitation of the Payments Mechanism 195 Operation as Fiscal Agent for the Government 196 Looking Out: The Eurosystem: Europe’s Central Bank 197 The Fed’s Major Policy Tools 198 Open Market Operations 198 The Discount Rate and Discount Rate Policy 198 Reserve Requirements 200 Looking Back: Early Attempts at Establishing a Central Bank 201 The Federal Reserve System and the Question of Central Bank Autonomy 201 Chapter 10 Monetary Policy 209 Can the Business Cycle Be Mitigated? 210 The Goals of Monetary Policy 210 A Closer Look: The Fed’s New Tool Kit 211 Sustainable Economic Growth 214 Stabilization of Unemployment and Inflation 215 The Policy Process 217 Assessing the Economic Situation 219 From Assessment to Action 219 From Action to Effect 219 A Closer Look: Why The Fed Has Become More Open 220 Pitfalls in Policy Making 222 Uncertainty and Lags 222 Federal Open Market Committee Decisions 224 A Closer Look: Monetary Rules Versus Discretionary Risk Management 226 The FOMC Policy Directive and Fed Communication 228 Looking Back: The Fed’s Response To The 9/11 Terrorist Attack 230 How the New York Fed implements the Policy Directive 231 Looking Forward: Will the Fed Have More or Less Power to Affect the Economy in the Future? 232 Part Financial Markets Chapter 11 The Money Markets 239 Financial Markets 240 Money Market Characteristics, Benefits, and Participants 240 Detailed Contents ix ship by the U.S government in September 2008 because it was virtually insolvent due to the ongoing crisis in the mortgage market Federal Housing Administration ( FHA) A federal agency that, for a percent fee, insures mortgage loans made by privately owned financial institutions up to a certain amount if the borrowers meet certain conditions defi ned by the FHA Federal Housing Finance Agency ( FHFA) An independent federal agency that regulates Fannie Mae and Freddie Mac and was established by law on July 30, 2008, replacing the Federal Housing Finance Board and the Office of Federal Housing Enterprise Oversight The FHFA had far greater regulatory powers than the previous regulators, including the ability to put the GSEs into conservatorship Federal National Mortgage Association ( Fannie Mae) A publicly traded, governmentsponsored enterprise that sells securities that are now backed by the government and uses the proceeds to buy mortgages primarily of banks Fannie Mae was put into receivorship by the U.S government in September 2008 because it was virtually insolvent due to the ongoing crisis in the mortgage market Federal Open Market Committee ( FOMC) The principal policy-making body within the Federal Reserve System Federal Savings and Loan Insurance Corporation ( FSLIC) The federal agency that insured the deposits of member savings associations from 1934 until 1989; replaced by the FDIC’s Savings Association Insurance Fund (SAIF ) Fedwire An electronic system for irrevocably and instantaneously transferring very large sums of funds (wholesaling funds) among about 9,500 Fedwire participants, which are generally very large institutions Finance The study of how the fi nancial system coordinates and channels the flow of funds from lenders to borrowers—and vice versa— and how new funds are created by fi nancial intermediaries during the borrowing process Finance Companies Intermediaries that lend funds to households to fi nance consumer purchases and to firms to finance inventories Financial Claims Claims issued by net borrowers in order to borrow funds from net lenders who purchase the claims; assets to the purchaser, liabilities to the issuer Financial Conglomerates Firms that own and operate several different types of financial intermediaries and fi nancial institutions on a global basis Financial Crisis A critical upset in a financial market(s) characterized by sharp declines in asset prices and the default of many fi nancial and nonfinancial firms Federal Reserve ( The Fed) The central bank of the United States that regulates the banking system and determines monetary policy Financial Forward Contract An agreement in which the terms, including price, are completed today for a transaction that will occur in the future Federal Reserve Act The 1913 congressional statute that created the Federal Reserve System Financial Forward Markets Markets that trade financial forward agreements usually arranged by banks or other brokers and dealers Financial Futures Standardized futures contracts that trade financial instruments on a future date according to terms (including the price) determined today Financial Futures Markets Organized markets that trade financial futures including the Chicago Board of Trade, the Chicago Mercantile Exchange, and the London International Financial Futures Exchange Financial Holding Companies (FHCs) Bank holding companies that have applied for and been certified to become FHCs; FHCs can engage in an even broader array of financial-related activities than bank holding companies, including securities underwriting and dealing, insurance agency and underwriting activities, and merchant banking activities; fi nancial holding companies may engage in any other fi nancial and nonfi nancial activities as determined by the Fed Financial Industry Regulatory Authority ( FINRA) A nongovernmental regulator of the U.S securities industry with authority over more than 5,000 brokerage firms FINRA was created in July 2007 by consolidation of regulatory functions of the NASD and the New York Stock Exchange Financial Innovation The creation of new financial instruments, markets, and institutions in the financial ser vices industry Financial Instability Hypothesis Hyman Minsky’s theory that (1) the mixture of hedge, speculative, and Ponzi spending units in the economy determines the economy’s predisposition to a fi nancial crisis, and (2) after sustained periods of prosperity, Glossary 659 spending units tend to take on more debt, which may in time lead to another crisis Financial Institutions Firms that provide financial ser vices to net lenders and net borrowers; the most important fi nancial institutions are fi nancial intermediaries Financial Institutions Reform, Recovery, and Enforcement Act ( FIRREA) of 1989 An act that attempted to resolve the S&L crisis by creating a new regulatory structure, limiting the assets S&Ls can acquire, and requiring S&Ls to maintain adequate capital Financial Intermediaries Financial institutions that borrow from net lenders for the purpose of lending to net borrowers Financial Markets Markets in which spending units trade financial claims Financial Stability Forum ( FSF ) An organization of representatives of central banks, Treasury departments, and international fi nancial institutions created in 1999 to promote international fi nancial stability through the exchange of information and to foster cooperation in international fi nancial supervision and surveillance Financing Corporation ( FICO) A GSE created in response to the S&L crisis that issued bonds to help shore up the FSLIC Firm-Specific Risk Premium A risk measured by beta that shows the overall sensitivity of the stock’s return relative to changes in the entire market Fiscal Policy Government spending and taxing decisions to speed up or slow down the level of economic activity Five Cs of Credit The primary factors lenders must assess and manage to avoid excessive default 660 Glossary risk exposure; these include a loan applicant’s capacity, character, capital, collateral, and conditions Fixed Exchange Rate System An exchange rate system in which currency values not fluctuate, and in which countries agree to buy or sell their currency to maintain the agreed upon exchange rates with other currencies Fixed Interest Rate Mortgage Mortgage where the interest rate remains the same over the life of the loan Flexible Exchange Rate System An exchange rate system in which the value of a currency is determined by supply and demand Floating ( Flexible) Exchange Rate System An exchange rate system in which currency values are determined by supply and demand and fluctuate in response to changes in supply and demand Floor-Plan Loans Finance company loan products that allow dealers of automobiles, boats, and construction equipment to use their inventory as collateral for loans that are repaid when vehicles are sold Flow of Funds A social accounting system that divides the economy into a number of sectors including the household, business, government, foreign, and financial sector Foreign CDs Certificates of deposit issued by the foreign branches of commercial banks and denominated in the currency of the branch’s host country (e.g., Citibank issuing a yendenominated CD in Japan) Foreign Currency (Money) Supplies of foreign exchange Foreign Exchange Supplies of foreign currencies Foreign Exchange Futures Contract A standardized contract to buy or sell a certain amount of a foreign currency on a date in the future at a price determined today Foreign Exchange Market The market for buying and selling the different currencies of the world Forward Rate The price today for a delivery on a future date Freedom of Information Act (1966) A 1966 law that requires more openness in government and more public access to government documents Full Dollarization Abandonment of a country’s own currency to adopt another country’s currency as its official currency Fund of Funds A mutual fund that invests in a portfolio of other mutual funds rather than individual stocks and/or bonds Futures Contracts Standardized agreements in agricultural and commodity markets to trade a fi xed amount of the product or commodity on specific dates in the future at a price determined today G Garn-St Germain Act of 1982 A statute that, along with the DIDMCA, deregulated the fi nancial structure, expanded the lending power of S&Ls and authorized money market deposit accounts and Super NOW accounts General Obligation Bonds Bonds that are paid out of the general revenues and backed by the full faith and credit of the issuer Geometric Average An average that takes into account the effects of compounding; used to calculate the long-term rate from the short-term rate and the short-term rates expected to prevail over the term to maturity of the long-term security Glass-Steagall Act of 1933 Banking legislation that established Regulation Q interest rate ceilings, separated commercial and investment banking, and created the FDIC It was enacted in response to the fi nancial crisis that led to the Great Depression Health Maintenance Organizations ( HMOs) Specialized health care insurers that provide almost complete medical care in exchange for fi xed-per-person premiums Hedge An investment made to reduce risk Government Agency Securities Bonds issued by private enterprises that were publicly chartered by Congress to reduce the cost of borrowing to certain sectors of the economy, such as farming, housing, and student loans Hedge Fund A nontraditional type of mutual fund formed as a partnership of up to either 99 or 499 wealthy investors with large minimum investments; attempts to earn maximum returns regardless of rising or falling fi nancial prices Government National Mortgage Association (Ginnie Mae) A government-owned program that guarantees the timely payment of interest and principal on bundles of at least $1 million of standardized mortgages Hedge Spending Unit A spending unit such as a household or firm where the anticipated revenues (inflows) significantly exceed the anticipated payment obligations (outflows) Government-Sponsored Enterprises (GSEs) Publicly held and traded enterprises that have been chartered by Congress to reduce the cost of borrowing in such sectors as housing, farming, the savings and loan industry, and student loans Gramm-Leach-Bliley Act (GLBA) Legislation that removed decades-old barriers between banking and other financial ser vices by creating fi nancial holding companies that linked commercial banks with securities firms, insurance firms, and merchant banks; it was passed by Congress in November 1999 and became effective March 2000 H Health Insurance Companies Intermediaries that offer protection, in exchange for premiums, against the fi nancial costs associated with events such as doctor visits, hospital stays, and prescriptions drugs Home Equity Lines of Credit Credit cards that are secured by a second mortgage on one’s home Home Equity Loan A type of mortgage that allows a borrower to use the equity in his or her home as collateral for a loan or revolving line of credit Housing-to-Income Ratio A fi nancial ratio used to assess a mortgage loan applicant’s capacity to repay a loan, based on the share of total housing expenses relative to one’s gross monthly income I I Savings Bonds ( I-Bonds) Savings bonds whose interest rate is adjusted for changes in inflation Impact Lag The time between when an action is taken and when that action has a significant impact on economic variables Income Gap The difference between a bank’s interest-ratesensitive assets (SAs) and its interestrate-sensitive liabilities (SLs) Income Gap Analysis An evaluation of the bank’s exposure to interest rate risk that involves subtracting the institution’s interest-rate sensitive liabilities (SLs) from its interest-rate sensitive assets (SAs) The resulting “gap” describes the degree to which the bank income will be affected by changes in interest rates Index-Arbitrage Trading The purchasing (or selling) of a basket of stocks, usually through program trading, with the simultaneous selling (or purchasing) of a futures agreement in the same basket of securities in order to make a riskless profit (arbitrage) from the price differential between the basket of stocks and the futures agreement Indexed Mutual Funds A mutual fund that holds the same basket of securities that are represented in an index such as the S&P 500 or the Wilshire 5000, so that the investor receives roughly the same return as the index to which the fund is tied Indirect Finance When net borrowers borrow from financial intermediaries that have acquired the funds to lend from net lenders Individual Retirement Accounts ( IRAs) Tax-advantaged savings accounts administered by insurance companies, pension funds, and other intermediaries for the purposes of accumulating wealth for retirement Inflation Premium The amount of nominal interest added to the real interest rate to compensate the lender for the expected loss in purchasing power that will accompany any inflation Inflation Rate The rate of change in the Consumer Price Index, which measures the growth Glossary 661 rate of the average level of prices paid by consumers payment streams to better match payment inflows and outflows effectively allows unimpeded nationwide branching Initial Public Offering ( IPO) An offering of stocks or bonds to the public by a company that has not previously sold securities to the public Internal Financing Spending money balances on hand or liquidating financial or real assets to fi nance spending that exceeds current receipts Investment Banks Financial institutions that design, market, and underwrite new issuances of securities in the primary market Insolvent Describes the condition in which a bank’s liabilities are greater than the value of its assets International Bank for Reconstruction and Development ( IBRD) A bank that makes 12- to 15-year loans to poor, but not the poorest, countries, charging an interest rate just above the rate at which the bank borrows Insurance Company A contractual-type fi nancial intermediary that offers the public protection against the fi nancial costs associated with the loss of life, health, or property in exchange for a premium Interest Rate The cost to borrowers of obtaining money and the return (or yield) on money to lenders Interest Rate Cap An agreement whereby the seller of the cap agrees, for a fee, to compensate the cap buyer when an interest rate index exceeds a specified strike rate Interest Rate Floor An agreement whereby the seller of the cap agrees, for a fee, to compensate the cap buyer when an interest rate index falls below a specified strike rate Interest Rate Parity The theory that in equilibrium, interest rates adjust so that after adjustments have been made for expected inflation and exchange rate risk, returns are equalized across countries Interest Rate Risk The risk that nominal interest rates rise and the value of long-term assets fall or that the interest rate will unexpectedly change so that the costs of an FI’s liabilities exceed the earnings on its assets Interest Rate Swaps Financial instruments that allow fi nancial institutions to trade their interest 662 Glossary International Banking Facilities ( IBFs) Financial institutions located in the United States that cater to the needs of foreign individuals, corporations, and/or governments They allow non-U.S residents to hold unregulated Eurodollar deposits International Development Association An association that makes interest-free loans with a maturity of 35 to 40 years to the world’s poorest countries International Finance Corporation An organization that mobilizes funding for private enterprise projects in poor countries International Financial System The numerous rules, customs, instruments, facilities, markets, and organizations that enable international payments to be made and funds to flow across borders International Monetary Fund ( IMF ) An organization created in 1944 to oversee the monetary and exchange rate policies of its members, who pay quotas that are used to assist countries with temporary imbalances in their balance of payments Interstate Banking and Branching Efficiency Act ( IBBEA) Signed into law in September 1994, an act by Congress that Investment Companies Companies that own and manage a large group of different securities for investors who have purchased shares of the companies J Junk Bonds Highly speculative, high yield bonds with low credit ratings that are not recommended for investment because of high credit risk K Keogh Plans Tax-advantaged savings accounts administered by banks and other fi nancial intermediaries for the retirement needs of self-employed people L Laissez-Faire The view that government should pursue a hands-off policy with regard to the economy Lender of Last Resort The roll of the Fed as a provider of liquidity to commercial banks (and increasingly other fi nancial firms) during crises Letters of Credit A form of credit enhancement offered by banks that guarantees a bank will redeem a security if the issuer does not Leverage Ratio The ratio of the firm’s debt relative to its equity Leveraging The degree to which a spending unit relies on borrowed funds Lien A public record that stays with the property title and gives the lender the right to repossess and sell the property if the borrower defaults Life Insurance Companies Intermediaries that offer protection against the financial costs associated with events such as death and disability in exchange for premiums Limit Orders Orders that instruct the broker or dealer to purchase securities at the market price up to a certain maximum or to sell the securities at the market price if it is above a certain minimum Liquidity The ease with which a financial claim can be converted to cash without loss of value Liquidity Premium The extra return required to induce lenders to lend long-term rather than short-term Liquidity Ratio A commonly used measure of liquidity and interest rate risk It is computed by taking the difference between a bank’s short-term investments and liabilities and dividing them by the bank’s assets equity or capital a loan applicant has at stake in an investment project It is computed by dividing the total loan amount fi nanced by the total market value of the property London Interbank Bid Rate ( LIBID) The interest rate at which London banks are willing to borrow Eurodollar balances London Interbank Offered Rate ( LIBOR) The interest rate at which London banks are willing to loan Eurodollar balances Long-Term Care Insurance Private insurance, purchased typically before assistance is required, by individual payment of premiums It covers care received either at home or in a facility for someone needing assistance with activities of daily living ( bathing, dressing, toileting, transferring, continence, and eating), or suffering severe cognitive impairment (such as Alzheimer’s disease) Long-term care insurance is not intended to improve or correct medial problems Liquidity Risk The risk that an FI will be required to make a payment when the intermediary has only long-term assets that cannot be converted to liquid funds quickly without a capital loss M Load A sales commission paid to a broker to purchase mutual funds Macroeconomics The branch of economics that studies the aggregate, or total behavior of all households and firms Loan Commitments Promises made by banks to a firm to lend a given amount of funds at a particular rate for a specified period of time Loan Participation A loan agreement that allows an originating bank to give partial interest in a loan to one or more additional banks Loan-to-Value Ratio A financial ratio used to assess the degree of M1 Currency in the hands of the public plus checkable deposits M2 Everything in M1 plus other highly liquid assets Maintenance Margin Requirement The minimum amount of equity the investor needs in his account relative to the market value of his stock Managed Float Exchange Rate System A system in which currency values fluctuate with changes in supply and demand but central banks may intervene if currency values are thought to be overvalued or undervalued Margin Loans Loans to investors for which the proceeds are used to purchase securities Margin Requirement The percentage of invested funds that can be borrowed as opposed to being paid in readily available funds; currently, margin requirements are set by the Fed at 50 percent Marginal Tax Rate The tax rate paid on the last dollar of income the taxpayer earns Market Fundamentals Factors that have a direct effect on future income streams of financial instruments, including the value of the assets and the expected future income streams of those assets on which the fi nancial instruments represent claims Market Makers Dealers who link up buyers and sellers of financial securities and sometimes take positions in the securities Market Orders Orders by an investor that direct the broker or dealer to purchase or sell securities at the present market price Market Risk Premium The risk based on historical data that shows how much on average the ownership of stocks pays over a risk-free return McCarran-Ferguson Act Federal statute passed in 1945 that exempts life insurance companies from federal regulation and defers their oversight to state insurance commissioners in each state McFadden Act The 1927 act by Congress that outlawed interstate branching and made national banks conform to the intrastate branching laws of the states in which they were located Means of Payment ( Medium of Exchange) Something generally acceptable for making payments Glossary 663 Merchandise Exports Foreign purchases of U.S goods Merchandise Imports U.S purchases of foreign goods Merchant Banking Direct equity investment (the purchasing of stock) in a start-up or growing company by a bank Microeconomics The branch of economics that studies the behavior of individual decision-making units such as households and business firms Monetary Aggregates The measures of money—including M1 and M2—monitored and tracked by the Fed Monetary Policy The attempts by the Fed to stabilize the economy and to ensure sufficient money and credit for an expanding economy Money Anything that functions as a means of payment (medium of exchange), unit of account, and store of value Money Illusion When spending units react to nominal changes caused by changes in prices, even though real variables such as interest rates have not changed Money Market The market for fi nancial assets with an original maturity of less than one year Money Market Deposit Accounts ( MMDAs) Financial claims with limited check-writing privileges, offered by banks since 1982; they earn higher interest than fully checkable deposits and require a higher minimum balance Money Market Mutual Funds ( MMMFs) Short-term investment pools that use the proceeds they raise from selling shares to invest in various money market instruments Moral Hazard Problem When the borrower has an incentive to 664 Glossary use the proceeds of a loan for a riskier venture after the loan is funded Mortality Tables Schedules used to estimate the number of people of a given age who are expected to die during a year Mortgage-Backed Securities Securities backed by a pool of mortgages; they have had a low default risk and provide a steady stream of income Mortgage Bonds Bonds backed by real personal property Mortgages Loans made to purchase single- or multiplefamily residential housing, land, or other real structures, with the structure or land serving as collateral for the loan Multiple-Price Method An auction method whereby the seller of securities accepts bids prior to selling securities Sales are awarded beginning with the highest bidder and continuing toward the lowest until the desired number of securities has been sold Buyers end up paying different prices for the same securities based upon their respective bids The Treasury discontinued this auction-pricing method in November 1998 Mutual Savings Bank Savings banks that lack stockholders and whose assets are managed to benefit its collective owners— present and future depositors N National Association of Securities Dealers Automated Quotation System ( NASDAQ) An electronic stock market for trading securities In 2002, it became an investor-owned corporation, completely independent of the National Association of Securities Dealers ( NASD), which had founded it in 1971 It lists more companies and trades more shares on average than the NYSE National Bank A bank that has received a charter from the Comptroller of the Currency National Credit Union Association ( NCUA) A federal regulatory agency created in 1970 to charter and regulate federally chartered credit unions and state member institutions National Credit Union Share Insurance Fund (NCUSIF) A federal agency created in 1970 to insure the deposits of federally chartered credit unions and state member institutions Municipal Bonds (munis) Bonds issued by state, county, and local governments to finance public projects such as schools, utilities, roads, and transportation ventures; the interest on municipal securities is exempt from federal taxes and from state taxes for investors living in the issuing state Near Monies Highly liquid financial assets that can easily be converted to transactions money ( M1) without loss of value Mutual Funds Investment-type intermediaries that pool the funds of net lenders, purchase the long-term fi nancial claims of net borrowers, and return the income received minus a fee to the net lenders Negotiable Certificates of Deposit (CDs) Certificates of deposit with a minimum denomination of $100,000 that can be traded in a secondary market, most with an original maturity of one to 12 months Negative Spread When the rate of return on assets is less than the cost of funds on liabilities; this occurs for commercial banks when loan rates are below deposit rates Net Borrowers Spending units such as households and firms whose spending exceeds their income Net Capital Inflow Status when there is a surplus in the capital account (or “financial account”) and capital inflows exceed capital outflows Net Lenders Spending units such as households and firms whose income exceeds their spending Net Transfer Payments In the current account, the difference between transfer payments received from and transfer payments made to foreigners New York Stock Exchange ( NYSE) The world’s largest market for trading stocks; it trades the stocks of more than 2,800 companies; part of NYSE Euronext since 2007 No-Fault Insurance Insurance coverage that pays an accident victim regardless of who caused an accident or damage No-Load Mutual funds that are purchased directly from the mutual fund company and are not subject to a load Nominal Interest Rate The market interest rate, or the real return plus the rate of inflation expected to prevail over the life of the asset Nonbanks Other intermediaries and nonfi nancial companies that have taken an increasing share of intermediation Noncompetitive Bid A bid that includes only the number of T-bills desired Noncontributory Plans Pension plans in which only the employer contributes O Off-Balance-Sheet Activities Activities such as standby lines of credit, overdraft protection, unused credit card balances, and other commitments for which a bank is liable but that not show up on the balance sheet Option Premium The premium paid by the buyer of an option to compensate the seller for accepting the risk of a loss with no possibility of a gain Office of Thrift Supervision (OTS) An agency created by the Financial Institutions Reform, Recover, and Enforcement Act (FIRREA) to replace the Federal Home Loan Bank Board as the overseer of the S&L industry Options on Futures Options that give the buyer the right, but not the obligation, to buy or sell a futures contract up to the expiration date on the option Official Reserve Account The balance of payments account that records official government transactions in the foreign exchange market to bring the balance of payments into balance Official Reserve Asset The asset (such as the dollar or gold) by which other countries define the value of their currency; used as international reserves Official Reserve Currency The currency used by other countries to defi ne their own currency; the U.S dollar was the official reserve currency under the Bretton Woods Accord Old Age Survivors and Disability Insurance (OASDI) Core program of Social Security that is funded by payroll taxes to pay retirement and disability payments to eligible individuals and their dependents Open Market Operations The buying and selling of government securities by the Fed to change the reserves of depository institutions Open-End A mutual fund (type of investment company) that continually sells new shares to the public or buys outstanding shares from the public at a price equal to the net asset value Optimal Forecast The best guess possible arrived at by using all of the available information Over-the-Counter (OTC) Market A network of securities dealers that trades stocks of companies not listed on an official exchange such as NASDAQ or the NYSE P Par Value The face value printed on a bond; the amount the bond originally sold for Participation Certificate A mortgage-backed security issued by Freddie Mac and backed by a pool of conventional mortgages Payments Mechanism The means by which transactions are consummated; that is, how money is transferred in an exchange Payoff Method The method of resolving a bank insolvency by paying off the depositors and closing the institution Pension Funds Tax-exempt intermediaries set up to provide participants with income at retirement in exchange for premiums Per for mance Bond A bond required by an organized exchange from both the buyer and the seller of a futures agreement to ensure that both parties abide by the agreement Personal Consumption Expenditures Price Index ( PCEPI) A price index measures the average change in the prices of all domestic personal consumption expenditures The PCEPI changes the weights of items in the index as Glossary 665 consumers substitute out of things that have become relatively more expensive and into items that have become relatively cheaper Thus, it gives a better measure of inflation than the CPI, which does not Pit The trading area on the floor of an organized exchange (such as the Chicago Board of Trade) where authorized brokers gather to buy and sell for their customers Point-of-Sale Terminal A computer terminal that uses a debit card to electronically transfer funds from a deposit account to the account of a third party Points A measure of interest prepayment at the time a mortgage loan is made that lowers the nominal interest rate on the loan; one point is equal to one percent of the loan balance Policy Directive A statement issued by the FOMC to the Trading Desk of the New York Fed that directs monetary policy until the next FOMC meeting; in recent years, the policy directive has targeted a specific fed funds rate Policy Lag The time between the point when the need for action is recognized and the point when an adjustment policy is decided on and set in motion Policy Regret A situation in which policy actions based on available data would not have been taken if more accurate data revisions had been available Ponzi Spending Unit A spending unit that must continuously increase its outstanding debt to meet its current obligations or payments Positive Spread When the rate of return on assets is greater that the cost of funds on liabilities; this occurs when loan rates are above deposit rates 666 Glossary Preferred Habitats An expectations theory modification hypothesizing that many borrowers and lenders have preferred maturities, which creates a degree of market segmentation between the short-term and long-term markets Preferred Stock Restricted equity claims with characteristics of both bonds and common stock While dividends must be paid to preferred stockholders before common stockholders, preferred dividends are set at a specific level and not increase if extraordinary profits are earned Preferred stockholders generally not have voting rights Premium above Par When a bond sells above its face value because interest rates have decreased since the bond was originally issued Prepayment Risk The risk that a mortgage may be prepaid early and the lender will have to reinvest the funds at a lower interest rate Present Value The value today of funds to be received or paid on a future date Price Risk The threat that an increase in interest rates will reduce the market value of security holdings Primary Credit Rate The rate for short-term borrowing of reserves by the healthiest depository institutions from the Fed, also known as the discount rate Primary Dealer Credit Facility ( PDCF ) A program begun in March 2008, whereby primary dealers can borrow overnight from the Fed at the primary credit rate Designed to increase liquidity and to provide support for the financial system Primary Dealers The large banks and government securities dealers that are approved by the Fed to be the main participants in the auctions of Treasury securities that are conducted by the Fed They also participate in open market operations with the New York Fed Primary Market The market in which a security is initially sold for the first time Principal The original amount of funds lent Private Placement The sale of new securities to a limited number of large investors; because the number of investors is small, the underwriting process is avoided Producer Price Index ( PPI) A price index that measures changes in cost of goods and ser vices purchased by the typical producer Program Trading The preprogramming of computers to buy or sell a large number (basket) of stocks, usually by institutional investors Property and Casualty Companies Intermediaries that provide protection against the effects of unexpected occurrences on property Property Insurance Contingent claims, exchange for premiums that protect insured policyholders from the financial costs of property loss, damage, or destruction Prospectus A subpart of the registration statement that must be given to investors before they purchase the securities Purchase and Assumption Method The method of resolving a bank insolvency by fi nding a buyer for the institution Purchasing Power Parity The theory that, in the long run, exchange rates adjust so that the relative purchasing power of various currencies is equalized Put Options Options that give the buyer of the option the right, but not the obligation, to sell a standardized contract of a fi nancial instrument at a strike price determined today Q Quantity Demanded of Money The specific amount of money that spending units wish to hold at a specific interest rate ( price) Quantity Supplied of Money The specific amount of money that will be supplied at a specific interest rate R Rational Expectations Expectations formed by looking both backward and forward Real Estate Investment Trusts ( REITs) A special type of mutual fund that pools the funds of many small investors and uses them to buy or build income property or to make or purchase mortgage loans; pass-through institutions in which the rents from the income property and/or the interest income from the mortgages are passed through to shareholders Real Gross Domestic Product (GDP) The real or inflationadjusted quantity of fi nal goods and ser vices produced in an economy in a given time period Real Interest Rate The interest rate corrected for changes in the purchasing power of money Recession The phase of the business cycle in which economic activity decreases and unemployment rises Recognition Lag The time it takes policy makers to recognize that a change in the economy’s performance has occurred Redlining The practice of restricting the number or dollar amounts of loans in an area regardless of the creditworthiness of the borrower Registered Bonds Bonds in which the issuer keeps records of ownership and automatically sends the coupon payment to the bondholder Registration Statement A statement that must be filed with the SEC before a new securities offering can be issued Regulation Q Interest rate ceilings on deposits at commercial banks that were established during the Great Depression and phased out after 1980 Reinsurance The practice by smaller insurance companies of sharing the risk of a large policy with other insurance companies to reduce risk exposure Reinvestment Risk The threat that falling interest rates will reduce future rates of return on current and future cash flows Repossession The process whereby a lender takes back the assets used to secure a loan Repurchase Agreement Shortterm contract in which the seller agrees to sell a government security to a buyer and simultaneously agrees to buy it back on a later date at a higher price Required Reserve Ratio The fraction of deposit liabilities that depository institutions must hold as reserve assets Required Reserves The amount of reserve assets that the Fed requires depository institutions to hold against outstanding checkable deposit liabilities Reserve Bank One of the 12 Federal Reserve Banks; each is located in a large city in its district Reserve Need The projected amount of reserves to be supplied or withdrawn by open market operations to reach or keep the fed funds rate prescribed by the policy directive Reserves Assets that are held as either vault cash or reserve deposit accounts with the Fed Resolution Trust Corporation ( RTC) A GSE created in 1989 in response to the savings and loan crisis that issued bonds and used the proceeds to dissolve or fi nd buyers for the failed thrifts and their properties The RTC went out of business on December 31, 1995, after completing its work Restrictive Covenants Stipulations within the bond indenture that limit the ability of the corporation with regard to certain activities Restructure (a Loan) Change a loan to allow a borrower who would otherwise likely default to repay (e.g., allow the borrower to pay amounts currently due at some future date instead) Revaluation Under fixed exchange rates, an increase in the value of a currency by the monetary authorities relative to the official reserve asset Revalue Under a fi xed exchange rate system, to increase the value of a country’s currency Revenue Bonds Bonds used to finance specific projects with the proceeds of those projects being used to pay off the bondholders Reverse Repurchase Agreement or Matched Sale-Purchase ( MSP) Agreement A repurchase agreement viewed from the perspective of the initial buyer Short-term agreements in which the buyer buys a government security from a seller and Glossary 667 simultaneously agrees to sell it back on a later date at a higher price tion and purchase of homes; have offered checkable deposits since 1980 Risk Averse A state of being wherein an economic agent is willing to accept a lower expected return in order to reduce the variability of the return Savings Associations Savings and Loan Associations and Savings Banks Risk-Based Premiums Insurance charges that increase with the perceived risk of the policyholder Risk-Based Pricing Charging different interest rates to borrowers based on an assessment of a loan applicant’s default risk; highly rated applicants are charged the lowest rates Risk Premium The extra return or interest that a lender is compensated with for accepting more risk Roth IRA A special type of individual retirement account in which one’s contributions are taxed, but the earnings accumulated within the account are tax-exempt S Sales Finance Companies (Captive Finance Companies) Companies that make loans to consumers so they can purchase a product from a particular manufacturer or retailer Saving Income not spent on consumption (or paid in tax) Saving Association Insurance Fund (SAIF ) An orga nization created by FIRREA in 1989 and managed by the FDIC to provide insurance for savings association deposits In 2005 the SAIF was merged with the Bank Insurance Fund (BIF ) to form the Deposit Insurance Fund ( DIF ) Savings and Loan Associations (S&Ls) Depository institutions established for the purpose of pooling the savings of local residents to finance the construc- 668 Glossary Savings Banks Depository institutions set up to help fi nance the construction and purchase of homes; located mainly on the East Coast Savings Deposits Highly liquid deposits that can usually be withdrawn on demand but not by writing a check Seasoned Issuance The offering of new securities by a corporation that has outstanding previously issued securities Secondary Credit Rate The rate for short-term borrowing of reserves from the Fed by depository institutions experiencing fi nancial difficulties Secondary Market The market in which previously issued fi nancial securities are sold Secondary Stock Offering An offering of newly issued shares by a firm that already has outstanding publicly held shares Securities and Exchange Commission (SEC) The government agency that regulates the securities industry and monitors illegal and fraudulent behavior in securities markets Securities Industry Protection Corporation (SIPC) A nonprofit membership corporation established by Congress that provides insurance to protect investors’ securities from liquidation by the brokerage firm Securitization The pooling and repackaging of similar loans into marketable securities Seigniorage The difference between the cost of producing and distributing currency and any revenues earned Share Accounts Highly liquid credit union accounts that allow withdrawals on demand, but not by writing a check Share Certificates The credit union equivalent of a CD Share Draft Accounts Interestbearing checking accounts of credit unions Shelf Registration A procedure that permits a company to register a number of securities with the SEC and sell them over a two-year period rather than at the time of registration Short Sell Investors’ instructions to brokers or dealers to borrow shares of stocks and sell them today with the guarantee that the investors will replace the borrowed stocks by a date in the future SIMPLE Plans (Savings Incentive Match Plan for Employees of Small Employers) Simplified defi ned-contribution plans created by Congress in 1996 to assist small businesses in offering salary deductions and matching contributions to fund retirement savings for their workers Simplified Employee Pensions (SEPs) Small-business pension plans allowed by Congress in 1978 with fewer reporting requirements and costs, and less administrative complexity than traditional pension plans Sinking Fund Provisions Provisions of a bond indenture that specify whether the corporation is required to pay off a portion of the newly issued bonds each year Smart Cards Plastic cards with a microprocessor chip that are used to make payments; the chip stores information that allows the payment to be validated Social Security The federal government program that provides retirement and survivors’ pensions, and disability and health insurance benefits to qualifying individuals Solvent When a bank or other firm has assets worth more than liabilities (opposite of “bankrupt” or “insolvent”) Sources and Uses of Funds Statement A statement showing the sources and uses of funds for any sector Sources of Funds For any sector, income and borrowing Special Drawing Rights (SDRs) International reserve assets created by the IMF to supplement other international reserves Special-Purpose Trust A corporate agent that buys fi nancial obligations from a loan originator and works with a security underwriter, credit enhancer, and rating agency to issue asset-backed securities; sometimes responsible for loan-servicing responsibilities Speculation The buying or selling of fi nancial securities in the hopes of profiting from future price changes Speculative Bubble A increase in asset prices which can not be supported by market fundamentals which may be accompanied by euphoric or irrational expectations Speculative Spending Unit A spending unit in which the funds coming in may potentially fall short of the payment outflows if there is an increase in interest rates Spot Markets Markets in which the trading of financial securities takes place instantaneously Stagflation A condition of concurrent high unemployment and high inflation cial instrument but also the true fundamental value of the instrument Standard & Poor’s, Moody’s, and Fitch Investors Ser vice The three major credit-rating agencies that evaluate a borrower’s probability of default and assign the borrower to a particular risk class Visit their sites at http://www stockinfo.standardpoor.com, http://www.moodys.com, and http://www.fitchratings.com Student Loan Marketing Association (Sallie Mae) A former GSE, fully privatized in 2004, that issues securities to purchase student loans, thus increasing the funds flowing into student loans and making them more liquid Standby Lines of Credit Lines of credit (commitments) for which a bank is liable but that not show up on the balance sheet State and Local Government Bonds ( Municipals) Long-term instruments issued by state and local governments to finance expenditures on schools, roads, and so on Stock Savings Bank A type of savings bank charter in which ownership is held by the stockholders Stocks Equity claims that represent ownership of the net assets and income of a corporation Stop-Out Yield The lowest accepted bid price or yield in a securities auction Store of Value Something that retains its value over time Stored-Value Cards Plastic cards that have a magnetic strip that is swiped through a card reader to make payments; usually single use Subordinated Debenture Bonds Bonds with no collateral backing that have a general claim after debenture bondholders have been paid Subprime Lending The issuing of high-fee, high-interest-rate loans typically made to borrowers with blemished (or nonex istent) credit records Subprime Mortgage A mortgage loan made to a borrower with bad credit and little or no down payment Superior/Subordinated Debt Structure A framework that allows securities to be sold in at least two different classes or tranches Supply of Loanable Funds The supply of borrowed funds originating (1) from household, business, government, and foreign net lenders or (2) from the Fed through its provision of reserves Supply of Money The stock of money ( M1), which includes currency in the hands of the public plus checkable deposits Strike Rate The agreed-upon rate in an interest agreement Surplus Sector A sector where the combined surpluses of the lenders are greater than the combined deficits of the net borrowers Stronger Version of the Efficient Markets Hypothesis The theory that the prices of all financial instruments not only reflect the optimal forecast of the fi nan- Sweep Accounts A financial innovation that allows depository institutions to shift customers’ funds out of checkable accounts that are subject to reserve Strike Price The agreed-upon price in an options contract Glossary 669 requirements and into highly liquid money market deposit accounts ( MMDAs) that are not Syndicate A group of investment banks, each of which underwrites a proportion of new securities offerings T Temporary Auction Facility ( TAF ) A program begun in December 2007, whereby the Fed auctions funds to depository institutions for 28 or 84 days Designed to provide liquidity to the fi nancial system Term Life Insurance Life insurance that provides a death benefit to an insured policyholder’s beneficiary only if the insured dies within the specified period of time or “term” of the policy Term Securities Lending Facility ( TSLF ) A program where the Fed auctions government securities to primary dealers for a 28-day or longer period in exchange for less liquid and less credit-worthy securities such as mortgage-backed securities Designed to increase liquidity without increasing reserves Term Structure of Interest Rates The relationship between yields and time to maturity Term to Maturity The length of time from when a financial security is initially issued until it matures Theory of Rational Expectations The theory that expectations will, on average, be equal to the optimal forecast Thrift CDs Certificates of deposit issued by savings associations and credit unions Thrifts Depository institutions known as S&Ls, savings banks, and credit unions 670 Glossary Tilt Problem The tilt problem refers to that fact that with inflation, conventional amortized home loans with fi xed periodic nominal payments imply declining real payments over time If homebuyers’ earnings increase over time, they will face a larger real burden of home payments early in the loan period, precisely when they are least able to afford them Time Deposits Deposits that have a scheduled maturity and a penalty for early withdrawal Time Value of Money The terms on which one can trade off present purchasing power for future purchasing power; the interest rate “Too Big to Fail” The position adopted by FDIC regulators in 1984 whereby the failure of a large bank would be resolved using the purchase and assumption method rather than the payoff method Trade Balance The difference between merchandise exports and imports Trade Deficit Situation where merchandise imports are greater than exports Trade Surplus Situation where merchandise exports are greater than imports Tranche A particular class or part of a securitization issue; some parts may be backed only by principal payments, others only by interest payments Transactions Costs The costs associated with borrowing and lending or engaging in other exchanges Transactions Deposits Deposits that can be exchanged for currency and are used to make payments through writing a check or making an electronic transfer Treasury Inflation-Protected Securities ( TIPS) Bonds whose principal amount is adjusted for inflation or deflation at the time when coupon payments are made (usually every six months) Treasury Notes Securities issued by the U.S government with an original maturity of one to 10 years Treasury STRIPS A type of government security that allows investors to register and trade ownership of the interest (coupon) payments and the principal separately Troubled Assets Relief Program ( TARP) The program under the EESA that initially authorized the U.S Treasury to purchase up to $700 billion of “toxic” mortgage-backed securities from fi nancial institutions The TARP program was revised 10 days after the EESA was signed Under the revised TARP program, the Treasury would use the bailout funds to purchase newly-issued preferred stock in troubled institutions U U.S Central Credit Union The central bank for credit unions U.S Government Agency Securities Long-term bonds issued by various government agencies, including those that support real estate lending and student loans U.S Government Securities Long-term debt instruments of the U.S government with original maturities of two to 30 years U.S Treasury Bills ( T-bills) Short-term debt instruments of the U.S government with typical maturities of three to 12 months Uniform-Price Method An auction method whereby the seller of securities accepts bids prior to selling securities Sales are awarded beginning with the highest bidder and continuing toward the lowest until the desired number of securities has been sold All buyers pay the same price for the securities based on the stop-out yield The Treasury instituted this auction-pricing method in 1998 Uniform Reserve Requirements Reserve requirements that apply to particular types of deposits and are the same across all depository institutions Unit of Account A standardized accounting unit such as the dollar that provides a consistent measure of value Universal Life Insurance A form of permanent life insurance that provides a pure insurance product as well as a separate account This separate account grows at a fluctuating rate of interest similar to that received on a money market account or short-term CD Premium payment amounts may be flexible as long as the minimum premium for the pure insurance benefit is met Universal Reserve Requirements Reserve requirements to which all depository institutions are subject Uses of Funds For any sector, current spending and changes in fi nancial instruments held Usury Ceilings Maximum interest rates that FIs may charge on certain loans V Variable Life Insurance A form of permanent life insurance that provides a pure insurance product as well as a separate account The separate account may be used by the policyholder to purchase mutual funds from a list of insurance company-approved funds These equity-linked funds pay a minimum death benefit as long as sufficient premium payments are received Veterans Administration ( VA) A federal agency that, among other things, insures mortgage loans made by privately owned fi nancial institutions up to a certain amount if the borrowers meet certain conditions, including being military veterans Whole Life Insurance A permanent type of life insurance that charges a fi xed premium and pays a fi xed death benefit, and whose separate account is invested by the insurance company for the policyholder’s benefit World Bank An investment bank created in 1944 that issues bonds to make long-term loans at low interest rates to poor countries for economic development projects Write-Off Officially recognize a loan to a borrower who is not repaying, and not likely to repay in the future, as worthless Y Yield Curve A graphical representation of the relationship between interest rates (yields) on particular securities and their terms to maturity Yield to Maturity The return on a bond held to maturity, which includes both the interest return and any capital gain or loss W Z Warrant Contracts sometimes issued with newly issued bonds; warrants give the holder the right to purchase a designated security at a price set today; warrants may be sold to a third party Zero-Coupon Bonds Corporate bonds sold at a discount, with the difference between the amount paid for the bond and the amount received at maturity equal to the interest Glossary 671 This page intentionally left blank About the Authors MAUREEN BURTON CALIFORNIA STATE POLYTECHNIC UNIVERSITY, POMONA Maureen Burton received a B.A from the University of Missouri at Columbia in 1971, an M.A from California State University Fullerton in 1979, and a Ph.D from the University of California at Riverside in 1986 All were in economics She taught at Chaffey College from 1984 to 1987 and at Cal Poly Pomona since 1987 where she is a full professor At Cal Poly Pomona, she has served as Coordinator of the Graduate Program and a Chair of the Economics Department She is currently the Chair of the Faculty Rights Committee for the Cal Poly Chapter of the California Faculty Association In addition to other publications, she co-authored an introductory text Economics (Harper Collins, 1987) with S Craig Justice and An Introduction to Financial Markets and Institutions, (South-Western College Publishing, 2002) with Reynold Nesiba and Ray Lombra, with a second edition to be published in 2010 by M.E Sharpe Her main areas of interest include monetary policy and financial crisis BRUCE BROWN CALIFORNIA STATE POLYTECHNIC UNIVERSITY, POMONA Bruce Brown is currently Associate Professor of Economics at Cal Poly He earned his A.B degree in economics from the University of California, Berkeley and M.A and Ph.D degrees from the University of California, Los Angeles Bruce has taught a wide variety of students ranging from those at UCLA and USC where he has held visiting positions, to Santa Monica College From 1997 to 2000 Bruce was Associate Professor of Economics at Niigata University in Japan and experienced the tail end of the “lost decade” firsthand His eclectic research interests have resulted in publications concerning immigration, inter-industry wage differentials, Japan’s health care system, and economic methodology Bruce’s current research concerns credit rationing as a result of asymmetric information ... Third, and most importantly, to present an analytical framework that enables students to understand and anticipate changes in financial markets and institutions as the fi nancial system continues to. .. Markets 237 Introduction and Overview Money: A Unique Financial Instrument Financial Markets, Instruments, and Market Makers An Introduction to Financial Intermediaries and Risk Part Financial Prices... Funds, and Financial Conglomerates 477 Part Managing Financial Risk 505 21 Financial Instability and Strains on the Financial System 507 22 Risk Assessment and Management 531 23 Forward, Futures, and