Ebook Financial markets and institutions (7th edition): Part 2

(BQ) Part 2 book Financial markets and institutions has contents: The money markets, the stock market, the foreign exchange market, the international financial system, banking and the management of financial institutions, financial regulation, the mutual fund industry,...and other contents.

PA R T F I V E F I N A N C I A L M A R K E T S CHAPTER 11 The Money Markets Preview If you were to review Microsoft’s annual report for 2009, you would find that the company had over $6 billion in cash and equivalents The firm also listed $25 billion in short-term securities The firm chose to hold over $30 billion in highly liquid short-term assets in order to be ready to take advantage of investment opportunities and to avoid the risks associated with other types of investments Microsoft will have much of these funds invested in the money markets Recall that money market securities are short-term, low-risk, and very liquid Because of the high degree of safety and liquidity these securities exhibit, they are close to being money, hence their name The money markets have been active since the early 1800s but have become much more important since 1970, when interest rates rose above historic levels In fact, the rise in short-term rates, coupled with a regulated ceiling on the rate that banks could pay for deposits, resulted in a rapid outflow of funds from financial institutions in the late 1970s and early 1980s This outflow in turn caused many banks and savings and loans to fail The industry regained its health only after massive changes were made to bank regulations with regard to money market interest rates This chapter carefully reviews the money markets and the securities that are traded there In addition, we discuss why the money markets are important to our financial system 254 Chapter 11 The Money Markets 255 The Money Markets Defined The term money market is actually a misnomer Money—currency—is not traded in the money markets Because the securities that trade there are short-term and highly liquid, however, they are close to being money Money market securities, which are discussed in detail in this chapter, have three basic characteristics in common: • They are usually sold in large denominations • They have low default risk • They mature in one year or less from their original issue date Most money market instruments mature in less than 120 days Money market transactions not take place in any one particular location or building Instead, traders usually arrange purchases and sales between participants over the phone and complete them electronically Because of this characteristic, money market securities usually have an active secondary market This means that after the security has been sold initially, it is relatively easy to find buyers who will purchase it in the future An active secondary market makes money market securities very flexible instruments to use to fill short-term financial needs For example, Microsoft’s annual report states, “We consider all highly liquid interest-earning investments with a maturity of months or less at date of purchase to be cash equivalents.” Another characteristic of the money markets is that they are wholesale markets This means that most transactions are very large, usually in excess of $1 million The size of these transactions prevents most individual investors from participating directly in the money markets Instead, dealers and brokers, operating in the trading rooms of large banks and brokerage houses, bring customers together These traders will buy or sell $50 or $100 million in mere seconds—certainly not a job for the faint of heart! As you may recall from Chapter 2, flexibility and innovation are two important characteristics of any financial market, and the money markets are no exception Despite the wholesale nature of the money market, innovative securities and trading methods have been developed to give small investors access to money market securities We will discuss these securities and their characteristics later in the chapter, and in greater detail in Chapter 20 Why Do We Need the Money Markets? In a totally unregulated world, the money markets should not be needed The banking industry exists primarily to provide short-term loans and to accept short-term deposits Banks should have an efficiency advantage in gathering information, an advantage that should eliminate the need for the money markets Thanks to continuing relationships with customers, banks should be able to offer loans more cheaply than diversified markets, which must evaluate each borrower every time a new security is offered Furthermore, short-term securities offered for sale in the money markets are neither as liquid nor as safe as deposits placed in banks and thrifts Given the advantages that banks have, why the money markets exist at all? The banking industry exists primarily to mediate the asymmetric information problem between saver-lenders and borrower-spenders, and banks can earn profits by capturing economies of scale while providing this service However, the banking industry is subject to more regulations and governmental costs than are the money markets In situations where the asymmetric information problem is not severe, the money markets have a distinct cost advantage over banks in providing short-term funds 256 Part Financial Markets Money Market Cost Advantages Banks must put aside a portion of their deposits in the form of reserves that are held without interest at the Federal Reserve Thus, a bank may not be able to invest 100% of every dollar it holds in deposits.1 This means that it must pay a lower interest rate to the depositor than if the full deposit could be invested Interest-rate regulations were a second competitive obstacle for banks One of the principal purposes of the banking regulations of the 1930s was to reduce competition among banks With less competition, regulators felt, banks were less likely to fail The cost to consumers of the greater profits banks earned because of the lack of free market competition was justified by the greater economic stability that a healthy banking system would provide One way that banking profits were assured was by regulations that set a ceiling on the rate of interest that banks could pay for funds The Glass-Steagall Act of 1933 prohibited payment of interest on checking accounts and limited the interest that could be paid on time deposits The limits on interest rates were not particularly relevant until the late 1950s Figure 11.1 shows that the limits became especially troublesome to banks in the late 1970s and early 1980s when inflation pushed short-term interest rates above the level that banks could legally pay Investors pulled their money out of banks and put it into money market security accounts offered by many Percent 16 3-Month Treasury Bill Rate 14 12 10 Ceiling Rate on Savings Deposits at Commercial Banks 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 Year FIGURE 11.1 3-Month Treasury Bill Rate and Ceiling Rate on Savings Deposits at Commercial Banks Source: http://www.stlouisfed.org/default.cfm The reserve requirement on nonpersonal time deposits with an original maturity of less than 112 years was reduced from 3% to 0% in December 1990 Chapter 11 The Money Markets 257 brokerage firms These new investors caused the money markets to grow rapidly Commercial bank interest rate ceilings were removed in March of 1986, but by then the retail money markets were well established Banks continue to provide valuable intermediation, as we will see in several later chapters In some situations, however, the cost structure of the banking industry makes it unable to compete effectively in the market for short-term funds against the less restricted money markets The Purpose of the Money Markets The well-developed secondary market for money market instruments makes the money market an ideal place for a firm or financial institution to “warehouse” surplus funds until they are needed Similarly, the money markets provide a low-cost source of funds to firms, the government, and intermediaries that need a short-term infusion of funds Most investors in the money market who are temporarily warehousing funds are ordinarily not trying to earn unusually high returns on their money market funds Rather, they use the money market as an interim investment that provides a higher return than holding cash or money in banks They may feel that market conditions are not right to warrant the purchase of additional stock, or they may expect interest rates to rise and hence not want to purchase bonds It is important to keep in mind that holding idle surplus cash is expensive for an investor because cash balances earn no income for the owner Idle cash represents an opportunity cost in terms of lost interest income Recall from Chapter that an asset’s opportunity cost is the amount of interest sacrificed by not holding an alternative asset The money markets provide a means to invest idle funds and to reduce this opportunity cost Investment advisers often hold some funds in the money market so that they will be able to act quickly to take advantage of investment opportunities they identify Most investment funds and financial intermediaries also hold money market securities to meet investment or deposit outflows The sellers of money market securities find that the money market provides a lowcost source of temporary funds Table 11.1 shows the interest rates available on a variety of money market instruments sold by a variety of firms and institutions For example, banks may issue federal funds (we will define the money market securities TA B L E 1 Sample Money Market Rates, April 8, 2010 Instrument Interest Rate (%) Prime rate 3.25 Federal funds 0.19 Commercial paper 0.23 month CDs (secondary market) 0.23 London interbank offer rate 0.45 Eurodollar 0.30 Treasury bills (4 week) 0.16 Source: Federal Reserve Statistical Bulletin, Table H15, April 9, 2010 258 Part Financial Markets later in this chapter) to obtain funds in the money market to meet short-term reserve requirement shortages The government funds a large portion of the U.S debt with Treasury bills Finance companies like GMAC (General Motors Acceptance Company) may enter the money market to raise the funds that it uses to make car loans.2 Why corporations and the U.S government sometimes need to get their hands on funds quickly? The primary reason is that cash inflows and outflows are rarely synchronized Government tax revenues, for example, usually come only at certain times of the year, but expenses are incurred all year long The government can borrow short-term funds that it will pay back when it receives tax revenues Businesses also face problems caused by revenues and expenses occurring at different times The money markets provide an efficient, low-cost way of solving these problems Who Participates in the Money Markets? An obvious way to discuss the players in the money market would be to list those who borrow and those who lend The problem with this approach is that most money market participants operate on both sides of the market For example, any large bank will borrow aggressively in the money market by selling large commercial CDs At the same time, it will lend short-term funds to businesses through its commercial lending departments Nevertheless, we can identify the primary money market players—the U.S Treasury, the Federal Reserve System, commercial banks, businesses, investments and securities firms, and individuals—and discuss their roles (summarized in Table 11.2) U.S Treasury Department The U.S Treasury Department is unique because it is always a demander of money market funds and never a supplier The U.S Treasury is the largest of all money market borrowers worldwide It issues Treasury bills (often called T-bills) and other securities that are popular with other money market participants Short-term issues enable the government to raise funds until tax revenues are received The Treasury also issues T-bills to replace maturing issues Federal Reserve System The Federal Reserve is the Treasury’s agent for the distribution of all government securities The Fed holds vast quantities of Treasury securities that it sells if it believes the money supply should be reduced Similarly, the Fed will purchase Treasury securities if it believes the money supply should be expanded The Fed’s responsibility for the money supply makes it the single most influential participant in the U.S money market The Federal Reserve’s role in controlling the economy through open market operations was discussed in detail in Chapters and 10 Commercial Banks Commercial banks hold a percentage of U.S government securities second only to pension funds This is partly because of regulations that limit the investment opportunities available to banks Specifically, banks are prohibited from owning risky securities, such GMAC was once a wholly owned subsidiary of General Motors that provided financing options exclusively for GM car buyers In December 2008 it became an independent bank holding company Chapter 11 The Money Markets TA B L E 1 259 Money Market Participants Participant Role U.S Treasury Department Sells U.S Treasury securities to fund the national debt Federal Reserve System Buys and sells U.S Treasury securities as its primary method of controlling the money supply Commercial banks Buy U.S Treasury securities; sell certificates of deposit and make short-term loans; offer individual investors accounts that invest in money market securities Businesses Buy and sell various short-term securities as a regular part of their cash management Investment companies (brokerage firms) Trade on behalf of commercial accounts Finance companies (commercial leasing companies) Lend funds to individuals Insurance companies (property Maintain liquidity needed to meet unexpected and casualty insurance companies) demands Pension funds Maintain funds in money market instruments in readiness for investment in stocks and bonds Individuals Buy money market mutual funds Money market mutual funds Allow small investors to participate in the money market by aggregating their funds to invest in large-denomination money market securities as stocks or corporate bonds There are no restrictions against holding Treasury securities because of their low risk and high liquidity Banks are also the major issuer of negotiable certificates of deposit (CDs), banker’s acceptances, federal funds, and repurchase agreements (we will discuss these securities in the next section) In addition to using money market securities to help manage their own liquidity, many banks trade on behalf of their customers Not all commercial banks deal in the secondary money market for their customers The ones that are among the largest in the country and are often referred to as money center banks The biggest money center banks include Citigroup, Bank of America, J.P Morgan, and Wells Fargo Businesses Many businesses buy and sell securities in the money markets Such activity is usually limited to major corporations because of the large dollar amounts involved As discussed earlier, the money markets are used extensively by businesses both to warehouse surplus funds and to raise short-term funds We will discuss the specific money market securities that businesses issue later in this chapter 260 Part Financial Markets Investment and Securities Firms The other financial institutions that participate in the money markets are listed in Table 11.2 Investment Companies Large diversified brokerage firms are active in the money markets The largest of these include Bank of America, Merrill Lynch, Barclays Capital, Credit Suisse, and Goldman Sachs The primary function of these dealers is to “make a market” for money market securities by maintaining an inventory from which to buy or sell These firms are very important to the liquidity of the money market because they ensure that sellers can readily market their securities We discuss investment companies in Chapter 22 Finance Companies Finance companies raise funds in the money markets primarily by selling commercial paper They then lend the funds to consumers for the purchase of durable goods such as cars, boats, or home improvements Finance companies and related firms are discussed in Chapter 26 (on the Web at www pearsonhighered.com/mishkin_eakins) Insurance Companies Property and casualty insurance companies must maintain liquidity because of their unpredictable need for funds When four hurricanes hit Florida in 2004, for example, insurance companies paid out billions of dollars in benefits to policyholders To meet this demand for funds, the insurance companies sold some of their money market securities to raise cash In 2010 the insurance industry held about the same amount of treasury securities as did commercial banks ($196 billion versus $199 billion) Insurance companies are discussed in Chapter 21 Pension Funds Pension funds invest a portion of their cash in the money markets so that they can take advantage of investment opportunities that they may identify in the stock or bond markets Like insurance companies, pension funds must have sufficient liquidity to meet their obligations However, because their obligations are reasonably predictable, large money market security holdings are unnecessary Pension funds are discussed in Chapter 21 Individuals When inflation rose in the late 1970s, the interest rates that banks were offering on deposits became unattractive to individual investors At this same time, brokerage houses began promoting money market mutual funds, which paid much higher rates Banks could not stop large amounts of cash from moving out to mutual funds because regulations capped the rate they could pay on deposits To combat this flight of money from banks, the authorities revised the regulations Banks quickly raised rates in an attempt to recapture individual investors’ dollars This halted the rapid movement of funds, but money market mutual funds remain a popular individual investment option The advantage of mutual funds is that they give investors with relatively small amounts of cash access to large-denomination securities We will discuss money market mutual funds in more depth in Chapter 20 Money Market Instruments A variety of money market instruments are available to meet the diverse needs of market participants One security will be perfect for one investor; a different security may be best for another In this section we gain a greater understanding of money Chapter 11 The Money Markets 261 market security characteristics and how money market participants use them to manage their cash Treasury Bills To finance the national debt, the U.S Treasury Department issues a variety of debt securities The most widely held and most liquid security is the Treasury bill Treasury bills are sold with 28, 91, and 182-day maturities The Treasury bill had a minimum denomination of $1,000 until 2008, at which time new $100 denominations became available The Fed has set up a direct purchase option that individuals may use to purchase Treasury bills over the Internet First available in September 1998, this method of buying securities represented an effort to make Treasury securities more widely available The government does not actually pay interest on Treasury bills Instead, they are issued at a discount from par (their value at maturity) The investor’s yield comes from the increase in the value of the security between the time it was purchased and the time it matures CASE Discounting the Price of Treasury Securities to Pay the Interest Most money market securities not pay interest Instead, the investor pays less for the security than it will be worth when it matures, and the increase in price provides a return This is called discounting and is common to short-term securities because they often mature before the issuer can mail out interest checks (We discussed discounting in Chapter 3.) Table 11.3 shows the results of a typical Treasury bill auction as reported on the Treasury direct Web site If we look at the first listing we see that the 28-day Treasury bill sold for $99.988722 per $100 This means that a $1,000 bill was discounted to $999.89 The table also reports the discount rate % and the investment rate % The discount rate % is computed as: idiscount ϭ where 360 FϪP ϫ n F (1) idiscount = annualized discount rate % P = purchase price F = face or maturity value n = number of days until maturity Notice a few features about this equation First, the return is computed using the face amount in the denominator You will actually pay less than the face amount, since this is sold as a discount instrument, so the return is underestimated Second, a 360-day year (30 ϫ 12) is used when annualizing the return This also underestimates the return when compared to using a 365-day year The investment rate % is computed as: iinvestment ϭ FϪP 365 ϫ n P (2) 262 Part Financial Markets TA B L E 1 Security Term Recent Bill Auction Results Issue Date Maturity Date Discount Investment Rate Rate Price Per $100 CUSIP 28 day 04-15-2010 05-13-2010 0.145 0.147 99.988722 912795UQ2 91 day 04-15-2010 07-15-2010 0.155 0.157 99.960819 912795UY5 182 day 04-15-2010 10-14-2010 0.24 0.244 99.878667 912795W31 28 day 04-08-2010 05-06-2010 0.16 0.162 99.987556 912795U41 91 day 04-08-2010 07-08-2010 0.175 0.178 99.955764 912795UW9 Source: http://www.treasurydirect.gov/RI/OFBills The investment rate % is a more accurate representation of what an investor will earn since it uses the actual number of days per year and the true initial investment in its calculation Note that when computing the investment rate % the Treasury uses the actual number of days in the following year This means that there are 366 days in leap years E X A M P L E 1 Discount and Investment Rate Percent Calculations You submit a noncompetitive bid in April 2010 to purchase a 28-day $1,000 Treasury bill, and you find that you are buying the bond for $999.88722 What are the discount rate % and the investment rate %? Solution Discount rate % idiscount ϭ $1000 Ϫ $999.88722 360 ϫ $1000 28 idiscount ϭ 00145 ϭ 0.145% Investment rate % iinvestment ϭ $1000 Ϫ $999.88722 365 ϫ 999.88722 28 iinvestment ϭ 0.00147 ϭ 0.147% These solutions for the discount rate % and the investment rate % match those reported by Treasury direct for the first Treasury bill in Table 11.3 Chapter 11 The Money Markets GO ONLINE Access www.treasurydirect gov Visit this site to study how Treasury securities are auctioned 263 Risk Treasury bills have virtually zero default risk because even if the government ran out of money, it could simply print more to redeem them when they mature The risk of unexpected changes in inflation is also low because of the short term to maturity The market for Treasury bills is extremely deep and liquid A deep market is one with many different buyers and sellers A liquid market is one in which securities can be bought and sold quickly and with low transaction costs Investors in markets that are deep and liquid have little risk that they will not be able to sell their securities when they want to On a historical note, the budget debates in early 1996 almost caused the government to default on its debt, despite the long-held belief that such a thing could not happen Congress attempted to force President Clinton to sign a budget bill by refusing to approve a temporary spending package If the stalemate had lasted much longer, we would have witnessed the first-ever U.S government security default We can only speculate what the long-term effect on interest rates might have been if the market decided to add a default risk premium to all government securities Treasury Bill Auctions Each week the Treasury announces how many and what kind of Treasury bills it will offer for sale The Treasury accepts the bids offering the highest price The Treasury accepts competitive bids in ascending order of yield until the accepted bids reach the offering amount Each accepted bid is then awarded at the highest yield paid to any accepted bid As an alternative to the competitive bidding procedure just outlined, the Treasury also permits noncompetitive bidding When competitive bids are offered, investors state both the amount of securities desired and the price they are willing to pay By contrast, noncompetitive bids include only the amount of securities the investor wants The Treasury accepts all noncompetitive bids The price is set as the highest yield paid to any accepted competitive bid Thus, noncompetitive bidders pay the same price paid by competitive bidders The significant difference between the two methods is that competitive bidders may or may not end up buying securities whereas the noncompetitive bidders are guaranteed to so In 1976, the Treasury switched the entire marketable portion of the federal debt over to book entry securities, replacing engraved pieces of paper In a book entry system, ownership of Treasury securities is documented only in the Fed’s computer: Essentially, a ledger entry replaces the actual security This procedure reduces the cost of issuing Treasury securities as well as the cost of transferring them as they are bought and sold in the secondary market The Treasury auction of securities is supposed to be highly competitive and fair To ensure proper levels of competition, no one dealer is allowed to purchase more than 35% of any one issue About 40 primary dealers regularly participate in the auction Salomon Smith Barney was caught violating the limits on the percentage of one issue a dealer may purchase, with serious consequences (See the Mini-Case box “Treasury Bill Auctions Go Haywire.”) Treasury Bill Interest Rates Treasury bills are very close to being risk-free As expected for a risk-free security, the interest rate earned on Treasury bill securities is among the lowest in the economy Investors in Treasury bills have found that in some years, their earnings did not even compensate them for changes in purchasing power I-14 Index Lehman Brothers, 159, 167, 177, 230, 294, 427, 448, 467, 481, 499, 545, 552 Lemons problem, 140–45, 162, 528n Lender of last resort Federal Reserve as, 227–30, 392, 394 financial crisis of 2007–2009 and, 229–30, 392, 428 International Monetary Fund as, 392–94 moral hazard and, 228, 393 Lender-savers, 16 Lending Tree, 335 Letters of interest, 551 Leveraged buyouts, 444 Leverage ratio, 430 Levine, Dennis, 122 Levitt, Arthur, 509 Liabilities of banks, 399, 401–2 decline in cost advantages of acquiring, 470–71 defined, 16 duration gap analysis, 576–84 of Federal Reserve, 214, 215–16 of life insurance companies, 521–22 rate-sensitive, 573–74 Liability insurance, 524–25 Liability management, 405, 409–10 “Liar loans,” 438 Liens, 327–28 Life expectancy, 519, 519t, 536, 537 Life insurance, 518–22, 540 adverse selection and, 516 annuities, 521 beneficiaries of, 519 decreasing term life, 520t life expectancy and, 519 purpose of, 518, 519 term life, 520, 521 types of, 519 universal life, 521 whole life, 520, 521 Life insurance companies, 27t, 28t assets and liabilities of, 521–22, 522f, 523f defined, 29 mortgages held by, 334f number of, in U.S., 518f screening by, 527 Limit orders, 553–54, 556, 564 Lipper Convertibles, 505 Liquid, 19 Liquidity asset demand and, 64, 67–68 bond demand curve and, 73t, 75 defined, 64 discount window and, 226–27 financial futures market and, 599 of financial instruments, 19 of government securities, 402 interest on reserves and, 220 interest-rate forward contracts and, 592 interest rates and, 93–94, 112 intermediation, of mutual funds, 490 intervention, 274 management, 405, 406–8 of money market securities, 274 risk premium and, 94 of Treasury bills, 274 Liquidity preference framework, 84n Liquidity premium (term premium), 103–6 Liquidity premium theory calculations, 105 defined, 103 term structure of interest rates and, 97–98, 103–6, 113 value of, 107–8 Liquidity services, 24, 139 Liquid market, 263 Lithuania, 385 Living wills, for financial institutions, 449 Load funds, 501–2 Loanable funds, 72f Loan commitments, 414, 571 Loan losses, 417, 419 Loan proceeds, for mortgages, 328 Loans as bank assets, 402 bank management of, 407–9 fixed-payment, 39 real interest rate and, 49 sales of, by banks, 414 screening for, 569–70 servicing, 334 simple, 37, 39 specialization in lending, 570 Loan terms, for residential mortgages, 325, 327–29 Loan-to-value ratio (LTV), 173, 328 Lombard facility, 226n Lombard rate, 226n London, 484, 485 London interbank bid rate (LIBID), 271–72 London Interbank Market, 271–72 London interbank offer rate (LIBOR), 271–72 London International Financial Futures Exchange, 597 London Stock Exchange, 304 Longer-term refinancing operations, 231 Long position, 590–91, 593, 595, 596, 601 Long-term bonds default risk and, 90–92 expectations theory and, 97–102, 102n interest rates, 89–90 liquidity premium theory and, 97–98, 103–6 market segmentation theory and, 97–98, 102–3 reinvestment risk and, 468 risk premium, 90, 91 Long Term Capital Management, 503–6 Long-term debt instruments, 2n, 18, 53–54 Long-term securities, 280–81 Long-term Treasury rates, 326f Loophole mining, 465, 476 Loss aversion, 131 LTV, 539 M Maastricht Treaty, 204, 205, 235–36 Macaulay, Frederick, 56–57, 576 Macroeconomic Advisors, 84 Macro hedge, 596–97 Macroprudential regulation, 245 Mahathir Mohamad, 391 Main refinancing operations, 231 Malaysia, 389, 391 Managed care, 523 Managed float regimes (dirty float), 380, 381, 390–91 Managerial expertise, mutual funds and, 491 Managers, of financial institutions, 366–67 Mandate-consistent inflation, 242 Marché Terme International de France, 597 Marginal lending facility, 231 Marginal lending rate, 231 Margin credit, 554 Margin requirements, 599 Marine insurance, 518 Marked to market, 599–600 Market See stock markets Market-clearing price, 71 Market efficiency See efficient market hypothesis Market equilibrium in bond market, 70–71 in reserves market, 219 Market fundamentals, 120 Market makers, 555 Market orders, 553, 554, 564 Market rates, 296t, 325 Market segmentation theory, 97–98, 102–3, 113 “Markets Lineup,” Wall Street Journal, 318 Market timing, 508 Market traders, 306 Market value, 61 Mark-to-market accounting, 436, 437 Marsh & McLennan Cos (MMC), 526 Index Martin, William McChesney, Jr., 197n, 200, 203n MasterCharge (MasterCard), 459 Matched sale-purchase transactions (reverse repos), 226 Mattel, 550 Maturity, 18, 296t Maturity bucket approach, 575 Maturity date, 37 Maximum acceptable prices, 553 McCain, John, 443n McCarran-Ferguson Act 1945, 525–26f McFadden Act of 1927, 441t, 474 McKinney, Stewart, 429 Mean-reversing interest rates, 102n Mean reversion, 126 Medicaid, 522 Medicare, 522 Meltzer, Alan, 393 Merchant banks, 185–86 Mergers of banks, 476 defined, 551 failed banks and, 426–27 investment banks and, 551–52 Mergers and acquisitions market, 551–52 Merrill Lynch, 159, 177, 260, 284, 467, 468, 481, 544, 545, 552, 554, 555, 556, 558 Mexico financial crisis in, 181, 184–88 fiscal policy, 179 foreign exchange crisis in, 388–89, 393 Micro hedge, 596 Microsoft, 254, 305, 306, 559 MidAmerica Commodity Exchange, 597 Milken, Michael, 291, 293, 464, 551–52 Miller, Merton, 603 Minimum acceptable prices, 553 Ministry of Finance, Japan, 207 Mondex, 463 Monetary base, 215, 217 Monetary liabilities, of Federal Reserve, 215 Monetary policy, 214–50 asset-price bubbles and, 244–45 central banks and, 6–7, 191 defined, economic growth and, 234 employment and, 233–34, 246 federal funds rate and, 218, 219–24 Federal Reserve banks and, 6, 191, 195 financial market stability and, 234 fiscal policy and, 211 FOMC and, 199 foreign-exchange market stability and, 235 goals of, 232–37 housing price bubble and, 174 inflation targeting and, 237–52, 246 interest-rate stability and, 234–35 policy instrument selection, 246–48, 250 price stability and, 232–33, 235–37 repurchase agreements (repos) and, 266–67 time-inconsistency problem, 233 Monetary Policy Report to the Congress, 203 Monetary policy tools, 216–31 discount policy, 217, 221–22, 226–28, 250 European Central Bank, 230–31 federal funds rate and, 219–24 Federal Reserve, 216–30 lending to banks, 231 open market operations, 216–17, 220–21, 224–26, 231, 250 reserve requirements, 217–19, 222–24, 228–30, 231, 250 Money (money supply), See also money supply Money center banks, 259, 409–10 Money market deposit accounts, 400, 574 Money Market Investor Funding Facility (MMIFF), 230 Money market mutual funds (MMMF), 27t, 28t, 497f, 499 average distribution of assets, 501f characteristics of, 499 checks, 30 defined, 30, 499 Federal Reserve and, 229–30 history of, 466 money markets and, 259t net assets, 500f regulation of, 499 shares, 30 Money market rates, 274, 275t Money markets, 254–76 banks vs., 255–57 characteristics of, 255 cost advantages of, 256–57 defined, 20, 255–57 importance of, 254 need for, 255 opportunity costs and, 257 participants in, 258–60 purpose of, 257–58 sample interest rates, 257t wholesale markets, 255 Money market securities, 254–76, 260–73 banker’s acceptance, 271 calculating present value of, 274–76 characteristics of, 255 commercial paper, 268–71 comparing, 273–76 defined, 276 Eurodollars, 271–73 federal funds, 264–66 I-15 interest rates, 273, 275t, 276 liquidity, 274 markets, 276t negotiable certificates of deposit, 267, 268f repurchase agreements (repos), 266–67 secondary market for, 255 transactions, 255 Treasury bills, 261–64 “Money Rates,” Wall Street Journal, 274 Money supply discount lending and, 217 foreign exchange interventions and, 374–77 monetary liabilities of Federal Reserve, 215 open market operations and, 217 reserves and, 215 Monitoring credit risk management and, 569–70, 571 information, 146–47 Monoline insurance companies, 531 Montgomery Securities, 545 Moody’s Investor Service, 92, 141, 157 bond ratings, 292t Moral hazard conflicts of interest, 26, 154–60 credit rationing and, 572–73 credit risk management and, 569, 572–73 in debt contracts, 145, 147–51, 151t defined, 26, 139 in equity contracts, 145–48, 151t financial crises and, 166 financial information and, 146–47 financial structure in debt markets and, 148–51 government regulation and, 30–31 government safety net and, 428 in insurance, 516, 540 insurance fraud, 528 lender of last resort and, 228, 393 mortgage down payments and, 328 principal-agent problem, 145–48, 161 “too big to fail” policy and, 429–30 tools for dealing with, 146–51, 151t Morgan Stanley, 156, 159, 456, 481, 538, 544, 556 Morningstar, 512 Mortgage-backed securities, 336–40 collateralized debt obligations, 339 defined, 336 financial crisis of 2007–2009 and, 171, 174, 175 real estate bubble and, 339–40 subprime loans, 338–39 types of, 337–38 Mortgage Bankers Association, 338 I-16 Index Mortgage banks, 335–36 Mortgage bonds, 291 Mortgage brokers, 438 Mortgage interest rates, 325–27, 340 discount points and, 325–27 loan terms and, 325 long-term Treasure interest rates and, 326f market rates, 325 Mortgage-lending institutions, 325, 333 types of, 333, 334t on the Web, 334, 335 Mortgage markets, 323–40 agency problems in, 172–73 characteristics of, 323 defined, 323 financial crisis of 2007–2009 and, 172–73 financial innovation in, 172 government regulation of, 324–25 originate-and-distribute model, 325 principal-agent problem in, 325 secondary, 325, 335–36 Mortgage pass-through, 336 Mortgage pools and trusts, 336 mortgages held by, 333, 334f value of mortgages held in, 337f Mortgages adjustable-rate, 330–31 amortization of, 329–30 amortized, 324 balloon loans, 324–25 borrower qualification, 328–29 calculators, 343 characteristics of, 325–30 collateral for, 327–28 conventional, 330 credit-worthiness and, 328–29, 339 defaults, 333 defined, 324, 340 down payments, 328, 332 fixed-rate, 330–31, 574 fully amortized, 329 graduated-payment, 331, 333t growing-equity, 331, 333t history of, 324–25 insured, 330 interest payments, 329–30 Internet sources of, 334, 335 loan servicing, 334 loan terms, 325, 327–29 option adjustable-rate, 332 property types, 324t refinancing, 343 residential, 324, 325–30 reverse annuity, 332, 333t second, 328, 331–32, 333t securitization of, 336–40, 464 servicing, 334, 336 tax considerations, 332 types of, 324, 330–33, 333t, 340 uninsured, 336 variable-rate, 573–74 Municipal bonds, 286–88, 498 calculating interest rates, 286 default rates, 288 defined, 286 general obligation, 287 income tax considerations, 94, 96 interest rates, 94–96 revenue, 287 tax-free, 286 Mutual Benefit Life, 522 Mutual funds, 27t, 28t See also money market mutual funds annual statements, 503 asset distribution among, 497f benefits of, 490 board of directors, 494, 496, 509 bond funds, 498 closed-end, 494 complexes, 494 defined, 30, 489 efficient market hypothesis and, 120–21 equity funds, 497–98 ethics and, 507 fee structure, 501–2 PM valuation rule, 508, 510 for 401(k) plans, 491, 493t growth of, 489–91 hedge funds, 503–6 hybrid funds, 498 independent directors of, 503 index funds, 500–501 interest-rate risk of, 54 investment advisors and, 500–501, 503 investment in, 129 investment objective classes, 497–501 late trading, 508 market timing, 508 money market, 499, 500f net asset value, 495–96, 508–10 open-end, 494 organizational structure, 494–96, 496f origins of, 490 ownership of, 491, 493t prospectus, 503 redemption fees, 508, 510 regulation of, 495, 502–3, 509–10 Securities and Exchange Commission and, 495, 502–3, 509–10 shareholder reports, 503 shareholders, 494, 496, 507 total industry net assets, 492t transaction costs and, 138–39 transparency, 510 Mutual funds industry, 489–510 abuses, 507–10 conflicts of interest in, 506–10 regulation and, 509–10 Mutual insurance companies, 517 Mutual savings banks, 27t, 28–29, 28t, 483 N Named-peril policies, 524 NASDAQ (National Association of Securities Dealers Automated Quotation System), 19, 130, 133, 305, 307, 318, 555 National Banking Act of 1863, 324 National banks (federally chartered banks), 456 National Bureau of Economic Research, 56–57 National Central Banks (NCBs), 204 National Credit Union Administration (NCUA), 31t, 483 National Credit Union Share Insurance Fund (NCUSIF), 32, 483 National Steel, 539 NationsBank, 478, 545 Nationwide banks, 478–79 Natural rate of unemployment, 234 Negative interest rates, 47, 81–82 Negotiable certificates of deposit (CDs), 267, 268f, 272, 273f, 276t Net asset value (NAV), 495–96, 508–10 Net income, banks, 419 Net interest margin (NIM), 420, 421t Netscape, 559 Net worth adverse selection and, 145 calculation of, 576n debt contracts and, 149 duration gap analysis and, 576–77, 582, 584 New Finance, The (Haugen), 313 New York, regulation in, 525–26 New York Futures Exchange, 597 New York Mercantile Exchange, 623 New York Stock Exchange (NYSE), 19, 304, 305, 555, 556 Direct+ order routing system, 306–7 program trading and, 603 New Zealand, 237–38, 239, 241 Nikkei 225 contracts, 597 Nikkei 300 Average, 22 Nikkei stock exchange, 304, 416 NINJA loans, 329, 339, 438 Nippon Ginko (Bank of Japan), 207 No Doc loans, 329, 339, 438 No-load funds, 502 Nominal anchors, 232, 250 Nominal interest rates, 48–50, 49n See also interest rates fluctuations in, 64 foreign exchange rates and, 363, 364f yield curves and, 108 Index Nonbank corporations, 269 Nonbank financial institutions, 581–82 Nonbank loans, 135, 136f Nonborrowed reserves (NBR), 218–19, 221, 246, 247f Noncompetitive bidding, 263 Noninterest expenses, for banks, 417 Noninterest income, for banks, 417 Nontransaction deposits, 400–401 Northern Rock, 176 Notional principal, 613 NOW accounts, 404, 405 NYSE Euronext, 304 O Obama, Barack, 96 Off-balance-sheet activities, 414–15 defined, 414, 431 fee income from, 414, 417 loan sales, 414 regulation and, 431 risk management techniques, 415 trading activities, 415 Office of Federal Housing Enterprise Oversight (OFHEO), 285 Office of the Comptroller of the Currency, 31t, 32, 196, 434, 456–57, 480 Office of Thrift Supervision (OTS), 31t, 482 Official reserve transactions balance, 379 Offshore deposits, 484 Ohio Life Insurance and Trust Company, 167 One-period valuation model, 308 Online banking, 461–62 Online-only banks, 461 Open-end mutual funds, 494 Open interest, 597 Open market operations, 216–17 defensive, 224 dynamic, 224 European Central Bank, 231 Federal Reserve banks and, 195, 196, 216–17 monetary policy and, 220–21, 224–26 open market desk, 224–26 Open-peril policies, 524 Operating expenses, for banks, 417, 419 Operating income, for banks, 417, 419 Operating instruments, 246 Opportunity costs, 257 Option adjustable-rate mortgages (option ARMs), 332 Options, 606–13 contracts, 606–7 defined, 606, 619–20 futures contracts vs., 609 owners or buyers of, 606 premiums, 606, 607, 609, 610–11 profits and losses on, 607–10 sellers or writers of, 606 strike price, 610, 611 term to expiration, 611 types of, 606–7 Organized exchanges, 280–81, 320 Organized securities exchanges, 304–7 listing stocks on, 304 over-the-counter markets vs., 305–6 regional, 305 Originate-to-distribute business model, 171 Osaka Securities Exchange, 597 Overconfidence, 131 Overdraft privileges, 414 Overfunded pension plans, 532 Overnight cash rate, 230 Overregulation, 450 Oversubscribed issues, 549 Over-the-counter (OTC) markets, 19, 280, 305–6, 320 Overvalued exchange rates, 382 P Panic of 1907, 192 Paper loss, 53 Parmalat, 142 Participation certificates (PCs), 338 Par value, 39, 296t Pass-through securities FHLMC, 338 GNMA, 337 mortgage, 336 private, 338 types of, 337–38 Patient Protection and Affordable Care Act, 523–24 Payable on demand accounts, 400 Payoff method, for failed banks, 426 Pecking order hypothesis, 144 Pension Benefit Guarantee Corporation (PBGC) (Penny Benny), 538–39, 539f, 540 Pension fund managers, 534 Pension funds, 27t, 28t defined, 29 money markets and, 259t, 260 prudent man rule and, 560 Pension plans defined, 531 defined-benefit, 532, 538 defined-contribution, 532–33 as financial intermediaries, 513 fully funded, 532 future of, 540 growth of, 531–32 insurance on, 538 private, 533–34 public, 534–37 I-17 regulation of, 537–40 Social Security, 534–37 types of, 532–37, 540 underfunded, 532 vesting requirements, 538 Perfect substitutes, 99 Performance measures, banks, 417–20 income statements, 417–19 net income, 419 net interest margin, 420, 421t return on assets, 419, 420, 421t return on equity, 419, 420, 421t trends in, 420, 421t Perpetuities (consols), 44–46, 294 Peso/dollar exchange, 384 Philippines, 389 Piggyback mortgages, 331, 339 Piper, 525 Plain vanilla swaps, 613 Points, for residential mortgages, 325–27 Policy Targets Agreement, 237–38 Political business cycle, 210 Portfolio balance effect, 378n Portfolio insurance, 603 Portfolios, 25, 28, 59–60 Positive feedback loop, 131 Preferred stockholders, 303–4 Preferred stocks, 303–4 Premium, bonds selling at, 298 Premiums, for options, 606, 607, 609, 610–11 Premiums, in insurance liability insurance, 525 life insurance, 514, 520t, 521 risk-based, 527–28 Prepayment risk, 336 Present value (present discounted value), 37–39 Price/earnings ratio (PE), 311, 320 Price earnings valuation model, 311 Prices See also bond prices; housing prices; stock prices efficient market hypothesis and, 117–20 equilibrium (market-clearing), 71 foreign exchange rates and, 351, 352t, 358, 359t Price stability economic growth and, 235 employment and, 236 as goal of monetary policy, 232–33, 235–37 nominal anchor, 232 time-inconsistency problem, 232–33 Primary credit, 226–27 Primary credit facility, 226–27 Primary Dealer Credit Facility (PDCF), 229 Primary dealers, 225 I-18 Index Primary markets, 18–19, 543 Prime rate, 269f, 274 Principal (funds), 37 Principal-agent problems, 145–48 bank management and, 415, 416 financial crisis of 2007–2009 and, 171, 438 moral hazard and, 146 in mortgage markets, 325 tools for resolving, 146–48 Principals (stockholders), 145–46 Privacy, electronic banking and, 439 Private equity buyouts, 562–64 Private equity investment, 558–62 Private mortgage insurance (PMI), 328 Private pass-throughs (PIPs), 338 Private pension plans, 513, 533–34, 533f See also pension funds Private placements, 549–50 Probability distributions, 519–20 Productivity, foreign exchange rates and, 351–52, 352t, 359t, 360 Profits before taxes, banks, 419 Program trading, 603 Property and casualty insurance, 524–25, 540 history of, 524 purpose of, 518 reinsurance, 525 terrorism and, 525 Property and casualty insurance companies, 260, 524 Property insurance, 524 Property rights, 152, 153 Property titles, mortgage liens and, 328 Proprietary trading, 449 Prospectus, 546 Prudential Insurance, 517 Prudential supervision, 433 Prudent man rule, 560 Public Accounting Return and Investor Protection Act (Sarbanes-Oxley Act) See Sarbanes-Oxley Act of 2002 Public Company Accounting Oversight Board (PCAOB), 159, 436 Public interest view of bureaucracies, 207 Public pension plans, 534–37 Purchase and assumption method, 426–27, 429 Purchasing power parity (PPP) theory, 349–50 Putnam Investments, 507 Put options, 606–11 Q Qubes, 307 Quotas, foreign exchange rates and, 351 Qwest, 157 R Raines, Franklin, 285 Random walk defined, 121 foreign markets and, 124 stock market prices theory, 121 Rate of capital gain, 52, 55–56 Rate of return, 36 calculating, 51–52 for chaebols, South Korea, 185 on coupon bonds, 53t defined, 50 interest rates and, 50–61 Rate-sensitive assets and liabilities, 573–76, 581–82, 584 Reagan, Ronald, 203, 603 Real estate bubble, 339–40 Real estate mortgage investment conduits (REMICs), 338 Real estate speculation, 339–40 Real exchange rate, 349 Real interest rates, 48–50, 49n after-tax, 50n foreign exchange rates and, 363, 364f Real terms, 48 Recession, 81–82 Reciprocal regional regulations, 476 “Red book,” 199, 200 Redemption fees, 502 Redlining, 436 Refinancing operations, 231 Regional securities markets, 19 Registered bonds, 289 Registration statements, Securities and Exchange Commission, 546 Regulation, 30–33, 425–50 asset holdings restrictions, 430 asymmetric information and, 425–42 avoidance of, 465–69 banking crises and, 443–44, 445–48 capital requirements, 430–31 chartering, 433–34 circumvention of, 439 competition restrictions, 436–38 consumer protection, 436 disclosure requirements, 435–36 Dodd-Frank Act, 448–49 early, 455–56 of electronic banking, 439 in emerging market economies, 179–80, 181 examination, 433–34 FDIC Improvement Act of 1991, 444–45 of financial information, 30–31, 142, 147, 153 future, 449–50 government safety net, 425–30 international, 440 major legislation, 441–42t moral hazard and, 30–31 multiple agencies, 456–57 of mutual funds, 502–3 in other countries, 33 overregulation, 450 pension plans, 537–40 principal-agent problem and, 147 prompt corrective action, 431, 433 purpose of, 137 reciprocal regional compacts, 476 risk management assessment, 434–35 savings and loan crisis and, 443–44 of securities firms, 556–57 of stock market, 319–20 of systemic risk, 449 types of, 425–42 Regulation B, 436 Regulation K, 485 Regulation Q, 33, 197, 267, 444, 465, 466, 470–71, 499 Regulation Z, 436, 438 Regulatory agencies, 31t, 456–57 Regulatory arbitrage, 431 Regulatory forbearance, 539 Reinsurance, 525 Reinvestment risk, 54–55, 468 Repurchase agreements (repos), 174 interest rates on, 267 markets, 276t money markets and, 266–67 open market operations and, 226 Required reserve ratio, 216, 401 Required reserves, 215–16 changes in, 228–30 defined, 401 demand curve, 218 discount window and, 226–27 European Central Bank, 231 financial innovation and, 465 monetary policy and, 222, 223f Research conflicts of interest and, 155–56 online, Reserve accounts, 334 Reserve Bank of New Zealand, 236, 237–38 Reserve Bank of New Zealand Act, 237–38 Reserve currency, 381, 382, 389–90 Reserve Primary Fund, 467, 499 Reserve requirements, 401, 465 Reserves (bank assets) banking operations and, 403–5 defined, 401 liquidity management and, 406–8 Reserves (Federal Reserve deposits) bank borrowings of, 401 borrowed, 218–19 defined, 215 Index demand and supply in market for, 218–19 demand curve, 218–19 discount lending and, 217 excess, 215–16, 218 interest paid by Federal Reserve, 220 interest rates on, 218, 221 market equilibrium, 219 market for, 217–22 nonborrowed, 218–19 open market operations and, 217 required, 215–16, 218, 226–30 supply curve, 218–19 Reserves (savings), insurance vs., 514 Residential mortgages, 325–30 See also mortgages; subprime mortgage crisis Residual claimants, 18, 303 Resolution authority, 448 Restrictive covenants on corporate bonds, 289 credit risk management and, 570, 571 defined, 137 in developing countries, 152 monitoring and enforcement of, 149–50 Restrictive provisions, in insurance policies, 528 Retirement mutual funds, 491 Return (rate of return) See also rate of return interest rates and, 50–61 Return on assets (ROA), 411–12, 419, 421t Return on equity (ROE), 411–12, 419, 421t Revaluation, of currency, 383 Revenue bonds, 287 Reverse annuity mortgages (RAMs), 332, 333t Reverse repos, 226 Reverse transactions, 231 Revolving underwriting facilities (RUFs), 414 Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, 429, 442t, 477–78, 480 Risk arbitrage and, 119 asset demand and, 64, 66–67 in bank loans, 402 bond demand curve and, 73t, 75 defined, 25, 64 estimating, 312–13, 314 in municipal bond market, 288 stock valuation and, 312–13 Risk-adverse behavior, 514 Risk-adverse investors, 67 Risk assessment, by banks, 415 Risk-based premiums, 527–28 Risk management, 568–85 assessment of, 434–35 in financial institutions, 7–8 regulation of, 434–35 Risk premiums, 90, 91, 94, 115, 170 Risk sharing, 25 Risk structure of interest rates, 89–96, 90–92, 112 Risk taking financial crises and, 164, 166, 167 lender of last resort and, 228 regulation of, 434–35 Risky assets, 32, 430 Robertson Stephens & Co., 545 Rouge traders, 416 Royal Bank of Canada, 460 Russia, 152, 181, 232 See also Soviet Union S Sallie Mae, 284 Salomon Brothers, 467, 468 Salomon Smith Barney, 159, 263, 264, 480, 556 Sarbanes-Oxley Act of 2002, 21, 158–60, 435, 442t, 563 Savers, 17 Savings accounts, 400 Savings and loan associations, 27t, 28–29, 28t 1980s financial crisis, 443–44 bailout of, 444 interest-rate risk and, 573 mortgages issued by, 325, 333, 334t regulation of, 443–44, 482 structure of, 482 Savings deposits, 28, 256f Scandinavia, 462 Screening in credit risk management, 569–70 by insurance companies, 527 Sears, 460 Seasonal credit, 227 Seasoned issues, 546 Secondary credit, 227 Secondary loan participation, 414 Secondary markets, 18–19 capital markets, 280 defined, 543 money market securities, 255 mortgages, 325, 328, 335–36 organization of, 19 Secondary reserves, 402, 408 Second Bank of the United States, 192, 455 Second mortgages, 328, 331–32, 333t Secured corporate bonds, 290–91 Secured debt, 137 Secured loans, 571–72 I-19 Securities bank holdings of, 402 bank management of, 407 defined, 2, 16 efficient market hypothesis and, 117–18 equity sales, 550–51 guarantees of, 414 new issues, 548f pricing, 545–46 primary markets for, 18–19 secondary markets for, 18–19 taking public, 547–50, 550f underwriting, 18, 545–50 unexploited profit opportunities, 119 Securities Act of 1933, 31, 319, 435, 441t, 502, 557 Securities Act of 1934, 319–20, 502–3, 557 Securities Acts Amendment of 1975, 554 Securities and Exchange Commission (SEC), 30, 31t, 122, 435, 467, 480 Corporate Finance division, 319 credit rating agencies and, 158 Enforcement division, 320 Enron and, 143, 157 exemption from registration, 268 financial information and, 142 functions of, 31, 319–20, 546, 557 hedge funds and, 506 insider trading and, 556 investment banks and, 546 Investment Management division, 320 Market Regulation division, 320 mutual funds and, 495, 502, 503, 509–10 options and, 606 organization of, 319–20 registration statements, 546 Sarbanes-Oxley Act and, 159 Securities brokers, 543, 552–55, 564 Securities dealers, 543, 552, 555–56, 564 Securities Exchange Act of 1934, 441t Securities firms brokers and dealers, 552–56 commercial banks and, 558 functions of, 543 regulation of, 556–57 Securities Investor Protection Corporation (SIPC), 554, 557 Securities orders, 553–54 Securities prices, efficient market hypothesis and, 117–20 Securities Protection Corporation Act of 1970, 557 Securitization, 171, 336, 464–65 See also mortgage-backed securities Securitized mortgages, 336–40, 464 See also mortgage-backed securities Security First Network, 460 I-20 Index Seed investing, 562 Self-Employed Individual Tax Retirement Act of 1962, 539 Semiannual bonds, 296–98 Semistrong-form efficiency test, 123n Separate Trading of Registered Interest and Principal Securities (STRIPS), 283–84, 467–69 September 11 terrorist attacks stock market and, 315 terrorism insurance and, 525 Sequoia Capital, 563 Settlement price, 600 Shadow banking system, 174–75, 176, 457 Shareholders, mutual funds, 30, 494, 496, 507 Shares, 28, 29, 30 Shiller, Robert, 125 Short position, 590–91, 593, 595, 596, 599, 601 Short sales, 131, 553 Short-term capital flows, 185 Short-term debt instruments, 18, 53–54 Short-term interest rates, bonds expectations theory and, 102n, 103 liquidity premium theory and, 103, 104, 106 yield curve and, 107f, 108–9 Short-term securities, 254 Silver market, 600 Simple interest rate, 37–38, 41 Simple loans, 37, 39, 40–41 Simple present value, 37–39 SIMPLE retirement plans, 540 Singapore, 389 Sinking fund, 289 Small Business Protection Act of 1996, 540 Small-denomination time deposits, 400 Small-firm effect, 124–25 Smart cards, 462 “Smart money,” 119, 131 “Snake,” 381 Social contagion, 131 Social Security, 534–37, 540 baby boom generation and, 534–35 benefits calculations, 534 cost-of-living adjustment, 536 establishment of, 534 life expectancy and, 536, 537 maximum wage taxed, 535 minimum age for receiving, 535–36, 537 reform of, 536–37 trust fund assets, 535f, 536f trust fund depletion, 535 Social Security Act, 536 Soros, George, 388 South Korea, 185–86, 389 Soviet Union, 154, 272 See also Russia S&P 500 Index, 133, 307, 318, 603–5 Spain, 237 Spanish peseta, 387 Speculation Commodity Futures Modernization Act and, 293–94 real estate, 339–40 Speculative attacks, 182, 186, 385, 387 Speculative bubbles, 131 Speculative-grade bonds, 92, 291 Spiders, 307 Spinning, 156 Spitzer, Eliot, 159, 509, 526 Spot exchange rate, 346, 347t, 353, 601n Spot rates, 110 Spot transactions, 346 Spread, 552 Standard and Poor’s Corp., 92, 141, 157, 176 bond ratings, 292t S&P 500 Index, 133, 307, 318, 603–5 Standard deviation, 66–67 Standing lending facility, 226 Staples, 559 Starbucks, 559 State and local government securities, 402 State banking and insurance commissions, 31t State banks (state-chartered banks), 456 State bonds, 498 State-owned banks, in developing countries, 153 Sterilized foreign exchange interventions, 377–78, 383–84 Stern, Edward J., 508 Stewart, Martha, 553 Stock brokers, 307, 308 Stock companies, 517 Stock funds, 497–98 Stockholders bondholders vs., 289 common, 303 insiders, 31 preferred, 303–4 rights of, 303 Stock index futures contracts, 603–5, 619 Stock market crashes, See also Great Depression of 1929, 169–70, 319 of 1987 (Black Monday), 3, 130, 131, 132, 553–54, 603 federal regulation and, 319 stock prices, 130, 131 Tech Crash of 2000, 3, 130, 131, 132 Stock market indexes, 314–18, 322 Stock market risk, 603 Stock markets, 302–20 behavioral finance and, 131 business investment decisions and, defined, 3–4 electronic communications networks, 306–7 Enron scandal and, 315 excessive volatility of, 125 exchange traded funds, 307 falling prices, 175 financial crisis of 2007–2009 and, 176, 314–15 foreign, 22, 23f functions of, 15 hot tips on, 128 investing guide, 127–29 lemons problem and, 140–41 in Mexico, 186 organization of, 19 organized securities exchanges, 304–6 overreaction of, 125 over-the-counter, 305–206 prices set by, 311–13 price volatility, 3–4 record highs, 302 regulation of, 319–20 security prices set by, 311–13 September 11 terrorist attacks and, 315 in South Korea, 186 in Thailand, 186 types of, 304–7, 320 Stock options, 606 Stock prices See also stock valuation efficient market hypothesis and, 117–26, 132 fluctuations in, 125–26, 314 forecasting, 121 in foreign markets, 124 good news and, 128–29 during the Great Depression, 169f information and, 121, 126 January effect on, 126 market crashes, 130, 131 market overreaction and, 126 mean reversion and, 126 random walk behavior of, 121–23 semistrong-form efficiency test, 123n set by markets, 311–13 small-firm effect on, 125–26 strong-form efficiency test, 123n technical analysis of, 123 trader interaction and, 312–13, 320 unpredictability of, 120–21, 123, 127, 128–29, 132 volatility and, 126 weak-form efficiency test, 123n Stocks, 319–20 defined, 3, 17 Index dividends on, 302 earning a return on, 302 foreign, 318–19 initial public offerings (IPO), 156 investing in, 302–7 issued, 299f sale of, 304–7 as source of external funds, 135, 135n, 136f underwriting, 545–50 valuation errors, 313–14 valuation of, 307–11 Stock valuation, 307–11, 320 See also stock prices company growth and, 309–10 determining present value of, 308 errors in, 313–14 financial information and, 312–13 generalized dividend valuation model, 309 Gordon growth model, 309–10 market price and, 312–13 one-period valuation model, 308 perceived risk and, 312–13 price earnings valuation model, 311 Stop loss orders, 553 Stored-value cards, 463 Strategic income bonds, 498 Stress testing, 415, 435 Strike price, 606, 610, 611 Strong-form efficiency test, 123n Structural unemployment, 234 Structured credit products, 171, 172 Structured investment vehicles (SIVs), 413, 449 Student Loan Marketing Association (Sallie Mae), 284 Subordinated debentures, 291 Subprime mortgage crisis, 552 federal bailout of Fannie Mae and Freddie Mac, 284–86 financial crisis of 2007–2009 and, 171, 172–73 financial derivatives and, 618–19 market collapse, 93 monoline insurers and, 531 Subprime mortgage loans, 338–40 asset-backed commercial paper and, 270–71 credit rating agencies and, 158 defined, 338 foreign exchange rate and, 364–65 Gordon growth model and, 314–15 mortgage brokers and, 438 Sumitomo Corp., 416 Sun Microsystems, 559 SuperDOT (Super Designated Order Turnaround) system, 305 Superregional banks, 476 Supply, excess, 71 Supply and demand analysis analysis, 71–72 of bond market, 68–72 Bush tax cuts and, 96 efficient market hypothesis and, 118 federal funds rate and, 223 fixed exchange rate regimes, 381–82 foreign exchange rates behavior and, 352–54 liquidity premium theory and, 103–4 market equilibrium and, 70–71 market segmentation theory and, 103 monetary policy and, 246, 247f of reserves market, 218–19, 220 Supply curve for bonds, 72–77 business cycle expansion and, 79–80 defined, 69–70 for domestic assets, 353 equilibrium interest rates and, 75–77 expected inflation and, 76–77 expected investment profitability and, 76 for fixed exchange rate regimes, 382 government deficits and, 77 for reserves market, 218–19, 220–21 Supply-side economics, 234 Survivorship benefits, 520 Sutton, Willie, 181 Swap lines, 229 Swaps, 613 Swaptions, 613 Sweden, 237, 240, 387, 462 Sweep accounts, 466–67 Swiss National Bank, 229 Syndicates, 547 Systemic financial institutions, 448 Systemic risk regulation, 449 T T-accounts, 216–17, 375–76, 403–5 Tails, 525 Taiwan, 389 Takeovers, 122 Tanner, Michael, 535 Target financing rate, 230 Tariffs, 351 Taxes bank income before, 419 bearer bonds and, 289 bond interest rates and, 94–96 bonds and, 94–96 Bush tax cuts, 96 capital gains, 129n debt contracts and, 148n insurance company dividends policy, 517 interest rates and, 94–96 second mortgage deductions, 332 Tax Reform Act of 1986, 338, 540 I-21 Taylor, John, 174 Taylor rule, 174 TCBY, 559 “Teal book,” 199, 200 “Teaser” loans, 339 Tech Crash of 2000, 3, 130, 131, 132 Technical analysis, of stock prices, 123 Tech-stock bubble, 243–44 Temporary Guarantee Program, 499 Tender offers, 551 “Tequila effect,” 389 Term Asset-Backed Securities Loan Facility (TALF), 230 Term Auction Facility (TAF), 229 Term life insurance policies, 520, 520t, 521 Term securities, 267 Term Securities Lending Facility (TSLF), 229 Term structure of interest rates, 89, 96–112 defined, 89 evidence on, 106–7 expectations theory and, 97–102, 112–13 forecasting interest rates with, 110–12 liquidity premium theory and, 97–98, 103–6, 113 market segmentation theory and, 97–98, 102–3, 113 yield curve and, 96–97 Term to expiration, 606 Term to maturity bond interest rates and, 96–97 coupon bonds, 103n duration and, 58 Terrorism Risk Insurance Act of 2002, 525 Texaco, 534 Thailand, 186–87, 388–89 Theory of efficient capital markets, 117 See also efficient market hypothesis Theory of purchasing power parity (PPP), 349–50 Thrift institutions (thrifts), 28, 482–83 decline of, 469 mortgages held by, 333 savings and loan and banking crisis of 1980s, 443–44 Time deposits, 28, 400 Time-inconsistency problem, 232–33 TIPS (Treasury Inflation Protection Securities), 51 Title insurance, 328 Title searches, 328 Tokyo Stock Exchange, 597 Tombstones, 547–48, 548f, 549 “Too big to fail” policy, 428–30 Toronto Stock Exchange, 304 I-22 Index Total return funds, 497 Trade balance, 379 Trade barriers, 351, 352t, 358, 360t Trading activities, by banks, 415, 416 Trading Activities Manual, 434 Tranches, 338 Transaction costs defined, 22, 160 financial intermediaries and, 22, 24, 25, 138–39 financial structure and, 138–39 Transition countries, 152–53 TRAPS (Trading Room Automated Processing System), 225–26 Travelers Group, 480 Treasury bills (Japan), 47 Treasury inflation-protected securities (TIPS), 282 Treasury Investment Growth Fund (TIGRs), 284 Trichet, Jean-Claude, 205 Truth in Lending Act, 436, 438 Turkey, 181 12b-1 fees, 502 “Twin crises,” 183 Tyco International, 146 U UBS Warburg, 159 Uncertainty, financial crises and, 165f, 167 Underdeveloped financial systems, 152–53 Underfunded pension plans, 532 Undersubscribed issues, 549 Undervaluation, of currency, 383 Underwriters, 517, 547t Underwriting conflicts of interest and, 155–56 defined, 18, 564 stocks and bonds, by investment banks, 545–50 Unemployment, 233–34 Unexploited profit opportunities, 119–20 Uninsured mortgages, 336 United Kingdom Bank of England, 206–7 inflation targeting in, 237, 238, 240 purchasing power parity theory and, 349–50 United States balance of payments deficit, 380 capital markets, 21 major regulatory legislation, 441–42t Universal banking, 481 Universal life insurance policies, 521 Unsecured corporate bonds, 291 Unsecured debt, 137 Unsterilized foreign exchange interventions, 376, 377, 377n U.S Congress Federal Reserve and, 202–3, 209–11 U.S Department of Agriculture, 597 U.S dollar See also foreign exchange rates Argentine peso and, 384 Chinese yuan pegged to, 389–90 dollarization, 385 euro and, 383 exchange process, 348 exchange rates, 5, 344, 365–66 foreign exchange market stability and, 235 interest rates and, 362–63 Japanese yen and, 348–49 subprime mortgage loans and, 364–65 U.K exchange rate, 350 Used-car market, 140, 143–44 U.S Flow of Funds report, 35 U.S government and agency securities as bank assets, 402 bank management of, 407 U.S Supreme Court, 537 U.S Treasury Exchange Stabilization Fund, 376 Federal Reserve and, 210 foreign exchange policy, 376 monetary liabilities of, 215 money markets and, 258, 259t savings and loan and banking crisis of 1980s and, 444 Separate Trading of Registered Interest and Principal Securities (STRIPS), 283–84, 467–69 Series I savings bonds, 51 Temporary Guarantee Program, 499 TIPS (Treasury Inflation Protection Securities), 51 U.S Treasury bills auctions, 262t, 263, 264 book entry, 263 competitive bidding, 263 deep market for, 263 default risk, 263 Eurodollars and, 272 inflation rates, 265f interest rates, 2, 64, 256f, 263–64, 265–66, 265f, 266f, 268f, 273f, 274, 283f investment rate for, 261–62 liquidity of, 67–68, 263, 274 markets, 276t money markets and, 258, 261–64 noncompetitive bidding, 263 real and nominal interest rates, 49n riskiness of, 82, 83 U.S Treasury bonds, 282–83, 504 default-free, 90, 91, 93 defined, 2n Federal Reserve purchase of, 210n financial futures market and, 598–99 forward rate calculations, 112 futures, 607–9, 611–13 income tax considerations, 94–96 inflation rate and, 283f interest rates on, 94–96, 282, 283f liquidity of, 93–94, 94–96 U.S Treasury notes, 282–83 U.S Treasury securities, 504 lending programs, 229 open market operations, 224 types of, 282–83 V Value at risk (VAR), 415, 435 Value Line, 141 Value Line Survey, 125n Vanguard Group, 54, 307, 501 Vanguard S&P 500 index fund, 494, 501 Variable-rate bonds, 291 Variable-rate mortgages, 573 Vault cash, 215, 401 Venture capital firms, 543, 558–62 asymmetric information and, 559–60 dot-com companies, 563 functions of, 558–59 history of, 560–61 investments, 559t operations of, 561–62 principal-agent problem and, 147 profitability of, 562 structure of, 561 Vesting requirements, for pension plans, 538 Veterans Administration (VA), 284, 330, 335 Vipers, 307 Virtual banking, 460–61 Visa, 459 Volcker, Paul A., 200, 203n, 229, 449 Volcker Rule, 449 Voting rights, of stockholders, 303 W Wall Street Journal, 9, 23f, 85, 156 “Commodities,” 594 “Credit Markets” column, 82, 83 “Currency Trading,” 365–66 Dow Jones Industrial Average, 318 financial futures contracts published in, 597 foreign exchange rates, 347t “Futures Prices,” 604 “Heard on the Street,” 127 “Investment Dartboard,” 120–21, 127 “Markets Lineup,” 318 “Money Rates,” 274 yield curves, 96, 97 Wall Street Week, 308 Index Washington Public Power Supply System, 287 Weak-form efficiency test, 123n Wealth asset demand and, 64, 65 bond demand curve and, 72–74, 73t demand curve for bonds and, 72–74 Web See Internet Webvan, 563 Welch, Jack, 563 Wells Fargo, 259, 460–61 Wharton Econometric Forecasting Associates, 84 Whole life insurance policies, 520, 521 Wholesale markets, 255 Wingspan, 461 World Bank, 381, 384 WorldCom, 142, 157 World equity funds, 497 World Trade Association (WTO), 381 World Wide Web See Internet Y Yield curves bond interest rates and, 96–97 defined, 96 evidence on, 106–7 expectations theory and, 101–2 forecasting interest rates with, 108, 110–12 gap analysis and, 583 interpreting, 108–9 I-23 inverted, 96–97 liquidity premium theory and, 104, 106 market segmentation theory and, 103 shape of, 96–97, 106, 108, 110, 113 Yield to maturity, 36, 40–47 bond prices and, 294–95 coupon bonds, 42–46 defined, 40, 296t discount bonds, 46–47 fixed-payment loans, 41–42 simple loans, 40–41 Z Zero-coupon bonds See discount bonds (zero-coupon bonds) 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 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 2007–2009 Financial Crisis Financial Crises in Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002 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 Subprime Crisis and the Dollar Reading the Wall Street Journal: The “Currency Trading” Column CHAPTER 16 The Foreign Exchange Crisis of September 1992 Recent Foreign Exchange Crises in Emerging Market Countries: Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002 How Did China Accumulate Over $2 Trillion of International Reserves? CHAPTER 17 How a Capital Crunch Caused a Credit Crunch in 2008 CHAPTER 20 Calculating a Mutual Fund’s Net Asset Value 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 Reading the Wall Street Journal: “Credit Markets” Column CHAPTER The Subprime Collapse and the Baa Treasury Spread Effects of the Bush Tax Cut and Its Possible Repeal on Bond Interest Rates Interpreting Yield Curves, 1980–2010 CHAPTER Should Foreign Exchange Rates Follow a Random Walk? What Do the Black Monday Crash of 1987 and the Tech Crash of 2000 Tell Us About the Efficient Market Hypothesis? CHAPTER 24 Lessons from the Subprime 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: Ivan Boesky 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 Inside the Fed: Was the Fed to Blame for the Housing Price Bubble? Global: Ireland and the 2007–2009 Financial Crisis Global: The Perversion of the Financial Liberalization/Globalization Process: Chaebols and the South Korean 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: 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: Why Does the Fed Need to Pay Interest on Reserves? Inside the Fed: Federal Reserve Lender-of Last-Resort Facilities During the 2007–2009 Financial Crisis Global: The European Central Bank’s Monetary Policy Strategy Inside the Fed: Chairman Bernanke and Inflation Targeting 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 2007–2009 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: Insurance Behemoth Charged with Conflicts of Interest Violations Mini-Case: Power to the Pensions Conflicts of Interest: The AIG Blowup Conflicts of Interest: The Subprime Financial Crisis and the Monoline Insurers 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? 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 Global: The Euro’s Challenge to the Dollar Global: Argentina’s Currency Board Global: Dollarization CHAPTER 17 Conflicts of Interest: Barings, Daiwa, Sumitomo, and Societé Generale: 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: Whither the Basel Accord? Mini-Case: Mark-to-Market Accounting and the 2007–2009 Financial Crisis Mini-Case: The 2007–2009 Financial Crisis and Consumer Protection Regulation Following the Financial News CHAPTER Foreign Stock Market Indexes CHAPTER The “Credit Markets” Column Forecasting Interest Rates CHAPTER Yield Curves CHAPTER 11 Money Market Rates CHAPTER 15 Foreign Exchange Rates The “Currency Trading” Column CHAPTER 22 New Securities Issues CHAPTER 24 Financial Futures Stock Index Futures Guide to Commonly Used Symbols Page Where Introduced Symbol Term ⌬ 60 change in a variable ␲e 48 expected inflation ␴ 66 standard deviation Bd 70 demand for bonds s 70 supply of bonds C 43 yearly coupon payment D 91 demand curve DUR 58 duration B DURGAP 578 duration gap E 352 exchange (spot) rate 371 expected appreciation of domestic currency EM 411 equity multiplier GAP 574 income gap (E i e tϩ1 Ϫ E t )/E t 37 interest rate (yield to maturity) Symbol Page Where Introduced Term iD 370 interest rate on dollar assets iF 370 interest rate on foreign assets ir 48 real interest rate Pt 51 price of a security at time t R 51 return RD 371 expected return on dollar deposits RF 371 expected return on foreign deposits ROA 411 return on assets ROE 411 return on equity RSA 574 rate-sensitive assets RSL 574 rate-sensitive liabilities S 91 supply curve ... 99.988 722 9 127 95UQ2 91 day 04-15 -20 10 07-15 -20 10 0.155 0.157 99.960819 9 127 95UY5 1 82 day 04-15 -20 10 10-14 -20 10 0 .24 0 .24 4 99.878667 9 127 95W31 28 day 04-08 -20 10 05-06 -20 10 0.16 0.1 62 99.987556 9 127 95U41... 26 8 Part Financial Markets Interest Rate (%) Negotiable Certificates of Deposit Treasury Bills 1990 1991 19 92 1993 1994 1995 1996 1997 1998 1999 20 00 20 01 20 02 2003 20 04 20 05 20 06 20 07 20 08 20 09... 1990 1991 19 92 1993 1994 1995 1996 1997 1998 1999 20 00 20 01 20 02 2003 20 04 20 05 20 06 20 07 20 08 20 09 20 10 FIGURE 11.3 Federal Funds and Treasury Bill Interest Rates, January 1990–January 20 10 Source: