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PART I
Chapter 1
WHY STUDY FINANCIAL MARKETS AND INSTITUIONS?
Why Study Financial Markets?
Debt Market and Interest Rates
The Stock Market
The Foreign Exchange Market
Why Study Financial Institutions?
Central Banks and the Conduct of Monetary Policy
Structure of the Financial System
Banks and Other Financial Institutions
Financial Innovation
Managing Risk in Financial Institutions
Applied Managerial Perspective
How We Will Study Financial Markets and Institutions
Chapter 2
AN OVERVIEW OF THE FINANCIAL SYSTEM
Function of Financial Markets
Structure of Financial Markets
Debt and Equity Markets
Primary and Secondary Markets
Exchanges and Over-the-Counter Markets
Money and Capital Markets
Internationalization of Financial Markets
International Bond Market, Eurobonds and Eurocurrencies
World Stock Markets
Following the Financial News: Foreign Stock Market Indexes
Function of Financial Intermediaries
Box 1: The Importance of Financial Intermediaries To Securities Markets:
An International Comparison
Transactions Costs
Asymmetric Information: Adverse Selection and Moral Hazard
Financial Intermediaries
Depository Institutions
Contractual Savings Institutions
Investment Intermediaries
Regulation of the Financial System
Increasing Information Available to Investors
Ensuring the Soundness of Financial Intermediaries
Improving Control of Monetary Policy
Financial Regulation Abroad
PART II
PRINCIPLES OF FINANCIAL MARKETS
Chapter 3
UNDERSTANDING INTEREST RATES
Measuring Interest Rates
Present Value
Application: The Cost of the S&L Bailout: An Application of the Present
Value Concept
Yield to Maturity
Box 1: Negative T-Bill Rates? Japan Shows the Way
Other Measures of Interest Rates
Current Yield
Yield on a Discount Basis
Application: Reading the Wall Street Journal: The Bond Page
Following the Financial News: Treasury Bonds and Notes
Following the Financial News: Treasury Bills
Following the Financial News: Corporate Bonds
The Distinction Between Real and Nominal Interest Rates
Box 2: With TIPS, Real Interest Rates Have Become Observable in the
United States
The Distinction Between Interest Rates and Returns
Maturity and the Volatility of Bond Returns: Interest-Rate Risk
Box 3: Helping Investors to Select Desired Interest-Rate Risk
Reinvestment Risk
Application: Should Retirees Invest in "Gilt-edged" Long-Term Bonds?
Summary
The Practicing Financial Institution Manager: Calculating Duration to Measure InterestRate Risk
Calculating Duration
Duration and Interest-Rate Risk
Chapter 4
THE BEHAVIOR OF INTEREST RATES
Determinants of Asset Demand
Wealth
Expected Returns
Risk
Liquidity
Summary
Benefits of Diversification
Loanable Funds Framework: Supply and Demand in the Bond Market
Demand Curve
Supply Curve
Market Equilibrium
Supply and Demand Analysis
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds
Shifts in the Supply of Bonds
Application: Changes in the Equilibrium Interest Rate Due to Expected
Inflation Or Business Cycle Expansions
Changes in Expected Inflation: The Fischer Effect
Business Cycle Expansion
Application: Explaining Low Japanese Interest Rates
Application: Reading the Wall Street Journal: The "Credit Markets"
Column
Following the Financal News: The "Credit Markets" Column
Application: Have Negative Savings Rates in the United States Led to
Higher Interest Rates?
Liquidity Preference Framework: Supply and Demand in the Market for
Money
Changes in Equilibrium Interest Rates
Shifts in the Demand for Money
Shifts in the Supply of Money
Application: Changes in the Equilibrium Interest Rate Due to
Changes in Income, the Price Level, or the Money Supply
Changes in Income
Changes in the Price Level
Changes in the Money Supply
Application: Money and Interest Rates
Does a Higher Rate of Growth of the Money Supply Lower Interest
Rates?
The Practicing Financial Institutions Manager: Profiting from Interest-Rate
Forecasts
Following the Financial News: Forecasting Interest Rates
Appendix to Chapter 4: Applying the Asset Market Approach to a Commodity Market: The Case
of Gold
Supply and Demand in the Gold Market
Demand Curve
Supply Curve
Market Equilibrium
Changes in the Equilibrium Price of Gold
Shift in the Demand Curve for Gold
Shifts in the Supply Curve for Gold
Application: Changes in the Equilibrium Price of Gold Due to a Rise in
Expected Inflation
Application: Reading the Wall Street Journal: The "Commodities"
Column
Following the Financial News: The “Commodities” Column
Chapter 5
THE RISK AND TERM STRUCTURE OF INTEREST RATES
Risk Structure of Interest Rates
Default Risk
Application: The Stock Market Crash of 1987 and the Junk Bond-Treasury
Spread
Application: What If Treasury Securities Were No Longer Default Free?
Liquidity
Income Tax Considerations
Summary
Application: Effects of the Clinton Tax Increase on Bond Interest Rates
Term Structure of Interest Rates
Following the Financial News: Yield Curves
Pure Expectations Theory
Market Segmentation Theory
Liquidity Premium Theory
Evidence on the Term Structure
Summary
Application: Interpreting Yield Curves, 1980-1999
The Practicing Financial Institution Manager: Using the Term Structure to Forecast Interest
Rates
Chapter 6
THE THEORY OF EFFICIENT CAPITAL MARKETS
Theory of Rational Expectations
Formal Statement of the Theory
Rationale Behind the Theory
Implications of the Theory
Efficient Markets Theory: Rational Expectations in Financial Markets
Rationale Behind the Theory
Stronger Version of Efficient Markets Theory
Evidence on Efficient Markets Theory
Evidence in Favor of Market Efficiency
Box 1: An Exception That Proves the Rule: Ivan Boesky
Application: Should Foreign Exchange Rates Follow a Random Walk?
Evidence Against Market Efficiency
Overview of the Evidence on Efficient Markets Theory
The Practicing Financial Institution Manager: Practical Guide to Investing in the Stock
Market
How Valuable are Published Reports by Investment Advisors?
Box 2: Should You Hire and Ape as Your Investment Adviser?
Should You Be Skeptical of Hot Tips?
Do Stock Prices Always Rise When There is Good News?
Efficient Markets Prescription for the Investor
Application: What Does the Stock Market Crash of 1987 Tell Us About
Rational
Expectations and Efficient Markets?
PART III CENTRAL BANKING AND THE CONDUCT OF
MONETARY POLICY
Chapter 7
THE STRUCTURE OF CENTRAL BANKS AND THE FEDERAL
RESERVE SYSTEM
Origins of the Federal Reserve System
Box 1: Inside the Fed: The Political Genius of the Founders of the Federal
Reserve System
Formal Structure of the Federal Reserve System
Federal Reserve Banks
Box 2: Inside the Fed: Special Role of the Federal Reserve Bank of New
York
Member Banks
Board of Governors of the Federal Reserve System
Box 3: Inside the Fed: Role of the Research Staff
Federal Open Market Committee (FOMC)
The FOMC Meeting
Box 4: Green, Blue and Beige: What Do These Colors Mean at the Fed
Box 5: Inside the Fed: The FOMC Directive
Informal Structure of the Federal Reserve System
Box 6: Inside the Fed: Role of Member Banks in the Federal Reserve
System
How Independent is the Fed?
Structure and Independence of Foreign Central Banks
Bank of Canada
Bank of England
Bank of Japan
European Central Bank
The Trend Toward Greater Independence
Explaining the Central Bank Behavior
Box 7: Inside the Fed: Games the Fed Plays
Should the Fed be Independent?
The Case for Independence
The Case Against Independence
Central Bank Independence and Macroeconomic Performance in Seventeen Countries
Chapter 8
THE CONDUCT OF MONETARY POLICY: TOOLS, GOALS, AND
TARGETS
The Federal Reserve’s Balance Sheet
Liabilities
Assets
Open Market Operations
Discount Lending
The Market for Reserves and the Federal Funds Rate
Supply and Demand in the Market for Reserves
How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate
Tools of Monetary Policy
Open Market Operations
A Day at the Trading Desk
Discount Policy
Operations of the Discount Window
Box 1: Inside the Fed: Why Has Adjustment Credit Borrowing Shrunk to
Low Levels?
Lender of Last Resort
Box 2: Inside the Fed: Discounting to Troubled Banks: Franklin National
and Continental Illinois
Announcement Effect
Box 3: Inside the Fed: Discounting to Prevent a Financial Panic: The Black
Monday Stock Market Crash of 1987
Reserve Requirements
Advantages of Open Market Operations over the Other Tools
Goals of Monetary Policy
High Employment
Economic Growth
Price Stability
Box 4: The Growing European Commitment to Price Stability
Interest-Rate Stability
Stability in Financial Markets
Stability of Foreign Exchange Markets
Conflict Among Goals
Central Bank Strategy: Use of Targets
Choosing the Targets
Criteria for Choosing Intermediate Targets
Criteria for Choosing Operating Targets
Fed Policy Procedures: Historical Perspective
The Early Years: Discount Policy as the Primary Tool
Discovery of Open Market Operations
The Great Depression
Box 5: Inside the Fed: Bank Panics of 1930-33: Why Did the Fed Let Them
Happen?
War Finance and the Pegging of Interest Rates: 1942-1951
Targeting Money Market Conditions: The 1950s and 1960s
Targeting Monetary Aggregates: The 1970s
New Fed Operating Procedures: October 1979-October 1982
Deemphasis of Monetary Aggregates: October 1982-Early 1990s
Federal Funds Targeting Again: Early 1990s and Beyond
International Considerations
Box 6: International Policy Coordination: The Plaza Agreement and the
Louvre Accord
Monetary Targeting in Other Countries
United Kingdom
Canada
Germany
Japan
Lessons from Monetary Targeting Experiences
The New International Trend in Monetary Policy Strategy: Inflation Targeting
New Zealand
Canada
United Kingdom
Lessons from Inflation Targeting Experiences
The Practicing Financial Institution Manager: Using a Fed Watcher
PART IV FINANCIAL MARKETS
Chapter 9
THE MONEY MARKETS
The Money Markets Defined
Why Do We Need Money Markets?
Cost Advantages
The Purpose of the Money Markets
Who Participates in the Money Markets?
U.S. Treasury Department
Federal Reserve System
Commercial Banks
Businesses
Investment and Securities Firms
Individuals
Money Market Instruments
Treasury Bills
Application: Discounting the Price of Treasury Securities to Pay the Interest
Box 1: Treasury Bill Auctions Go Haywire
Federal Funds
Repurchase Agreements
Negotiable Certificates of Deposit
Commercial Paper
Banker’s Acceptances
Eurodollars
Comparing Money Market Securities
Interest Rates
Following the Financial News: Money Market Rates
Liquidity
Money Market Mutual Funds
History of Money Market Mutual Funds
Description of Money Market Mutual Funds
MMMF Risk
Current Trends in MMMFs
Chapter 10
THE CAPITAL MARKETS
Purpose of the Capital Market
Capital Market Participants
Capital Market Trading
Organized Securities Exchanges
Over-the-Counter Markets
Capital Market Securities: Bonds
Treasury Bonds
Application: Interest-Rate Risk in Bond Investment
Treasury Bond Interest Rates
Treasury Strips
Agency Bonds
Municipal Bonds
Risk in the Municipal Bond Market
Corporate Bonds
Characteristics of Corporate Bonds
Types of Corporate Bonds
Financial Guarantees for Bonds
Trends in the Bond Market
Capital Market Securities: Stock
Common Stock Versus Preferred Stock
Following the Financial News: Stock Prices
Application: The Valuation of Common Stock
Stock Market Indexes
Box 1: History of the Dow Jones Industrial Average
Buying Foreign Stock
Public Issues of Stocks and Bonds
Using Investment Bankers
Private Placement
Chapter 11
THE MORTGAGE MARKETS
What are Mortgages?
Characteristics of the Residential Mortgage
Mortgage Interest Rates
Application: The Discount Point Decision
Application: Computing the Payment on Mortgage Loans
Loan Terms
Mortgage Loan Amortization
Types of Mortgage Loans
Insured and Conventional Mortgages
Fixed- and Adjustable-Rate Mortgages
Other Types of Mortgages
Mortgage-Lending Institutions
Loan Servicing
Secondary Mortgage Market
Mortgage Backed Securities
What is a Mortgage-Backed Security?
Types of Pass-through Securities
Mortgage-Backed Security Clearing Corporation
The Impact of Securitized Mortgages in the Mortgage Market
Chapter 12
THE FOREIGN EXCHANGE MARKET
Foreign Exchange Market
What are Foreign Exchange Rates?
Following the Financial News: Foreign Exchange Rates
Why are Exchange Rates Important?
How is Foreign Echange Traded?
Exchange Rates in the Long Run
Law of One Price
Theory of Purchasing Power Parity: Why the Theory of Purchasing Power Parity
Cannot Fully Explain Exchange Rates
Factors That Affect Exchange Rates in the Long Run
Exchange Rates in the Short Run
Comparing Expected Returns on Domestic and Foreign Deposits
Interest Parity Condition
Equilibrium in the Foreign Exchange Market
Explaining Changes in Exchange Rates
Shift in the Expected-Return Schedule for Foreign Deposits
Shifts in the Expected-Return Schedule for Domestic Deposits
Application: Changes in the Equilibrium
Exchange Rate: Two Examples
Changes in Domestic Interest Rates
Changes in the Money Supply
Exchange Rate Overshooting
Application: Why are Exchange Rates So Volatile?
Application: The Dollar and Interest Rates, 1973-1998
Application:: Reading the Wall Street Journal: The “Foreign Exchange”
Column
Following the Financial News: The “Foreign Exchange”Column
Chapter 13
THE INTERNATIONAL FINANCIAL SYSTEM
Intervention in the Foreign Exchange Market
Foreign Exchange Intervention and the Money Supply
Box 1: Inside the Fed: A Day at the Federal Reserve Bank of New York's
Foreign Exchange Desk
Unsterilized Intervention
Sterilized Intervention
Balance of Payments
Following the Financial News: The Balance of Payments
Current Account
Capital Account
Official Reserve Transactions Balance
Methods of Financing the Balance of Payments
Evolution of the International Financial System
Gold Standard
Bretton Woods System and the IMF
Box 2: Argentina's Currency Board
Managed Float
European Monetary System (EMS)
Application: The Foreign Exchange Crisis of September 1992
The Practicing Financial Institution Manager: Profiting from a Foreign Exchange
Crisis
Application: The Mexican Peso Crisis of December 1994
Application: The East Asian Currency Crisis of 1997
International Considerations and Monetary Policy
Direct Effects of the Foreign Exchange Market on the Money Supply
Balance-of-Payments Considerations
Exchange Rate Considerations
PART V
THE FINANCIAL INSTITUTIONS INDUSTRY
Chapter 14
THE THEORY OF FINANCIAL STRUCTURE
Basic Puzzles About Financial Structure Throughout the World
Transaction Costs
How Transaction Costs Influence Financial Structure
How Financial Intermediaries Reduce Transaction Costs
Asymmetric Information: Adverse Selection and Moral Hazard
The Lemons Problem: How Adverse Selection Influences Financial Structure
Lemons in the Stock and Bond Markets
Tools to Help Solve Adverse Selection Problems
How Moral Hazard Affects the Choice Between Debt and Equity Contracts
Moral Hazard in Equity Contracts: The Principal-Agent Problem
Box 1: "Hollywood Accounting": Was Forrest Gump a Money Loser?
Tools to Help Solve the Principal-Agent Problem
How Moral Hazard Influences Financial Structure in Debt Markets
Tools to Help Solve Moral Hazard in Debt Contracts
Summary
Application: Financial Development and Economic Growth
Financial Crises and Aggregate Economic Activity
Factors Causing Financial Crises
Application: Financial Crises in the United States
Box 2: Case Study of a Financial Crisis: The Great Depression
Application: Financial Crises in Emerging-Market Countries: Mexico, 19941995, and East Asia, 1997-1998
Chapter 15
THE BANKING FIRM AND BANK MANAGEMENT
The Bank Balance Sheet
Liabilities
Assets
Box 1: Understanding Loan Loss Reserves
Basic Operation of a Bank
General Principles of Bank Management
Liquidity Management and the Role of Reserves
Asset Management
Liability Management
Capital Adequacy Management
The Practicing Financial Institution Manager: Strategies for Managing Bank Capital
Application: Did the Capital Crunch Cause a Credit Crunch in the Early
1990s?
Off-Balance-Sheet Activities
Loan Sales
Generation of Fee Income
Trading Activities and Risk Management Techniques
Box 3: Barings, Daiwa, and Sumitomo: Rogue Traders and the PrincipalAgent Problem
Measuring Bank Performance
Bank's Income Statement
Measures of Bank Performance
Recent Trends in Bank Performance Measures
Financial Innovation
Response to Changes in Demand Conditions
Response to Changes in Supply Conditions
Avoidance of Existing Regulations
The Practicing Financial Institution Manager: Profiting from a New Financial Product: A
Case Study of Treasury Strips
Chapter 16
COMMERCIAL BANKING INDUSTRY: STRUCTURE AND
COMPETITION
Historical Development of the Banking System
Multiple Regulatory Agencies
Structure of the U.S. Commercial Banking Industry
Restrictions on Branching
Response to Branching Restrictions
Bank Consolidation and Nationwide Banking
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
What Will the Structure of the U.S. Banking Industry Look Like in the Future?
Box 1: A Comparison of Banking Structure in the United States and Abroad
Are Bank Consolidation and Nationwide Banking Good Things?
Separation of the Banking and Securities Industries
Repeal of the Glass-Steagall Act
Box 2: The Citicorp-Travelers Merger
Separation of the Banking and Securities Industries in Other Countries
International Banking
Eurodollar Market
Structure of U.S. Banking Overseas
Foreign Banks in the United States
Financial Innovation and the Decline of Traditional Banking
Behind the Decline: Four Financial Innovations
Decline of Traditional Banking
Reasons for the Decline
Banks’ Responses
Decline in Traditional Banking in Other Industrialized Countries
Chapter 17
THRIFTS: SAVINGS AND LOANS AND CREDIT UNIONS
Mutual Savings Banks
Savings and Loan Associations
Mutual Savings Banks and Savings and Loans Compared
Savings and Loans in Trouble: The Thrift Crisis
Later Stages of the Crisis: Regulatory Forbearance
Competitive Equality in Banking Act of 1987
Political Economy of the Savings and Loan Crisis
Principal-Agent Problem for Regulators and Politicians
Application: Principal-Agent Problem in Action: Charles Keating and the
Lincoln Savings and Loan Scandal
Savings and Loan Bailout: Financial Institution Reform, Recovery, and Enforcement Act
of 1989
The Savings and Loan Industry Today
Number of Institutions
S&L Size
S&L Assets
S&L Liabilities and Net Worth
Capital
Profitability and Health
The Future of the Savings and Loan Industry
Credit Unions
History and Organization
Sources of Funds
Uses of Funds
Advantages and Disadvantages of Credit Unions
The Future of Credit Unions
Chapter 18
BANKING REGULATION
Asymmetric Information and Bank Regulation
Government Safety Net: Deposit Insurance and the FDIC
Box 1: A Tale of Two Bank Collapses: Bank of New England and Freedom
National Bank
Restrictions on Asset Holdings and Bank Capital
Requirements
Box 2: The Basle Accord on Risk-based Capital Requirements
Bank Supervision: Chartering and Examination
New Trend in Bank Supervision: Assessment of Risk Management
Disclosure Requirements
Box 3: New Zealand's Disclosure-Based Experiment in Bank Regulation
Consumer Protection
Box 4: Political Hot Button: The Community Reinvestment Act
Restrictions on Competition
Separation of the Banking and Securities Industries: The Glass-Steagall Act
International Banking Regulation
Problems in Regulating International Banking
Box 5: The BCCI Scandal
Summary
The 1980s U.S. Banking Crisis: Federal Deposit Insurance Corporation Improvement Act
of 1991
Box 6: The SAIF Fix and the Future of the S&L Industry
Application: Evaluating FDICIA and Other Proposed Reforms of the Banking
Regulatory System
Limits on the Scope of Deposit Insurance
Prompt Corrective Action
Risk-Based Insurance Premiums
Other FDICIA Provisions
Other Proposed Changes in Banking Regulations
Overall Evaluation
Banking Crises Throughout the World
Scandanavia
Latin America
Russia and Eastern Europe
Japan
East Asia
Deja Vu All Over Again
The Practicing Financial Institutions Manager: Calculating Capital Requirements
Chapter 19
INSURANCE COMPANIES AND PENSION FUNDS
Insurance Companies
Fundamentals of Insurance
Adverse Selection and Moral Hazard in Insurance
Selling Insurance
Box 1: Insurance Agent: The Customer’s Ally
Growth and Organization of Insurance Companies
Box 2: The Woes of Lloyd’s of London
Types of Insurance
Life Insurance
Health Insurance
Property and Casualty Insurance
Insurance Regulation
The Practicing Financial Institution Manager: Insurance Management
Screening
Risk-Based Premiums
Restrictive Provisions
Prevention of Fraud
Cancellation of Insurance
Deductibles
Coinsurance
Summary Limits on the Amount of Insurance
Pensions
Types of Pensions
Defined-Benefit Pension Plans
Defined-Contribution Pension Plans
Private and Public Pension Plans
Regulation of Pension Plans
Employee Retirement Income Security Act
Box 3: The Perils of Penny Benny: A Repeat of the S&L Bailout?
Individual Retirement Plan
The Future of Pension Funds
Chapter 20
FINANCE COMPANIES AND FINANCIAL CONGLOMERATES
History of Finance Companies
Purpose of Finance Companies
Risk in Finance Companies
Types of Finance Companies
Business (Commercial) Finance Companies
Consumer Finance Companies
Sales Finance Companies
Box 1: The Expansion of Ford Motor Credit
Regulation of Finance Companies
Finance Company Balance Sheet
Assets
Liabilities
Income
Finance Company Growth
Financial Conglomerates