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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