Money and

Capital Markets

Financial Institutions and Instruments

in a Global Marketplace

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 Contents

PART1 Primary versus Secondary

Markets 14
Spot versus Futures, Forward, and
The Global Financial System
Option Markets 14
in Perspective 1 1.5 Factors Tying All Financial
Markets Together 15
1 Functions and Roles of the Financial Credit, the Common Commodity 16
System in the Economy 2 Speculation and Arbitrage 16
1.1 Introduction to the Financial 1.6 The Dynamic Financial
System 3 System 16
1.2 The Global Economy and the 1.7 The Plan of This Book 17
Financial System 3 Summary of the Chapter's Main
Flows within the Global Economic Points 19
System 3 Key Terms Appearing in This
The Role of Markets in the Global Chapter 20
Economic System 4
Problems and Issues 20
Types of Markets 5
Web-Based Problems 22
The Financial Markets and the
Selected References to Explore 23
Financial System: Channel for
Financial Assets, Money, Financial
Savings and Investment 5 Transactions, and Financial
Nature of Savings 6 Institutions 25
Nature of Investment 6 2.1 Introduction: The Role of Financial
1.3 Economic Functions Performed by Assets 26
the Global Financial System and 2.2 The Nature and Characteristics of
the Financial Markets 7 Financial Assets 26
Savings Function 7 Characteristics of Financial
Wealth Function 8 Assets 26
Liquidity Function 9 Types of Financial Assets 27
Credit Function 9 2.3 How Financial Assets Are
Payments Function 9 Created 27
Risk Protection Function 10 2.4 Financial Assets and the Financial
Policy Function 11 System 31
1.4 Types of Financial Markets within 2.5 Lending and Borrowing in the
the Global Financial System 11 Financial System 33
The Money Market versus the Capital 2.6 Money as a Financial Asset 36
Market 12 What Is Money? 36
Divisions of the Money and Capital The Functions of Money 37
Markets 12 The Value of Money and Other
Open versus Negotiated Markets 14 Financial Assets and Inflation 38

xxii
 Contents

2.7 The Evolution of Financial Problems Asymmetries Can Create:

Transactions 40 Moral Hazard 63
Direct Finance 40 Asymmetry, Efficiency, and Real-
Semidirect Finance 41 World Markets 64
Indirect Finarite and-Financial Informational Asymmetries and the
Intermediation 42 Law 65
2.8 Relative Sizes and Types of Major 3.3 Debt Security Prices and Yields:
Financial Institutions 44 Sources of Information 68
Comparative Sizes of Key Financial- Bonds and Notes 68
Service Providers 44 Bid and Asked Prices and Pricing
Classifying Financial Institutions 45 Information 68
Portfolio (Financial-Asset) Decisions 3.4 Stock Prices and Dividend Yields:
by Financial Institutions 46 Sources of Information 69
2.9 The Disintermediation of Funds 47 Price and Yield Information 70
New Types of Disintermediation 47 Stock Price Indexes and Foreign Stock
2.10 Bank-Dominated versus Market- Prices 70
Dominated Financial Systems 48 3.5 Information on Security
Summary of the Chapter's Main Issuers 71
Points 49 Moody's and Standard & Poor's
Key Terms Appearing in This Reports 71
Chapter 50 Securities and Exchange Commission
Problems and Issues 51 (SEC) Reports 72
Web-Based Problems 53 Company Histories 72
Selected References to Explore 53 Dun & Bradstreet Ratings and Risk
The Financial Information Management 72
Marketplace 55 Financial Institutions 73
3.1 Introduction: The Importance Credit Bureaus 73
of Information in the Financial 3.6 General Economic and Financial
Marketplace 56 Conditions 73
3.2 The Great Debate over Efficient The Federal Reserve System 73
Markets and Asymmetric Other Domestic and International
Information 56 Sources of Information 74
The Efficient Markets Hypothesis Summary of the Chapter's Main
(EMH) 57 Points 75
What Is an Efficient Market? 57 Key Terms Appearing in This
Different Forms of the EMH 58 Chapter 76
Insiders and Insider Trading 59 Problems and Issues 76
What Is Insider Trading ? 59 Web-Based Problems 78
When Is Insider Trading Legal or Selected References to Explore 79
Illegal? 59 Appendix 3A: The Flow of Funds in
The Asymmetric Information the Financial System 80
Hypothesis (AIH) 60 The Future of the Financial System
Problems Asymmetries Can Create: and Trends in the Money and Capital
Lemons and Plums 61 Markets 88
Problems Asymmetries Can Create: 4.1 Introduction: The Financial
Adverse Selection 62 Markets in Change 89
xxiv Contents

4.2 Financial Forces Reshaping the Money Financial Disclosure 109

and Capital Markets Today 89 Privacy Protection and Identity
4.3 Economic and Demographic Theft 110
Forces Reshaping the Financial Social Responsibility 111
System 91 Promoting a Level Playing Field 111
4.4 The Challenges and Opportunities Summary of the Chapter's Main
Presented by Recent Trends 94 Points 112
Dealing with Risk in the Financial Key Terms Appearing in This
System: Ensuring the Strength of
Chapter 113
Financial Institutions and Increasing
Public Confidence 95 Problems and Issues 113
Web-B ased Problems 114
The Consequences of Reduced Public
Confidence 95 Selected References to Explore 115
Ways to Promote Public Confidence
in Financial Institutions and Reduce PART 2
Risk in the Financial System 95
Developing Better Management Tools Interest Rates and the Prices of
to Deal with Risk 97 Financial Assets 117
The Information Problem 98
The Effect of New Technology on 5 The Determinants of Interest Rates:
the Design and Delivery of Financial Competing Ideas 118
Services 99 5.1 Introduction: Interest Rates and the
The Information Revolution 99 Price of Credit 119
Recent Technological Advances 99 5.2 Functions of the Rate of Interest in
Public Attitudes and Cost 100 the Economy 119
The Changing Mix of Financial-Service 5.3 The Classical Theory of Interest
Suppliers in the Financial System . 101 Rates 120
Price Sensitivity and Local Saving by Households 120
Competition 101 Saving by Business Firms 121
Importance of Established Delivery Saving by Government 122
Systems 101 The Demand for Investment
New Financial Institutions and Funds 122
Instruments 101 The Investment Decision-Making
Securitization 102 Process 122
Consolidations and Convergences Investment Demand and the Rate of
within the Financial System 102 Interest 124
4.5 A New Role for Regulation The Equilibrium Rate of Interest in
in an Age of Financial- the Classical Theory of Interest 124
Services: Consolidation and Limitations of the Classical Theory of
Convergence 104 Interest 125
4.6 The Payments System: Current and 5.4 The Liquidity Preference or Cash
Future 107 Balances Theory of Interest Rates 126
4.7 The Current and Future Need The Demand for Liquidity 126
for Regulation of Financial Motives for Holding Money (Cash
Institutions 108 Balances) 127
Financial Service Regulations That Total Demand for Money (Cash
Could Grow 109 Balances) 128
 Contents xxv

The Supply of Money (Cash 6.3 Interest Rates in the Wholesale

Balances) 130 Money Markets 149
The Equilibrium Rate of Interest in Computing Interest Rates on Money
Liquidity Preference Theory 130 Market Assets That Are Sold at a
Limitations of the Liquidity Discount 149
Preference Theory 131 Holding-Period Yield on Money
5.5 The Loanable Funds Theory of Market Assets Sold at a Discount 150
Interest 132 Interest Rate Quotations on U.S.
The Demand for Loanable Funds 132 Treasury Bills 151
Consumer (Household) Demand for 6.4 Interest Rates on Bonds and Other
Loanable Funds 132 Long-Term Debt Securities 152
Domestic Business Demand for Yield to Maturity (YTM) 152
Loanable Funds 132 Holding-Period Yield on Bonds and
Government Demand for Loanable Other Long-Term Debt Securities 153
Funds 132 Understanding the Concepts of Yield
Foreign Demand for Loanable to Maturity and Holding-Period
Funds 132 Yield 154
Total Demand for Loanable Price Quotations on U.S. Treasury
Funds 133 Notes and Bonds 155
The Supply of Loanable Funds 133 Price Quotations on Corporate
Domestic Saving 133 Bonds 156
Dishoarding of Money Balances 134 6.5 Interest Rates and the Prices of
Debt Securities 157
Creation of Credit by the Domestic
Banking System 134 6.6 Rates of Return on a Perpetual
Foreign Lending to the Domestic Funds Financial Instrument 160
Market 134 The Rate of Return on Fixed-Income
Total Supply of Loanable Funds 135 Perpetuities 160
The Equilibrium Rate of Interest in Interest Rates and Stock Prices 161
the Loanable Funds Theory 135 Calculating the Holding-Period Yield
5.6 The Rational Expectations Theory on Stock 162
of Interest 137 Price Quotations in Corporate
Summary of the Chapter's Main Stock 162
Points 141 6.7 Interest Rates Charged by
Key Terms Appearing in This Institutional Lenders 164
Chapter 142 The Simple Interest Method 164
Problems and Issues 142 Add-On Rate of Interest 165
Web-Based Problems 144 Discount Loan Method 165
Selected References to Explore 145 Home Mortgage Interest Rate 165
Measuring and Calculating Interest Annual Percentage Rate (APR) 167
Rates and Financial Asset Prices 147 Compound Interest 168
6.1 Introduction to Interest Rates and The Annual Percentage Yield (APY)
Asset Prices 148 on Deposits 169
6.2 Units of Measurement for Interest Summary of the Chapter's Main
Rates 148 Points 170
Calculating and Quoting Interest Key Terms Appearing in This
Rates 148 Chapter 171
Basis Points 148 Problems and Issues 172
 Contents

Web-Related Problems 173 7.7 Uses of the Yield Curve 197

Selected References to Explore 174 Forecasting Interest Rates 197
Inflation, Yield Curves, and Duration: Uses for Financial Intermediaries 197
Impact on Interest Rates and Asset Detecting Overpriced and Underpriced
Prices 175 Financial Assets 198
7.1 Introduction 176 Indicating Trade-Offs between Maturity
7.2 Inflation and Interest Rates 176 and Yield 198
The Correlation between Inflation and Riding the Yield Curve 198
Interest Rates 176 7.8 Duration: A Different Approach to
Nominal and Real Interest Rates 177 Maturity 199
The Fisher Effect 178 The Price Elasticity of a Bond or
Alternative Views about Inflation and Other Debt Security 199
Interest Rates 178 The Impact of Varying Coupon
The Harrod-Keynes Effect ofInflation 178 Rates 200
Anticipated versus Unanticipated An Alternative Maturity Index for a
Inflation 179 Financial Asset: Duration 201
The Inflation-Risk Premium 180 The Convexity Factor 203
The Inflation-Caused Income Tax Uses of Duration 204
Effect 180 Estimating Asset Price Changes 204
Conclusions from Recent Research on Portfolio Immunization 205
. Inflation and Interest Rates 181 Limitations of Duration 207
7.3 Inflation and Stock Prices 182 Summary of the Chapter's Main
7.4 The Development of Inflation- Points 208
Adjusted Securities 184 Key Terms Appearing in This
7.5 The Maturity of a Loan 188 Chapter 210
The Yield Curve and the Term Problems and Issues 210
Structure of Interest Rates 188 Web-B ased Problems 213
Types of Yield Curves 189 Selected References to Explore 214
The Unbiased Expectations The Risk Structure of Interest Rates:
Hypothesis 189 Defaults, Prepayments, Taxes, and
Assumptions of the Expectations Other Rate-Determining Factors 216
Hypothesis 191 8.1 Introduction 217
Policy Implications of the Unbiased 8.2 Marketability 217
Expectations Hypothesis 191 8.3 Liquidity 218
The Liquidity Premium View of the 8.4 Default Risk and Interest Rates 218
Yield Curve 192 The Premium for Default Risk 219
7.6 The Segmented-Markets and The Expected Rate of Return or Yield
Preferred Habitat Arguments 193 on a Risky Asset 219
The Possible Impact of Segmented Anticipated Loss and Default-Risk
Markets on the Yield Curve 193 Premiums 220
Policy Implications of the Segmented- Factors Influencing Default-Risk
Markets Theory 194 Premiums 221
The Preferred Habitat or Composite Inflation and Default-Risk
Theory of the Yield Curve 194 Premiums 223
Research Evidence on the Yield Yield Curves for Risky
Curve 194 Securities 224
 Contents

The Volatile History of Junk Bonds 224 9.3 Interest Rate Swaps 250
The Junk-Bond Spread and the What Are Swaps? 250
Economy 226 How Swaps Work 251
8.5 New Ways ofDealing with Default The Risks of Swapping 253
Risk: Credit Derivatives 227 9.4 Financial Futures Contracts 255
A Summary of the Default Risk— The Nature of Futures Trading 255
Interest Rate Relationship 229 Examples of Daily Price Quotations
8.6 Call Privileges and Call Risk 229 for U.S. Treasury Futures 255
Calculating the Yields on Called Why Hedging with Futures Can Be
Financial Assets 229
Effective 256
Advantages and Disadvantages of the
Types of Hedges in Futures 258
Call Privilege 231
The Long (or Buying) Hedge 258
The Call Premium and Interest Rate
The Short (or Selling) Hedge 259
Expectations 231
Cross Hedging 260
Research Evidence on Call Privileges
and Call Risk 231 Executing a Trade, the Cash Margin,
and the Settlement of the Contract 261
8.7 Prepayment Risk and the Yields on
Loan-Backed Securities 232 Payoff Diagrams for Long and Short
8.8 Taxation of Returns on Financial Futures Contracts 262
Assets 235 Futures Contracts Offered on
Tax-Exempt Securities 235 Exchanges Today 262
The Effect of Marginal Tax Rates on 9.5 Option Contracts 264
After-Tax Yields 236 Basic Types of Option Contracts and
Comparing Taxable and Tax-Exempt Price Quotations 264
Securities 237 Examples of Price Quotes on Options
Treatment of Capital Losses and Contracts 265
Capital Gains 238 Uses of Options 266
8.9 Convertible Securities 238 Protecting against Declining Investment
Advantages for the Convertible Bond Yields 267
Issuer 239 Protecting against Rising Interest
Advantages for the Investor in Rates 267
Convertible Bonds 240 Payoff Diagrams for Valuing
8.10 The Structure of Interest Rates in Options 267
the Financial System 240 Options Offered on Exchanges
Summary of the Chapter's Main Today 270
Points 242 9.6 Exchanges Where Futures and
Key Terms Appearing in This Options Contracts Are Traded 270
Chapter 243 9.7 Risks, Costs, and Rules for Trading
Problems and Issues 243 in Derivatives 271
Web-Based Problems 245 Risks and Costs Associated with
Selected References to Explore 246 Futures and Options 271
Interest Rate Forecasting and Hedging: Accounting Rules for Transactions
Swaps, Financial Futures, and Involving Derivatives 271
Options 248 Summary of the Chapter's Main
9.1 Introduction 249 Points 272
9.2 Implicit Interest Rate Forecasts and Key Terms Appearing in This
Asset Prices 249 Chapter 273
 Contents

Problems and Issues 274 10.4 Primary Dealers in Government

Web-Based Problems 276 Securities 297
Selected References to Explore 276 10.5 Dealer Borrowing and Lending
Appendix 9A: The Black-Scholes Activities in the Money Market 299
Model for Valuing Options 278 v Demand Loans for Dealers 299
Repurchase Agreements (RPs) for
Dealers and Other Money Market
PART 3
Participants 300
A New Type of RP: The GCF Repo 301
The Money Market and Central Sources of Dealer Income 302
Banking 281 Dealer Positions in Securities 303
Dealer Transactions and Government
10 Introduction to the Money Market and Security Brokers 304
the Roles Played by Governments and Summary of the Chapter's Main
Security Dealers 282 Points 306
10.1 Introduction: The Market for Key Terms Appearing in This
Short-Term Credit 283 Chapter 307
10.2 Characteristics of the Money Problems and Issues 307
Market 283 Web-Based Problems 308
What the Money Market Does 283 Selected References to Explore 309
The Need for a Money Market 284 11 Commercial Banks, Major Corporations,
Key Borrowers and Lenders in the and Federal Credit Agencies in the
Money Market 284 Money Market 311
The Goals of Money Market 11.1 Introduction 312
Investors 286 11.2 The Roles Played by Banks in the
Types of Investment Risk That Money Market 312
Investors Face 287 11.3 Federal Funds Provided by the
Money Market Maturities 289 Banking System 313
Depth and Breadth of the Money The Nature of Federal Funds and
Market 289 Their Uses 313
The Speed of Money Market Payments: Use of the Federal Funds Market to
Federal Funds versus Clearinghouse Meet Reserve Requirements 314
Funds 289 Mechanics of Federal Funds Trading 314
A Market for Large Borrowers and Volume of Borrowings in the Funds
Lenders 291 Market 316
10.3 Government Involvement in the Interest Rates on Federal Funds 316
Money Market 291 Federal Funds and Government
The Roles That Governments Play in Economic Policy 316
the Money Market 291 11.4 Negotiable Certificates of Deposit
Selling Treasury Bills to Money (CDs) Issued by Banks 318
Market Investors: The Anchor of the Terms Attached to CDs and Who
Money Market 292 Buys Them 318
Volume of Bills Outstanding 292 Buyers of CDs 320
Types of Treasury Bills 292 New Types of CDs 321
How Bills Are Sold 293 11.5 Eurocurrency Deposits in
Results of a Recent Bill Auction 295 International Banks 322
Market Interest Rates on Treasury What Is a Eurodollar? 322
Bills 295 The Creation of Eurocurrency
Investors in Treasury Bills 297 Deposits 323
 Contents

Eurocurrency Maturities and Summary of the Chapter's Main

Risks 326 Points 346
The Supply of Eurocurrency Key Terms Appearing in This
Deposits 326 ~" Chapter 348
Eurodollars in U.S Domestic Bank Problems and Issues 348
Operations 327 Web-Based Problems 351
Recent Innovations in the Selected References to Explore 352
Eurocurrency Markets 328 12 Roles and Services of the Federal
Benefits and Costs of the Reserve and Other Central Banks around
Eurocurrency Markets 328 the World 354
11.6 Bankers' Acceptances 328 12.1 Introduction to Central
How Bankers' Acceptances Are Used Banking 355
in International Trade 328 12.2 The Roles of Central Banks in the
Bankers' Acceptances as Investment Economy and Financial System 355
Instruments 329 Control of the Money Supply to
The Decline in Bankers' Avoid Severe Inflation 355
Acceptances 330 Stabilizing the Money and Capital
11.7 Evaluating the Money Market Markets 356
Costs of Funds Needed by Lender of Last Resort and Supervisor
Bankers 331 of the Banking System 357
11.8 Concluding Comment on Bank Maintaining and Improving the
Activity in the Money Market 332 Payments Mechanism 357
11.9 Major Corporations in the Money 12.3 The Goals and Channels of Central
Market: Commercial Paper 333 Banking 357
The Nature of Commercial Paper 333 Central Banks' Goals 357
Types of Commercial Paper 333 Challenges in Achieving Central Bank
The Recent Track Record of Goals 358
Commercial Paper 335 The Channels through Which Central
Commercial Paper as Investment Banks Work 359
Instruments 336 12.4 History of the Federal Reserve
Advantages of Issuing Commercial System—Central Bank of the
Paper 338 United States 362
Possible Disadvantages from Issuing Problems in the Early U.S. Banking
Commercial Paper 339 System 362
Who Buys Commercial Paper? 339 Creation of the Federal Reserve
Continuing Innovations in the Paper System 363
Market 340 The Early Structure of the Federal
Commercial Paper Ratings and Dealer Reserve 364
Operations 341 Goals and Policy Tools of the
Dealers in Paper 341 Fed 364
11.10 Credit Agencies in the Money 12.5 How the Fed Is Organized
Market 342 Today 365
Types of Federal Credit The Board of Governors 366
Agencies 342 The Federal Open Market
Growth of the Agency Security Committee 367
Market 343 The Federal Reserve Banks 368
Characteristics and Marketing of The Member Banks of the Federal
Agency Securities 346 Reserve System 370
XXX Contents

12.6 Roles of the Federal Reserve Changes in the Federal Reserve's

System Today 372 Discount Rate 394
The Clearing and Collection of Checks Borrowing and Repaying Discount
and Other Payments Media 372 Window Loans 396
Issuing Currency and Coin and Effects of a Discount Rate
Related Services 373 Change 397
Maintaining a Sound Banking and Reserve Requirements 398
Financial System 373 Effects of a Change in Deposit Reserve
Serving as the Federal Government's Requirements 399
Fiscal Agent 373 An Illustration 400
Providing Information to the Public 374 Current Levels of Reserve
Carrying Out Monetary Policy 374 Requirements 400
12.7 The Key Focus of Central Bank 13.4 Selective Credit Controls Used in
Monetary Policy: Interest Rates, Central Banking 403
Reserves, and Money 374
Moral Suasion by Central Bank
12.8 Reserve Composition and Officials 403
the Deposit and Money
Margin Requirements 403
Multipliers 375
13.5 Interest Rate Targeting 404
The Deposit Multiplier 376
The Federal Funds Rate 404
The Money Multiplier 378
Summary of the Chapter's Main Fed Funds Targeting and Long-Term
Interest Rates 407
Points 380
Key Terms Appearing in This 13.6 The Federal Reserve and Economic
Goals 408
Chapter 381
The Goal of Controlling
Problems and Issues 381
Inflation 408
Web-Based Problems 382
Central Bank Targeting of
Selected References to
Inflation 410
Explore 383
The Tools and Goals of Central Bank Deflation 411
13
Monetary Policy 384 Hyperinflation 411
13.1 Introduction to the Tools and Goals The Goals of Full Employment and
of Monetary Policy 385 Stable Economic Growth 412
13.2 General versus Selective Credit The Natural Rate of
Controls 385 Unemployment 412
13.3 General Credit Controls in Central The Output Gap 413
Banking 385 13.7 The Conflicting Goals and
Open Market Operations 385 the Limitations of Monetary
Effects of Open Market Operations on Policy 414
Interest Rates 385 Summary of the Chapter's Main
Effects of Open Market Operations on Points 416
Reserves 386 Key Terms Appearing in This
How Open Market Operations Are Chapter 418
Conducted in the United States 387 Problems and Issues 418
Types of Open Market Operations 389 Web-Based Problems 419
Goals of Open Market Operations: Selected References to
Defensive and Dynamic 392 Explore 419
 Contents

PART 4 14.5 Managing Commercial Bank

Performance Today 441
Financial Institutions:,Organization, Managing Bank Assets, Liabilities,
Revenues, and Expenses 441
Activities, and Regulation"^ 421 . Monitoring the Performance of a
Bank 442
14 The Commercial Banking
14.6 Money Creation and Destruction
Industry: Structure, Products, and
by Banks and Bank Accounting
Management 422
Methods 445
14.1 Introduction to Banking 423
The Creation of Money and
14.2 The Structure of U.S. Commercial Credit 446
Banking 423
Destruction of Deposits and
A Trend toward Consolidation 424 Reserves 448
Falling Industry Numbers As Small Implications of Money Creation and
Banks Are Taken Over by Larger Destruction 448
Ones 424
Summary of the Chapter's Main
A Countertrend: Both Small and Points 450
Large Banks May Survive 425 Key Terms Appearing in This
Economies of Scale Support a
Chapter 451
Consolidating Industry 425
Problems and Issues 451
Branch Banking 425
Bank Holding Companies Web-Based Problems 453
(BHCs) 426 Selected References to
Explore 454
, Financial Holding Companies
15 Nonbank Thrift Institutions: Savings and
(FHCs) 427 Loans, Savings Banks, Credit Unions,
International Banking 427 and Money Market Funds 456
14.3 The Convergence Trend in 15.1 Introduction to Thrift
Banking 429 Institutions 457
Bank Failures 429 15.2 Savings and Loan Associations
Changing Technology 430 (S&Ls) 457
14.4 Portfolio Characteristics of Origins of S&Ls 457
Commercial Banks 432 How Funds Are Raised and
Balance Sheet Items 432 Allocated 458
Cash and Due from Banks (Primary Asset Portfolios 458
Reserves) 432
Liabilities of S&Ls 459
Investment Security Holdings and
Trends in Revenues and Costs 460
Secondary Reserves 434
Possible Ways to Strengthen the S&L
Loans 434
Industry in the Future 462
Loan Loss Allowances and Loan 15.3 Savings Banks (SBs) 464
Risk 435 Number and Distribution of
Deposits 436 Savings Banks and Regulatory
Nondeposit Sources of Funds 437 Supervision 464
Equity Capital 439 How Funds Are Raised and
Income Statement Items 439 Allocated 465
Revenues and Expenses 439 Current Trends and Future
Interest and Noninterest Margins 440 Problems 466
 Contents

15.4 Credit Unions (CUs) 467 Pension Fund Assets 493

Credit Union Membership 469 Factors Affecting the Future Growth
Size of Credit Unions 469 of Pension Funds 495
New Services Offered 470 16.4 Life Insurance Companies 496
A Strong Competitive Force 472 The Insurance Principle 498
15.5 Money Market Funds (MMFs) 472 Investments of Life Insurance
Summary of the Chapter's Main Companies 498
Points 476 Sources of Life Insurance Company
Key Terms Appearing in This Funds 500
Chapter 477 Structure and Growth of the Life
Insurance Industry 501
Problems and Issues 477
New Services 502
Web-Based Problems 478
16.5 Property-Casualty Insurance
Selected References to Explore 479
Companies 503
16 Mutual Funds, Insurance Companies,
Investment Banks, and Other Financial Makeup of the Property-Casualty
Firms 481 (P/C) Insurance Industry 503
16.1 Introduction 482 Changing Risk Patterns in Property/
Liability Coverage 504
16.2 Mutual Funds (or Investment
Companies) 482 Investments by Property-Casualty
(P/C) Companies 506
The Background of Investment
Sources of Income 507
Companies 482
Business Cycles, Inflation, and
Bonds and Money Market Funds 482
Competition 507
Stock Funds 483
16.6 Finance Companies 508
Index and Exchange-Traded
Different Finance Companies for
Funds 483
Different Purposes 508
Global and Vulture Funds 484
Growth of Finance Companies 510
Small-Cap to Large-Cap Funds 485 Methods of Industry Financing 510
Life-Cycle Funds 485 Recent Changes in the Character of
Hedge Funds 485 the Finance Company Industry 510
Tax and Regulatory Status of the Consolidation in the Industry 510
Industry 485 New Types of Finance
Open-End and Closed-End Investment Companies 511
Companies 486
16.7 Investment Banks 511
Changing Investment Strategies 487
The Underwriting Function of
Goals and Earnings of Investment Investment Banks 511
Companies 487
Other Investment Banking
Scandal Envelops the Mutual Fund
Services 512
Industry 488
Leading Investment Banks and the
16.3 Pension Funds 489
Convergence of Commercial and
Types of Pension Funds 489 Investment B anking 512
Defined-Benefit and Contribution
16.8 Other Important Financial
Plans 490 Institutions 512
Cash-Balance Pension Funds 490 16.9 Trends Affecting All Financial
Growth of Pension Funds 491 Institutions Today 514
Investment Strategies of Pension Summary of the Chapter's Main
Funds 492 Points 516
 Contents

Key Terms Appearing in This 17.6 The Regulation of Pension

Chapter 517 Funds 545
Problems and Jssues 518 17.7 The Regulation of Finance
Web-Based Problems 519 Companies 546
Selected References to 17.8 The Regulation of Invest-ment
Explore 520 Companies (Mutual Funds) 547
17 Regulation of the Financial Institutions' 17.9 An Overview of Trends in
Sector 522 the Regulation of Financial
17.1 Introduction to Financial Institutions 547
Institutions' Regulation 523 Summary of the Chapter's Main
17.2 The Reasons behind the Points 551
Regulation of Financial Key Terms Appearing in This
Institutions 523 Chapter 552
Does Regulation Benefit or Harm Problems and Issues 552
Financial Institutions? 525 Web-Based Problems 553
17.3 The Regulation of Commercial Selected References to Explore 555
Banks 527
The Federal Reserve System
(The Fed) 527 PART 5
Office of the Comptroller of the
Currency (The OCC) 527 Governments and Businesses in the
Federal Deposit Insurance Financial Markets 557
Corporation (FDIC) 529
State Banking Commissions 530 18 Federal, State, and Local Governments
Opening Competition across Political Operating in the Financial Markets 558
Boundaries 530 18.1 Introduction to the Role of
Regulation of the Services Banks Can Governments in the Financial
Offer 533 Marketplace 559
The Gramm-Leach-Bliley (GLB) 18.2 Federal Government Activity
Act 534 in the Money and Capital
The Rise of Disclosure and Privacy Markets 559
Laws in Banking 535 The Treasury Department in the
The Growing Importance of Financial Marketplace 559
Capital Regulation in The Fiscal Policy Activities of the
Banking 536 U.S. Treasury 559
Basel I 536 Sources of Federal Government
Basel II 538 Funds 560
The Unfinished Agenda for Banking Federal Government Expenditures 562
Regulation 539 Effects of Government Borrowing
17.4 The Regulation of Thrift on the Financial System and the
Insitutions 540 Economy 562
Credit Unions 541 Management of the Federal
Savings and Loans 542 Debt 565
Savings Banks 544 The Size and Growth of the Public
Money Market Funds 544 Debt 566
17.5 The Regulation of Insurance The Composition of the Public
Companies 544 Debt 568
 Contents

Marketable Public Debt 568 Serialization 590

Nonmarketable Public Debt 569 How Municipal Bonds Are
Investors in U.S. Government Marketed 591
Securities 569 Problems in the Municipal
Methods of Offering Treasury Market 592
Securities 571 Summary of the Chapter's Main
The Auction Method 572 Points 594
Types of Treasury Auctions 572 Key Terms Appearing in This
Marketing Techniques 572 Chapter 596
Book Entry 573 Problems and Issues 596
Other Services Offered Investors 573 Web-Based Problems 598
On-the-Run and Off-the-Run Treasury Selected References to
Securities 573 Explore 599
Treasury Interest Rates as Global 19 Business Borrowing: Corporate
Benchmarks for Other Interest Bonds, Asset-Backed Securities, Bank
Rates 573 Loans, and Other Forms of Business
The Goals of Federal Debt Debt 601
Management 574 19.1 Introduction to Business
Minimize Interest Costs 574 Borrowing 602
Economic Stabilization 574 19.2 Factors Affecting Business
The Impact of Federal Debt Activity in the Money and Capital
Management on the Financial Markets Markets 602
and the Economy 574 19.3 Characteristics of Corporate Notes
18.3 State and Local Governments in the and Bonds 603
Financial Markets 576 Principal Features of Corporate Notes
Growth of State and Local and Bonds 603
Government Borrowing 576 Recent Trends in Original Maturities
Sources of Revenue for State and of Corporate Bonds 604
Local Governments 578 Call Privileges Attached to Corporate
State and Local Government Bonds 604
Expenditures 579 Sinking Fund Provisions 604
Motivations for State and Local Yields and Costs of Corporate
Government Borrowing 581 Bonds 605
Types of Securities Issued by State Signals Corporate Bond Issues
and Local Governments 582 May Send to the Financial
Short-Term Securities 583 Marketplace 606
Long-Term Securities 583 The Most Common Types of
Types of Revenue Bonds _ 584 Corporate Bonds 606
Innovations in Municipal Debentures 606
Securities 584 Subordinated Debentures 607
Key Features of Municipal Debt 585 Mortgage Bonds 607
Tax Exemption 585 Income Bonds 607
Exemption Contributes to Market Equipment Trust Certificates 607
Volatility 587 Industrial Development Bonds 607
Credit Ratings 588 Innovations in Corporate Debt 608
 Contents

19.4 Asset-Backed Securities Issued by 20.6 The Third Market: Trading

Corporations 609 in Listed Securities off the
19.5 Investors in Corporate Debt 612 Exchanges 644
19.6 The Secondary Market for 20.7 The Private Equity Market 647
Corporate Debt 614 20.8 Investment Banking and the Sale of
19.7 The Marketing of Corporate New Stock 647
Debt 614 20.9 The Development of a Unified
Public Sales 614 International Market for
Private Placements 617 Stock 649
19.8 The Volume of Borrowing by The National Market System 649
Corporations 619 NASD and Automated Price
19.9 Bank Loans to Business Quotations 649
Firms 621 The Advent of Shelf
The Volume of Bank Credit Supplied Registration 650
to Businesses 621 Global Trading in Equities 650
The Prime, or Base, Interest Rate on The Development of ADRs 65.1
Business Loans 622 20.10 Valuing Stocks: Alternative
Other Examples of Base Rates for Approaches 652
Business Loans 623 Technical and Fundamental
19.10 Commercial Mortgages 623 Analysis 652
Summary of the Chapter's Main Private Information 653
Points 625 Summary of the Chapter's Main
Key Terms Appearing in This Points 654
, Chapter 626 Key Terms Appearing in This
Problems and Issues 626 Chapter 655
Web-Based Problems 628 Problems and Issues 656
Selected References to Explore 629 Web-Based Problems 656
20 The Market for Corporate Stock 630 Selected References to
20.1 Introduction to the Stock Explore 657
Market 631
20.2 Characteristics of Corporate PART 6
Stock 631
Common Stock 631
Consumers in the Financial
Preferred Stock 632
Markets 659
20.3 Stock Market Investors 634
20.4 Equity as a Source of 21 Consumer Lending and
Funding 638 Borrowing 660
20.5 The Process of Price Discovery in 21.1 Introduction to Consumer Lending
the Equity Markets 640 and Borrowing 661
Organized Exchanges 640 21.2 Consumers as Lenders of
Foreign Exchanges 642 Funds 661
Contributions of Exchanges 642 Financial Assets Purchased by
Over-the-Counter (OTC) Consumers 661
Markets 642 Recent Innovations in Consumer
Evolving Trading Platforms 643 Savings Instruments 663
xxxvi Contents

21.3 Consumers as Borrowers of Key Terms Appearing in This

Funds 666 Chapter 685
Is Consumer Borrowing Problems and Issues 686
Excessive? 666 Web-Based Problems 687
Categories of Consumer Selected References to Explore 688
Borrowing 668 "22 The Residential Mortgage Market 690
21.4 Home Equity Loans 669 22.1 Introduction to the Residential
21.5 Credit and Debit Cards 670 Mortgage Market 691
Credit Cards 671 22.2 Recent Trends in New Home
Debit Cards 672 Prices and the Terms of Mortgage
21.6 The Determinants of Consumer Loans 691
Borrowing 673 22.3 The Structure of the Mortgage
21.7 Consumer Lending Market 693
Institutions 674 Volume of Mortgage Loans 693
Commercial Banks 675 Residential versus Nonresidential
Finance Companies 675 Mortgage Loans 693
Other Consumer Lenders: Credit 22.4 Mortgage-Lending
Unions, Savings Associations, and Institutions 694
Small Loan Companies 675 22.5 The Roles Played by Leading
21.8 Factors Considered in Making Financial Institutions in the
Consumer Loans 676 Mortgage Market 696
21.9 Credit Scoring Techniques 677 Savings and Loan Associations 697
21.10 Financial Disclosure and Consumer Commercial Banks 697
Credit 678 Life Insurance Companies 697
Truth in Lending 678 Savings Banks 698
Fair Credit Billing Act 679 Mortgage Bankers 698
Fair Credit Reporting Act 679 22.6 Government Activity in the
Consumer Leasing Act 680 Mortgage Market 698
Competitive Banking Equality Act 680 The Impact of the Great Depression
on Government Involvement in the
Fair Credit and Charge Card
Mortgage Market 698
Disclosure Act 680
Launching the Federal Home Loan
Truth in Savings Act 680 Bank System 699
The Financial Services Modernization Setting Up the Federal Housing
(Gramm-Leach-B liley) Act 681 Administration (FHA) and the
Identity Theft 681 Veterans Administration (VA) 699
21.11 Credit Discrimination Laws 682 The Creation of Fannie Mae—A
Community Reinvestment Act Government-Sponsored Enterprise
and Financial Institutions Reform, (GSE) 700
Recovery, and Enforcement Act 682 The Creation of Ginnie Mae
Equal Credit Opportunity Act 682 (GNMA) 700
Fair Housing and Home Mortgage GNMA Mortgage-Backed
Disclosure Acts 682 Securities 701
21.12 Bankruptcy Law Changes 683 The Federal Home Loan Mortgage
Summary of the Chapter's Main Corporation—Another Government-
Points 684 Sponsored Enterprise (GSE) 701
 Contents xxxvi i

FHLMC Mortgage-Backed 23.2 The Balance-of-Payments (BOP)

Securities 701 Accounts 717
Freddie and Fannie Face New The U.S. Balance of International
Problems 701 \ Payments 718
Collateralized Mortgage Obligations The Current Account 719
(CMOs) and Real Estate Mortgage The Merchandise Trade Balance in the
Investment Conduits (REMICs) 702 Current Account 719
Impact of Securitized Mortgages 702 The Service Balance in the Current
22.7 Innovations in Mortgage Account 720
Instruments 703 Investment Income Receipts
Fixed-Rate Home Mortgages—The and Payments in the Current
Oldest Form of Home Loan 703 Account 721
Variable-Rate and Adjustable Compensation of Employees in the
Mortgage Instruments 704 Current Account 721
Interest-Only Mortgages 704 Unilateral Transfers in the Current
Reverse-Annuity Mortgages 705 Account 721
Epilogue on the Fixed-Rate The Balance on Current Account 721
Mortgage 705 The Capital and Financial
22.8 Pricing and Other Issues in Home Accounts 722
Mortgage Lending 705 Official Transactions 722
Pricing Home Mortgages and the Disequilibrium in the Balance of
Treasury Security Market 705 Payments 723
Mortgage Lock-Ins, Loan 23.3 The Problem of Different Monetary
Modifications, and Foreclosures 707 Units in International Trade and
Refinancing Home Mortgages and Finance 724
"Cash Outs" 707 The Gold Standard 724
Predatory Lending 708 The Gold Exchange Standard 725
Summary of the Chapter's Main The Modified Exchange
Points 709 Standard 725
Key Terms Appearing in This The Managed Floating Currency
Chapter 711 Standard 726
Problems and Issues 711 23.4 Determining Foreign Currency
Web-Based Problems 712 Values 728
Selected References to Essential Features of the Foreign
Explore 713 Exchange Market 729
Exchange Rate Quotations 729
PART 7 Factors Affecting Foreign Exchange
Rates 731
The International Financial BOP Position 731
System 715 Speculation 731
Domestic Political and Economic
23 International Transactions and Currency Conditions 731
Values 716 Purchasing Power Parity 731
23.1 Introduction to International Central Bank Intervention 732
Transactions and Currency Supply and Demand for Foreign
Values 717 Exchange 732
xxxviii Contents

23.5 The Forward Market for Accepting Eurocurrency Deposits and

Currencies 735 Making Eurocurrency Loans 751
Methods of Quoting Forward Marketing and Underwriting of Both
Exchange Rates 735 Domestic and Eurocurrency Bonds,
23.6 Functions of the Forward Exchange Notes, and Equity Shares 751
Market 736 Securitizing Loans 753
Commercial Covering 736 Advisory Services Provided by
Hedging an Investment Position 737 International Banks 753
Speculation on Future Currency Universal Banking Services and
Prices 737 One-Stop Shopping 754
Covered Interest Arbitrage 737 24.4 Foreign Banks Operating in the
The Principle of Interest Rate United States 754
Parity 738 The Growth of Foreign Bank Activity
23.7 The Market for Foreign Currency in the United States 755
Futures 739 Federal Regulation of Foreign Bank
The Buying Hedge 740 Activity 755
The Selling Hedge 740 24.5 Regulation of the International
Banking Activities of U.S.
23.8 Other Innovative Methods for Banks 756
Dealing with Currency Risk 740
24.6 The Future of International
23.9 Government Intervention in the Banking 757
Foreign Exchange Markets 742
The Risks of International
Summary of the Chapter's Main
Lending 757
Points 743
Political and Currency Risk 757
Key Terms Appearing in This
Geographic Distribution of
Chapter 744
International Bank Lending 759
Problems and Issues 745
Public Confidence and Protecting
Web-Based Problems 746 Against Bank Failures 759
Selected References to Explore 747 The Spread of Deregulation: How
24 International Banking 748 Fast Should We Go? 761
24.1 Introduction to International 24.7 Prospects and Challenges for the
Banking 749 Twenty-First Century 762
24.2 The Scope of International Banking Summary of the Chapter's Main
Activities 749 Points 763
Multinational Banking Key Terms Appearing in This
Corporations 749 Chapter 765
Types of Facilities Operated by Banks Problems and Issues 765
Abroad 749
Web-Based Problems 766
Choosing the Right Kind of Facility to
Selected References to Explore 767
Serve Foreign Markets 750
24.3 Services Offered by International Money and Capital Markets Dictionary D-1
Banks 751
Index 1-1
Issuing Letters of Credit 751
Buying and Selling Foreign Exchange
(FOREX) 751