Chap 1: Why study Financial markets and institutions

1. Activities in financial markets have direct effects on individuals’ wealth, the behavior of businesses, and the efficiency
of our economy. Three financial markets deserve particular attention: the bond market (where interest rates are
determined), the stock market (which has a major effect on people’s wealth and on firms’ investment decisions), and the
foreign exchange market (because fluctuations in the foreign exchange rate have major consequences for the U.S.
economy).
2. Because monetary policy affects interest rates, inflation, and business cycles, all of which have an impor tant impact on
financial markets and institutions, we need to understand how monetary policy is conducted by central banks in the United
States and abroad
3. Banks and other financial institutions channel funds from people who might not put them to productive use to people
who can do so and thus play a crucial role in improving the efficiency of the economy.
4. Understanding how financial institutions are managed is important because there will be many times in your life, as an
individual, an employee, or the owner of a business, when you will interact with them. “The Practicing Manager” cases not
only provide special analytic tools that are useful if you choose a career with a financial institution but also give you a feel
for what a job as the manager of a financial institution is all about.
5. This textbook emphasizes an analytic way of thinking by developing a unifying framework for the study of financial
markets and institutions using a few basic principles. This textbook also focuses on the inter action of theoretical analysis
and empirical data.

Chap 2: Overview of the Financial System.

1. The basic function of financial markets is to channel funds from savers who have an excess of funds to spenders who
have a shortage of funds. Financial mar kets can do this either through direct finance, in which borrowers borrow funds
directly from lenders by sell ing them securities, or through indirect finance, which involves a financial intermediary that
stands between the lender-savers and the borrower-spenders and helps transfer funds from one to the other. This
channeling of funds improves the economic welfare of everyone in the society. Because they allow funds to move from peo
ple who have no productive investment opportunities to those who have such opportunities, financial markets contribute
to economic efficiency. In addition, channel ing of funds directly benefits consumers by allowing them to make purchases
when they need them most.
2. Financial markets can be classified as debt and equity markets, primary and secondary markets, exchanges and over-
the-counter markets, and money and capi tal markets.
3. An important trend in recent years is the growing internationalization of financial markets. Eurobonds, which are
denominated in a currency other than that of the country in which they are sold, are now the dominant security in the
international bond market and have surpassed U.S. corporate bonds as a source of new funds. Eurodollars, which are U.S.
dollars deposited in foreign banks, are an important source of funds for American banks.
4. Financial intermediaries are financial institutions that acquire funds by issuing liabilities and, in turn, use those funds to
acquire assets by purchasing securities or making loans. Financial intermediaries play an important role in the financial
system because they reduce transaction costs, allow risk sharing, and solve problems created by adverse selection and
moral haz ard. As a result, financial intermediaries allow small savers and borrowers to benefit from the existence of
financial markets, thereby increasing the efficiency of the economy.
5. The principal financial intermediaries fall into three categories: (a) banks—commercial banks, savings and loan
associations, mutual savings banks, and credit unions; (b) contractual savings institutions— life insurance companies, fire
and casualty insurance companies, and pension funds; and (c) investment intermediaries—finance companies, mutual
funds, and money market mutual funds.
6. The government regulates financial markets and financial intermediaries for two main reasons: to increase the
information available to investors and to ensure the soundness of the financial system. Regulations include requiring
disclosure of informa tion to the public, restrictions on who can set up a financial intermediary, restrictions on the assets
financial intermediaries can hold, the provision of deposit insurance, limits on competition, and restric tions on interest
rates.

Chap 3: What do interest rates mean and what is there role in valuation
1. The yield to maturity, which is the measure that most accurately reflects the interest rate, is the interest rate that
equates the present value of future cash flows of a debt instrument with its value today. Application of this principle
reveals that bond prices and interest rates are negatively related: When the interest rate rises, the price of the bond must
fall, and vice versa.
2. The real interest rate is defined as the nominal inter est rate minus the expected rate of inflation. It is a bet ter
measure of the incentives to borrow and lend than the nominal interest rate, and it is a more accurate indicator of the
tightness of credit market conditions than the nominal interest rate.
3. The return on a security, which tells you how well you have done by holding this security over a stated period of time,
can differ substantially from the inter est rate as measured by the yield to maturity. Long term bond prices have substantial
fluctuations when interest rates change and thus bear interest-rate risk. The resulting capital gains and losses can be large,
which is why long-term bonds are not considered to be safe assets with a sure return. Bonds whose matu rity is shorter
than the holding period are also subject to reinvestment risk, which occurs because the pro ceeds from the short-term
bond need to be reinvested at a future interest rate that is uncertain.
4. Duration, the average lifetime of a debt security’s stream of payments, is a measure of effective maturity, the term to
maturity that accurately measures interest rate risk. Everything else being equal, the duration of a bond is greater the
longer the maturity of a bond, when interest rates fall, or when the coupon rate of a coupon bond falls. Duration is
additive: The duration of a portfolio of securities is the weighted average of the durations of the individual securities, with
the weights reflecting the proportion of the portfolio invested in each. The greater the duration of a secu rity, the greater
the percentage change in the market value of the security for a given change in interest rates. Therefore, the greater the
duration of a security, the greater its interest-rate risk.

Chap 4: Why do interest rates change?

1. The quantity demanded of an asset is (a) positively related to wealth, (b) positively related to the expected return on
the asset relative to alternative assets, (c) negatively related to the riskiness of the asset relative to alternative assets, and
(d) positively related to the liquidity of the asset relative to alter native assets.
2. Diversification (the holding of more than one asset) benefits investors because it reduces the risk they face, and the
benefits are greater the less returns on securities move together.
3. The supply-and-demand analysis for bonds provides a theory of how interest rates are determined. It pre dicts that
interest rates will change when there is a change in demand because of changes in income (or wealth), expected returns,
risk, or liquidity, or when there is a change in supply because of changes in the attractiveness of investment opportunities,
the real cost of borrowing, or government activities.

Chap 5: How do the risk and term structure affect interest rates
1. Bonds with the same maturity will have different interest rates because of three factors: default risk, liquidity, and tax
considerations. The greater a bond’s default risk, the higher its interest rate relative to other bonds; the greater a bond’s
liquidity, the lower its interest rate; and bonds with tax-exempt status will have lower interest rates than they otherwise
would. The relationship among interest rates on bonds with the same maturity that arise because of these three factors is
known as the risk structure of interest rates.
2. Several theories of the term structure provide expla nations of how interest rates on bonds with different terms to
maturity are related. The expectations the ory views long-term interest rates as equaling the average of future short-term
interest rates expected to occur over the life of the bond. By contrast, the market segmentation theory treats the
determination of interest rates for each bond’s maturity as the out come of supply and demand in that market only.
Neither of these theories by itself can explain the fact that interest rates on bonds of different maturities move together
over time and that yield curves usually slope upward.
3. The liquidity premium theory combines the features of the other two theories, and by so doing is able to explain the
facts just mentioned. It views long-term interest rates as equaling the average of future short-term interest rates expected
to occur over the life of the bond plus a liquidity premium. This the ory allows us to infer the market’s expectations about
the movement of future short-term interest rates from the yield curve. A steeply upward-sloping curve indicates that
future short-term rates are expected to rise, a mildly upward-sloping curve indi cates that short-term rates are expected to
stay the same, a flat curve indicates that short-term rates are expected to decline slightly, and an inverted yield curve
indicates that a substantial decline in short term rates is expected in the future.

Chap 6: Are Financial markets efficient.

1. The efficient market hypothesis states that current security prices will fully reflect all available informa tion because in
an efficient market, all unexploited profit opportunities are eliminated. The elimination of unexploited profit opportunities
necessary for a finan cial market to be efficient does not require that all market participants be well informed.
2. The evidence on the efficient market hypothesis is quite mixed. Early evidence on the performance of invest ment
analysts and mutual funds, whether stock prices reflect publicly available information, the random-walk behavior of stock
prices, or the success of so-called technical analysis, was quite favorable to the efficient market hypothesis. However, in
recent years, evidence on the small-firm effect, the January effect, market overreaction, excessive volatility, mean
reversion, and that new information is not always incorporated into stock prices suggests that the hypothesis may not
always be entirely correct. The evidence seems to sug gest that the efficient market hypothesis may be a rea sonable
starting point for evaluating behavior in financial markets, but it may not be generalizable to all behavior in financial
markets.
3. The efficient market hypothesis indicates that hot tips, investment advisers’ published recommendations, and technical
analysis cannot help an investor outperform the market. The prescription for investors is to pursue a buy-and-hold strategy
—purchase stocks and hold them for long periods of time. Empirical evidence gen erally supports these implications of the
efficient mar ket hypothesis in the stock market.
4. The stock market crashes of 1987 and 2000 have con vinced many financial economists that the stronger version of the
efficient market hypothesis, which states that asset prices reflect the true fundamental (intrinsic) value of securities, is not
correct. It is less clear that the stock market crashes show that the weaker version of the efficient market hypothesis is
wrong. Even if the stock market was driven by factors other than fundamentals, the crashes do not clearly demonstrate
that many of the basic lessons of the effi cient market hypothesis are no longer valid as long as the crashes could not have
been predicted.
5. The new field of behavioral finance applies concepts from other social sciences, such as anthropology, soci ology, and
particularly psychology, to understand the behavior of securities prices. Loss aversion, overcon fidence, and social
contagion can explain why trading volume is so high, stock prices get overvalued, and speculative bubbles occur.
Chap 11: The money markets
1. Money market securities are short-term instruments with an original maturity of less than one year. These securities
include Treasury bills, commercial paper, fed eral funds, repurchase agreements, negotiable certifi cates of deposit,
banker’s acceptances, and Eurodollars.
2. Money market securities are used to “warehouse” funds until needed. The returns earned on these investments are
low due to their low risk and high liquidity.
3. Many participants in the money markets both buy and sell money market securities. The U.S. Treasury, commercial
banks, businesses, and individuals all benefit by having access to low-risk short-term investments.
4. Interest rates on all money market securities tend to follow one another closely over time. Treasury bill returns are the
lowest because they are virtually devoid of default risk. Banker’s acceptances and nego tiable certificates of deposit are
next lowest because they are backed by the creditworthiness of large money center banks.

Chap 12: The bond market

1. The capital markets exist to provide financing for long term capital assets. Households, often through invest ments in
pension and mutual funds, are net investors in the capital markets. Corporations and the federal and state governments
are net users of these funds.
2. The three main capital market instruments are bonds, stocks, and mortgages. Bonds represent borrowing by the
issuing firm. Stock represents ownership in the issuing firm. Mortgages are long-term loans secured by real property. Only
corporations can issue stock. Corporations and governments can issue bonds. In any given year, far more funds are raised
with bonds than with stock.
3. Firm managers are hired by stockholders to protect and increase their wealth. Bondholders must rely on a contract
called an indenture to protect their inter ests. Bond indentures contain covenants that restrict the firm from activities that
increase risk and hence the chance of defaulting on the bonds. Bond inden tures also contain many provisions that make
them more or less attractive to investors, such as a call option, convertibility, or a sinking fund.
4. The value of any business asset is computed the same way, by computing the present value of the cash flows that will
go to the holder of the asset. For example, a commercial building is valued by computing the present value of the net cash
flows the owner will receive. We compute the value of bonds by finding the present value of the cash flows, which consist
of peri odic interest payments and a final principal payment.
5. The value of bonds fluctuates with current market prices. If a bond has an interest payment based on a 5% coupon
rate, no investor will buy it at face value if new bonds are available for the same price with interest payments based on 8%
coupon interest. To sell the bond, the holder will have to discount the price until the yield to the holder equals 8%. The
amount of the discount is greater the longer the term to maturity.

Chap 13: The stock market

1. There are both organized and over-the-counter exchanges. Organized exchanges are distinguished by a physical
building where trading takes place. The over-the-counter market operates primarily over phone lines and computer links.
Typically, larger firms trade on organized exchanges and smaller firms trade in the over-the-counter market, though there
are many exceptions to this rule. In recent years, ECNs have begun to capture a significant portion of busi ness traditionally
belonging to the stock exchanges. These electronic networks are likely to become increasingly significant players in the
future.
2. Stocks are valued as the present value of the dividends. Unfortunately, we do not know very precisely what these
dividends will be. This introduces a great deal of error to the valuation process. The Gordon growth model is a simplified
method of computing stock value that depends on the assumption that the dividends are growing at a constant rate
forever. KEY TERMS Given our uncertainty regarding future dividends, this assumption is often the best we can do.
3. An alternative method for estimating a stock price is to multiply the firm’s earnings per share times the industry price
earnings ratio. This ratio can be adjusted up or down to reflect specific characteristics of the firm.
4. The interaction among traders in the market is what actually sets prices on a day-to-day basis. The trader that values
the security the most, either because of less uncertainty about the cash flows or because of greater estimated cash flows,
will be willing to pay the most. As new information is released, investors will revise their estimates of the true value of the
security and will either buy or sell it depending upon how the market price compares to their estimated valuation. Because
small changes in estimated growth rates or required return result in large changes in price, it is not surprising that the
markets are often volatile.