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Why Study FinancialMarkets and Institutions?
PreviewOn the evening news you have just heard that the bond
market has beenbooming. Does this mean that interest rates will
fall so that it is easier for youto finance the purchase of a new
computer system for your small retail busi-ness? Will the economy
improve in the future so that it is a good time tobuild a new
building or add to the one you are in? Should you try to raisefunds
by issuing stocks or bonds, or instead go to the bank for a loan?
If youimport goods from abroad, should you be concerned that they
will becomemore expensive?
This book provides answers to these questions by examining how
financialmarkets (such as those for bonds, stocks, and foreign
exchange) and financialinstitutions (banks, insurance companies,
mutual funds, and other institutions)work. Financial markets and
institutions not only affect your everyday life butalso involve
huge flows of fundstrillions of dollarsthroughout our economy,which
in turn affect business profits, the production of goods and
services, andeven the economic well-being of countries other than
the United States. Whathappens to financial markets and
institutions is of great concern to politiciansand can even have a
major impact on elections. The study of financial marketsand
institutions will reward you with an understanding of many exciting
issues.In this chapter we provide a road map of the book by
outlining these excitingissues and exploring why they are worth
studying.
1
1C H A P T E RPA RT O N E I N T R O D U C T I O N
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Why Study Financial Markets?Parts 2 and 5 of this book focus on
financial markets, markets in which funds aretransferred from
people who have an excess of available funds to people who havea
shortage. Financial markets, such as bond and stock markets, are
crucial to pro-moting greater economic efficiency by channeling
funds from people who do not havea productive use for them to those
who do. Indeed, well-functioning financial mar-kets are a key
factor in producing high economic growth, and poorly performing
finan-cial markets are one reason that many countries in the world
remain desperately poor.Activities in financial markets also have
direct effects on personal wealth, the behav-ior of businesses and
consumers, and the cyclical performance of the economy.
Debt Markets and Interest RatesA security (also called a
financial instrument) is a claim on the issuers futureincome or
assets (any financial claim or piece of property that is subject to
owner-ship). A bond is a debt security that promises to make
payments periodically fora specified period of time.1 Debt markets,
also often referred to generically as thebond market, are
especially important to economic activity because they enable
cor-porations and governments to borrow in order to finance their
activities; the bondmarket is also where interest rates are
determined. An interest rate is the costof borrowing or the price
paid for the rental of funds (usually expressed as a per-centage of
the rental of $100 per year). There are many interest rates in the
econ-omymortgage interest rates, car loan rates, and interest rates
on many differenttypes of bonds.
Interest rates are important on a number of levels. On a
personal level, high inter-est rates could deter you from buying a
house or a car because the cost of financ-ing it would be high.
Conversely, high interest rates could encourage you to savebecause
you can earn more interest income by putting aside some of your
earningsas savings. On a more general level, interest rates have an
impact on the overall healthof the economy because they affect not
only consumers willingness to spend orsave but also businesses
investment decisions. High interest rates, for example, mightcause
a corporation to postpone building a new plant that would provide
more jobs.
Because changes in interest rates have important effects on
individuals, finan-cial institutions, businesses, and the overall
economy, it is important to explain fluc-tuations in interest rates
that have been substantial over the past 20 years. Forexample, the
interest rate on three-month Treasury bills peaked at over 16% in
1981.This interest rate fell to 3% in late 1992 and 1993, and then
rose to above 5% in themid to late 1990s. It then fell below 1% in
2004, rose to 5% by 2007, only to fall tozero in 2008 where it
remained close to that level into 2010.
Because different interest rates have a tendency to move in
unison, economistsfrequently lump interest rates together and refer
to the interest rate. As Figure 1.1shows, however, interest rates
on several types of bonds can differ substantially.The interest
rate on three-month Treasury bills, for example, fluctuates more
thanthe other interest rates and is lower, on average. The interest
rate on Baa (medium-quality) corporate bonds is higher, on average,
than the other interest rates, and
2 Part 1 Introduction
http://www.federalreserve.gov/econresdata/releases/statisticsdata.htmAccess
daily, weekly,monthly, quarterly, andannual releases andhistorical
data for selectedinterest rates, foreignexchange rates, and so
on.
GO ONLINE
1The definition of bond used throughout this book is the broad
one in common use by academics,which covers both short- and
long-term debt instruments. However, some practitioners in
financialmarkets use the word bond to describe only specific
long-term debt instruments such as corporatebonds or U.S. Treasury
bonds.
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Chapter 1 Why Study Financial Markets and Institutions? 3
0
5
10
15
20
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
2010
InterestRate (%)
U.S. GovernmentLong-Term Bonds
Corporate Baa Bonds
Three-MonthTreasury Bills
F I G U R E 1 . 1 Interest Rates on Selected Bonds, 19502010
Sources: Federal Reserve Bulletin;
www.federalreserve.gov/releases/H15/data.htm.
the spread between it and the other rates became larger in the
1970s, narrowed inthe 1990s and particularly in the middle 2000s,
only to surge to extremely high lev-els during the financial crisis
of 20072009 before narrowing again.
In Chapters 2, 11, 12, and 14 we study the role of debt markets
in the economy,and in Chapters 3 through 5 we examine what an
interest rate is, how the commonmovements in interest rates come
about, and why the interest rates on differentbonds vary.
The Stock MarketA common stock (typically just called a stock)
represents a share of ownership ina corporation. It is a security
that is a claim on the earnings and assets of the corpo-ration.
Issuing stock and selling it to the public is a way for
corporations to raise fundsto finance their activities. The stock
market, in which claims on the earnings of cor-porations (shares of
stock) are traded, is the most widely followed financial marketin
almost every country that has one; thats why it is often called
simply the market.A big swing in the prices of shares in the stock
market is always a major story on theevening news. People often
speculate on where the market is heading and get veryexcited when
they can brag about their latest big killing, but they become
depressedwhen they suffer a big loss. The attention the market
receives can probably be bestexplained by one simple fact: It is a
place where people can get richor poorquickly.
As Figure 1.2 indicates, stock prices are extremely volatile.
After the market rosein the 1980s, on Black Monday, October 19,
1987, it experienced the worst one-day drop in its entire history,
with the Dow Jones Industrial Average (DJIA) fallingby 22%. From
then until 2000, the stock market experienced one of the great
bullmarkets in its history, with the Dow climbing to a peak of over
11,000. With the col-lapse of the high-tech bubble in 2000, the
stock market fell sharply, dropping byover 30% by late 2002. It
then recovered again, reaching the 14,000 level in 2007, onlyto
fall by over 50% of its value to a low below 7,000 in 2009. These
considerable
http://stockcharts.com/charts/historical/Access historical
charts ofvarious stock indexes overdiffering time periods.
GO ONLINE
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4 Part 1 Introduction
01950 1955 1960 1965 1970 1975 1980 1985 1990 2000 20051995
2,000
4,000
6,000
8,000
10,000
12,000
14,000
2010
Dow JonesIndustrial Average
F I G U R E 1 . 2 Stock Prices as Measured by the Dow Jones
Industrial Average, 19502010
Source: Dow Jones Indexes: http://finance.yahoo.com/?u.
fluctuations in stock prices affect the size of peoples wealth
and as a result may affecttheir willingness to spend.
The stock market is also an important factor in business
investment decisions,because the price of shares affects the amount
of funds that can be raised by sell-ing newly issued stock to
finance investment spending. A higher price for a firmsshares means
that it can raise a larger amount of funds, which can be used to
buyproduction facilities and equipment.
In Chapter 2 we examine the role that the stock market plays in
the financial sys-tem, and we return to the issue of how stock
prices behave and respond to infor-mation in the marketplace in
Chapters 6 and 13.
The Foreign Exchange MarketFor funds to be transferred from one
country to another, they have to be convertedfrom the currency in
the country of origin (say, dollars) into the currency of the
coun-try they are going to (say, euros). The foreign exchange
market is where this
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Chapter 1 Why Study Financial Markets and Institutions? 5
1970 1975 1980 1985 1990 1995 2000 2005
75
90
105
120
135
150
Index(March 1973 = 100)
F I G U R E 1 . 3 Exchange Rate of the U.S. Dollar, 19702010
Source:
www.federalreserve.gov/releases/H10/summary/indexbc_m.txt.
conversion takes place, so it is instrumental in moving funds
between countries. Itis also important because it is where the
foreign exchange rate, the price of onecountrys currency in terms
of anothers, is determined.
Figure 1.3 shows the exchange rate for the U.S. dollar from 1970
to 2010 (mea-sured as the value of the U.S. dollar in terms of a
basket of major foreign curren-cies). The fluctuations in prices in
this market have also been substantial: The dollarsvalue weakened
considerably from 1971 to 1973, rose slightly until 1976, and
thenreached a low point in the 19781980 period. From 1980 to early
1985, the dollarsvalue appreciated dramatically, and then declined
again, reaching another low in1995. The dollar appreciated from
1995 to 2000, only to depreciate thereafter untilit recovered some
of its value starting in 2008.
What have these fluctuations in the exchange rate meant to the
American pub-lic and businesses? A change in the exchange rate has
a direct effect on American con-sumers because it affects the cost
of imports. In 2001, when the euro was worth around85 cents, 100
euros of European goods (say, French wine) cost $85. When the
dol-lar subsequently weakened, raising the cost of a euro to $1.50,
the same 100 eurosof wine now cost $150. Thus, a weaker dollar
leads to more expensive foreign goods,makes vacationing abroad more
expensive, and raises the cost of indulging yourdesire for imported
delicacies. When the value of the dollar drops, Americansdecrease
their purchases of foreign goods and increase their consumption of
domes-tic goods (such as travel in the United States or
American-made wine).
Conversely, a strong dollar means that U.S. goods exported
abroad will cost morein foreign countries, and hence foreigners
will buy fewer of them. Exports of steel,for example, declined
sharply when the dollar strengthened in the 19801985 and19952001
periods. A strong dollar benefited American consumers by making
for-eign goods cheaper but hurt American businesses and eliminated
some jobs by cut-ting both domestic and foreign sales of their
products. The decline in the value ofthe dollar from 1985 to 1995
and 2001 to 2007 had the opposite effect: It madeforeign goods more
expensive, but made American businesses more
competitive.Fluctuations in the foreign exchange markets thus have
major consequences for theAmerican economy.
In Chapter 15 we study how exchange rates are determined in the
foreignexchange market, in which dollars are bought and sold for
foreign currencies.
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Why Study Financial Institutions?The second major focus of this
book is financial institutions. Financial institutions arewhat make
financial markets work. Without them, financial markets would not
be ableto move funds from people who save to people who have
productive investment oppor-tunities. They thus play a crucial role
in improving the efficiency of the economy.
Structure of the Financial SystemThe financial system is
complex, comprising many different types of private-sectorfinancial
institutions, including banks, insurance companies, mutual funds,
financecompanies, and investment banksall of which are heavily
regulated by the govern-ment. If you wanted to make a loan to IBM
or General Motors, for example, you wouldnot go directly to the
president of the company and offer a loan. Instead, you wouldlend
to such companies indirectly through financial intermediaries,
institutionssuch as commercial banks, savings and loan
associations, mutual savings banks, creditunions, insurance
companies, mutual funds, pension funds, and finance companiesthat
borrow funds from people who have saved and in turn make loans to
others.
Why are financial intermediaries so crucial to well-functioning
financial markets?Why do they give credit to one party but not to
another? Why do they usually writecomplicated legal documents when
they extend loans? Why are they the most heav-ily regulated
businesses in the economy?
We answer these questions by developing a coherent framework for
analyz-ing financial structure both in the United States and in the
rest of the world inChapter 7.
Financial CrisesAt times, the financial system seizes up and
produces financial crises, majordisruptions in financial markets
that are characterized by sharp declines in assetprices and the
failures of many financial and nonfinancial firms. Financial
criseshave been a feature of capitalist economies for hundreds of
years and are typicallyfollowed by the worst business cycle
downturns. From 2007 to 2009, the U.S. economy was hit by the worst
financial crisis since the Great Depression. Defaultsin subprime
residential mortgages led to major losses in financial
institutions, producing not only numerous bank failures, but also
leading to the demise ofBear Stearns and Lehman Brothers, two of
the largest investment banks in theUnited States.
Why these crises occur and why they do so much damage to the
economy isdiscussed in Chapter 8.
Central Banks and the Conduct of Monetary PolicyThe most
important financial institution in the financial system is the
central bank,the government agency responsible for the conduct of
monetary policy, which inthe United States is the Federal Reserve
System (also called simply the Fed).Monetary policy involves the
management of interest rates and the quantity ofmoney, also
referred to as the money supply (defined as anything that is
gener-ally accepted in payment for goods and services or in the
repayment of debt).Because monetary policy affects interest rates,
inflation, and business cycles, all of
6 Part 1 Introduction
www.federalreserve.govAccess generalinformation as well
asmonetary policy, bankingsystem, research, andeconomic data of
theFederal Reserve.
GO ONLINE
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Chapter 1 Why Study Financial Markets and Institutions? 7
which have a major impact on financial markets and institutions,
we study how mon-etary policy is conducted by central banks in both
the United States and abroad inChapters 9 and 10.
The International Financial SystemThe tremendous increase in
capital flows between countries means that the inter-national
financial system has a growing impact on domestic economies.
Whether acountry fixes its exchange rate to that of another is an
important determinant ofhow monetary policy is conducted. Whether
there are capital controls that restrictmobility of capital across
national borders has a large effect on domestic financialsystems
and the performance of the economy. What role international
financial insti-tutions such as the International Monetary Fund
should play in the international finan-cial system is very
controversial. All of these issues are explored in Chapter 16.
Banks and Other Financial InstitutionsBanks are financial
institutions that accept deposits and make loans. Included underthe
term banks are firms such as commercial banks, savings and loan
associations,mutual savings banks, and credit unions. Banks are the
financial intermediaries thatthe average person interacts with most
frequently. A person who needs a loan to buya house or a car
usually obtains it from a local bank. Most Americans keep a
largeproportion of their financial wealth in banks in the form of
checking accounts, sav-ings accounts, or other types of bank
deposits. Because banks are the largest finan-cial intermediaries
in our economy, they deserve careful study. However, banks are
notthe only important financial institutions. Indeed, in recent
years, other financial insti-tutions such as insurance companies,
finance companies, pension funds, mutual funds,and investment banks
have been growing at the expense of banks, and so we need tostudy
them as well. We study banks and all these other institutions in
Parts 6 and 7.
Financial InnovationIn the good old days, when you took cash out
of the bank or wanted to check youraccount balance, you got to say
hello to a friendly human. Nowadays, you are more likelyto interact
with an automatic teller machine (ATM) when withdrawing cash, and
touse your home computer to check your account balance. To see why
these options havedeveloped, we study why and how financial
innovation takes place in Chapter 19, withparticular emphasis on
how the dramatic improvements in information technology haveled to
new means of delivering financial services electronically, in what
has becomeknown as e-finance. We also study financial innovation
because it shows us how cre-ative thinking on the part of financial
institutions can lead to higher profits. By seeinghow and why
financial institutions have been creative in the past, we obtain a
bettergrasp of how they may be creative in the future. This
knowledge provides us with use-ful clues about how the financial
system may change over time and will help keep ourunderstanding
about banks and other financial institutions from becoming
obsolete.
Managing Risk in Financial InstitutionsIn recent years, the
economic environment has become an increasingly risky
place.Interest rates have fluctuated wildly, stock markets have
crashed both here andabroad, speculative crises have occurred in
the foreign exchange markets, and failures
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8 Part 1 Introduction
of financial institutions have reached levels unprecedented
since the GreatDepression. To avoid wild swings in profitability
(and even possibly failure) result-ing from this environment,
financial institutions must be concerned with how to copewith
increased risk. We look at techniques that these institutions use
when theyengage in risk management in Chapter 23. Then in Chapter
24, we look at how theseinstitutions make use of new financial
instruments, such as financial futures, options,and swaps, to
manage risk.
Applied Managerial PerspectiveAnother reason for studying
financial institutions is that they are among the largestemployers
in the country and frequently pay very high salaries. Hence, some
of youhave a very practical reason for studying financial
institutions: It may help you geta good job in the financial
sector. Even if your interests lie elsewhere, you should stillcare
about how financial institutions are run because there will be many
times in yourlife, as an individual, an employee, or the owner of a
business, when you will inter-act with these institutions. Knowing
how financial institutions are managed may helpyou get a better
deal when you need to borrow from them or if you decide to sup-ply
them with funds.
This book emphasizes an applied managerial perspective in
teaching you aboutfinancial markets and institutions by including
special case applications headed ThePracticing Manager. These cases
introduce you to the real-world problems that man-agers of
financial institutions commonly face and need to solve in their
day-to-dayjobs. For example, how does the manager of a financial
institution come up with anew financial product that will be
profitable? How does a manager of a financial insti-tution manage
the risk that the institution faces from fluctuations in interest
rates,stock prices, or foreign exchange rates? Should a manager
hire an expert on FederalReserve policy making, referred to as a
Fed watcher, to help the institution dis-cern where monetary policy
might be going in the future?
Not only do The Practicing Manager cases, which answer these
questions andothers like them, provide you with some special
analytic tools that you will need ifyou make your career at a
financial institution, but they also give you a feel for whata job
as the manager of a financial institution is all about.
How We Will Study Financial Markets and InstitutionsInstead of
focusing on a mass of dull facts that will soon become obsolete,
this text-book emphasizes a unifying, analytic framework for
studying financial markets andinstitutions. This framework uses a
few basic concepts to help organize your think-ing about the
determination of asset prices, the structure of financial markets,
bankmanagement, and the role of monetary policy in the economy. The
basic concepts areequilibrium, basic supply and demand analysis to
explain behavior in financial mar-kets, the search for profits, and
an approach to financial structure based on trans-action costs and
asymmetric information.
The unifying framework used in this book will keep your
knowledge from becom-ing obsolete and make the material more
interesting. It will enable you to learn whatreally matters without
having to memorize material that you will forget soon afterthe
final exam. This framework will also provide you with the tools
needed to under-stand trends in the financial marketplace and in
variables such as interest rates andexchange rates.
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Chapter 1 Why Study Financial Markets and Institutions? 9
To help you understand and apply the unifying analytic
framework, simple mod-els are constructed in which the variables
held constant are carefully delineated, eachstep in the derivation
of the model is clearly and carefully laid out, and the modelsare
then used to explain various phenomena by focusing on changes in
one variableat a time, holding all other variables constant.
To reinforce the models usefulness, this text also emphasizes
the interactionof theoretical analysis and empirical data in order
to expose you to real-life eventsand data. To make the study of
financial markets and institutions even more rele-vant and to help
you learn the material, the book contains, besides The
PracticingManager cases, numerous additional cases and mini-cases
that demonstrate how youcan use the analysis in the book to explain
many real-world situations.
To function better in the real world outside the classroom, you
must have thetools to follow the financial news that appears in
leading financial publications. Tohelp and encourage you to read
the financial section of the newspaper, this book con-tains two
special features. The first is a set of special boxed inserts
titled Followingthe Financial News that contain actual columns and
data from the Wall StreetJournal (subscription required on the Web
at http://online.wsj.com/home-page) or thatare found in other
financial publications or Web sites that appear daily or
periodically.These boxes give you the detailed information and
definitions you need to evaluatethe data being presented. The
second feature is a set of special case applications titledReading
the Wall Street Journal that expand on the Following the
FinancialNews boxes. These cases show you how you can use the
analytic framework in thebook directly to make sense of the daily
columns in the United States leading finan-cial newspaper. In
addition to these cases, this book also contains nearly 400
end-of-chapter problems that ask you to apply the analytic concepts
you have learnedto other real-world issues. Particularly relevant
is a special class of problems headedPredicting the Future. These
questions give you an opportunity to review and applymany of the
important financial concepts and tools presented throughout the
book.
Exploring the WebThe World Wide Web has become an extremely
valuable and convenient resourcefor financial research. We
emphasize the importance of this tool in several ways.
First,wherever we use the Web to find information to build the
charts and tables thatappear throughout the text, we include the
source sites URL. These sites often con-tain additional information
and are updated frequently. Second, we have added Webexercises to
the end of each chapter. These exercises prompt you to visit sites
relatedto the chapter and to work with real-time data and
information. We have also addedWeb references to the end of each
chapter that list the URLs of sites related to thematerial being
discussed. Visit these sites to further explore a topic you find of
par-ticular interest. Web site URLs are subject to frequent change.
We have tried to selectstable sites, but we realize that even
government URLs change. The publishers Website
(www.pearsonhighered.com/mishkin_eakins) will maintain an updated
list of cur-rent URLs for your reference.
Collecting and Graphing DataThe following Web exercise is
especially important because it demonstrates how toexport data from
a Web site into Microsoft Excel for further analysis. We suggestyou
work through this problem on your own so that you will be able to
perform thisactivity when prompted in subsequent Web exercises.
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10 Part 1 Introduction
Web ExerciseYou have been hired by Risky Ventures, Inc., as a
consultant to help the company ana-lyze interest-rate trends. Your
employers are initially interested in determining thehistorical
relationship between long- and short-term interest rates. The
biggest taskyou must immediately undertake is collecting market
interest-rate data. You knowthe best source of this information is
the Web.
1. You decide that your best indicator of long-term interest
rates is the 10-yearU.S. Treasury note. Your first task is to
gather historical data. Go towww.federalreserve.gov/releases/H15.
The site should look like Figure 1.4. Atthe top, click HISTORICAL
DATA. Now scroll down to Treasury ConstantMaturities, and click on
the ANNUAL TAG to the right of the 10 Year category.
F I G U R E 1 . 4 Federal Reserve Web Site for Selected Interest
Rates
Source: www.federalreserve.gov.
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Chapter 1 Why Study Financial Markets and Institutions? 11
F I G U R E 1 . 5 Excel Spreadsheet with Interest-Rate Data
Source: Used with permission from Microsoft
2. Now that you have located an accurate source of historical
interest-rate data,the next step is getting it onto a spreadsheet.
Excel will let you convert textdata into columns. Begin by
highlighting the two columns of data (the yearand rate).
Right-click and choose COPY. Now open Excel and put the cursorin a
cell. Click PASTE. Now choose data from the menu bar and click TEXT
TOCOLUMNS. Follow the wizard (Figure 1.5), checking the fixed-width
option. Thelist of interest rates should now have the year in one
column and the inter-est rate in the next column. Label your
columns.
Repeat the preceding steps to collect the one-year interest rate
series.Put it in the column next to the 10-year series. Be sure to
line up the yearscorrectly and delete any years that are not
included in both series.
3. You now want to analyze the interest rates by graphing them.
Highlight thetwo columns of interest-rate data you just created in
Excel. Click on theCHART WIZARD ICON on the toolbar (or
INSERT/CHART). Select the Scatter charttype, and choose any type of
scatter chart subtype that connects the dots.Let the Excel wizard
take you through the steps of completing the graph.(See Figure
1.6.)
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12 Part 1 Introduction
S U M M A R Y
1. Activities in financial markets have direct effects
onindividuals wealth, the behavior of businesses, and theefficiency
of our economy. Three financial marketsdeserve particular
attention: the bond market (whereinterest rates are determined),
the stock market(which has a major effect on peoples wealth and
onfirms investment decisions), and the foreign exchange
market (because fluctuations in the foreign exchangerate have
major consequences for the U.S. economy).
2. Because monetary policy affects interest rates, infla-tion,
and business cycles, all of which have an impor-tant impact on
financial markets and institutions, weneed to understand how
monetary policy is conductedby central banks in the United States
and abroad.
F I G U R E 1 . 6 Excel Graph of Interest-Data
Source: Used with permission from Microsoft
Concluding RemarksThe field of financial markets and
institutions is an exciting one. Not only will youdevelop skills
that will be valuable in your career, but you will also gain a
clearerunderstanding of events in financial markets and
institutions you frequently hearabout in the news media. This book
will introduce you to many of the controver-sies that are hotly
debated in the current political arena.
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Chapter 1 Why Study Financial Markets and Institutions? 13
K E Y T E R M S
asset, p. 2banks, p. 7bond, p. 2central bank, p. 6common stock
(stock), p. 3e-finance, p. 7
Federal Reserve System (the Fed), p. 6
financial crises, p. 6financial intermediaries, p. 6financial
markets, p. 2foreign exchange market, p. 4
foreign exchange rate, p. 5interest rate, p. 2monetary policy,
p. 6money (money supply), p. 6security, p. 2
Q U E S T I O N S
1. Why are financial markets important to the health ofthe
economy?
2. When interest rates rise, how might businesses andconsumers
change their economic behavior?
3. How can a change in interest rates affect the prof-itability
of financial institutions?
4. Is everybody worse off when interest rates rise?
5. What effect might a fall in stock prices have on busi-ness
investment?
6. What effect might a rise in stock prices have on con-sumers
decisions to spend?
7. How does a decline in the value of the pound ster-ling affect
British consumers?
8. How does an increase in the value of the pound ster-ling
affect American businesses?
9. How can changes in foreign exchange rates affect
theprofitability of financial institutions?
10. Looking at Figure 1.3, in what years would you havechosen to
visit the Grand Canyon in Arizona ratherthan the Tower of
London?
11. What is the basic activity of banks?
12. What are the other important financial intermediariesin the
economy besides banks?
13. Can you think of any financial innovation in the past10
years that has affected you personally? Has it madeyou better or
worse off? In what way?
14. What types of risks do financial institutions face?
15. Why do managers of financial institutions care somuch about
the activities of the Federal ReserveSystem?
3. Banks and other financial institutions channel fundsfrom
people who might not put them to productiveuse to people who can do
so and thus play a crucialrole in improving the efficiency of the
economy.
4. Understanding how financial institutions are managedis
important because there will be many times in yourlife, as an
individual, an employee, or the owner of abusiness, when you will
interact with them. ThePracticing Manager cases not only provide
special
analytic tools that are useful if you choose a careerwith a
financial institution but also give you a feel forwhat a job as the
manager of a financial institutionis all about.
5. This textbook emphasizes an analytic way of thinkingby
developing a unifying framework for the study offinancial markets
and institutions using a few basicprinciples. This textbook also
focuses on the inter-action of theoretical analysis and empirical
data.
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14 Part 1 Introduction
W E B E X E R C I S E S
Working with Financial Market Data
1. In this exercise we will practice collecting data fromthe Web
and graphing it using Excel. Use the exam-ple on pages 1012 as a
guide. Go to www.forecasts.org/data/index.htm, click on Data at the
top of thepage, click on Stock Index Data, and choose theU.S. Stock
IndicesMonthly option. Finally, choosethe Dow Jones Industrial
Average option.
a. Using the method presented in this chapter, movethe data into
an Excel spreadsheet.
b. Using the data from step a, prepare a chart. Usethe Chart
Wizard to properly label your axes.
2. In Web Exercise 1 you collected and graphed the DowJones
Industrial Average. This same site reports fore-cast values of the
DJIA. Go to www.forecasts.org/data/index.htm. Click the Dow Jones
Industrials linkunder 6 Month Forecasts in the far-left column.
a. What is the Dow forecast to be in six months?
b. What percentage increase is forecast for the nextsix
months?
Date U.S. Dollars per GBP
4/1 1.95644/4 1.92934/5 1.9144/6 1.93744/7 1.9614/8 1.89254/11
1.88224/12 1.85584/13 1.7964/14 1.79024/15 1.77854/18 1.75044/19
1.72554/20 1.69144/21 1.6724/22 1.66844/25 1.66744/26 1.68574/27
1.69254/28 1.72014/29 1.7512
Q U A N T I TAT I V E P R O B L E M S
1. The following table lists foreign exchange ratesbetween U.S.
dollars and British pounds (GBP) dur-ing April.
Which day would have been the best day to convert$200 into
British pounds? Which day would have beenthe worst day? What would
be the difference in pounds?
CoverTitle PageCopyright PageContentsContents on the WebPrefaceA
Note from Frederic MishkinWhats New in the Seventh
EditionHallmarksFlexibilityMaking It Easier to Teach Financial
Markets and InstitutionsPedagogical AidsSupplementary
MaterialsAcknowledgments
AcknowledgmentsAbout the AuthorsPART ONE: INTRODUCTIONChapter 1
Why Study Financial Markets and Institutions?PreviewWhy Study
Financial Markets?Why Study Financial Institutions?Applied
Managerial PerspectiveHow We Will Study Financial Markets and
InstitutionsWeb ExerciseConcluding RemarksSummaryKey
TermsQuestionsQuantitative ProblemsWeb Exercises
Chapter 2 Overview of the Financial SystemPreviewFunction of
Financial MarketsStructure of Financial MarketsInternationalization
of Financial MarketsGLOBAL: Are U.S. Capital Markets Losing Their
Edge?Function of Financial Intermediaries: Indirect
FinanceFOLLOWING THE FINANCIAL NEWS: Foreign Stock Market
IndexesGLOBAL: The Importance of Financial Intermediaries Relative
to Securities Markets: An International ComparisonTypes of
Financial IntermediariesRegulation of the Financial
SystemSummaryKey TermsQuestionsWeb Exercises
PART TWO: FUNDAMENTALS OF FINANCIAL MARKETSChapter 3 What Do
Interest Rates Mean and What Is Their Role in
Valuation?PreviewMeasuring Interest RatesGLOBAL: Negative T-Bill
Rates? It Can HappenThe Distinction Between Real and Nominal
Interest RatesThe Distinction Between Interest Rates and
ReturnsMINI-CASE: With TIPS, Real Interest Rates Have Become
Observable in the United StatesMINI-CASE: Helping Investors Select
Desired Interest-Rate RiskTHE PRACTICING MANAGER: Calculating
Duration to Measure Interest-Rate RiskSummaryKey
TermsQuestionsQuantitative ProblemsWeb Exercises
Chapter 4 Why Do Interest Rates Change?PreviewDeterminants of
Asset DemandSupply and Demand in the Bond MarketChanges in
Equilibrium Interest RatesCASE: Changes in the Interest Rate Due to
Expected Inflation: The Fisher EffectCASE: Changes in the Interest
Rate Due to a Business Cycle ExpansionCASE: Explaining Low Japanese
Interest RatesCASE: Reading the Wall Street Journal "Credit
Markets" ColumnFOLLOWING THE FINANCIAL NEWS: The "Credit Markets"
ColumnTHE PRACTICING MANAGER: Profiting from Interest-Rate
ForecastsFOLLOWING THE FINANCIAL NEWS: Forecasting Interest
RatesSummaryKey TermsQuestionsQuantitative ProblemsWeb ExercisesWeb
Appendices
Chapter 5 How Do Risk and Term Structure Affect Interest
Rates?PreviewRisk Structure of Interest RatesCASE: The Subprime
Collapse and the Baa-Treasury SpreadCASE: Effects of the Bush Tax
Cut and Its Possible Repeal on Bond Interest RatesTerm Structure of
Interest RatesFOLLOWING THE FINANCIAL NEWS: Yield CurvesMINI-CASE:
The Yield Curve as a Forecasting Tool for Inflation and the
Business CycleCASE: Interpreting Yield Curves, 19802010THE
PRACTICING MANAGER: Using the Term Structure to Forecast Interest
RatesSummaryKey TermsQuestionsQuantitative ProblemsWeb
Exercises
Chapter 6 Are Financial Markets Efficient?PreviewThe Efficient
Market HypothesisEvidence on the Efficient Market
HypothesisMINI-CASE: An Exception That Proves the Rule: Ivan
BoeskyCASE: Should Foreign Exchange Rates Follow a Random
Walk?Overview of the Evidence on the Efficient Market HypothesisTHE
PRACTICING MANAGER: Practical Guide to Investing in the Stock
MarketMINI-CASE: Should You Hire an Ape as Your Investment
Adviser?CASE: What Do the Black Monday Crash of 1987 and the Tech
Crash of 2000 Tell Us About the Efficient Market
Hypothesis?Behavioral FinanceSummaryKey TermsQuestionsQuantitative
ProblemsWeb Exercises
PART THREE: FUNDAMENTALS OF FINANCIAL INSTITUTIONSChapter 7 Why
Do Financial Institutions Exist?PreviewBasic Facts About Financial
Structure Throughout the WorldTransaction CostsAsymmetric
Information: Adverse Selection and Moral HazardThe Lemons Problem:
How Adverse Selection Influences Financial StructureMINI-CASE: The
Enron ImplosionHow Moral Hazard Affects the Choice Between Debt and
Equity ContractsHow Moral Hazard Influences Financial Structure in
Debt MarketsCASE: Financial Development and Economic
GrowthMINI-CASE: Should We Kill All the Lawyers?CASE: Is China a
Counter-Example to the Importance of Financial
Development?Conflicts of InterestMINI-CASE: The Demise of Arthur
AndersenMINI-CASE: Credit Rating Agencies and the 20072009
Financial CrisisMINI-CASE: Has Sarbanes-Oxley Led to a Decline in
U.S. Capital Markets?SummaryKey TermsQuestionsQuantitative
ProblemsWeb Exercises
Chapter 8 Why Do Financial Crises Occur and Why Are They So
Damaging to the Economy?PreviewAsymmetric Information and Financial
CrisesDynamics of Financial Crises in Advanced EconomiesCASE: The
Mother of All Financial Crises: The Great DepressionCASE: The
20072009 Financial CrisisINSIDE THE FED: Was the Fed to Blame for
the Housing Price Bubble?GLOBAL: Ireland and the 20072009 Financial
CrisisDynamics of Financial Crises in Emerging Market
EconomiesCASE: Financial Crises in Mexico, 19941995; East Asia,
19971998; and Argentina, 20012002GLOBAL: The Perversion of the
Financial Liberalization/Globalization Process: Chaebols and the
South Korean CrisisSummaryKey TermsQuestionsWeb ExercisesWeb
References
PART FOUR: CENTRAL BANKING AND THE CONDUCT OF MONETARY
POLICYChapter 9 Central Banks and the Federal Reserve
SystemPreviewOrigins of the Federal Reserve SystemINSIDE THE FED:
The Political Genius of the Founders of the Federal Reserve
SystemStructure of the Federal Reserve SystemINSIDE THE FED: The
Special Role of the Federal Reserve Bank of New YorkINSIDE THE FED:
The Role of the Research StaffINSIDE THE FED: Green, Blue, Teal,
and Beige: What Do These Colors Mean at the Fed?INSIDE THE FED: How
Bernanke's Style Differs from Greenspan'sHow Independent Is the
Fed?Structure and Independence of the European Central
BankStructure and Independence of Other Foreign Central
BanksExplaining Central Bank BehaviorShould the Fed Be
Independent?INSIDE THE FED: The Evolution of the Fed's
Communication StrategySummaryKey TermsQuestions and ProblemsWeb
Exercises
Chapter 10 Conduct of Monetary Policy: Tools, Goals, Strategy,
and TacticsPreviewThe Federal Reserve's Balance SheetThe Market for
Reserves and the Federal Funds RateINSIDE THE FED: Why Does the Fed
Need to Pay Interest on Reserves?CASE: How the Federal Reserve's
Operating Procedures Limit Fluctuations in the Federal Funds
RateTools of Monetary PolicyDiscount PolicyReserve
RequirementsINSIDE THE FED: Federal Reserve Lender-of-Last-Resort
Facilities During the 20072009 Financial CrisisMonetary Policy
Tools of the European Central BankThe Price Stability Goal and the
Nominal AnchorOther Goals of Monetary PolicyShould Price Stability
Be the Primary Goal of Monetary Policy?Inflation TargetingGLOBAL:
The European Central Bank's Monetary Policy StrategyDisadvantages
of Inflation TargetingINSIDE THE FED: Chairman Bernanke and
Inflation TargetingCentral Banks' Response to Asset-Price Bubbles:
Lessons from the 20072009 Financial CrisisTactics: Choosing the
Policy InstrumentTHE PRACTICING MANAGER: Using a Fed
WatcherSummaryKey TermsQuestionsQuantitative ProblemsWeb
ExercisesWeb Appendices
PART FIVE: FINANCIAL MARKETSChapter 11 The Money
MarketsPreviewThe Money Markets DefinedThe Purpose of the Money
MarketsWho Participates in the Money Markets?Money Market
InstrumentsCASE: Discounting the Price of Treasury Securities to
Pay the InterestMINI-CASE: Treasury Bill Auctions Go HaywireGLOBAL:
Ironic Birth of the Eurodollar MarketComparing Money Market
SecuritiesLiquidityFOLLOWING THE FINANCIAL NEWS: Money Market
RatesSummaryKey TermsQuestionsQuantitative ProblemsWeb
Exercises
Chapter 12 The Bond MarketPreviewPurpose of the Capital
MarketCapital Market ParticipantsCapital Market TradingTypes of
BondsTreasury Notes and BondsCASE: The 20072009 Financial Crisis
and the Bailout of Fannie Mae and Freddie MacMunicipal
BondsCorporate BondsFinancial Guarantees for BondsCurrent Yield
CalculationFinding the Value of Coupon BondsInvesting in
BondsSummaryKey TermsQuestionsQuantitative ProblemsWeb
Exercises
Chapter 13 The Stock MarketPreviewInvesting in StocksComputing
the Price of Common StockHow the Market Sets Security PricesErrors
in ValuationCASE: The 20072009 Financial Crisis and the Stock
MarketCASE: The September 11 Terrorist Attack, the Enron Scandal,
and the Stock MarketStock Market IndexesMINI-CASE: History of the
Dow Jones Industrial AverageBuying Foreign StocksRegulation of the
Stock MarketSummaryKey TermsQuestionsQuantitative ProblemsWeb
Exercises
Chapter 14 The Mortgage MarketsPreviewWhat Are
Mortgages?Characteristics of the Residential MortgageCASE: The
Discount Point DecisionTypes of Mortgage LoansMortgage-Lending
InstitutionsLoan ServicingE-FINANCE: Borrowers Shop the Web for
MortgagesSecondary Mortgage MarketSecuritization of
MortgagesSummaryKey TermsQuestionsQuantitative ProblemsWeb
Exercises
Chapter 15 The Foreign Exchange MarketPreviewForeign Exchange
MarketFOLLOWING THE FINANCIAL NEWS: Foreign Exchange RatesExchange
Rates in the Long RunExchange Rates in the Short Run: A Supply and
Demand AnalysisExplaining Changes in Exchange RatesCASE: Changes in
the Equilibrium Exchange Rate: An ExampleCASE: Why Are Exchange
Rates So Volatile?CASE: The Dollar and Interest RatesCASE: The
Subprime Crisis and the DollarCASE: Reading the Wall Street
Journal: The "Currency Trading" ColumnFOLLOWING THE FINANCIAL NEWS:
The "Currency Trading" ColumnTHE PRACTICING MANAGER: Profiting from
Foreign Exchange ForecastsSummaryKey TermsQuestionsQuantitative
ProblemsWeb Exercises
Chapter 15 Appendix: The Interest Parity ConditionComparing
Expected Returns on Domestic and Foreign AssetsInterest Parity
Condition
Chapter 16 The International Financial SystemPreviewIntervention
in the Foreign Exchange MarketINSIDE THE FED: A Day at the Federal
Reserve Bank of New York's Foreign Exchange DeskBalance of
PaymentsGLOBAL: Why the Large U.S. Current Account Deficit Worries
EconomistsExchange Rate Regimes in the International Financial
SystemGLOBAL: The Euro's Challenge to the DollarGLOBAL: Argentina's
Currency BoardGLOBAL: DollarizationCASE: The Foreign Exchange
Crisis of September 1992THE PRACTICING MANAGER: Profiting from a
Foreign Exchange CrisisCASE: Recent Foreign Exchange Crises in
Emerging Market Countries: Mexico 1994, East Asia 1997, Brazil
1999, and Argentina 2002CASE: How Did China Accumulate Over $2
Trillion of International Reserves?Capital ControlsThe Role of the
IMFSummaryKey TermsQuestionsQuantitative ProblemsWeb ExercisesWeb
Appendices
PART SIX: THE FINANCIAL INSTITUTIONS INDUSTRYChapter 17 Banking
and the Management of Financial InstitutionsPreviewThe Bank Balance
SheetBasic BankingGeneral Principles of Bank ManagementTHE
PRACTICING MANAGER: Strategies for Managing Bank CapitalCASE: How a
Capital Crunch Caused a Credit Crunch in 2008Off-Balance-Sheet
ActivitiesCONFLICTS OF INTEREST: Barings, Daiwa, Sumitomo, and
Societ Generale: Rogue Traders and the PrincipalAgent
ProblemMeasuring Bank PerformanceSummaryKey
TermsQuestionsQuantitative ProblemsWeb Exercises
Chapter 18 Financial RegulationPreviewAsymmetric Information and
Financial RegulationGLOBAL: The Spread of Government Deposit
Insurance Throughout the World: Is This a Good Thing?GLOBAL:
Whither the Basel Accord?MINI-CASE: Mark-to-Market Accounting and
the 20072009 Financial CrisisMINI-CASE: The 20072009 Financial
Crisis and Consumer Protection RegulationE-FINANCE: Electronic
Banking: New Challenges for Bank RegulationGLOBAL: International
Financial RegulationThe 1980s Savings and Loan and Banking
CrisisFederal Deposit Insurance Corporation Improvement Act of
1991Banking Crises Throughout the World in Recent YearsThe
Dodd-Frank Bill and Future RegulationSummaryKey
TermsQuestionsQuantitative ProblemsWeb ExercisesWeb Appendices
Chapter 19 Banking Industry: Structure and
CompetitionPreviewHistorical Development of the Banking
SystemFinancial Innovation and the Growth of the Shadow Banking
SystemE-FINANCE: Will "Clicks" Dominate "Bricks" in the Banking
Industry?E-FINANCE: Why Are Scandinavians So Far Ahead of Americans
in Using Electronic Payments and Online Banking?E-FINANCE: Are We
Headed for a Cashless Society?MINI-CASE: Bruce Bent and the Money
Market Mutual Fund Panic of 2008THE PRACTICING MANAGER: Profiting
from a New Financial Product: A Case Study of Treasury
StripsStructure of the U.S. Commercial Banking IndustryBank
Consolidation and Nationwide BankingE-FINANCE: Information
Technology and Bank ConsolidationSeparation of the Banking and
Other Financial Service IndustriesMINI-CASE: The 2007-2009
Financial Crisis and the Demise of Large, Free-Standing Investment
BanksThrift Industry: Regulation and StructureInternational
BankingSummaryKey TermsQuestionsWeb Exercises
Chapter 20 The Mutual Fund IndustryPreviewThe Growth of Mutual
FundsMutual Fund StructureCASE: Calculating a Mutual Fund's Net
Asset ValueInvestment Objective ClassesFee Structure of Investment
FundsRegulation of Mutual FundsHedge FundsMINI-CASE: The Long Term
Capital DebacleConflicts of Interest in the Mutual Fund
IndustryCONFLICTS OF INTEREST: Many Mutual Funds Are Caught
Ignoring Ethical StandardsCONFLICTS OF INTEREST: SEC Survey Reports
Mutual Fund Abuses WidespreadSummaryKey TermsQuestionsQuantitative
ProblemsWeb Exercises
Chapter 21 Insurance Companies and Pension FundsPreviewInsurance
CompaniesFundamentals of InsuranceMINI-CASE: Insurance Agent: The
Customer's AllyGrowth and Organization of Insurance CompaniesTypes
of InsuranceCONFLICTS OF INTEREST: Insurance Behemoth Charged with
Conflicts of Interest ViolationsTHE PRACTICING MANAGER: Insurance
ManagementCONFLICTS OF INTEREST: The AIG BlowupPensionsCONFLICTS OF
INTEREST: The Subprime Financial Crisis and the Monoline
InsurersTypes of PensionsMINI-CASE: Power to the PensionsRegulation
of Pension PlansThe Future of Pension FundsSummaryKey
TermsQuestionsQuantitative ProblemsWeb Exercises
Chapter 22 Investment Banks, Security Brokers and Dealers, and
Venture Capital FirmsPreviewInvestment BanksFOLLOWING THE FINANCIAL
NEWS: New Securities IssuesSecurities Brokers and DealersMINI-CASE:
Example of Using the Limit-Order BookRegulation of Securities
FirmsRelationship Between Securities Firms and Commercial
BanksPrivate Equity InvestmentPrivate Equity BuyoutsE-FINANCE:
Venture Capitalists Lose Focus with Internet CompaniesSummaryKey
TermsQuestionsQuantitative ProblemsWeb Exercises
PART SEVEN: THE MANAGEMENT OF FINANCIAL INSTITUTIONSChapter 23
Risk Management in Financial InstitutionsPreviewManaging Credit
RiskManaging Interest-Rate RiskTHE PRACTICING MANAGER: Strategies
for Managing Interest-Rate RiskSummaryKey
TermsQuestionsQuantitative ProblemsWeb Exercises
Chapter 24 Hedging with Financial
DerivativesPreviewHedgingForward MarketsTHE PRACTICING MANAGER:
Hedging Interest-Rate Risk with Forward ContractsFinancial Futures
MarketsFOLLOWING THE FINANCIAL NEWS: Financial FuturesTHE
PRACTICING MANAGER: Hedging with Financial FuturesMINI-CASE: The
Hunt Brothers and the Silver CrashTHE PRACTICING MANAGER: Hedging
Foreign Exchange Risk with Forward and Futures ContractsHedging
Foreign Exchange Risk with Forward ContractsHedging Foreign
Exchange Risk with Futures ContractsStock Index FuturesMINI-CASE:
Program Trading and Portfolio Insurance: Were They to Blame for the
Stock Market Crash of 1987?FOLLOWING THE FINANCIAL NEWS: Stock
Index FuturesTHE PRACTICING MANAGER: Hedging with Stock Index
FuturesOptionsTHE PRACTICING MANAGER: Hedging with Futures
OptionsInterest-Rate SwapsTHE PRACTICING MANAGER: Hedging with
Interest-Rate SwapsCredit DerivativesCASE: Lessons from the
Subprime Financial Crisis: When Are Financial Derivatives Likely to
Be a Worldwide Time Bomb?SummaryKey TermsQuestionsQuantitative
ProblemsWeb ExercisesWeb Appendices
GlossaryABCDEFGHIJLMNOPQRSTUVWYZ
IndexABCDEFGHIJKLMNOPQRSTUVWYZ
Contents on the Web
PART SEVEN: THE MANAGEMENT OF FINANCIAL INSTITUTIONS