Money andCapital Markets

Financial Institutions and Instrumentsin a Global Marketplace

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Contents

PART1

The Global Financial Systemin Perspective 1

1 Functions and Roles of the FinancialSystem in the Economy 2

1.1 Introduction to the FinancialSystem 3

1.2 The Global Economy and theFinancial System 3Flows within the Global EconomicSystem 3The Role of Markets in the GlobalEconomic System 4Types of Markets 5The Financial Markets and theFinancial System: Channel forSavings and Investment 5Nature of Savings 6Nature of Investment 6

1.3 Economic Functions Performed bythe Global Financial System andthe Financial Markets 7Savings Function 7Wealth Function 8Liquidity Function 9Credit Function 9Payments Function 9Risk Protection Function 10Policy Function 11

1.4 Types of Financial Markets withinthe Global Financial System 11The Money Market versus the CapitalMarket 12Divisions of the Money and CapitalMarkets 12Open versus Negotiated Markets 14

Primary versus SecondaryMarkets 14Spot versus Futures, Forward, andOption Markets 14

1.5 Factors Tying All FinancialMarkets Together 15Credit, the Common Commodity 16Speculation and Arbitrage 16

1.6 The Dynamic FinancialSystem 16

1.7 The Plan of This Book 17Summary of the Chapter's MainPoints 19Key Terms Appearing in ThisChapter 20Problems and Issues 20Web-Based Problems 22Selected References to Explore 23

Financial Assets, Money, FinancialTransactions, and FinancialInstitutions 252.1 Introduction: The Role of Financial

Assets 262.2 The Nature and Characteristics of

Financial Assets 26Characteristics of FinancialAssets 26Types of Financial Assets 27

2.3 How Financial Assets AreCreated 27

2.4 Financial Assets and the FinancialSystem 31

2.5 Lending and Borrowing in theFinancial System 33

2.6 Money as a Financial Asset 36What Is Money? 36The Functions of Money 37The Value of Money and OtherFinancial Assets and Inflation 38

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Contents

2.7 The Evolution of FinancialTransactions 40Direct Finance 40Semidirect Finance 41Indirect Finarite and-FinancialIntermediation 42

2.8 Relative Sizes and Types of MajorFinancial Institutions 44Comparative Sizes of Key Financial-Service Providers 44Classifying Financial Institutions 45Portfolio (Financial-Asset) Decisionsby Financial Institutions 46

2.9 The Disintermediation of Funds 47New Types of Disintermediation 47

2.10 Bank-Dominated versus Market-Dominated Financial Systems 48Summary of the Chapter's MainPoints 49Key Terms Appearing in ThisChapter 50Problems and Issues 51Web-Based Problems 53Selected References to Explore 53

The Financial InformationMarketplace 553.1 Introduction: The Importance

of Information in the FinancialMarketplace 56

3.2 The Great Debate over EfficientMarkets and AsymmetricInformation 56The Efficient Markets Hypothesis(EMH) 57What Is an Efficient Market? 57Different Forms of the EMH 58Insiders and Insider Trading 59What Is Insider Trading ? 59When Is Insider Trading Legal orIllegal? 59The Asymmetric InformationHypothesis (AIH) 60Problems Asymmetries Can Create:Lemons and Plums 61Problems Asymmetries Can Create:Adverse Selection 62

Problems Asymmetries Can Create:Moral Hazard 63Asymmetry, Efficiency, and Real-World Markets 64Informational Asymmetries and theLaw 65

3.3 Debt Security Prices and Yields:Sources of Information 68Bonds and Notes 68Bid and Asked Prices and PricingInformation 68

3.4 Stock Prices and Dividend Yields:Sources of Information 69Price and Yield Information 70Stock Price Indexes and Foreign StockPrices 70

3.5 Information on SecurityIssuers 71Moody's and Standard & Poor'sReports 71Securities and Exchange Commission(SEC) Reports 72Company Histories 72Dun & Bradstreet Ratings and RiskManagement 72Financial Institutions 73

Credit Bureaus 733.6 General Economic and Financial

Conditions 73The Federal Reserve System 73Other Domestic and InternationalSources of Information 74Summary of the Chapter's MainPoints 75Key Terms Appearing in ThisChapter 76Problems and Issues 76Web-Based Problems 78Selected References to Explore 79Appendix 3A: The Flow of Funds inthe Financial System 80

The Future of the Financial Systemand Trends in the Money and CapitalMarkets 884.1 Introduction: The Financial

Markets in Change 89

xxiv Contents

4.2 Financial Forces Reshaping the Moneyand Capital Markets Today 89

4.3 Economic and DemographicForces Reshaping the FinancialSystem 91

4.4 The Challenges and OpportunitiesPresented by Recent Trends 94Dealing with Risk in the FinancialSystem: Ensuring the Strength ofFinancial Institutions and IncreasingPublic Confidence 95

The Consequences of Reduced PublicConfidence 95

Ways to Promote Public Confidencein Financial Institutions and ReduceRisk in the Financial System 95

Developing Better Management Toolsto Deal with Risk 97

The Information Problem 98

The Effect of New Technology onthe Design and Delivery of FinancialServices 99The Information Revolution 99Recent Technological Advances 99Public Attitudes and Cost 100The Changing Mix of Financial-ServiceSuppliers in the Financial System . 101Price Sensitivity and LocalCompetition 101Importance of Established DeliverySystems 101New Financial Institutions andInstruments 101Securitization 102Consolidations and Convergenceswithin the Financial System 102

4.5 A New Role for Regulationin an Age of Financial-Services: Consolidation andConvergence 104

4.6 The Payments System: Current andFuture 107

4.7 The Current and Future Needfor Regulation of FinancialInstitutions 108Financial Service Regulations ThatCould Grow 109

Financial Disclosure 109

Privacy Protection and IdentityTheft 110

Social Responsibility 111

Promoting a Level Playing Field 111

Summary of the Chapter's MainPoints 112Key Terms Appearing in ThisChapter 113Problems and Issues 113Web-B ased Problems 114Selected References to Explore 115

PART 2

Interest Rates and the Prices ofFinancial Assets 117

5 The Determinants of Interest Rates:Competing Ideas 1185.1 Introduction: Interest Rates and the

Price of Credit 1195.2 Functions of the Rate of Interest in

the Economy 1195.3 The Classical Theory of Interest

Rates 120Saving by Households 120Saving by Business Firms 121Saving by Government 122The Demand for InvestmentFunds 122The Investment Decision-MakingProcess 122Investment Demand and the Rate ofInterest 124The Equilibrium Rate of Interest inthe Classical Theory of Interest 124Limitations of the Classical Theory ofInterest 125

5.4 The Liquidity Preference or CashBalances Theory of Interest Rates 126The Demand for Liquidity 126Motives for Holding Money (CashBalances) 127Total Demand for Money (CashBalances) 128

Contents xxv

The Supply of Money (CashBalances) 130The Equilibrium Rate of Interest inLiquidity Preference Theory 130Limitations of the LiquidityPreference Theory 131

5.5 The Loanable Funds Theory ofInterest 132The Demand for Loanable Funds 132Consumer (Household) Demand forLoanable Funds 132Domestic Business Demand forLoanable Funds 132Government Demand for LoanableFunds 132Foreign Demand for LoanableFunds 132Total Demand for LoanableFunds 133The Supply of Loanable Funds 133Domestic Saving 133Dishoarding of Money Balances 134Creation of Credit by the DomesticBanking System 134Foreign Lending to the Domestic FundsMarket 134Total Supply of Loanable Funds 135The Equilibrium Rate of Interest inthe Loanable Funds Theory 135

5.6 The Rational Expectations Theoryof Interest 137Summary of the Chapter's MainPoints 141Key Terms Appearing in ThisChapter 142Problems and Issues 142Web-Based Problems 144Selected References to Explore 145

Measuring and Calculating InterestRates and Financial Asset Prices 1476.1 Introduction to Interest Rates and

Asset Prices 1486.2 Units of Measurement for Interest

Rates 148Calculating and Quoting InterestRates 148Basis Points 148

6.3 Interest Rates in the WholesaleMoney Markets 149Computing Interest Rates on MoneyMarket Assets That Are Sold at aDiscount 149Holding-Period Yield on MoneyMarket Assets Sold at a Discount 150Interest Rate Quotations on U.S.Treasury Bills 151

6.4 Interest Rates on Bonds and OtherLong-Term Debt Securities 152Yield to Maturity (YTM) 152Holding-Period Yield on Bonds andOther Long-Term Debt Securities 153Understanding the Concepts of Yieldto Maturity and Holding-PeriodYield 154

Price Quotations on U.S. TreasuryNotes and Bonds 155Price Quotations on CorporateBonds 156

6.5 Interest Rates and the Prices ofDebt Securities 157

6.6 Rates of Return on a PerpetualFinancial Instrument 160The Rate of Return on Fixed-IncomePerpetuities 160Interest Rates and Stock Prices 161Calculating the Holding-Period Yieldon Stock 162Price Quotations in CorporateStock 162

6.7 Interest Rates Charged byInstitutional Lenders 164The Simple Interest Method 164Add-On Rate of Interest 165Discount Loan Method 165Home Mortgage Interest Rate 165Annual Percentage Rate (APR) 167Compound Interest 168The Annual Percentage Yield (APY)on Deposits 169Summary of the Chapter's MainPoints 170Key Terms Appearing in ThisChapter 171Problems and Issues 172

Contents

Web-Related Problems 173Selected References to Explore 174

Inflation, Yield Curves, and Duration:Impact on Interest Rates and AssetPrices 175

7.1 Introduction 176

7.2 Inflation and Interest Rates 176The Correlation between Inflation andInterest Rates 176Nominal and Real Interest Rates 177The Fisher Effect 178Alternative Views about Inflation andInterest Rates 178The Harrod-Keynes Effect of Inflation 178Anticipated versus UnanticipatedInflation 179

The Inflation-Risk Premium 180The Inflation-Caused Income TaxEffect 180Conclusions from Recent Research on

. Inflation and Interest Rates 181

7.3 Inflation and Stock Prices 1827.4 The Development of Inflation-

Adjusted Securities 184

7.5 The Maturity of a Loan 188The Yield Curve and the TermStructure of Interest Rates 188Types of Yield Curves 189The Unbiased ExpectationsHypothesis 189Assumptions of the ExpectationsHypothesis 191

Policy Implications of the UnbiasedExpectations Hypothesis 191The Liquidity Premium View of theYield Curve 192

7.6 The Segmented-Markets andPreferred Habitat Arguments 193The Possible Impact of SegmentedMarkets on the Yield Curve 193Policy Implications of the Segmented-Markets Theory 194The Preferred Habitat or CompositeTheory of the Yield Curve 194Research Evidence on the YieldCurve 194

7.7 Uses of the Yield Curve 197Forecasting Interest Rates 197

Uses for Financial Intermediaries 197

Detecting Overpriced and UnderpricedFinancial Assets 198

Indicating Trade-Offs between Maturityand Yield 198

Riding the Yield Curve 1987.8 Duration: A Different Approach to

Maturity 199The Price Elasticity of a Bond orOther Debt Security 199The Impact of Varying CouponRates 200

An Alternative Maturity Index for aFinancial Asset: Duration 201The Convexity Factor 203Uses of Duration 204Estimating Asset Price Changes 204

Portfolio Immunization 205

Limitations of Duration 207Summary of the Chapter's MainPoints 208Key Terms Appearing in ThisChapter 210Problems and Issues 210Web-B ased Problems 213Selected References to Explore 214

The Risk Structure of Interest Rates:Defaults, Prepayments, Taxes, andOther Rate-Determining Factors 2168.1 Introduction 2178.2 Marketability 2178.3 Liquidity 2188.4 Default Risk and Interest Rates 218

The Premium for Default Risk 219The Expected Rate of Return or Yieldon a Risky Asset 219Anticipated Loss and Default-RiskPremiums 220

Factors Influencing Default-RiskPremiums 221Inflation and Default-RiskPremiums 223Yield Curves for RiskySecurities 224

Contents

The Volatile History of Junk Bonds 224The Junk-Bond Spread and theEconomy 226

8.5 New Ways ofDealing with DefaultRisk: Credit Derivatives 227A Summary of the Default Risk—Interest Rate Relationship 229

8.6 Call Privileges and Call Risk 229Calculating the Yields on CalledFinancial Assets 229Advantages and Disadvantages of theCall Privilege 231The Call Premium and Interest RateExpectations 231Research Evidence on Call Privilegesand Call Risk 231

8.7 Prepayment Risk and the Yields onLoan-Backed Securities 232

8.8 Taxation of Returns on FinancialAssets 235Tax-Exempt Securities 235The Effect of Marginal Tax Rates onAfter-Tax Yields 236Comparing Taxable and Tax-ExemptSecurities 237Treatment of Capital Losses andCapital Gains 238

8.9 Convertible Securities 238Advantages for the Convertible BondIssuer 239

Advantages for the Investor inConvertible Bonds 240

8.10 The Structure of Interest Rates inthe Financial System 240Summary of the Chapter's MainPoints 242Key Terms Appearing in ThisChapter 243Problems and Issues 243Web-Based Problems 245Selected References to Explore 246

Interest Rate Forecasting and Hedging:Swaps, Financial Futures, andOptions 2489.1 Introduction 2499.2 Implicit Interest Rate Forecasts and

Asset Prices 249

9.3 Interest Rate Swaps 250What Are Swaps? 250How Swaps Work 251The Risks of Swapping 253

9.4 Financial Futures Contracts 255The Nature of Futures Trading 255Examples of Daily Price Quotationsfor U.S. Treasury Futures 255Why Hedging with Futures Can BeEffective 256Types of Hedges in Futures 258The Long (or Buying) Hedge 258The Short (or Selling) Hedge 259Cross Hedging 260Executing a Trade, the Cash Margin,and the Settlement of the Contract 261Payoff Diagrams for Long and ShortFutures Contracts 262Futures Contracts Offered onExchanges Today 262

9.5 Option Contracts 264Basic Types of Option Contracts andPrice Quotations 264Examples of Price Quotes on OptionsContracts 265Uses of Options 266Protecting against Declining InvestmentYields 267Protecting against Rising InterestRates 267

Payoff Diagrams for ValuingOptions 267Options Offered on ExchangesToday 270

9.6 Exchanges Where Futures andOptions Contracts Are Traded 270

9.7 Risks, Costs, and Rules for Tradingin Derivatives 271Risks and Costs Associated withFutures and Options 271Accounting Rules for TransactionsInvolving Derivatives 271Summary of the Chapter's MainPoints 272Key Terms Appearing in ThisChapter 273

Contents

Problems and Issues 274Web-Based Problems 276Selected References to Explore 276Appendix 9A: The Black-ScholesModel for Valuing Options 278 v

PART 3

The Money Market and CentralBanking 281

10 Introduction to the Money Market andthe Roles Played by Governments andSecurity Dealers 28210.1 Introduction: The Market for

Short-Term Credit 28310.2 Characteristics of the Money

Market 283What the Money Market Does 283The Need for a Money Market 284Key Borrowers and Lenders in theMoney Market 284The Goals of Money MarketInvestors 286Types of Investment Risk ThatInvestors Face 287Money Market Maturities 289Depth and Breadth of the MoneyMarket 289The Speed of Money Market Payments:Federal Funds versus ClearinghouseFunds 289A Market for Large Borrowers andLenders 291

10.3 Government Involvement in theMoney Market 291The Roles That Governments Play inthe Money Market 291Selling Treasury Bills to MoneyMarket Investors: The Anchor of theMoney Market 292Volume of Bills Outstanding 292Types of Treasury Bills 292How Bills Are Sold 293Results of a Recent Bill Auction 295Market Interest Rates on TreasuryBills 295Investors in Treasury Bills 297

10.4 Primary Dealers in GovernmentSecurities 297

10.5 Dealer Borrowing and LendingActivities in the Money Market 299Demand Loans for Dealers 299Repurchase Agreements (RPs) forDealers and Other Money MarketParticipants 300A New Type of RP: The GCF Repo 301Sources of Dealer Income 302Dealer Positions in Securities 303Dealer Transactions and GovernmentSecurity Brokers 304Summary of the Chapter's MainPoints 306

Key Terms Appearing in ThisChapter 307Problems and Issues 307Web-Based Problems 308Selected References to Explore 309

11 Commercial Banks, Major Corporations,

and Federal Credit Agencies in theMoney Market 31111.1 Introduction 31211.2 The Roles Played by Banks in the

Money Market 31211.3 Federal Funds Provided by the

Banking System 313The Nature of Federal Funds andTheir Uses 313Use of the Federal Funds Market toMeet Reserve Requirements 314Mechanics of Federal Funds Trading 314Volume of Borrowings in the FundsMarket 316Interest Rates on Federal Funds 316Federal Funds and GovernmentEconomic Policy 316

11.4 Negotiable Certificates of Deposit(CDs) Issued by Banks 318Terms Attached to CDs and WhoBuys Them 318Buyers of CDs 320New Types of CDs 321

11.5 Eurocurrency Deposits inInternational Banks 322What Is a Eurodollar? 322The Creation of EurocurrencyDeposits 323

Contents

Eurocurrency Maturities andRisks 326The Supply of EurocurrencyDeposits 326 ~"Eurodollars in U.S Domestic BankOperations 327Recent Innovations in theEurocurrency Markets 328Benefits and Costs of theEurocurrency Markets 328

11.6 Bankers' Acceptances 328How Bankers' Acceptances Are Usedin International Trade 328Bankers' Acceptances as InvestmentInstruments 329The Decline in Bankers'Acceptances 330

11.7 Evaluating the Money MarketCosts of Funds Needed byBankers 331

11.8 Concluding Comment on BankActivity in the Money Market 332

11.9 Major Corporations in the MoneyMarket: Commercial Paper 333The Nature of Commercial Paper 333Types of Commercial Paper 333The Recent Track Record ofCommercial Paper 335Commercial Paper as InvestmentInstruments 336Advantages of Issuing CommercialPaper 338Possible Disadvantages from IssuingCommercial Paper 339Who Buys Commercial Paper? 339Continuing Innovations in the PaperMarket 340Commercial Paper Ratings and DealerOperations 341Dealers in Paper 341

11.10 Credit Agencies in the MoneyMarket 342Types of Federal CreditAgencies 342Growth of the Agency SecurityMarket 343Characteristics and Marketing ofAgency Securities 346

Summary of the Chapter's MainPoints 346Key Terms Appearing in ThisChapter 348Problems and Issues 348Web-Based Problems 351Selected References to Explore 352

12 Roles and Services of the FederalReserve and Other Central Banks aroundthe World 35412.1 Introduction to Central

Banking 35512.2 The Roles of Central Banks in the

Economy and Financial System 355Control of the Money Supply toAvoid Severe Inflation 355Stabilizing the Money and CapitalMarkets 356Lender of Last Resort and Supervisorof the Banking System 357Maintaining and Improving thePayments Mechanism 357

12.3 The Goals and Channels of CentralBanking 357Central Banks' Goals 357Challenges in Achieving Central BankGoals 358The Channels through Which CentralBanks Work 359

12.4 History of the Federal ReserveSystem—Central Bank of theUnited States 362Problems in the Early U.S. BankingSystem 362Creation of the Federal ReserveSystem 363The Early Structure of the FederalReserve 364Goals and Policy Tools of theFed 364

12.5 How the Fed Is OrganizedToday 365The Board of Governors 366The Federal Open MarketCommittee 367The Federal Reserve Banks 368The Member Banks of the FederalReserve System 370

XXX Contents

13

12.6 Roles of the Federal ReserveSystem Today 372The Clearing and Collection of Checksand Other Payments Media 372Issuing Currency and Coin andRelated Services 373Maintaining a Sound Banking andFinancial System 373

Serving as the Federal Government'sFiscal Agent 373Providing Information to the Public 374Carrying Out Monetary Policy 374

12.7 The Key Focus of Central BankMonetary Policy: Interest Rates,Reserves, and Money 374

12.8 Reserve Composition andthe Deposit and MoneyMultipliers 375The Deposit Multiplier 376The Money Multiplier 378Summary of the Chapter's MainPoints 380Key Terms Appearing in ThisChapter 381Problems and Issues 381Web-Based Problems 382Selected References toExplore 383

The Tools and Goals of Central BankMonetary Policy 38413.1 Introduction to the Tools and Goals

of Monetary Policy 38513.2 General versus Selective Credit

Controls 38513.3 General Credit Controls in Central

Banking 385Open Market Operations 385

Effects of Open Market Operations onInterest Rates 385Effects of Open Market Operations onReserves 386

How Open Market Operations AreConducted in the United States 387

Types of Open Market Operations 389

Goals of Open Market Operations:Defensive and Dynamic 392

Changes in the Federal Reserve'sDiscount Rate 394Borrowing and Repaying DiscountWindow Loans 396

Effects of a Discount RateChange 397

Reserve Requirements 398Effects of a Change in Deposit ReserveRequirements 399An Illustration 400

Current Levels of ReserveRequirements 400

13.4 Selective Credit Controls Used inCentral Banking 403Moral Suasion by Central BankOfficials 403

Margin Requirements 403

13.5 Interest Rate Targeting 404The Federal Funds Rate 404

Fed Funds Targeting and Long-TermInterest Rates 407

13.6 The Federal Reserve and EconomicGoals 408The Goal of ControllingInflation 408

Central Bank Targeting ofInflation 410

Deflation 411

Hyperinflation 411

The Goals of Full Employment andStable Economic Growth 412The Natural Rate ofUnemployment 412

The Output Gap 413

13.7 The Conflicting Goals andthe Limitations of MonetaryPolicy 414Summary of the Chapter's MainPoints 416

Key Terms Appearing in ThisChapter 418

Problems and Issues 418

Web-Based Problems 419

Selected References toExplore 419

Contents

PART 4

Financial Institutions:,Organization,Activities, and Regulation"^ 421

14 The Commercial BankingIndustry: Structure, Products, andManagement 42214.1 Introduction to Banking 42314.2 The Structure of U.S. Commercial

Banking 423A Trend toward Consolidation 424Falling Industry Numbers As SmallBanks Are Taken Over by LargerOnes 424A Countertrend: Both Small andLarge Banks May Survive 425Economies of Scale Support aConsolidating Industry 425Branch Banking 425Bank Holding Companies(BHCs) 426

, Financial Holding Companies(FHCs) 427International Banking 427

14.3 The Convergence Trend inBanking 429Bank Failures 429Changing Technology 430

14.4 Portfolio Characteristics ofCommercial Banks 432Balance Sheet Items 432Cash and Due from Banks (PrimaryReserves) 432

Investment Security Holdings andSecondary Reserves 434

Loans 434

Loan Loss Allowances and LoanRisk 435Deposits 436

Nondeposit Sources of Funds 437

Equity Capital 439Income Statement Items 439Revenues and Expenses 439Interest and Noninterest Margins 440

15

14.5 Managing Commercial BankPerformance Today 441Managing Bank Assets, Liabilities,Revenues, and Expenses 441

. Monitoring the Performance of aBank 442

14.6 Money Creation and Destructionby Banks and Bank AccountingMethods 445The Creation of Money andCredit 446Destruction of Deposits andReserves 448Implications of Money Creation andDestruction 448Summary of the Chapter's MainPoints 450Key Terms Appearing in ThisChapter 451Problems and Issues 451Web-Based Problems 453Selected References toExplore 454

Nonbank Thrift Institutions: Savings andLoans, Savings Banks, Credit Unions,and Money Market Funds 45615.1 Introduction to Thrift

Institutions 45715.2 Savings and Loan Associations

(S&Ls) 457Origins of S&Ls 457How Funds Are Raised andAllocated 458Asset Portfolios 458

Liabilities of S&Ls 459

Trends in Revenues and Costs 460Possible Ways to Strengthen the S&LIndustry in the Future 462

15.3 Savings Banks (SBs) 464Number and Distribution ofSavings Banks and RegulatorySupervision 464How Funds Are Raised andAllocated 465Current Trends and FutureProblems 466

Contents

15.4 Credit Unions (CUs) 467Credit Union Membership 469Size of Credit Unions 469New Services Offered 470A Strong Competitive Force 472

15.5 Money Market Funds (MMFs) 472Summary of the Chapter's MainPoints 476Key Terms Appearing in ThisChapter 477Problems and Issues 477Web-Based Problems 478Selected References to Explore 479

16 Mutual Funds, Insurance Companies,Investment Banks, and Other FinancialFirms 48116.1 Introduction 48216.2 Mutual Funds (or Investment

Companies) 482The Background of InvestmentCompanies 482Bonds and Money Market Funds 482Stock Funds 483Index and Exchange-TradedFunds 483Global and Vulture Funds 484Small-Cap to Large-Cap Funds 485Life-Cycle Funds 485Hedge Funds 485Tax and Regulatory Status of theIndustry 485Open-End and Closed-End InvestmentCompanies 486Changing Investment Strategies 487Goals and Earnings of InvestmentCompanies 487Scandal Envelops the Mutual FundIndustry 488

16.3 Pension Funds 489Types of Pension Funds 489Defined-Benefit and ContributionPlans 490

Cash-Balance Pension Funds 490Growth of Pension Funds 491Investment Strategies of PensionFunds 492

Pension Fund Assets 493Factors Affecting the Future Growthof Pension Funds 495

16.4 Life Insurance Companies 496The Insurance Principle 498Investments of Life InsuranceCompanies 498Sources of Life Insurance CompanyFunds 500Structure and Growth of the LifeInsurance Industry 501New Services 502

16.5 Property-Casualty InsuranceCompanies 503Makeup of the Property-Casualty(P/C) Insurance Industry 503Changing Risk Patterns in Property/Liability Coverage 504Investments by Property-Casualty(P/C) Companies 506Sources of Income 507Business Cycles, Inflation, andCompetition 507

16.6 Finance Companies 508Different Finance Companies forDifferent Purposes 508Growth of Finance Companies 510Methods of Industry Financing 510Recent Changes in the Character ofthe Finance Company Industry 510Consolidation in the Industry 510New Types of FinanceCompanies 511

16.7 Investment Banks 511The Underwriting Function ofInvestment Banks 511Other Investment BankingServices 512

Leading Investment Banks and theConvergence of Commercial andInvestment B anking 512

16.8 Other Important FinancialInstitutions 512

16.9 Trends Affecting All FinancialInstitutions Today 514Summary of the Chapter's MainPoints 516

Contents

Key Terms Appearing in ThisChapter 517Problems and Jssues 518Web-Based Problems 519Selected References toExplore 520

17 Regulation of the Financial Institutions'Sector 52217.1 Introduction to Financial

Institutions' Regulation 52317.2 The Reasons behind the

Regulation of FinancialInstitutions 523Does Regulation Benefit or HarmFinancial Institutions? 525

17.3 The Regulation of CommercialBanks 527The Federal Reserve System(The Fed) 527Office of the Comptroller of theCurrency (The OCC) 527Federal Deposit InsuranceCorporation (FDIC) 529State Banking Commissions 530Opening Competition across PoliticalBoundaries 530Regulation of the Services Banks CanOffer 533The Gramm-Leach-Bliley (GLB)Act 534The Rise of Disclosure and PrivacyLaws in Banking 535The Growing Importance ofCapital Regulation inBanking 536Basel I 536

Basel II 538The Unfinished Agenda for BankingRegulation 539

17.4 The Regulation of ThriftInsitutions 540Credit Unions 541Savings and Loans 542Savings Banks 544Money Market Funds 544

17.5 The Regulation of InsuranceCompanies 544

17.6 The Regulation of PensionFunds 545

17.7 The Regulation of FinanceCompanies 546

17.8 The Regulation of Invest-mentCompanies (Mutual Funds) 547

17.9 An Overview of Trends inthe Regulation of FinancialInstitutions 547Summary of the Chapter's MainPoints 551Key Terms Appearing in ThisChapter 552Problems and Issues 552Web-Based Problems 553Selected References to Explore 555

PART 5

Governments and Businesses in theFinancial Markets 557

18 Federal, State, and Local GovernmentsOperating in the Financial Markets 558

18.1 Introduction to the Role ofGovernments in the FinancialMarketplace 559

18.2 Federal Government Activityin the Money and CapitalMarkets 559The Treasury Department in theFinancial Marketplace 559The Fiscal Policy Activities of theU.S. Treasury 559Sources of Federal GovernmentFunds 560Federal Government Expenditures 562Effects of Government Borrowingon the Financial System and theEconomy 562Management of the FederalDebt 565The Size and Growth of the PublicDebt 566The Composition of the PublicDebt 568

Contents

Marketable Public Debt 568

Nonmarketable Public Debt 569

Investors in U.S. GovernmentSecurities 569

Methods of Offering TreasurySecurities 571The Auction Method 572

Types of Treasury Auctions 572

Marketing Techniques 572

Book Entry 573

Other Services Offered Investors 573

On-the-Run and Off-the-Run TreasurySecurities 573

Treasury Interest Rates as GlobalBenchmarks for Other InterestRates 573

The Goals of Federal DebtManagement 574Minimize Interest Costs 574Economic Stabilization 574The Impact of Federal DebtManagement on the Financial Marketsand the Economy 574

18.3 State and Local Governments in theFinancial Markets 576Growth of State and LocalGovernment Borrowing 576Sources of Revenue for State andLocal Governments 578State and Local GovernmentExpenditures 579Motivations for State and LocalGovernment Borrowing 581Types of Securities Issued by Stateand Local Governments 582Short-Term Securities 583Long-Term Securities 583Types of Revenue Bonds _ 584Innovations in MunicipalSecurities 584

Key Features of Municipal Debt 585Tax Exemption 585Exemption Contributes to MarketVolatility 587Credit Ratings 588

Serialization 590

How Municipal Bonds AreMarketed 591Problems in the MunicipalMarket 592Summary of the Chapter's MainPoints 594Key Terms Appearing in ThisChapter 596Problems and Issues 596Web-Based Problems 598Selected References toExplore 599

19 Business Borrowing: CorporateBonds, Asset-Backed Securities, BankLoans, and Other Forms of BusinessDebt 60119.1 Introduction to Business

Borrowing 60219.2 Factors Affecting Business

Activity in the Money and CapitalMarkets 602

19.3 Characteristics of Corporate Notesand Bonds 603Principal Features of Corporate Notesand Bonds 603Recent Trends in Original Maturitiesof Corporate Bonds 604Call Privileges Attached to CorporateBonds 604Sinking Fund Provisions 604Yields and Costs of CorporateBonds 605Signals Corporate Bond IssuesMay Send to the FinancialMarketplace 606The Most Common Types ofCorporate Bonds 606Debentures 606

Subordinated Debentures 607

Mortgage Bonds 607

Income Bonds 607

Equipment Trust Certificates 607

Industrial Development Bonds 607

Innovations in Corporate Debt 608

Contents

19.4 Asset-Backed Securities Issued byCorporations 609

19.5 Investors in Corporate Debt 61219.6 The Secondary Market for

Corporate Debt 61419.7 The Marketing of Corporate

Debt 614Public Sales 614Private Placements 617

19.8 The Volume of Borrowing byCorporations 619

19.9 Bank Loans to BusinessFirms 621The Volume of Bank Credit Suppliedto Businesses 621The Prime, or Base, Interest Rate onBusiness Loans 622Other Examples of Base Rates forBusiness Loans 623

19.10 Commercial Mortgages 623Summary of the Chapter's MainPoints 625Key Terms Appearing in This

, Chapter 626Problems and Issues 626Web-Based Problems 628Selected References to Explore 629

20 The Market for Corporate Stock 63020.1 Introduction to the Stock

Market 63120.2 Characteristics of Corporate

Stock 631Common Stock 631Preferred Stock 632

20.3 Stock Market Investors 63420.4 Equity as a Source of

Funding 63820.5 The Process of Price Discovery in

the Equity Markets 640Organized Exchanges 640Foreign Exchanges 642Contributions of Exchanges 642Over-the-Counter (OTC)Markets 642Evolving Trading Platforms 643

20.6 The Third Market: Tradingin Listed Securities off theExchanges 644

20.7 The Private Equity Market 64720.8 Investment Banking and the Sale of

New Stock 64720.9 The Development of a Unified

International Market forStock 649The National Market System 649NASD and Automated PriceQuotations 649The Advent of ShelfRegistration 650Global Trading in Equities 650The Development of ADRs 65.1

20.10 Valuing Stocks: AlternativeApproaches 652Technical and FundamentalAnalysis 652Private Information 653Summary of the Chapter's MainPoints 654

Key Terms Appearing in ThisChapter 655Problems and Issues 656Web-Based Problems 656Selected References toExplore 657

PART 6

Consumers in the FinancialMarkets 659

21 Consumer Lending andBorrowing 66021.1 Introduction to Consumer Lending

and Borrowing 66121.2 Consumers as Lenders of

Funds 661Financial Assets Purchased byConsumers 661Recent Innovations in ConsumerSavings Instruments 663

xxxvi Contents

21.3 Consumers as Borrowers ofFunds 666Is Consumer BorrowingExcessive? 666Categories of ConsumerBorrowing 668

21.4 Home Equity Loans 66921.5 Credit and Debit Cards 670

Credit Cards 671Debit Cards 672

21.6 The Determinants of ConsumerBorrowing 673

21.7 Consumer LendingInstitutions 674Commercial Banks 675Finance Companies 675Other Consumer Lenders: CreditUnions, Savings Associations, andSmall Loan Companies 675

21.8 Factors Considered in MakingConsumer Loans 676

21.9 Credit Scoring Techniques 67721.10 Financial Disclosure and Consumer

Credit 678Truth in Lending 678Fair Credit Billing Act 679Fair Credit Reporting Act 679Consumer Leasing Act 680Competitive Banking Equality Act 680Fair Credit and Charge CardDisclosure Act 680Truth in Savings Act 680The Financial Services Modernization(Gramm-Leach-B liley) Act 681Identity Theft 681

21.11 Credit Discrimination Laws 682Community Reinvestment Actand Financial Institutions Reform,Recovery, and Enforcement Act 682Equal Credit Opportunity Act 682Fair Housing and Home MortgageDisclosure Acts 682

21.12 Bankruptcy Law Changes 683Summary of the Chapter's MainPoints 684

Key Terms Appearing in ThisChapter 685Problems and Issues 686Web-Based Problems 687Selected References to Explore 688

"22 The Residential Mortgage Market 69022.1 Introduction to the Residential

Mortgage Market 69122.2 Recent Trends in New Home

Prices and the Terms of MortgageLoans 691

22.3 The Structure of the MortgageMarket 693Volume of Mortgage Loans 693Residential versus NonresidentialMortgage Loans 693

22.4 Mortgage-LendingInstitutions 694

22.5 The Roles Played by LeadingFinancial Institutions in theMortgage Market 696Savings and Loan Associations 697Commercial Banks 697Life Insurance Companies 697Savings Banks 698Mortgage Bankers 698

22.6 Government Activity in theMortgage Market 698The Impact of the Great Depressionon Government Involvement in theMortgage Market 698Launching the Federal Home LoanBank System 699Setting Up the Federal HousingAdministration (FHA) and theVeterans Administration (VA) 699The Creation of Fannie Mae—AGovernment-Sponsored Enterprise(GSE) 700The Creation of Ginnie Mae(GNMA) 700GNMA Mortgage-BackedSecurities 701

The Federal Home Loan MortgageCorporation—Another Government-Sponsored Enterprise (GSE) 701

Contents xxxvi i

FHLMC Mortgage-BackedSecurities 701

Freddie and Fannie Face NewProblems 701 \Collateralized Mortgage Obligations(CMOs) and Real Estate MortgageInvestment Conduits (REMICs) 702

Impact of Securitized Mortgages 702

22.7 Innovations in MortgageInstruments 703Fixed-Rate Home Mortgages—TheOldest Form of Home Loan 703Variable-Rate and AdjustableMortgage Instruments 704Interest-Only Mortgages 704Reverse-Annuity Mortgages 705Epilogue on the Fixed-RateMortgage 705

22.8 Pricing and Other Issues in HomeMortgage Lending 705Pricing Home Mortgages and theTreasury Security Market 705Mortgage Lock-Ins, LoanModifications, and Foreclosures 707Refinancing Home Mortgages and"Cash Outs" 707Predatory Lending 708Summary of the Chapter's MainPoints 709Key Terms Appearing in ThisChapter 711Problems and Issues 711Web-Based Problems 712Selected References toExplore 713

PART 7

The International FinancialSystem 715

23 International Transactions and CurrencyValues 71623.1 Introduction to International

Transactions and CurrencyValues 717

23.2 The Balance-of-Payments (BOP)Accounts 717The U.S. Balance of InternationalPayments 718The Current Account 719The Merchandise Trade Balance in theCurrent Account 719

The Service Balance in the CurrentAccount 720

Investment Income Receiptsand Payments in the CurrentAccount 721

Compensation of Employees in theCurrent Account 721

Unilateral Transfers in the CurrentAccount 721

The Balance on Current Account 721

The Capital and FinancialAccounts 722Official Transactions 722Disequilibrium in the Balance ofPayments 723

23.3 The Problem of Different MonetaryUnits in International Trade andFinance 724The Gold Standard 724The Gold Exchange Standard 725The Modified ExchangeStandard 725The Managed Floating CurrencyStandard 726

23.4 Determining Foreign CurrencyValues 728Essential Features of the ForeignExchange Market 729Exchange Rate Quotations 729Factors Affecting Foreign ExchangeRates 731BOP Position 731

Speculation 731

Domestic Political and Economic

Conditions 731

Purchasing Power Parity 731

Central Bank Intervention 732

Supply and Demand for ForeignExchange 732

xxxviii Contents

24

23.5 The Forward Market forCurrencies 735Methods of Quoting ForwardExchange Rates 735

23.6 Functions of the Forward ExchangeMarket 736Commercial Covering 736Hedging an Investment Position 737Speculation on Future CurrencyPrices 737Covered Interest Arbitrage 737The Principle of Interest RateParity 738

23.7 The Market for Foreign CurrencyFutures 739The Buying Hedge 740

The Selling Hedge 740

23.8 Other Innovative Methods forDealing with Currency Risk 740

23.9 Government Intervention in theForeign Exchange Markets 742Summary of the Chapter's MainPoints 743Key Terms Appearing in ThisChapter 744Problems and Issues 745Web-Based Problems 746Selected References to Explore 747

International Banking 748

24.1 Introduction to InternationalBanking 749

24.2 The Scope of International BankingActivities 749Multinational BankingCorporations 749Types of Facilities Operated by BanksAbroad 749Choosing the Right Kind of Facility toServe Foreign Markets 750

24.3 Services Offered by InternationalBanks 751Issuing Letters of Credit 751Buying and Selling Foreign Exchange(FOREX) 751

Accepting Eurocurrency Deposits andMaking Eurocurrency Loans 751Marketing and Underwriting of BothDomestic and Eurocurrency Bonds,Notes, and Equity Shares 751Securitizing Loans 753Advisory Services Provided byInternational Banks 753Universal Banking Services andOne-Stop Shopping 754

24.4 Foreign Banks Operating in theUnited States 754The Growth of Foreign Bank Activityin the United States 755Federal Regulation of Foreign BankActivity 755

24.5 Regulation of the InternationalBanking Activities of U.S.Banks 756

24.6 The Future of InternationalBanking 757The Risks of InternationalLending 757Political and Currency Risk 757Geographic Distribution ofInternational Bank Lending 759Public Confidence and ProtectingAgainst Bank Failures 759The Spread of Deregulation: HowFast Should We Go? 761

24.7 Prospects and Challenges for theTwenty-First Century 762Summary of the Chapter's MainPoints 763Key Terms Appearing in ThisChapter 765Problems and Issues 765Web-Based Problems 766Selected References to Explore 767

Money and Capital Markets Dictionary D-1Index 1-1