When we purchase certificates of deposit or bonds, we forgo ________ in exchange for interest.

FinancialMarketsandInstitutions7thEditionbyAnthonySaunders.pdf
Home>Business & Finance homework help>Finance assignment， Due 10/26
sau19714_fm_i-xxii.indd i 10/04/17 06:53 PM

s e v e n t h e d i t i o n

Financial Markets and Institutions

Final PDF to printer

sau19714_fm_i-xxii.indd ii 10/04/17 06:53 PM

FINANCIAL MANAGEMENT Block, Hirt, and Danielsen Foundations of Financial Management Sixteenth Edition

Brealey, Myers, and Allen Principles of Corporate Finance Twelfth Edition

Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition

Brealey, Myers, and Marcus Fundamentals of Corporate Finance Ninth Edition

Brooks FinGame Online 5.0 Bruner, Eades, and Schill Case Studies in Finance: Managing for Corporate Value Creation Eighth Edition

Cornett, Adair, and Nofsinger Finance: Applications and Theory Fourth Edition

Cornett, Adair, and Nofsinger M: Finance Fourth Edition

DeMello Cases in Finance Third Edition

Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition

Higgins Analysis for Financial Management Twelfth Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance Eleventh Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fifth Edition

Ross, Westerfield, and Jordan Essentials of Corporate Finance Ninth Edition

Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Twelfth Edition

Shefrin Behavioral Corporate Finance: Decisions that Create Value Second Edition

INVESTMENTS Bodie, Kane, and Marcus Essentials of Investments Tenth Edition

Bodie, Kane, and Marcus Investments Eleventh Edition

Hirt and Block Fundamentals of Investment Management Tenth Edition

Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and Management Eighth Edition

Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition

Sundaram and Das Derivatives: Principles and Practice Second Edition

FINANCIAL INSTITUTIONS AND MARKETS Rose and Hudgins Bank Management and Financial Services Ninth Edition

Rose and Marquis Financial Institutions and Markets Eleventh Edition

Saunders and Cornett Financial Institutions Management: A Risk Management Approach Ninth Edition

Saunders and Cornett Financial Markets and Institutions Seventh Edition

INTERNATIONAL FINANCE Eun and Resnick International Financial Management Eighth Edition

REAL ESTATE Brueggeman and Fisher Real Estate Finance and Investments Sixteenth Edition

Ling and Archer Real Estate Principles: A Value Approach Fifth Edition

FINANCIAL PLANNING AND INSURANCE Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Twelfth Edition

Altfest Personal Financial Planning Second Edition

Harrington and Niehaus Risk Management and Insurance Second Edition

Kapoor, Dlabay, Hughes, and Hart Focus on Personal Finance: An active approach to help you achieve financial literacy Sixth Edition

Kapoor, Dlabay, Hughes, and Hart Personal Finance Twelfth Edition

Walker and Walker Personal Finance: Building Your Future Second Edition

THE MCGRAW-HILL EDUCATION SERIES IN FINANCE, INSURANCE, AND REAL ESTATE

Final PDF to printer

sau19714_fm_i-xxii.indd iii 10/04/17 06:53 PM

s e v e n t h e d i t i o n

Financial Markets and Institutions Anthony Saunders

Stern School of Business New York University

Marcia Millon Cornett Bentley University

Final PDF to printer

sau19714_fm_i-xxii.indd iv 10/10/17 02:03 AM

FINANCIAL MARKETS AND INSTITUTIONS, SEVENTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2019 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2015, 2012, and 2009. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 LWI 21 20 19 18

ISBN 978-1-259-91971-8 MHID 1-259-91971-4

Brand Manager: Charles Synovec Product Developer: Noelle Bathurst Marketing Manager: Trina Maurer Content Project Managers: Heather Ervolino; Evan Roberts Buyer: Sandy Ludovissy Design: Matt Diamond Content Licensing Specialist: Beth Thole Cover Image: © Shutterstock / Rudy Balasko Compositor: SPi Global Printer: LSC Communications

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data

Names: Saunders, Anthony, 1949- author. | Cornett, Marcia Millon, author. Title: Financial markets and institutions / Anthony Saunders, Stern School of Business, New York University, Marcia Millon Cornett, Bentley University. Description: Seventh edition. | New York, NY : McGraw-Hill Education, [2019] Identifiers: LCCN 2017031881 | ISBN 9781259919718 (alk. paper) Subjects: LCSH: Securities—United States. | Stock exchanges—United States. | Financial institutions—United States. | Rate of return—United States. | Interest rates—United States. Classification: LCC HG4910 .S28 2019 | DDC 332—dc23 LC record available at https://lccn.loc.gov/2017031881

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

mheducation.com/highered

Final PDF to printer

sau19714_fm_i-xxii.indd v 10/04/17 06:53 PM

To Ingo Walter: a mentor, coauthor, and friend. —TONY SAUNDERS

To my parents, Tom and Sue. —MARCIA MILLON CORNETT

Final PDF to printer

vi

sau19714_fm_i-xxii.indd vi 10/04/17 06:53 PM

ABOUT THE AUTHORS

Anthony Saunders

Anthony Saunders is the John M. Schiff Professor of Finance

and former chair of the Department of Finance at the Stern

School of Business at New York University. Professor Saun-

ders received his PhD from the London School of Eco-

nomics and has taught both

undergraduate- and graduate-

level courses at NYU since

1978. Throughout his aca-

demic career, his teaching

and research have specialized

in financial institutions and

international banking. He has

served as a visiting professor all over the world, including

INSEAD, the Stockholm School of Economics, and the Uni-

versity of Melbourne.

Professor Saunders holds or has held positions on the

Board of Academic Consultants of the Federal Reserve

Board of Governors as well as the Council of Research

Advisors for the Federal National Mortgage Association. In

addition, Dr. Saunders has acted as a visiting scholar at the

Comptroller of the Currency and at the International Mon-

etary Fund. He is editor of the Journal of Financial Mar-

kets, Instruments and Institutions, as well as the associate

editor of a number of other journals. His research has been

published in all of the major finance and banking journals

and in several books. He has just published a new edition

of his textbook, with Dr. Marcia Millon Cornett, Financial

Institutions Management: A Risk Management Approach,

for McGraw-Hill/Irwin (ninth edition) as well as a third edi-

tion of his book on credit risk measurement for John Wiley

& Sons. Professor Saunders was ranked the most prolific

author out of more than 5,800 who have published in the

seven leading finance academic journals from 1959 to 2008

(“Most Prolific Authors in the Financial Literature, 1959–

2008,” Jean Heck and Philip Cooley).

Marcia Millon Cornett

Marcia Millon Cornett is the Robert A. and Julia E. Dorn

Professor of Finance at Bentley University. She received her

BS degree in economics from Knox College in Galesburg,

Illinois, and her MBA and PhD degrees in finance from

Indiana University in Bloomington, Indiana. Dr. Cornett has

written and published several articles in the areas of bank

performance, bank regulation, corporate finance, and invest-

ments. Articles authored by Dr. Cornett have appeared in

such academic journals as the Journal of Finance, the Jour-

nal of Money, Credit, and Banking, the Journal of Finan-

cial Economics, Financial Management, and the Journal

of Banking and Finance. She was recently ranked the 124th

most published out of more than 17,600 authors and the

number five female author in finance literature over the last

50 years. Along with Anthony Saunders, Dr. Cornett has

recently completed work on the ninth edition of Financial

Institutions Management

( M c G r a w - H i l l / I r w i n ) .

With Troy A. Adair Jr.

(Harvard University) and

John Nofsinger (University

of Alaska, Anchorage), she

has also recently completed

work on the fourth edition

of Finance: Applications and Theory and the third edition

of M: Finance (McGraw-Hill/Irwin). Professor Cornett

serves as an associate editor for the Journal of Banking

and Finance, the Journal of Financial Services Research,

Review of Financial Economics, Financial Review, and

Multi-national Finance Journal. Dr. Cornett has served as

a member of the Board of Directors, the Executive Commit-

tee, and the Finance Committee of the SIU Credit Union.

She has also taught at Southern Illinois University at Car-

bondale, the University of Colorado, Boston College, South-

ern Methodist University, and Boston University.

Final PDF to printer

vii

sau19714_fm_i-xxii.indd vii 10/04/17 06:53 PM

PREFACE

he last 30 years have been dramatic for the financial services industry. In the 1990s and 2000s, boundaries between the traditional industry sectors, such as commercial banking and investment banking, broke down and competi- tion became increasingly global in nature. Many forces contributed to this breakdown in interindustry and intercountry barriers, including financial innovation, technology, taxation, and regulation. Then in 2008–2009, the

financial services industry experienced the worst financial crisis since the Great Depres- sion. Even into the mid-2010s, the U.S. and world economies have not recovered from this crisis. It is in this context that this book is written.

As the economic and competitive environments change, attention to profit and, more than ever, risk become increasingly important. This book offers a unique analysis of the risks faced by investors and savers interacting through both financial institutions and financial mar- kets, as well as strategies that can be adopted for controlling and better managing these risks. Special emphasis is also put on new areas of operations in financial markets and institutions such as asset securitization, off-balance-sheet activities, and globalization of financial services.

While maintaining a risk measurement and management framework, Financial Markets and Institutions provides a broad application of this important perspective. This book recognizes that domestic and foreign financial markets are becoming increasingly integrated and that financial intermediaries are evolving toward a single financial services industry. The analytical rigor is mathematically accessible to all levels of students, under- graduate and graduate, and is balanced by a comprehensive discussion of the unique envi- ronment within which financial markets and institutions operate. Important practical tools such as how to issue and trade financial securities and how to analyze financial statements and loan applications will arm students with the skills necessary to understand and man- age financial market and institution risks in this dynamic environment. While descriptive concepts so important to financial management (financial market securities, regulation, industry trends, industry characteristics, etc.) are included in the book, ample analytical techniques are also included as practical tools to help students understand the operation of modern financial markets and institutions.

T

INTENDED AUDIENCE Financial Markets and Institutions is aimed at the first course in financial markets and institutions at both the undergraduate and MBA levels. While topics covered in this book are found in more advanced textbooks on financial markets and institutions, the explana- tions and illustrations are aimed at those with little or no practical or academic experience beyond the introductory-level finance courses. In most chapters, the main relationships are presented by figures, graphs, and simple examples. The more complicated details and tech- nical problems related to in-chapter discussion are provided in appendixes to the chapters (available through McGraw-Hill Connect Finance or your course instructor).

ORGANIZATION Since our focus is on return and risk and the sources of that return and risk in domestic and foreign financial markets and institutions, this book relates ways in which a modern finan- cial manager, saver, and investor can expand return with a managed level of risk to achieve the best, or most favorable, return–risk outcome.

Part 1 provides an introduction to the text and an overview of financial markets and institutions. Chapter 1 defines and introduces the various domestic and foreign financial markets and describes the special functions of FIs. This chapter also takes an analytical look at how financial markets and institutions benefit today’s economy. In Chapter 2, we provide an in-depth look at interest rates. We first look at factors that determine interest rate levels,

Final PDF to printer

viii Preface

sau19714_fm_i-xxii.indd viii 10/04/17 06:53 PM

as well as their past, present, and expected future movements. We then review the concept of time value of money. Chapter 3 then applies these interest rates to security valuation. In Chapter 4, we describe the Federal Reserve System and how monetary policy implemented by the Federal Reserve affects interest rates and, ultimately, the overall economy.

Part 2 of the text presents an overview of the various securities markets. We describe each securities market, its participants, the securities traded in each, the trading process, and how changes in interest rates, inflation, and foreign exchange rates impact a financial manager’s decisions to hedge risk. These chapters cover the money markets (Chapter 5), bond markets (Chapter 6), mortgage markets (Chapter 7), stock markets (Chapter 8), for- eign exchange markets (Chapter 9), and derivative securities markets (Chapter 10).

Part 3 of the text summarizes the operations of commercial banks. Chapter 11 describes the key characteristics and recent trends in the commercial banking sector. Chapter 12 describes the financial statements of a typical commercial bank and the ratios used to ana- lyze those statements. This chapter also analyzes actual financial statements for representative commercial banks. Chapter 13 provides a comprehensive look at the regulations under which these financial institutions operate and, particularly, the effect of recent changes in regulation.

Part 4 of the text provides an overview describing the key characteristics and regula- tory features of the other major sectors of the U.S. financial services industry. We discuss other lending institutions (savings institutions, credit unions, and finance companies) in Chapter 14, insurance companies in Chapter 15, securities firms and investment banks in Chapter 16, investment companies in Chapter 17, and pension funds in Chapter 18.

Part 5 concludes the text by examining the risks facing a modern FI and FI manag- ers and the various strategies for managing these risks. In Chapter 19, we preview the risk measurement and management chapters in this section with an overview of the risks facing a modern FI. We divide the chapters on risk measurement and management along two lines: measuring and managing risks on the balance sheet, and managing risks off the balance sheet. In Chapter 20, we begin the on-balance-sheet risk measurement and management section by looking at credit risk on individual loans and bonds and how these risks adversely impact an FI’s profits and value. The chapter also discusses the lending process, including loans made to households and small, medium-size, and large corpora- tions. Chapter 21 covers liquidity risk in financial institutions. This chapter includes a detailed analysis of the ways in which FIs can insulate themselves from liquidity risk and the key role deposit insurance and other guarantee schemes play in reducing liquidity risk.

In Chapter 22, we investigate the net interest margin as a source of profitability and risk, with a focus on the effects of interest rate risk and the mismatching of asset and liabil- ity maturities on FI risk exposure. At the core of FI risk insulation is the size and adequacy of the owner’s capital stake, which is also a focus of this chapter.

The management of risk off the balance sheet is examined in Chapter 23. The chapter highlights various new markets and instruments that have emerged to allow FIs to bet- ter manage three important types of risk: interest rate risk, foreign exchange risk, and credit risk. These markets and instruments and their strategic use by FIs include forwards, futures, options, and swaps.

Finally, Chapter 24 explores ways of removing credit risk from the loan portfolio through asset sales and securitization.

NEW FEATURES

· Tables and figures in all chapters have been revised to include the most recently avail- able data.

· Revised “After the Crisis” boxes highlighting significant events related to the financial crisis have been added to chapters throughout the book.

· Updates on the major changes proposed for the regulation of financial institutions are included where appropriate throughout the book.

· Discussion of how financial markets and institutions continue to recover from the financial crisis has been added throughout the book. Virtually every chapter includes

Final PDF to printer

Preface ix

sau19714_fm_i-xxii.indd ix 10/04/17 06:53 PM

new material detailing how the financial crisis affected risk management in financial institutions.

· Several chapters include a discussion of Brexit as its affects the risk and return for investors in financial markets and financial institutions.

· Several chapters include a discussion of the impact of initial interest rate increases by the Federal Reserve.

· Several chapters include a discussion of the impact of China’s economic policies and economic slowdown on financial markets.

· Chapter 1 includes a new section on enterprise risk management. The chapter also pro- vides an update on the implementation of the Wall Street Reform and Consumer Protec- tion Act enacted as a result of the financial crisis.

· Chapter 4 provides an update on the Federal Reserve’s actions intended to strengthen the U.S. economy, including the interest rate increases instituted by the Fed.

· Chapter 5 includes updates on the LIBOR scandal. · Chapter 6 discusses China’s and worldwide Treasury holdings and the potential impact

of these holdings on the U.S. economy. · Chapter 8 includes more on dark pools and Brexit’s impact on worldwide stock markets. · Excel spreadsheets containing bank financial statements and ratio calculations have

been added to Chapter 12. · Chapter 13 includes a discussion of how the Volcker Rule and Consumer Protection

Regulation have affected the operations of financial institutions. · Chapter 14 includes a discussion of new payday lending legislation · Chapter 17 includes more on new regulations for money market mutual funds. · Chapter 21 includes updates of the new international liquidity standards enacted as a

result of the financial crisis.

ACKNOWLEDGMENTS We take this opportunity to thank all of those individuals who helped us prepare this and previous editions. We want to express our appreciation to those instructors whose insight- ful comments and suggestions were invaluable to us during this revision.

Keldon Bauer Tarleton State University Jen-Chi Cheng Wichita State University Kathy English Wilmington University Andrew Fodor Ohio University–Athens Robert Goldberg Adelphi University Walt Nelson Missouri State University Abdullah Noman Nicholls State University

Ozde Oztekin Florida International University–Miami O. John Paskelian University of Houston Downtown Blaise Roncagli Cleveland State University Matthew Ross Western Michigan University–Kalamazoo Benjamin Thompson Lincoln Memorial University Ann Marie Whyte University of Central Florida–Orlando David Zalewski Providence College

We would like to thank the staff at McGraw-Hill for their help and guidance, especially Chuck Synovec, executive brand manager; Noelle Bathurst, senior product developer; Heather Ervolino, content project manager; Tobi Philips, digital product developer; Trina Maurer, senior marketing manager; and Dave O’Donnell, marketing specialist. Additional thanks to Alex Marden for his editorial assistance.

Anthony Saunders

Marcia Millon Cornett

Final PDF to printer

x

sau19714_fm_i-xxii.indd x 10/04/17 06:53 PM

Confirming Pages

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 97

sau19714_ch04_093-131.indd 97 07/07/17 03:10 PM

Federal Open Market Committee

The Federal Open Market Committee (FOMC) is the major monetary policy-making body of the Federal Reserve System. As alluded to earlier, the FOMC consists of the seven members of the Federal Reserve Board of Governors, the president of the Federal Reserve Bank of New York, and the presidents of four other Federal Reserve Banks (on a rotating basis). The chair of the Board of Governors is also the chair of the FOMC. The FOMC is required to meet at least four times each year in Washington, DC. However, eight regularly scheduled meetings have been held each year since 1980.

The main responsibilities of the FOMC are to formulate policies to promote full employment, economic growth, price stability, and a sustainable pattern of international trade. The FOMC seeks to accomplish this by setting guidelines regarding open market operations. Open market operations—the purchase and sale of U.S. government and fed- eral agency securities—is the main policy tool that the Fed uses to achieve its monetary tar- gets (although the operations themselves are normally carried out by traders at the Federal Reserve Bank of New York, as discussed below). The FOMC also sets ranges for the growth of the monetary aggregates, sets the federal funds rate (see below), and directs operations of the Federal Reserve in foreign exchange markets (see Chapter 9). In addition, although reserve requirements and the discount rate are not specifically set by the FOMC, their levels are monitored and guided by the FOMC. Associated with each meeting of the FOMC is the release of the Beige Book. The Beige Book summarizes information on current economic conditions by Federal Reserve district. Information included in the Beige Book is drawn from reports from bank directors, interviews with key business leaders, economists, market experts, and other sources. Meetings of the FOMC are some of the most closely watched economic meetings in the world. As the FOMC formulates and implements monetary pol- icy, its actions affect not only the U.S. economy, but economies worldwide.

Functions Performed by Federal Reserve Banks

As part of the Federal Reserve System, Federal Reserve Banks (FRBs) perform multiple func- tions. These include assistance in the conduct of monetary policy; supervision and regulation of member banks and other large financial institutions; consumer protection; and the provision of services such as new currency issue, check clearing, wire transfer, and research services to the federal government, member banks, or the general public. We summarize these functions in Table 4–1. The In the News box in this section describes how the Federal Reserve provided extraordinary services in many of these areas in response to the recent financial crisis.

Federal Open Market Committee (FOMC) The major monetary policy-making body of the Federal Reserve System.

open market operations Purchases and sales of U.S. government and fed- eral agency securities by the Federal Reserve.

TABLE 4–1 Functions Performed by the Federal Reserve Banks

Assistance in the conduct of monetary policy—Federal Reserve Bank presidents serve on the Federal Open Market Committee (FOMC). FRBs set and change discount rates.

Supervision and regulation—FRBs have supervisory and regulatory authority over the activities of banks and other large financial institutions located in their district.

Consumer protection and community affairs—FRBs write regulations to implement many of the major consumer protection laws and establish programs to promote community development and fair and impartial access to credit.

Government services—FRBs serve as the commercial bank for the U.S. Treasury. New currency issue—FRBs are responsible for the collection and replacement of damaged

currency from circulation. Check clearing—FRBs process, route, and transfer funds from one bank to another as checks

clear through the Federal Reserve System. Wire transfer services—FRBs and their member banks are linked electronically through the

Federal Reserve Communications System. Research services—each FRB has a staff of professional economists who gather, analyze, and

interpret economic data and developments in the banking sector in their district and economywide.

WALKTHROUGH

Chapter Features

Confirming Pages

93

sau19714_ch04_093-131.indd 93 07/07/17 03:10 PM

MAJOR DUTIES AND RESPONSIBILITIES OF THE FEDERAL RESERVE SYSTEM: CHAPTER OVERVIEW Central banks determine, implement, and control the monetary policy in their home countries. The Federal Reserve (the Fed) is the central bank of the United States. Founded by Congress under the Federal Reserve Act in 1913, the Fed’s original duties were to pro- vide the nation with a safer, more flexible, and more stable monetary and financial system. This was needed following a number of banking crises and panics that had occurred in the first decade of the 20th century (particularly 1907)1 and the last decades of the 19th century. As time passed, additional legislation, including the Banking Act of 1935, the Full Employment Act of 1946, and the Full Employment and Balanced Growth Act of 1978 (also called the Humphrey-Hawkins Act), revised and supplemented the original purposes and objectives of the Federal Reserve System. These objectives included economic growth

1. The Panic of 1907 was a financial crisis that hit the United States at the turn of the 20th century while the country was in the midst of an economic recession. The New York Stock Exchange index fell by 50 percent in less than a year, and a severe drop in market liquidity by banks resulted in numerous bank runs; bank, corporate, and municipal bank- ruptcies; and a near collapse of the U.S. financial system.

O U T L I N E

Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview

Structure of the Federal Reserve System

Organization of the Federal Reserve System

Board of Governors of the Federal Reserve System

Federal Open Market Committee

Functions Performed by Federal Reserve Banks

Balance Sheet of the Federal Reserve

Monetary Policy Tools

Open Market Operations

The Discount Rate

Reserve Requirements (Reserve Ratios)

The Federal Reserve, the Money Supply, and Interest Rates

Effects of Monetary Tools on Various Economic Variables

Money Supply versus Interest Rate Targeting

International Monetary Policies and Strategies

Systemwide Rescue Programs Employed during the Financial Crisis

Challenges Remain after the Crisis

The Federal Reserve System, Monetary Policy, and Interest Rates

L e a r n i n g G o a l s

4 c h a p t e r

LG 4-1 Understand the major functions of the Federal Reserve System.

LG 4-2 Identify the structure of the Federal Reserve System.

LG 4-3 Identify the monetary policy tools used by the Federal Reserve.

LG 4-4 Appreciate how monetary policy changes affect key economic variables.

LG 4-5 Understand how central banks around the world adjusted their monetary policy during the recent financial crisis.

Introduction and Overview of Financial Markets part one

Confirming Pages

93

sau19714_ch04_093-131.indd 93 07/07/17 03:10 PM

MAJOR DUTIES AND RESPONSIBILITIES OF THE FEDERAL RESERVE SYSTEM: CHAPTER OVERVIEW Central banks determine, implement, and control the monetary policy in their home countries. The Federal Reserve (the Fed) is the central bank of the United States. Founded by Congress under the Federal Reserve Act in 1913, the Fed’s original duties were to pro- vide the nation with a safer, more flexible, and more stable monetary and financial system. This was needed following a number of banking crises and panics that had occurred in the first decade of the 20th century (particularly 1907)1 and the last decades of the 19th century. As time passed, additional legislation, including the Banking Act of 1935, the Full Employment Act of 1946, and the Full Employment and Balanced Growth Act of 1978 (also called the Humphrey-Hawkins Act), revised and supplemented the original purposes and objectives of the Federal Reserve System. These objectives included economic growth

1. The Panic of 1907 was a financial crisis that hit the United States at the turn of the 20th century while the country was in the midst of an economic recession. The New York Stock Exchange index fell by 50 percent in less than a year, and a severe drop in market liquidity by banks resulted in numerous bank runs; bank, corporate, and municipal bank- ruptcies; and a near collapse of the U.S. financial system.

O U T L I N E

Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview

Structure of the Federal Reserve System

Organization of the Federal Reserve System

Board of Governors of the Federal Reserve System

Federal Open Market Committee

Functions Performed by Federal Reserve Banks

Balance Sheet of the Federal Reserve

Monetary Policy Tools

Open Market Operations

The Discount Rate

Reserve Requirements (Reserve Ratios)

The Federal Reserve, the Money Supply, and Interest Rates

Effects of Monetary Tools on Various Economic Variables

Money Supply versus Interest Rate Targeting

International Monetary Policies and Strategies

Systemwide Rescue Programs Employed during the Financial Crisis

Challenges Remain after the Crisis

The Federal Reserve System, Monetary Policy, and Interest Rates

L e a r n i n g G o a l s

4 c h a p t e r

LG 4-1 Understand the major functions of the Federal Reserve System.

LG 4-2 Identify the structure of the Federal Reserve System.

LG 4-3 Identify the monetary policy tools used by the Federal Reserve.

LG 4-4 Appreciate how monetary policy changes affect key economic variables.

LG 4-5 Understand how central banks around the world adjusted their monetary policy during the recent financial crisis.

Introduction and Overview of Financial Markets part one

Confirming Pages

96 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 96 07/07/17 03:10 PM

Federal Reserve Banks operate as nonprofit organizations. They generate income pri- marily from three sources: (1) interest earned on government securities acquired in the course of Federal Reserve open market transactions (see below), (2) interest earned on reserves that banks are required to deposit at the Fed (see reserve requirements below), and (3) fees from the provision of payment and other services to member depository institutions.

Board of Governors of the Federal Reserve System

The Board of Governors of the Federal Reserve (also called the Federal Reserve Board) is a seven-member board headquartered in Washington, DC. Each member is appointed by the president of the United States and must be confirmed by the Senate. Board mem- bers serve a nonrenewable 14-year term.4 Board members are often individuals with PhD degrees in economics and/or an extensive background in economic research and political service, particularly in the area of banking. Board members’ terms are staggered so that one term expires every other January. The president designates two members of the board to be the chair and vice chair for four-year terms. The board usually meets several times per week. As they carry out their duties, members routinely confer with officials of other gov- ernment agencies, representatives of banking industry groups, officials of central banks of other countries, members of Congress, and academics.

The primary responsibilities of the Federal Reserve Board are the formulation and con- duct of monetary policy and the supervision and regulation of banks. All seven board mem- bers sit on the Federal Open Market Committee, which makes key decisions affecting the availability of money and credit in the economy (see below). For example, the Federal Reserve Board, through the FOMC, can and usually does set money supply and interest rate targets. The Federal Reserve Board also sets bank reserve requirements (discussed in Chapter 13) and reviews and approves the discount rates (see below) set by the 12 Federal Reserve Banks.

The Federal Reserve Board also has primary responsibility for the supervision and regulation of (1) all bank holding companies (their nonbank subsidiaries and their foreign subsidiaries), (2) state-chartered banks that are members of the Federal Reserve System (state-chartered member banks), and (3) Edge Act and agreement corporations (through which U.S. banks conduct foreign operations).5 The Fed also shares supervisory and regu- latory responsibilities with state and other federal supervisors (e.g., the OCC, the FDIC), including overseeing both the operations of foreign banking organizations in the United States and the establishment, examination, and termination of branches, commercial lend- ing subsidiaries, and representative offices of foreign banks in the United States. The board approves member bank mergers and acquisitions and specifies permissible nonbank activities of bank holding companies. The board is also responsible for the development and administration of regulations governing the fair provision of consumer credit (e.g., the Truth in Lending Act, the Equal Credit Opportunity Act). Finally, the Wall Street Reform and Consumer Protection Act of 2010 provided unprecedented powers to the Federal Reserve, putting it in charge of monitoring any of the country’s biggest financial firms— those considered critical to the health of the financial system as a whole.

The chair of the Federal Reserve Board, currently Janet Yellen, often advises the pres- ident of the United States on economic policy and serves as the spokesperson for the Fed- eral Reserve System in Congress and to the public. All board members share the duties of conferring with officials of other government agencies, representatives of banking indus- try groups, officials of the central banks of other countries, and members of Congress.

4. The length of the term is intended to limit the president’s control over the Fed and thus to reduce political pressure on board members; the nonrenewable nature of an appointment prevents any incentives for governors to take actions that may not be in the best interests of the economy yet may improve their chances of being reappointed.

5. An Edge Act corporation is a subsidiary of a federally chartered domestic bank holding company that generally spe- cializes in financing international transactions. An agreement corporation operates like an Edge Act but is a subsidiary of a state-chartered domestic bank. Created by the Edge Act of 1919, Edge Act corporations are exempt from certain U.S. bank regulations, thus allowing U.S. banks to compete against foreign banks on an even level. For example, Edge Act corporations are exempt from prohibitions on investing in equities of foreign corporations. Ordinarily, U.S. banks are not allowed to undertake such investments.

www.occ.treas.gov

www.fdic.gov

The following special features have been integrated throughout the text to encourage student interaction and to aid students in absorbing and retaining the material

CHAPTER-OPENING OUTLINES

These outlines offer students a snapshot view of what they can expect to learn from each chapter’s discussion.

LEARNING GOALS

Learning goals (LGs) appear at the beginning of each chapter to provide a quick introduction to the key chapter material. These goals are also integrated with the end-of-chapter questions and problems, which allows instructors to easily emphasize the learning goal(s) as they choose.

BOLD KEY TERMS AND A MARGINAL GLOSSARY

The main terms and concepts are emphasized throughout the chapter by bold key terms called out in the text and defined in the margins

PERTINENT WEB ADDRESSES

Website addresses are referenced in the margins throughout each chapter, providing additional resources to aid in the learning process.

Final PDF to printer

xi

sau19714_fm_i-xxii.indd xi 10/04/17 06:53 PM

Confirming Pages

98

sau19714_ch04_093-131.indd 98 07/07/17 03:10 PM

In the first half of 2007, as the extent of declining home prices became apparent, banks and other financial market participants started to reas- sess the value of mortgages and mortgage-backed securities that they owned, especially those in the subprime segment of the housing market. The autumn of 2007 saw increasing strains in a number of market segments, including asset- backed commercial paper, and banks also began to exhibit a reluctance to lend to one another for terms much longer than overnight. This reluctance was reflected in a dramatic rise in the London Interbank Offered Rate (LIBOR) at most maturities greater than over- night. LIBOR is a measure of the rates at which international banks make dollar loans to one another. Since that initial disruption, financial markets have remained in a state of high vola- tility, with many interest rate spreads at historically high levels.

In response to this turbulence, the Fed and the federal govern- ment have taken a series of dramatic steps. As 2007 came to a close, the Federal Reserve Board announced the creation of a Term Auction Facil- ity (TAF), in which fixed amounts of term funds are auctioned to deposi- tory institutions against any collateral eligible for discount window loans. So while the TAF substituted an auc- tion mechanism for the usual fixed interest rate, this facility can be seen essentially as an extension of more conventional discount window lend- ing. In March 2008, the New York Fed provided term financing to facilitate the purchase of Bear Stearns by J.P. Morgan Chase through the creation of a facility that took a set of risky assets

The Financial Crisis: Toward an Explanation and Policy Response

I N T H E N E W S

off the company’s balance sheet. That month, the board also announced the creation of the Term Securities Lending Facility (TSLF), swapping Treasury securities on its balance sheet for less liquid private securities held in the private sector, and the Primary Dealer Credit Facility (PDCF). These actions, particularly the latter, represented a significant expansion of the federal financial safety net by making available a greater amount of central bank credit, at prices unavail- able in the market, to institutions (the primary dealers) beyond those banks that typically borrow at the discount window. . . .

In the fall of 2008, financial mar- kets worldwide experienced another round of heightened volatility and his- toric changes: Lehman Brothers filed for Chapter 11 bankruptcy protec- tion; investment banking companies Goldman Sachs and Morgan Stanley successfully submitted applications to become bank holding companies; Bank of America purchased Merrill Lynch; Wells Fargo acquired Wachovia; PNC Financial Services Group pur- chased National City Corporation; and the American International Group received significant financial assistance from the Federal Reserve and the Treasury Department. On the policy front, the Federal Reserve announced the creation of several new lending facilities—including the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), the Money Market Investor Funding Facility (MMIFF), and the Term Asset-Backed Securities Loan Facility (TALF), the last of which became operational in March

2009. The TALF was designed to support the issuance of asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration, while also expanding the TAF and the TSLF. The creation of these programs resulted in a tremendous expansion of the Federal Reserve’s balance sheet. Furthermore, Congress passed the Troubled Asset Relief Program (TARP) to be administered by the Treasury Department. And in February 2009, the president signed the American Recovery and Reinvestment Act, a fiscal stimulus program of roughly $789 billion. . . .

Much of the public policy response to turmoil in financial markets over the two years took the form of expanded lending by the Fed and central banks in other countries. The extension of credit to financial institutions has long been one of the tools available to a central bank for managing the supply of money—specifically, bank reserves—to the economy. Indeed, discount window lending by the 12 Reserve Banks was the primary means for affecting the money sup- ply at the time the Fed was created. Over time, open market operations, in which the Fed buys and sells securi- ties in transactions with market partici- pants, have become the main tool for managing the money supply. Lending has become a relatively little-used tool, mainly accessed by banks with occasional unexpected flows into or out of their Fed reserve accounts late in the day. If such banks were to seek funding in the market, they would likely have to pay above- normal rates for a short-term (overnight) loan.

continued

Confirming Pages

108 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 108 07/07/17 03:10 PM

of 0 percent to 0.25 percent as of December 16, 2008. The rate remained at these his- torically low levels into 2010, and in June 2010 the Fed announced that the fed funds rate would remain at these levels for an “extended period.” It was not until the spring and sum- mer of 2013 that the Fed mentioned the end of these low interest rates and the tightening of monetary policy. And even then, the Fed repeatedly stated that the end of its monetary eas- ing actions would not come until the very slow economic growth picked up. It was not until December 2015 that the Fed eventually raised interest rates (for the first time in 10 years).

Open Market Operations

As mentioned earlier, open market operations are the Federal Reserves’s purchases or sales of securities in the U.S. Treasury securities market. When a targeted monetary aggregate or interest rate level is determined by the FOMC, it is forwarded to the Federal Reserve Board Trading Desk at the Federal Reserve Bank of New York (FRBNY) through a state- ment called the policy directive. The manager of the Trading Desk uses the policy direc- tive to instruct traders on the daily amount of open market purchases or sales to transact. These transactions take place on an over-the-counter market in which traders are linked to each other electronically (see Chapter 5).

To determine a day’s activity for open market operations, the staff at the FRBNY begins each day with a review of developments in the fed funds market since the previous day and a determination of the actual amount of reserves in the banking system the previ- ous day. The staff also reviews forecasts of short-term factors that may affect the supply and demand of reserves on that day. With this information, the staff decides the level of transactions needed to obtain the desired fed funds rate. The process is completed with a daily conference call to the Monetary Affairs Division at the Board of Governors and one of the four voting Reserve Bank presidents (outside of New York) to discuss the FRBNY plans for the day’s open market operations. Once a plan is approved, the Trading Desk is instructed to execute the day’s transactions.

Open market operations are particularly important because they are the primary deter- minant of changes in bank excess reserves in the banking system and thus directly impact the size of the money supply and/or the level of interest rates (e.g., the fed funds rate). When the Federal Reserve purchases securities, it pays for the securities by either writing a check on itself or directly transferring funds (by wire transfer) into the seller’s account. Either way, the Fed credits the reserve deposit account of the bank that sells it (the Fed) the securities. This transaction increases the bank’s excess reserve levels. When the Fed sells securities, it either collects checks received as payment or receives wire transfers of funds from these agents (such as banks) using funds from their accounts at the Federal Reserve Banks to purchase securities. This reduces the balance of the reserve account of a bank that purchases securities. Thus, when the Federal Reserve sells (purchases) securities in the open market, it decreases (increases) banks’ (reserve account) deposits at the Fed.

www.newyorkfed.org

Federal Reserve Board Trading Desk Unit of the Federal Reserve Bank of New York through which open market opera- tions are conducted.

policy directive Statement sent to the Fed- eral Reserve Board Trading Desk from the FOMC that specifies the daily amount of open market purchases or sales to transact.

EXAMPLE 4–1 Purchases of Securities by the Federal Reserve Suppose the FOMC instructs the FRBNY Trading Desk to purchase $500 million of Trea- sury securities. Traders at the FRBNY call primary government securities dealers of major commercial and investment banks (such as Goldman Sachs and Morgan Stanley),9 who provide a list of securities they have available for sale, including the denomination, matu- rity, and the price on each security. FRBNY traders seek to purchase the target number of securities (at the desired maturities and lowest possible price) until they have purchased the $500 million. The FRBNY then notifies its government bond department to receive and pay the sellers for the securities it has purchased. The securities dealer sellers (such as

9. As of June 2016, there were 23 primary securities dealers trading, on average, $0.82 trillion of securities per day.

Confirming Pages

226

sau19714_ch07_208-239.indd 226 07/20/17 04:15 PM

bank retains the loan and the risk exposure, until the loan is paid off. Rather, mortgage securitization and loan syndication allows banks to retain little or no part of the loans, and hence little or no part of the default risk on loans that they originate: bank have moved to the originate-to-distribute model of banking. Thus, as long as the borrower does not default within the first months after a loan’s issuance and the loans are sold or securitized without recourse back to the bank, the issuing bank can ignore longer term credit risk con- cerns. This decoupling of the risk from the lending activity allows the market to efficiently transfer risk across counterparties. However, it also loosens the incentives to carefully per- form each of the steps of the lending process. This loosening of incentives was an important factor leading to the global financial crisis of 2008–2009, which witnessed the after-effects of poor loan underwriting, shoddy documentation and due diligence, failure to monitor borrower activity, and fraudulent activity on the part of both lenders and borrowers. The result was a deterioration in credit quality at the same time as there was a dramatic increase in consumer and corporate leverage. Eventually, in 2006, housing prices started to fall. At the same time, the Federal Reserve started to raise interest rates as it began to fear infla- tion. Since many of the subprime mortgages that originated in the 2001–2005 period had adjustable rates, the cost of meeting mortgage commitments rose to unsustainable levels for many low-income households. The result of these events was a wave of mortgage defaults in the subprime market and foreclosures that only reinforced the downward trend in hous- ing prices. As this happened, the poor quality of the collateral and credit quality underlying subprime mortgage pools became apparent, with default rates far exceeding those appar- ently anticipated by the rating agencies who set their initial subprime mortgage securitiza- tions ratings. The financial crisis began.

Although bank regulators attempt to examine the off-balance-sheet activities of banks so as to ascertain their safety and soundness, these activities receive far less scrutiny than on-balance-sheet activities (i.e., traditional lending and deposit taking). To the extent

In January 2016, Goldman Sachs agreed to pay more than $5 billion, the largest regulatory penalty in its history. In settling with the Justice Department and a collection of other state and federal entities, Goldman resolved claims stemming from the Wall Street firm’s sale of mortgage bonds heading into the financial crisis. It joined a list of other big banks in moving past one of the biggest, and most costly, legal problems of the crisis era. The govern- ment had earlier won multibillion-dollar settlements from J.P. Morgan Chase, Bank of America, and Citi- group. Crisis-related settlements by banks, mortgage firms, brokerages and others total at least $181.1 billion.

The investigations examined how Wall Street sold bonds tied to

Goldman Reaches $5 Billion Settlement over Mortgage-Backed Securities

A F T E R T H E C R I S I S

residential mortgages, and whether banks deceived investors by misrepre- senting the quality of underlying loans. The government’s inquiry into Goldman related to mortgage-backed securities the firm packaged and sold between 2005 and 2007, when the housing market was booming and investor demand for related bonds was strong.

The latest settlement is just one of several that Goldman has paid in relation to the crisis. Goldman agreed to pay $1.2 billion in penalties to the Federal Housing Finance Agency in 2014 to settle claims that it failed to disclose the risks on mortgage bonds it sold. In 2010, the firm agreed to pay $550 million to settle a Securi- ties and Exchange Commission complaint stemming from its handling

of a complex mortgage-linked deal. In February 2015, Morgan Stanley reached a preliminary accord with the Justice Department in which the firm agreed to pay $2.6 billion. That month, Goldman said in a regulatory filing that it had been informed by U.S. officials in December 2014 that it might face a civil lawsuit stemming from the govern- ment’s mortgage-bond probe. In May, the firm said it was in talks with U.S. and state authorities to resolve those claims. In the settlement, Goldman agreed to pay to the Justice Depart- ment a $2.385 billion civil monetary penalty. Goldman must also provide $1.8 billion in consumer relief through debt forgiveness to borrowers, the construction and financing of afford- able housing, and other programs.

Confirming Pages

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 123

sau19714_ch04_093-131.indd 123 07/07/17 03:10 PM

INTERNATIONAL MONETARY POLICIES AND STRATEGIES Central banks guide the monetary policy in virtually all countries. For example, the European Central Bank (ECB) is the central bank for the European Union, while the Bank of England is the central bank of the United Kingdom. Like the Federal Reserve, these are independent central banks whose decisions do not need to be ratified by the government. In contrast, the People’s Bank of China, the Reserve Bank of India, and the Central Bank of Brazil are less independent in that the government imposes direct political control over the operations of these central banks. Independence of a central bank generally means that the bank is free from pressure from politicians who may attempt to enhance economic activity in the short term (e.g., around election time) at the expense of long-term economic growth. Therefore, independent central banks operate with more credibility.

Regardless of their independence, in the increasingly global economy, central banks around the world must work not only to guide the monetary policy of their individual coun- tries, but also to coordinate their efforts with those of other central banks. In this section, we look at how central banks around the world took independent as well as coordinated actions as they set their monetary policy during the financial crisis. For example, as news spread that Lehman Brothers would not survive, FIs around the world moved to disentangle trades made with Lehman. The Dow fell more than 500 points, the largest drop in over seven years. By Wednesday, September 17, 2008, tension had mounted around the world. Stock markets saw huge swings in value as investors tried to sort out who might survive (markets from Russia to Europe were forced to suspend trading as stock prices plunged).

As the U.S. government debated a rescue plan, the financial crisis continued to spread worldwide. During the last week of September and the first week of October 2008, the German government guaranteed all consumer bank deposits and arranged a bailout of Hypo Real Estate, the country’s second-largest commercial property lender. The United Kingdom nationalized mortgage lender Bradford & Bingley (the country’s eighth- largest mortgage lender) and raised deposit guarantees from $62,220 to $88,890 per account. Ireland guaranteed the deposits and debt of its six major financial institutions. Iceland rescued its third-largest bank with an $860 million purchase of 75 percent of the bank’s stock and a few days later seized the country’s entire banking system. The Netherlands, Belgium, and Luxembourg central governments together agreed to inject $16.37 billion into Fortis NV (Europe’s first ever cross-border financial services company) to keep it afloat. However, five days later this deal fell apart and the bank was split up. The Dutch government bought all assets located in the Netherlands for approximately $23 billion. The central bank in India stepped in to stop a run on the country’s second-largest bank, ICICI Bank, by promising to pump in cash. Central banks in Asia injected cash into their bank- ing systems as banks’ reluctance to lend to each other and a run on Bank of East Asia Ltd. led the Hong Kong Monetary Authority to inject liquidity into its banking system. South Korean authorities offered loans and debt guarantees to help small and midsized busi- nesses with short-term funding. Table 4–9 lists some other systemwide support programs (e.g., on October 12, Australia committed an unspecified amount of funds to guarantee the country’s bank liabilities) and bank-specific actions (e.g., on September 30, the ECB and the French government pledged $3 billion to recapitalize Dexia, one of France’s largest banks) taken by central governments during the heat of the crisis. All of these actions were a result of the spread of the U.S. financial market crisis to world financial markets.

Systemwide Rescue Programs Employed during the Financial Crisis

While the previously mentioned actions by central banks represent steps taken by individ- ual countries, they were just part of a coordinated effort by major countries to ease the monetary conditions brought about by the financial crisis and avoid a deep worldwide recession. At the heart of the efforts were 11 countries, which accounted for the bulk of the rescue programs: Australia, Canada, France, Germany, Italy, Japan, the Netherlands, Spain, Switzerland, the United Kingdom, and the United States. The central banks in these coun- tries took substantive actions targeted at the balance sheets of financial institutions in their

LG 4-5

Confirming Pages

104 Part 1 Introduction and Overview of Financial Markets

sau19714_ch04_093-131.indd 104 07/07/17 03:10 PM

by the Federal Reserve in late 2008 and 2009 was simply sitting idle in banks’ reserve accounts. Many asked why banks were choosing to hold so many reserves instead of lend- ing them out, and some claimed that banks’ lending of their excess reserves was crucial for resolving the credit crisis. In this case, the Fed’s lending policy generated a large quantity of excess reserves without changing banks’ incentives to lend to firms and households. Thus, the total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not necessarily affected by private banks’ lending decisions.

Currency Outside Banks. The second-largest liability, in terms of percentage of total liabilities and equity, of the Federal Reserve System is currency in circulation (29.7 percent of total liabilities and equity in 2016). At the top of each Federal Reserve note ($1 bill, $5 bill, $10 bill, etc.) is the seal of the Federal Reserve Bank that issued it. Federal Reserve

therefore function as money (see Chapter 1).

Assets. The major assets on the Federal Reserve’s balance sheet are Treasury and gov- ernment agency (i.e., Fannie Mae, Freddie Mac) securities, Treasury currency, and gold and foreign exchange. While interbank loans (loans to domestic banks) are quite a small portion of the Federal Reserve’s assets, they play an important role in implementing mon- etary policy (see below).

Treasury Securities. Treasury securities (54.2 percent of total assets in 2016) are the largest asset on the Fed’s balance sheet. They represent the Fed’s holdings of securities issued by the U.S. Treasury (U.S. government). The Fed’s open market operations involve the buying and selling of these securities. An increase (decrease) in Treasury securities held by the Fed leads to an increase (decrease) in the money supply.

U.S. Government Agency Securities. U.S. government agency securities are the second-largest asset account on the Fed’s balance sheet (39.2 percent of total assets in 2016). However, in 2007 this account was 0.0 percent of total assets. This account grew

as the Fed took steps to improve credit market liquidity and support the mortgage and housing markets during the financial crisis by buying mortgage-backed secu- rities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Under the MBS purchase program, the FOMC called for the purchase of up to $1.25 trillion of agency MBS. The purchase activity began on January 5, 2009, and continued through 2016. Thus, the Fed expanded its role as purchaser/guarantor of assets in the financial markets.

Gold and Foreign Exchange and Treasury Currency. The Federal Reserve holds Treasury gold certificates that are redeemable at the U.S. Treasury for gold. The Fed also holds small amounts of Treasury-issued coinage and foreign- denominated assets to assist in foreign currency transactions or currency swap agreements with the central banks of other nations.

Interbank Loans. As mentioned earlier, depository institutions in need of additional funds can borrow at the Federal Reserve’s discount window (discussed in detail below). The interest rate or discount rate charged on these loans is often lower than other interest rates in the short-term money markets (see Chapter 5). As we discuss below, in January 2003 the Fed implemented changes to its discount window lending policy that increased the cost of discount window borrowing but eased the requirements on which depository institutions can borrow. As part of this change, the discount window rate was increased so that it would be higher than the fed funds rate. As a result, (discount) interbank loans are normally a relatively small portion of the Fed’s total assets.

D O YO U U N D E R S TA N D :

1. What the main functions of Federal Reserve Banks are?

2. What the main responsibilities of the Federal Reserve Board are?

3. How the FOMC implements monetary policy?

4. What the main assets and liabilities of the Federal Reserve are?

“DO YOU UNDERSTAND” BOXES

These boxes allow students to test themselves on the main concepts presented within each major chapter section. Solutions are provided in Connect.

“IN THE NEWS” BOXES

These boxes demonstrate the application of chapter material to real current events.

INTERNATIONAL COVERAGE

An international icon appears in the margin to easily communicate where international material is being introduced.

IN-CHAPTER EXAMPLES

These examples provide numerical demonstrations of the analytical material described in many chapters.

Pedagogical Features

“AFTER THE CRISIS” BOXES

These boxes use articles pertaining to events caused or affected by the 2008–2009 financial crisis to elaborate on chapter material.

Final PDF to printer

xii

sau19714_fm_i-xxii.indd xii 10/04/17 06:53 PM

EXCEL PROBLEMS

Excel problems are featured in selected chapters and are denoted by an icon. Spreadsheet templates are available in Connect.

Confirming Pages

sau19714_ch07_208-239.indd 238 07/20/17 04:15 PM

238 Part 2 Securities Markets

rate offered to you is 5.25 percent. You will make a down payment of 20 percent of the purchase price. (LG 7-4) a. Calculate your monthly payments on this mortgage. b. Construct the amortization schedule for the first six

payments. 5.

mortgage rate offered to you is 6.50 percent. You will make a down payment of 20 percent of the purchase price. (LG 7-4) a. Calculate your monthly payments on this mortgage. b. Construct the amortization schedule for the first six

payments. 6. Using a Spreadsheet to Calculate Mortgage

Payments: What is the monthly payment on a $150,000, 15-year mortgage if the mortgage rate is 5.75 percent? 6.25 percent? 7.5 percent? 9 percent? (LG 7-4)

7. Using a Spreadsheet to Calculate Mortgage Payments: What is the monthly payment on

a $150,000, 30-year mortgage if the mortgage rate is 5.75 percent? 6.25 percent? 7.5 percent? 9 percent? (LG 7-4)

8. You plan to purchase a $200,000 house using either a 30-year mortgage obtained from your local savings bank with a rate of 7.25 percent, or a 15-year mortgage with a rate of 6.50 percent. You will make a down payment of 20 per- cent of the purchase price. (LG 7-3) a. Calculate the amount of interest and, separately, prin-

cipal paid on each mortgage. What is the difference in interest paid?

b. Calculate your monthly payments on the two mortgages. What is the difference in the monthly payment on the two mortgages?

9. You plan to purchase a $240,000 house using either a 30-year mortgage obtained from your local bank with a rate of 5.75 percent, or a 15-year mortgage with a rate of 5.00 percent. You will make a down payment of 20 percent of the purchase price. (LG 7-3) a. Calculate the amount of interest and, separately, prin-

cipal paid on each mortgage. What is the difference in interest paid?

b. Calculate your monthly payments on the two mortgages. What is the difference in the monthly payment on the two mortgages?

10. You plan to purchase a house for $115,000 using a 30-year

LG 7-3) a. Your bank offers you the following two options for payment: Option 1: Mortgage rate of 9 percent and zero points. Option 2: Mortgage rate of 8.85 percent and 2 points. Which option should you choose? b. Your bank offers you the following two options for

payment: Option 1: Mortgage rate of 10.25 percent and 1 point. Option 2: Mortgage rate of 10 percent and 2.5 points. Which option should you choose?

11. You plan to purchase a house for $195,000 using a 30-year mortgage obtained from your local bank. You will make a down payment of 20 percent of the purchase price. You will not pay off the mortgage early. (LG 7-3) a. Your bank offers you the following two options for

payment: Option 1: Mortgage rate of 5.5 percent and zero points. Option 2: Mortgage rate of 5.35 percent and 1.5 points. Which option should you choose? b. Your bank offers you the following two options for

payments: Option 1: Mortgage rate of 5.35 percent and 1 point. Option 2: Mortgage rate of 5.25 percent and 2 points. Which option should you choose?

12. You plan to purchase a house for $175,000 using a 15-year mortgage obtained from your local bank. You will make a down payment of 25 percent of the purchase price. You will not pay off the mortgage early. (LG 7-3) a. Your bank offers you the following two options for

payment: Option 1: Mortgage rate of 5 percent and zero points. Option 2: Mortgage rate of 4.75 percent and 2 points. Which option should you choose? b. Your bank offers you the following two options for

payments: Option 1: Mortgage rate of 4.85 percent and 2 points. Option 2: Mortgage rate of 4.68 percent and 3 points. Which option should you choose?

13. You plan to purchase a $220,000 house using a 15-year mortgage obtained from your bank. The mortgage rate offered to you is 4.75 percent. You will make a down pay- ment of 20 percent of the purchase price. (LG 7-4) a. Calculate your monthly payments on this mortgage. b. Construct the amortization schedule for the mortgage.

How much total interest is paid on this mortgage? 14. You plan to purchase a $300,000 house using a 15-year

mortgage obtained from your bank. The mortgage rate offered to you is 4.50 percent. You will make a down pay- ment of 20 percent of the purchase price. (LG 7-4) a. Calculate your monthly payments on this mortgage. b. Construct the amortization schedule for the mortgage.

How much total interest is paid on this mortgage?

Present Value Periods

Interest Rate ⇒

The Payment Will Be

$150,000 15 × 12 5.75%/12 $1,245.62 150,000 15 × 12 6.25%/12 1,286.13 150,000 15 × 12 7.50%/12 1,390.52 150,000 15 × 12 9.00%/12 1,521.40

Present Value Periods

Interest Rate ⇒

The Payment Will Be

$150,000 30 × 12 5.75%/12 $ 875.36 150,000 30 × 12 6.25%/12 923.58 150,000 30 × 12 7.50%/12 1,048.82 150,000 30 × 12 9.00%/12 1,206.93

Confirming Pages

sau19714_ch04_093-131.indd 131 07/07/17 03:10 PM

Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates 131

6. MHM Bank currently has $250 million in transaction deposits on its balance sheet. The current reserve require- ment is 10 percent, but the Federal Reserve is increasing this requirement to 12 percent. (LG 4-3) a. Show the balance sheet of the Federal Reserve and

MHM Bank if MHM Bank converts all excess reserves to loans, but borrowers return only 80 percent of these funds to MHM Bank as transaction deposits.

b. Show the balance sheet of the Federal Reserve and MHM Bank if MHM Bank converts 85 percent of its excess reserves to loans and borrowers return 90 percent of these funds to MHM Bank as transaction deposits.

7. The FOMC has instructed the FRBNY Trading Desk to purchase $500 million in U.S. Treasury securities. The Fed- eral Reserve has currently set the reserve requirement at 5 percent of transaction deposits. Assume U.S. banks with- draw all excess reserves and give out loans. (LG 4-3) a. Assume also that borrowers eventually return all of these

funds to their banks in the form of transaction deposits. What is the full effect of this purchase on bank deposits and the money supply?

b. What is the full effect of this purchase on bank deposits and the money supply if borrowers return only 95 per- cent of these funds to their banks in the form of transac- tion deposits?

8. The FOMC has instructed the FRBNY Trading Desk to purchase $750 million in U.S. Treasury securities. The Federal Reserve has currently set the reserve requirement at 10 percent of transaction deposits. Assume U.S. banks withdraw all excess reserves and give out loans. (LG 4-3) a. Assume also that borrowers eventually return all of these

funds to their banks in the form of transaction deposits.

What is the full effect of this purchase on bank deposits and the money supply?

b. What is the full effect of this purchase on bank deposits and the money supply if borrowers return only 90 percent of these funds to their banks in the form of transaction deposits?

9. Marly Bank currently has $650 million in transaction deposits on its balance sheet. The current reserve require- ment is 10 percent, but the Federal Reserve is decreasing this requirement to 9 percent. (LG 4-3) a. Show the balance sheet of the Federal Reserve and

Marly Bank if Marly Bank converts all excess reserves to loans, but borrowers return only 60 percent of these funds to National Bank as transaction deposits.

b. Show the balance sheet of the Federal Reserve and Marly Bank if Marly Bank converts 90 percent of its excess reserves to loans and borrowers return 75 percent of these funds to Marly Bank as transaction deposits.

10. Brown Bank currently has $350 million in transaction deposits on its balance sheet. The current reserve require- ment is 10 percent, but the Federal Reserve is increasing this requirement to 11 percent. (LG 4-3) a. Show the balance sheet of the Federal Reserve and

Brown Bank if Brown Bank converts all excess reserves to loans, but borrowers return only 50 percent of these funds to Brown Bank as transaction deposits.

b. Show the balance sheet of the Federal Reserve and Brown Bank if National Bank converts 75 percent of its excess reserves to loans and borrowers return 60 percent of these funds to Brown Bank as transaction deposits.

Go to the Federal Reserve Board website and find the latest information available on the prime rate, the discount rate, and the three-month T-bill rate using the following steps. Go to www.federalreserve.gov. Under “Select Statistical Releases,” click on “Selected Interest Rates.” Click on the most recent date. The data will be in this file on your computer screen. Questions

1. What are the current levels for each of these interest rates? 2. Calculate the percentage change in each of these rates since June 2016.

S E A R C H T H E S I T E

Confirming Pages

sau19714_ch04_093-131.indd 130 07/07/17 03:10 PM

130 Part 1 Introduction and Overview of Financial Markets

SUMMARY

This chapter described the Federal Reserve System in the United States. The Federal Reserve is the central bank charged with conducting monetary policy, supervising and regulating depository institutions, maintaining the stability of the financial system, and providing specific financial services to the U.S. government, the public, and financial institutions. We reviewed the structure under which the Fed provides these functions, the monetary policy tools it uses, and the impact of monetary policy changes on money sup- ply, credit availability, interest rates, security prices, and foreign exchange rates.

QUESTIONS 1. Describe the functions performed by Federal Reserve

Banks. (LG 4-1) 2. Define the discount rate and the discount window. (LG 4-2) 3. Describe the structure of the Board of Governors of the

Federal Reserve System. (LG 4-2) 4. What are the primary responsibilities of the Federal Reserve

Board? (LG 4-1) 5. What are the primary responsibilities of the Federal Open

Market Committee? (LG 4-2) 6. What are the major liabilities of the Federal Reserve

System? Describe each. (LG 4-2) 7. Why did reserve deposits increase to the point that this

account represented the largest liability account on the Federal Reserve’s balance sheet in the late 2000s? (LG 4-2)

8. What are the major assets of the Federal Reserve System? Describe each. (LG 4-2)

9. Why did U.S. government agency securities go from nothing to being the largest asset account on the Federal Reserve’s balance sheet in the late 2000s? (LG 4-2)

10. What are the tools used by the Federal Reserve to imple- ment monetary policy? (LG 4-3)

11. Explain how a decrease in the discount rate affects credit availability and the money supply. (LG 4-3)

12. Why does the Federal Reserve rarely use the discount rate to implement its monetary policy? (LG 4-3)

13. What changes did the Fed implement to its discount window lending policy in the early 2000s? in the late 2000s? (LG 4-3)

14. Which of the monetary tools available to the Federal Reserve is most often used? Why? (LG 4-3)

15. Describe how expansionary activities conducted by the Fed- eral Reserve impact the money supply, credit availability, interest rates, and security prices. Do the same for contrac- tionary activities. (LG 4-4)

16. Summarize the monetary policy measures taken by central banks to address the worldwide financial crisis. (LG 4-5)

PROBLEMS 1. Suppose the Federal Reserve instructs the Trading Desk

to purchase $1 billion of securities. Show the result of this transaction on the balance sheets of the Federal Reserve System and commercial banks. (LG 4-3)

2. Suppose the Federal Reserve instructs the Trading Desk to sell $850 million of securities. Show the result of this trans- action on the balance sheets of the Federal Reserve System and commercial banks. (LG 4-3)

3. Bank Three currently has $600 million in transaction depos- its on its balance sheet. The Federal Reserve has currently set the reserve requirement at 10 percent of transaction deposits. (LG 4-3) a. If the Federal Reserve decreases the reserve requirement

to 8 percent, show the balance sheet of Bank Three and the Federal Reserve System just before and after the full effect of the reserve requirement change. Assume Bank Three withdraws all excess reserves and gives out loans and that borrowers eventually return all of these funds to Bank Three in the form of transaction deposits.

b. Redo part (a) using a 12 percent reserve requirement.

4. BSW Bank currently has $150 million in transaction depos- its on its balance sheet. The Federal Reserve has currently

set the reserve requirement at 10 percent of transaction deposits. (LG 4-3) a. If the Federal Reserve decreases the reserve require-

ment to 6 percent, show the balance sheet of BSW and the Federal Reserve System just before and after the full effect of the reserve requirement change. Assume BSW withdraws all excess reserves and gives out loans and that borrowers eventually return all of these funds to BSW in the form of transaction deposits.

b. Redo part (a) using a 14 percent reserve requirement. 5. National Bank currently has $500 million in transaction

deposits on its balance sheet. The current reserve require- ment is 10 percent, but the Federal Reserve is decreasing this requirement to 8 percent. (LG 4-3) a. Show the balance sheet of the Federal Reserve and

National Bank if National Bank converts all excess reserves to loans, but borrowers return only 50 percent of these funds to National Bank as transaction deposits.

b. Show the balance sheet of the Federal Reserve and National Bank if National Bank converts 75 percent of its excess reserves to loans and borrowers return 60 percent of these funds to National Bank as transaction deposits.

WALKTHROUGH

End-of-Chapter Features

END-OF-CHAPTER QUESTIONS AND PROBLEMS

The questions and problems in the end- of-chapter material appear in separate sections, allowing instructors to choose whether they prefer students to engage in quantitative or qualitative analysis of the material. Selected problems are assignable online in Connect.

SEARCH THE SITE

Featured among the end- of-chapter material in most chapters, these Internet exercises weave the web, real data, and practical applications with concepts found in the book.

Final PDF to printer

sau19714_fm_i-xxii.indd xiii 10/04/17 06:53 PM

▪ Connect content is authored by the world’s best subject matter experts, and is available to your class through a simple and intuitive interface.

▪ The Connect eBook makes it easy for students to access their reading material on smartphones and tablets. They can study on the go and don’t need internet access to use the eBook as a reference, with full functionality.

▪ Multimedia content such as videos, simulations, and games drive student engagement and critical thinking skills.

©McGraw-Hill Education

▪ Connect’s assignments help students contextualize what they’ve learned through application, so they can better understand the material and think critically.

▪ Connect will create a personalized study path customized to individual student needs through SmartBook®.

▪ SmartBook helps students study more efficiently by delivering an interactive reading experience through adaptive highlighting and review.

McGraw-Hill Connect® is a highly reliable, easy-to- use homework and learning management solution that utilizes learning science and award-winning adaptive tools to improve student results.

73% of instructors who use Connect

require it; instructor satisfaction increases by 28% when Connect

is required.

Homework and Adaptive Learning

Quality Content and Learning Resources

Over 7 billion questions have been answered, making McGraw-Hill

Education products more intelligent, reliable, and precise.

Using Connect improves retention rates by 19.8%, passing rates by 12.7%, and exam scores by 9.1%.

Final PDF to printer

sau19714_fm_i-xxii.indd xiv 10/04/17 06:53 PM

More students earn As and Bs when they

use Connect.

©Hero Images/Getty Images

▪ Connect Insight® generates easy-to-read reports on individual students, the class as a whole, and on specific assignments.

▪ The Connect Insight dashboard delivers data on performance, study behavior, and effort. Instructors can quickly identify students who struggle and focus on material that the class has yet to master.

▪ Connect automatically grades assignments and quizzes, providing easy-to-read reports on individual and class performance.

▪ Connect integrates with your LMS to provide single sign-on and automatic syncing of grades. Integration with Blackboard®, D2L®, and Canvas also provides automatic syncing of the course calendar and assignment-level linking.

▪ Connect offers comprehensive service, support, and training throughout every phase of your implementation.

▪ If you’re looking for some guidance on how to use Connect, or want to learn tips and tricks from super users, you can find tutorials as you work. Our Digital Faculty Consultants and Student Ambassadors offer insight into how to achieve the results you want with Connect.

Trusted Service and Support

Robust Analytics and Reporting

www.mheducation.com/connect

Final PDF to printer

xv

sau19714_fm_i-xxii.indd xv 10/04/17 06:53 PM

Student progress tracking Connect Finance keeps instructors informed about how each student, section, and class is performing, allowing for more productive use of lecture and office hours. The progress-tracking function enables you to:

· View scored work immediately and track individual or group performance with assignment and grade reports.

· Access an instant view of student or class performance relative to learning objectives.

· Collect data and generate reports required by many accreditation organizations, such as AACSB and AICPA.

MCGRAW-HILL CUSTOMER CARE CONTACT INFORMATION

At McGraw-Hill, we understand that getting the most from new technology can be challenging. That’s why our services don’t stop after you purchase our products. You can e-mail our Product Specialists 24 hours a day to get product-training online. Or you can search our knowledge bank of Frequently Asked Questions on our support website. For Customer Support, call 800-331-5094, e-mail hmsupport@ mcgraw-hill.com, or visit www.mhhe.com/support. One of our Technical Support Analysts will be able to assist you in a timely fashion.

FOR THE INSTRUCTOR

Instructors will have access to teaching support such as electronic files of the ancillary materials, described below, available within Connect.

· Instructor’s Manual Prepared by Tim Manuel, University of Montana, the Instructor’s Manual includes detailed chapter contents and outline, additional examples for use in the classroom, and extensive teaching notes.

· Test Bank Prepared by Ohaness Paskelian, University of Houston–Downtown, the Test Bank includes nearly 1,000 additional problems to be used for test material.

· Solutions Manual Prepared by coauthor Marcia Mil- lon Cornett, this manual provides worked-out solutions to the end-of-chapter questions. Author involvement ensures consistency between the approaches presented in the text and those in the manual.

· PowerPoint Developed by Courtney Baggett, Troy Univerity, the PowerPoint presentation includes full- color slides featuring lecture notes, figures, and tables. The slides can be easily downloaded and edited to bet- ter fit your lecture.

Student Resources The Students Resources page in Connect is the place for students to access additional resources. The Student Study Center offers quick access to the web appendixes, Excel files and templates, eBooks, and more.

SUPPLEMENTS

Final PDF to printer

xvi

sau19714_fm_i-xxii.indd xvi 10/04/17 06:53 PM

part 4 OTHER FINANCIAL INSTITUTIONS 454

14. Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies 454

15. Insurance Companies 480

16. Securities Firms and Investment Banks 506

17. Investment Companies 531

18. Pension Funds 564

part 5 RISK MANAGEMENT IN FINANCIAL INSTITUTIONS 585

19. Types of Risks Incurred by Financial Institutions 585

20. Managing Credit Risk on the Balance Sheet 604

21. Managing Liquidity Risk on the Balance Sheet 632

22. Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet 655

23. Managing Risk off the Balance Sheet with Derivative Securities 683

24. Managing Risk off the Balance Sheet with Loan Sales and Securitization 712

References 739

Index 741

Preface vii

part 1 INTRODUCTION AND OVERVIEW OF FINANCIAL MARKETS 1

1. Introduction 1

2. Determinants of Interest Rates 26

3. Interest Rates and Security Valuation 58

4. The Federal Reserve System, Monetary Policy, and Interest Rates 93

part 2 SECURITIES MARKETS 132 5. Money Markets 132

6. Bond Markets 169

7. Mortgage Markets 208

8. Stock Markets 240

9. Foreign Exchange Markets 282

10. Derivative Securities Markets 311

part 3 COMMERCIAL BANKS 353 11. Commercial Banks: Industry

Overview 353

12. Commercial Banks’ Financial Statements and Analysis 380

13. Regulation of Commercial Banks 413

CONTENTS IN BRIEF

Final PDF to printer

xvii

sau19714_fm_i-xxii.indd xvii 10/04/17 06:53 PM

Term Structure of Interest Rates 42 Unbiased Expectations Theory 42

Liquidity Premium Theory 44

Market Segmentation Theory 46

Forecasting Interest Rates 48

Time Value of Money and Interest Rates 49 Time Value of Money 49

Lump Sum Valuation 50

Annuity Valuation 52

3 Interest Rates and Security Valuation 58 Interest Rates as a Determinant of Financial Security Values: Chapter Overview 58

Various Interest Rate Measures 59 Coupon Rate 59

Required Rate of Return 59

Expected Rate of Return 60

Required versus Expected Rates of Return: The

Role of Efficient Markets 61

Realized Rate of Return 62

Bond Valuation 63 Bond Valuation Formula Used to Calculate Fair

Present Values 63

Bond Valuation Formula Used to Calculate

Yield to Maturity 65

Equity Valuation 66 Zero Growth in Dividends 68

Constant Growth in Dividends 69

Supernormal (or Nonconstant) Growth in

Dividends 70

Impact of Interest Rate Changes on Security Values 71

Impact of Maturity on Security Values 72 Maturity and Security Prices 73

Maturity and Security Price Sensitivity to

Changes in Interest Rates 73

Impact of Coupon Rates on Security Values 74 Coupon Rate and Security Price 75

Coupon Rate and Security Price Sensitivity to

Changes in Interest Rates 75

Duration 76 A Simple Illustration of Duration 76

A General Formula for Duration 78

Features of Duration 82

Economic Meaning of Duration 83

Large Interest Rate Changes and Duration 85

Appendix 3A: Duration and Immunization 92

Appendix 3B: More on Convexity 92

Preface vii

part 1 INTRODUCTION AND OVERVIEW OF FINANCIAL MARKETS 1

1 Introduction 1 Why Study Financial Markets and Institutions? Chapter Overview 1

Overview of Financial Markets 3 Primary Markets versus Secondary Markets 4

Money Markets versus Capital Markets 6

Foreign Exchange Markets 9

Derivative Security Markets 9

Financial Market Regulation 10

Overview of Financial Institutions 11 Unique Economic Functions Performed by

Financial Institutions 12

Additional Benefits FIs Provide to Suppliers of

Funds 14

Economic Functions FIs Provide

to the Financial System as a

Whole 15

Risks Incurred by Financial Institutions 16

Regulation of Financial Institutions 16

Trends in the United States 17

Globalization of Financial Markets and Institutions 21

Appendix 1A: The Financial Crisis: The Failure of Financial Institutions’ Specialness 25

2 Determinants of Interest Rates 26 Interest Rate Fundamentals: Chapter Overview 26

Loanable Funds Theory 27 Supply of Loanable Funds 28

Demand for Loanable Funds 29

Equilibrium Interest Rate 30

Factors That Cause the Supply and Demand

Curves for Loanable Funds to Shift 31

Movement Of Interest Rates Over Time 35

Determinants of Interest Rates for Individual Securities 36

Inflation 36

Real Risk-Free Rates 36

Default or Credit Risk 38

Liquidity Risk 40

Special Provisions or Covenants 40

Term to Maturity 40

CONTENTS

Final PDF to printer

xviii Contents

sau19714_fm_i-xxii.indd xviii 10/10/17 02:03 AM

Other Financial Institutions 158

Individuals 158

International Aspects of Money Markets 158 Euro Money Markets 160

Appendix 5A: Single versus Discriminating Price Treasury Auctions 168

Appendix 5B: Creation of a Banker’s Acceptance 168

6 Bond Markets 169 Definition of Bond Markets: Chapter Overview 169

Bond Market Securities 170 Treasury Notes and Bonds 170

Municipal Bonds 181

Corporate Bonds 187

Bond Ratings and Interest Rate Spreads 193

Bond Market Indexes 196

Bond Market Participants 197

Comparison of Bond Market Securities 198

International Aspects of Bond Markets 198 Eurobonds, Foreign Bonds, and Sovereign

Bonds 201

7 Mortgage Markets 208 Mortgages and Mortgage-Backed Securities: Chapter Overview 208

Primary Mortgage Market 210 Mortgage Characteristics 211

Mortgage Amortization 216

Other Types of Mortgages 221

Secondary Mortgage Markets 223 History and Background of Secondary Mortgage

Markets 224

Mortgage Sales 225

Mortgage-Backed Securities 225

Participants in the Mortgage Markets 233

International Trends in Securitization 234

Appendix 7A: Amortization Schedules for 30-Year Mortgage in Example 7–2 and No-Points versus Points Mortgages in Example 7–4 239

8 Stock Markets 240 The Stock Markets: Chapter Overview 240

Stock Market Securities 242 Common Stock 242

Preferred Stock 245

Primary and Secondary Stock Markets 247 Primary Stock Markets 247

Secondary Stock Markets 252

Stock Market Indexes 262

4 The Federal Reserve System, Monetary Policy, and Interest Rates 93 Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview 93

Structure of the Federal Reserve System 94 Organization of the Federal Reserve System 94

Board of Governors of the Federal Reserve

System 96

Federal Open Market Committee 97

Functions Performed by Federal Reserve

Banks 97

Balance Sheet of the Federal Reserve 102

Monetary Policy Tools 105 Open Market Operations 108

The Discount Rate 110

Reserve Requirements (Reserve Ratios) 113

The Federal Reserve, the Money Supply, and Interest Rates 116

Effects of Monetary Tools on Various Economic

Variables 117

Money Supply versus Interest Rate

Targeting 118

International Monetary Policies and Strategies 123

Systemwide Rescue Programs Employed during

the Financial Crisis 123

Challenges Remain after the Crisis 128

part 2 SECURITIES MARKETS 132 5 Money Markets 132

Definition of Money Markets: Chapter Overview 132

Money Markets 133

Yields on Money Market Securities 133 Bond Equivalent Yields 134

Effective Annual Return 134

Discount Yields 134

Single-Payment Yields 135

Money Market Securities 136 Treasury Bills 138

Federal Funds 144

Repurchase Agreements 145

Commercial Paper 148

Negotiable Certificates of Deposit 153

Banker’s Acceptances 154

Comparison of Money Market Securities 155

Money Market Participants 155 The U.S. Treasury 156

The Federal Reserve 156

Commercial Banks 156

Money Market Mutual Funds 157

Brokers and Dealers 157

Corporations 158

Final PDF to printer

Contents xix

sau19714_fm_i-xxii.indd xix 10/10/17 02:03 AM

part 3 COMMERCIAL BANKS 353 11 Commercial Banks: Industry

Overview 353 Commercial Banks as a Sector of the Financial Institutions Industry: Chapter Overview 353

Definition of a Commercial Bank 355

Balance Sheets and Recent Trends 355 Assets 355

Liabilities 358

Equity 359

Off-Balance-Sheet Activities 359

Other Fee-Generating Activities 363

Size, Structure, and Composition of the Industry 364

Bank Size and Concentration 365

Bank Size and Activities 367

Industry Performance 368

Regulators 371 Federal Deposit Insurance Corporation 371

Office of the Comptroller of the

Currency 372

Federal Reserve System 373

State Authorities 373

Global Issues 373 Advantages and Disadvantages of International

Expansion 373

Global Banking Performance 375

12 Commercial Banks’ Financial Statements and Analysis 380 Why Evaluate the Performance of Commercial Banks? Chapter Overview 380

Financial Statements of Commercial Banks 382

Balance Sheet Structure 383

Off-Balance-Sheet Assets and Liabilities 389

Other Fee-Generating Activities 392

Income Statement 393

Direct Relationship between the Income

Statement and the Balance Sheet 397

Financial Statement Analysis Using a Return on Equity Framework 398

Return on Equity and Its Components 399

Return on Assets and Its Components 401

Other Ratios 406

Impact of Market Niche and Bank Size on Financial Statement Analysis 407

Impact of a Bank’s Market Niche 407

Impact of Size on Financial Statement

Analysis 407

Stock Market Participants 266

Other Issues Pertaining to Stock Markets 268 Economic Indicators 268

Market Efficiency 269

Stock Market Regulations 272

International Aspects of Stock Markets 274

Appendix 8A: The Capital Asset Pricing Model 281

Appendix 8B: Event Study Tests 281

9 Foreign Exchange Markets 282 Foreign Exchange Markets and Risk: Chapter Overview 282

Background and History of Foreign Exchange Markets 283

Foreign Exchange Rates and Transactions 288 Foreign Exchange Rates 288

Foreign Exchange Transactions 288

Return and Risk of Foreign Exchange

Transactions 293

Role of Financial Institutions in Foreign

Exchange Transactions 299

Interaction of Interest Rates, Inflation, and Exchange Rates 302

Purchasing Power Parity 303

Interest Rate Parity 305

Appendix 9A: Balance of Payment Accounts 310

10 Derivative Securities Markets 311 Derivative Securities: Chapter Overview 311

Forwards and Futures 313 Spot Markets 313

Forward Markets 314

Futures Markets 316

Options 323 Call Options 323

Put Options 325

Option Values 327

Option Markets 329

Regulation of Futures and Options Markets 335

Swaps 336 Interest Rate Swaps 337

Currency Swaps 341

Credit Swaps 342

Swap Markets 343

Caps, Floors, and Collars 345

International Aspects of Derivative Securities Markets 347

Appendix 10A: Black–Scholes Option Pricing Model 352

Final PDF to printer

xx Contents

sau19714_fm_i-xxii.indd xx 10/04/17 06:53 PM

Size, Structure, and Composition of the

Industry 455

Balance Sheets and Recent Trends 457

Regulators 459

Savings Institution Recent Performance 460

Credit Unions 461 Size, Structure, and Composition of the

Industry 462

Balance Sheets and Recent Trends 464

Regulators 466

Industry Performance 466

Finance Companies 468 Size, Structure, and Composition of the

Industry 468

Balance Sheets and Recent Trends 469

Industry Performance 474

Regulation 475

Global Issues 476

15 Insurance Companies 480 Two Categories of Insurance Companies: Chapter Overview 480

Life Insurance Companies 481 Size, Structure, and Composition of the

Industry 481

Balance Sheets and Recent Trends 486

Regulation 489

Property–Casualty Insurance Companies 490 Size, Structure, and Composition of the

Industry 490

Balance Sheets and Recent Trends 492

Regulation 500

Global Issues 501

16 Securities Firms and Investment Banks 506 Services Offered by Securities Firms versus Investment Banks: Chapter Overview 506

Size, Structure, and Composition of the Industry 508

Securities Firm and Investment Bank Activity Areas 510

Investment Banking 510

Venture Capital 512

Market Making 514

Trading 514

Investing 515

Cash Management 516

Mergers and Acquisitions 516

Other Service Functions 516

Recent Trends and Balance Sheets 517 Recent Trends 517

Balance Sheets 520

Regulation 522 Global Issues 525

13 Regulation of Commercial Banks 413 Specialness and Regulation: Chapter Overview 413

Types of Regulations and the Regulators 414 Safety and Soundness Regulation 414

Monetary Policy Regulation 417

Credit Allocation Regulation 417

Consumer Protection Regulation 417

Investor Protection Regulation 418

Entry and Chartering Regulation 418

Regulators 419

Regulation of Product and Geographic Expansion 419

Product Segmentation in the U.S. Commercial

Banking Industry 419

Geographic Expansion in the U.S. Commercial

Banking Industry 426

Bank and Savings Institution Guarantee Funds 427

The Federal Deposit Insurance Corporation

(FDIC) 428

The Demise of the Federal Savings and Loan

Insurance Corporation (FSLIC) 429

Reform of Deposit Insurance 430

Non–U.S. Deposit Insurance Systems 431

Balance Sheet Regulations 431 Regulations on Commercial Bank

Liquidity 431

Regulations on Capital Adequacy

(Leverage) 432

Foreign versus Domestic Regulation of Commercial Banks 437

Product Diversification Activities 437

Global or International Expansion Activities 438

Appendix 13A: Calculating Deposit Insurance Premium Assessments 445

Appendix 13B: Calculating Minimum Required Reserves at U.s. Depository Institutions 450

Appendix 13C: Primary Regulators of Depository Institutions 453

Appendix 13D: Deposit Insurance Coverage for Commercial Banks in Various Countries 453

Appendix 13E: Calculating Risk-Based Capital Ratios 453

part 4 OTHER FINANCIAL INSTITUTIONS 454

14 Other Lending Institutions 454 Other Lending Institutions: Chapter Overview 454

Savings Institutions 455

Final PDF to printer

Contents xxi

sau19714_fm_i-xxii.indd xxi 10/10/17 06:53 PM

Liquidity Risk 589

Interest Rate Risk 590

Market Risk 592

Off-Balance-Sheet Risk 594

Foreign Exchange Risk 596

Country or Sovereign Risk 598

Technology and Operational Risk 598

Insolvency Risk 600

Other Risks and Interaction among Risks 600

20 Managing Credit Risk on the Balance Sheet 604 Credit Risk Management: Chapter Overview 604

Credit Quality Problems 606

Credit Analysis 607 Real Estate Lending 608

Consumer (Individual) and Small-Business

Lending 611

Mid-Market Commercial and Industrial

Lending 612

Large Commercial and Industrial Lending 620

Calculating the Return on a Loan 624 Return on Assets (ROA) 624

RAROC Models 626

Appendix 20A: Loan Portfolio Risk and Management 631

21 Managing Liquidity Risk on the Balance Sheet 632 Liquidity Risk Management: Chapter Overview 632

Causes of Liquidity Risk 633

Liquidity Risk and Depository Institutions 634 Liability-Side Liquidity Risk 634

Asset-Side Liquidity Risk 637

Measuring a DI’s Liquidity Exposure 638

Liquidity Risk, Unexpected Deposit Drains, and

Bank Runs 643

Bank Runs, the Discount Window, and Deposit

Insurance 644

Liquidity Risk and Insurance Companies 647 Life Insurance Companies 647

Property–Casualty Insurance Companies 648

Guarantee Programs for Life and

Property–Casualty Insurance

Companies 649

Liquidity Risk and Investment Funds 649

Appendix 21A: Sources and Uses of Funds Statement: J.P. Morgan Chase, September 2016 654

17 Investment Companies 531 Investment Companies: Chapter Overview 531

Size, Structure, and Composition of the Mutual Fund Industry 532

Historical Trends 532

Different Types of Mutual Funds 533

Other Types of Investment Company

Funds 538

Mutual Fund Returns and Costs 539 Mutual Fund Prospectuses and Objectives 539

Investor Returns from Mutual Fund

Ownership 542

Mutual Fund Costs 544

Mutual Fund Balance Sheets and Recent Trends 547

Long-Term Funds 547

Money Market Funds 548

Mutual Fund Regulation 549

Mutual Fund Global Issues 552

Hedge Funds 552 Types of Hedge Funds 555

Fees on Hedge Funds 558

Offshore Hedge Funds 559

Regulation of Hedge Funds 560

18 Pension Funds 564 Pension Funds Defined: Chapter Overview 564

Size, Structure, and Composition of the Industry 565

Defined Benefit versus Defined Contribution

Pension Funds 565

Insured versus Noninsured Pension Funds 567

Private Pension Funds 568

Public Pension Funds 575

Financial Asset Investments and Recent Trends 576

Private Pension Funds 576

Public Pension Funds 577

Regulation 579

Global Issues 581

Appendix 18A: Calculation of Growth in IRA Value during an Individual’s Working Years 584

part 5 RISK MANAGEMENT IN FINANCIAL INSTITUTIONS 585

19 Types of Risks Incurred by Financial Institutions 585 Why Financial Institutions Need to Manage Risk: Chapter Overview 585

Credit Risk 586

Final PDF to printer

xxii Contents

sau19714_fm_i-xxii.indd xxii 10/04/17 06:53 PM

Comparison of Hedging Methods 703 Writing versus Buying Options 703

Futures versus Options Hedging 705

Swaps versus Forwards, Futures, and

Options 706

Appendix 23A: Hedging with Futures Contracts 711

Appendix 23B: Hedging with Options 711

Appendix 23C: Hedging with Caps, Floors, and Collars 711

24 Managing Risk off the Balance Sheet with Loan Sales and Securitization 712 Why Financial Institutions Sell and Securitize Loans: Chapter Overview 712

Loan Sales 713 Types of Loan Sales Contracts 715

The Loan Sales Market 715

Secondary Market for Less Developed Country

Debt 718

Factors Encouraging Future Loan Sales

Growth 719

Factors Deterring Future Loan Sales

Growth 720

Loan Securitization 721 Pass-Through Security 721

Collateralized Mortgage Obligation 728

Mortgage-Backed Bond 732

Securitization of Other Assets 734

Can All Assets Be Securitized? 734

References 739

Index 741

Appendix 21B: New Liquidity Risk Measures Implemented by the Bank for International Settlements 654

22 Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet 655 Interest Rate and Insolvency Risk Management: Chapter Overview 655

Interest Rate Risk Measurement and Management 656

Repricing Gap Model 656

Duration Gap Model 665

Insolvency Risk Management 673 Capital and Insolvency Risk 673

23 Managing Risk off the Balance Sheet with Derivative Securities 683 Derivative Securities used to Manage Risk: Chapter Overview 683

Forward and Futures Contracts 684 Hedging with Forward Contracts 685

Hedging with Futures Contracts 686

Options 689 Basic Features of Options 689

Actual Interest Rate Options 692

Hedging with Options 692

Caps, Floors, and Collars 693

Risks Associated with Futures, Forwards, and Options 694

Swaps 695 Hedging with Interest Rate Swaps 695

Hedging with Currency Swaps 698

Credit Swaps 699

Credit Risk Concerns with Swaps 702

Final PDF to printer

1

sau19714_ch01_001-025.indd 1 06/28/17 11:03 AM

WHY STUDY FINANCIAL MARKETS AND INSTITUTIONS? CHAPTER OVERVIEW In the 1990s, financial markets in the United States boomed. As seen in Figure 1–1, the Dow Jones Industrial Index—a widely quoted index of the values of 30 large corpora- tions (see Chapter 8)—rose from a level of 2,800 in January 1990 to more than 11,000 by the end of the decade; this compares to a move from 100 at its inception in 1906 to 2,800 eighty-four years later. In the early 2000s, as a result of an economic downturn in the United States and elsewhere, this index fell back below 10,000. The index rose to over 14,000 in July 2007, but (because of an increasing mortgage market credit crunch, particularly the subprime mortgage market) fell back to below 13,000 within a month of hitting the all-time high. By 2008, problems in the subprime mortgage market esca- lated to a full-blown financial crisis and the worst recession in the United States since the Great Depression. The Dow Jones Industrial Average (DJIA) fell to 6,547 in March 2009 before recovering, along with the economy, to over 11,000 in April 2010. How- ever, it took until March 5, 2013, for the DJIA to surpass its pre-crisis high of 14,164.53, closing at 14,253.77 for the day, and the DJIA rose to over 21,000 in mid-2017.

O U T L I N E

Why Study Financial Markets and Institutions? Chapter Overview

Overview of Financial Markets

Primary Markets versus Secondary Markets

Money Markets versus Capital Markets

Foreign Exchange Markets

Derivative Security Markets

Financial Market Regulation

Overview of Financial Institutions

Unique Economic Functions Performed by Financial Institutions

Additional Benefits FIs Provide to Suppliers of Funds

Economic Functions FIs Provide to the Financial System as a Whole

Risks Incurred by Financial Institutions

Regulation of Financial Institutions

Trends in the United States

Globalization of Financial Markets and Institutions

Appendix 1A: The Financial Crisis: The Failure of Financial Institutions’ Specialness (available through Connect or your course instructor)

Introduction

Introduction and Overview of Financial Markets

L e a r n i n g G o a l s

LG 1-1 Differentiate between primary and secondary markets.

LG 1-2 Differentiate between money and capital markets.

LG 1-3 Understand what foreign exchange markets are.

LG 1-4 Understand what derivative security markets are.

LG 1-5 Distinguish between the different types of financial institutions.

LG 1-6 Know the services financial institutions perform.

LG 1-7 Know the risks financial institutions face.

LG 1-8 Appreciate why financial institutions are regulated.

LG 1-9 Recognize that financial markets are becoming increasingly global.

1 c h a p t e r

part one

Final PDF to printer

2 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 2 06/28/17 11:03 AM

During the financial crisis of 2008–2009, market swings seen in the United States quickly spread worldwide. Stock markets saw huge swings in value as investors tried to sort out who might survive and who would not (and markets from Russia to Europe were forced to suspend trading as stock prices plunged). As U.S. markets recovered in 2010–2013 and, as mentioned earlier, surpassed their pre-crisis highs, European stock markets struggled as Greece battled with a severe debt crisis that eventually spread to other European nations with fiscal problems, such as Portugal, Spain, and Italy. Even the growth in the robust Chinese economy slowed to 6.7 percent in 2016, the lowest level in seven years.

World markets were rocked again in June 2016 when the people of the United Kingdom voted to leave the European Union (EU) after 43 years (dubbed “Brexit”). The shock from the UK’s surprise vote to leave the EU swept across global markets, triggering steep drops in stock markets and the British pound and a flight into safe assets such as U.S. bonds and gold. The pound fell more than 11 percent to its lowest point since 1985. The DJIA dropped 610.32 points, or 3.4 percent. The Stoxx Europe 600 index fell 7 percent, its steepest drop since 2008, while Japan’s Nikkei Stock Average declined 7.9 percent. Bonds also sold off sharply, pushing UK government borrowing costs sharply higher, as traders and investors grappled with the market implications of Brexit. The UK had its credit rating outlook cut to “negative” by the ratings agency Moody’s.

The UK’s vote to leave the European Union shook the region, precipitating an imme- diate political crisis in Britain and shifting the path of a European project created to bind a continent torn by World War II. Prime Minister David Cameron, who had led the campaign to stay inside the 28-nation bloc, announced he would step down, setting off a leadership contest among Conservatives. Britain’s decision, one of the most momentous by a Western country in the past 50 years, reverses the course of expansion for the EU. It had grown over decades to include most of Europe, absorbing former dictatorships in Greece, Spain, and Portugal, and the countries of the east, formerly under Soviet domination. The UK would be the first member nation to leave, a step some leaders warned beforehand would diminish the global influence of the UK and the EU and risk setting in motion the European bloc’s eventual disintegration. The vote also raised questions about whether the UK itself would split. After a large majority of Scottish citizens voted to remain a part of the EU, Scotland’s First Minister said the Scottish National Party would seek to hold a new referendum on the country’s exit from the EU.

Figure 1–1 The Dow Jones Industrial Average, 1989–2016

Index Value DJIA Index Value

16,000 17,000 18,000 19,000

15,000 14,000 13,000 12,000 11,000 10,000

9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000

0

Ja n-

8 9

Ja n-

9 0

Ja n-

9 1

Ja n-

9 2

Ja n-

9 3

Ja n-

9 4

Ja n-

9 5

Ja n-

9 6

Ja n-

9 7

Ja n-

9 8

Ja n-

9 9

Ja n-

0 0

Ja n-

0 1

Ja n-

0 2

Ja n-

0 3

Ja n-

0 4

Ja n-

0 5

Ja n-

0 6

Ja n-

0 7

Ja n-

0 8

Ja n-

0 9

Ja n-

10

Ja n-

11 Ja

n- 12

Ja n-

13

Ja n-

14

Ja n-

15

Ja n-

16

Date

Final PDF to printer

Chapter 1 Introduction 3

sau19714_ch01_001-025.indd 3 06/28/17 11:03 AM

Originally the banking industry operated as a full-service industry, performing directly or indirectly all financial services (commercial banking, investment banking, stock invest- ing, insurance provision, etc.). In the early 1930s, the economic and industrial collapse resulted in the separation of some of these activities. In the 1970s and 1980s new, rela- tively unregulated financial services industries sprang up (e.g., mutual funds, brokerage funds) that separated the financial service functions even further.

The last 30 years, however, have seen a reversal of these trends. In the 1990s and 2000s, regulatory barriers, technology, and financial innovation changes were such that a full set of financial services could again be offered by a single financial services firm under the umbrella of a financial services holding company. For example, J.P. Morgan Chase & Co. operates a commercial bank (J.P. Morgan Chase Bank), an investment bank (J. P. Morgan Securities, which also sells mutual funds), and an insurance company (J. P. Morgan Insurance Agency). Not only did the boundaries between traditional industry sectors change, but competition became global in nature as well. For example, J.P. Morgan Chase is the world’s seventh-largest bank holding company, operating in 60 countries.

The financial crisis produced another reshaping of all financial institution (FI) sectors and the end of many major FIs (e.g., Bear Stearns and Lehman Brothers), with the two most prominent investment banks in the world, Goldman Sachs and Morgan Stanley, converting to bank holding company status. Indeed, as of 2010, all the major U.S. investment banks had either failed, been acquired by a commercial bank, or become bank holding compa- nies. Further, legislation enacted as a result of the financial crisis represents an attempt to again separate FI activities. For example, the “Volcker Rule” provision of the Wall Street Reform and Consumer Protection Act prohibits bank holding companies from engaging in proprietary trading and limits their investments in hedge funds, private equity, and related vehicles. Despite these most recent changes, many FIs operate in more than one FI sector.

As economic and competitive environments change, attention to profit and, more than ever, risk becomes increasingly important. This book provides a detailed overview and analysis of the financial system in which financial managers and individual investors operate. Making investment and financing decisions requires managers and individuals to understand the flow of funds throughout the economy as well as the operation and struc- ture of domestic and international financial markets. In particular, this book offers a unique analysis of the risks faced by investors and savers, as well as strategies that can be adopted for controlling and managing these risks. Newer areas of operations such as asset securi- tization, derivative securities, and internationalization of financial services also receive special emphasis. Further, as the United States and the world continue to recover from the collapse of the financial markets, this book highlights and discusses the impact of this crisis on the various financial markets and the financial institutions that operate in them.

This introductory chapter provides an overview of the structure and operations of various financial markets and financial institutions. Financial markets are differentiated by the characteristics (such as maturity) of the financial instruments or securities that are exchanged. Moreover, each financial market, in turn, depends in part or in whole on finan- cial institutions. Indeed, FIs play a special role in the functioning of financial markets. In particular, FIs often provide the least costly and most efficient way to channel funds to and from financial markets. As part of this discussion, we briefly examine how changes in the way FIs deliver services played a major part in the events leading up to the severe financial crisis of the late 2000s. A more detailed discussion of the causes of, the major events dur- ing, and the regulatory and industry changes resulting from the financial crisis is provided in Appendix 1A to the chapter (available through Connect or your course instructor).

OVERVIEW OF FINANCIAL MARKETS Financial markets are structures through which funds flow. Table 1–1 summarizes the financial markets discussed in this section. Financial markets can be distinguished along two major dimensions: (1) primary versus secondary markets and (2) money versus capital markets. The next sections discuss each of these dimensions.

financial markets The arenas through which funds flow.

Final PDF to printer

4 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 4 06/28/17 11:03 AM

Primary Markets versus Secondary Markets

Primary Markets. Primary markets are markets in which users of funds (e.g., corpora- tions) raise funds through new issues of financial instruments, such as stocks and bonds. Table 1–2 lists data on primary market sales of securities from 2000 through 2016. Note the impact the financial crisis had on primary market sales by firms. New issues fell to $1,068.0 billion in 2008, during the worst of the crisis, from $2,389.1 billion in 2007, pre- crisis. As of 2015, primary market sales had still not recovered as only $1,843.2 billion new securities were issued for the year.

Fund users have new projects or expanded production needs, but do not have sufficient internally generated funds (such as retained earnings) to support these needs. Thus, the fund users issue securities in the external primary markets to raise additional funds. New issues of financial instruments are sold to the initial suppliers of funds (e.g., households) in exchange for funds (money) that the issuer or user of funds needs.1 Most primary mar- ket transactions in the United States are arranged through financial institutions called investment banks—for example, Morgan Stanley or Bank of America Merrill Lynch—that serve as intermediaries between the issuing corporations (fund users) and investors (fund suppliers). For these public offerings, the investment bank provides the securities issuer (the funds user) with advice on the securities issue (such as the offer price and number of securities to issue) and attracts the initial public purchasers of the securities for the funds user. By issuing primary market securities with the help of an investment bank, the funds user saves the risk and cost of creating a market for its securities on its own (see the fol- lowing discussion). Figure 1–2 illustrates a time line for the primary market exchange of funds for a new issue of corporate bonds or equity. We discuss this process in detail in Chapters 6 and 8.

Primary market financial instruments include issues of equity by firms initially going public (e.g., allowing their equity—shares—to be publicly traded on stock markets for the first time). These first-time issues are usually referred to as initial public offerings (IPOs). For example, on June 16, 2015, Fitbit announced a $732 million IPO of its common stock.

LG 1-1

primary markets Markets in which corpora- tions raise funds through new issues of securities.

1. We discuss the users and suppliers of funds in more detail in Chapter 2.

initial public offering (IPO) The first public issue of a financial instrument by a firm.

TABLE 1–1 Types of Financial Markets

Primary markets—markets in which corporations raise funds through new issues of securities. Secondary markets—markets that trade financial instruments once they are issued. Money markets—markets that trade debt securities or instruments with maturities of less than

one year. Capital markets—markets that trade debt and equity instruments with maturities of more than

one year. Foreign exchange markets—markets in which cash flows from the sale of products or assets

denominated in a foreign currency are transacted. Derivative markets—markets in which derivative securities trade.

Security Type 2000 2005 2007 2008 2010 2012 2015 2016*

All issues $1,256.7 $2,439.0 $2,389.1 $1,068.0 $1,024.7 $1,401.0 $1,843.2 $318.9 Bonds 944.8 2,323.7 2,220.3 861.2 893.7 1,242.5 1,611.3 285.3 Stocks 311.9 115.3 168.8 206.8 131.0 129.5 174.0 33.2 Private placements 196.5 24.6 20.1 16.2 22.2 21.4 28.8 n.a.† IPOs 97.0 36.7 46.3 26.4 37.0 40.9 29.1 0.4

*Through first quarter. †n.a. = not applicable.

TABLE 1–2 Primary Market Sales of Securities (in billions of dollars)

Final PDF to printer

Chapter 1 Introduction 5

sau19714_ch01_001-025.indd 5 06/28/17 11:03 AM

The company’s stock was underwritten by several investment banks, including Morgan Stanley, Deutsche Bank, and Bank of America Merrill Lynch. Primary market securities also include the issue of additional equity or debt instruments of an already publicly traded firm. For example, on January 28, 2016, Molson Coors Brewing Company announced the sale of an additional 29.88 million shares of common stock underwritten by investment banks such as UBS, Bank of America Merrill Lynch, and Citigroup.

Secondary Markets. Once financial instruments such as stocks are issued in primary markets, they are then traded—that is, rebought and resold—in secondary markets. For example, on April 12, 2016, 9.7 million shares of ExxonMobil were traded in the secondary stock market. Buyers of secondary market securities are economic agents (consumers, businesses, and governments) with excess funds. Sellers of secondary mar- ket financial instruments are economic agents in need of funds. Secondary markets pro- vide a centralized marketplace where economic agents know they can transact quickly and efficiently.

These markets therefore save economic agents the search and other costs of seeking buyers or sellers on their own. Figure 1–2 illustrates a secondary market transfer of funds. When an economic agent buys a financial instrument in a secondary market, funds are exchanged, usually with the help of a securities broker such as Charles Schwab acting as an intermediary between the buyer and the seller of the instrument (see Chapter 8). The original issuer of the instrument (user of funds) is not involved in this transfer. The New York Stock Exchange (NYSE) and the National Association of Securities Dealers Auto- mated Quotation (NASDAQ) system are two well-known examples of secondary markets for trading stocks. We discuss the details of each of these markets in Chapter 8.

In addition to stocks and bonds, secondary markets also exist for financial instruments backed by mortgages and other assets (see Chapter 7), foreign exchange (see Chapter 9), and futures and options (i.e., derivative securities—financial securities whose payoffs

secondary market A market that trades finan- cial instruments once they are issued.

derivative security A financial security whose payoffs are linked to other, previously issued securi- ties or indices.

Figure 1–2 Primary and Secondary Market Transfer of Funds Time Line

Users of Funds (Corporations

issuing debt/equity instruments)

Underwriting with Investment Bank

Primary Markets

(Where new issues of financial instruments are o�ered for sale)

Secondary Markets

(Where financial instruments, once issued, are traded)

Financial instruments flow

Funds flow

Initial Suppliers of Funds

(Investors)

Economic Agents (Investors) Wanting to Sell Securities

Financial Markets Economic Agents

(Investors) Wanting to Buy Securities

Final PDF to printer

6 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 6 06/28/17 11:03 AM

are linked to other, previously issued [or underlying] primary securities or indexes of pri- mary securities) (see Chapter 10). As we will see in Chapter 10, derivative securities have existed for centuries, but the growth in derivative securities markets occurred mainly in the 1980s through 2000s. As major markets, therefore, derivative securities markets are among the newest of the financial security markets.

Secondary markets offer benefits to both investors (suppliers of funds) and issuing corporations (users of funds). For investors, secondary markets provide the opportunity to trade securities at their market values quickly as well as to purchase securities with vary- ing risk-return characteristics (see Chapter 2). Corporate security issuers are not directly involved in the transfer of funds or instruments in the secondary market. However, the issuer does obtain information about the current market value of its financial instruments, and thus the value of the corporation as perceived by investors such as its stockholders, through tracking the prices at which its financial instruments are being traded on second- ary markets. This price information allows issuers to evaluate how well they are using the funds generated from the financial instruments they have already issued and provides information on how well any subsequent offerings of debt or equity might do in terms of raising additional money (and at what cost).

Secondary markets offer buyers and sellers liquidity—the ability to turn an asset into cash quickly at its fair market value—as well as information about the prices or the value of their investments. Increased liquidity makes it more desirable and easier for the issuing firm to sell a security initially in the primary market. Further, the existence of centralized markets for buying and selling financial instruments allows investors to trade these instru- ments at low transaction costs.

Money Markets versus Capital Markets

Money Markets. Money markets are markets that trade debt securities or instruments with maturities of one year or less (see Figure 1–3). In the money markets, economic agents with short-term excess supplies of funds can lend funds (i.e., buy money mar- ket instruments) to economic agents who have short-term needs or shortages of funds (i.e., they sell money market instruments). The short-term nature of these instruments means that fluctuations in their prices in the secondary markets in which they trade are usually quite small (see Chapters 3 and 22 on interest rate risk). In the United States, money markets do not operate in a specific location—rather, transactions occur via tele- phones, wire transfers, and computer trading. Thus, most U.S. money markets are said to be over-the-counter (OTC) markets.

Money Market Instruments. A variety of money market securities are issued by corporations and government units to obtain short-term funds. These securities include Treasury bills, federal funds, repurchase agreements, commercial paper, negotiable certificates of deposit, and banker’s acceptances. Table 1–3 lists and defines the major money market securities. Figure 1–4 shows outstanding amounts of money market instruments in the United States in 1990, 2000, 2010, and 2016. Notice that in 2016 federal funds and repurchase agreements, followed by negotiable CDs, Treasury bills, and commercial paper, had the largest amounts outstanding. Money market instru- ments and the operation of the money markets are described and discussed in detail in Chapter 5.

liquidity The ease with which an asset can be converted into cash quickly and at fair market value.

LG 1-2

money markets Markets that trade debt securities or instruments with maturities of one year or less.

over-the-counter (OTC) markets Markets that do not operate in a specific fixed location—rather, transactions occur via tele- phones, wire transfers, and computer trading.

Figure 1–3 Money versus Capital Market Maturities

Money Market Securities

1 year to maturity

0 30 years to maturity

No specified maturity

Notes and Bonds

Capital Market Securities

Stocks (Equities) Maturity

Final PDF to printer

Chapter 1 Introduction 7

sau19714_ch01_001-025.indd 7 06/28/17 11:03 AM

MONEY MARKET INSTRUMENTS

Treasury bills—short-term obligations issued by the U.S. government. Federal funds—short-term funds transferred between financial institutions usually for no more

than one day. Repurchase agreements—agreements involving the sale of securities by one party to another with a

promise by the seller to repurchase the same securities from the buyer at a specified date and price. Commercial paper—short-term unsecured promissory notes issued by a company to raise

short-term cash. Negotiable certificates of deposit—bank-issued time deposits that specify an interest rate and

maturity date and are negotiable (i.e., can be sold by the holder to another party). Banker’s acceptances—time drafts payable to a seller of goods, with payment guaranteed by

a bank.

CAPITAL MARKET INSTRUMENTS

Corporate stock—the fundamental ownership claim in a public corporation. Mortgages—loans to individuals or businesses to purchase a home, land, or other real property. Corporate bonds—long-term bonds issued by corporations. Treasury bonds—long-term bonds issued by the U.S. government. State and local government bonds—long-term bonds issued by state and local governments. U.S. government agency bonds—long-term bonds collateralized by a pool of assets and issued

by agencies of the U.S. government. Bank and consumer loans—loans to commercial banks and individuals.

TABLE 1–3 Money and Capital Market Instruments

Sources: Federal Reserve Board, “Financial Accounts of the United States,” Statistical Releases, Washington, DC, various issues. www .federalreserve.gov

Figure 1–4 Money Market Instruments Outstanding

1990 $2.06 trillion outstanding

2000 $4.51 trillion outstanding

2016 $7.97 trillion outstanding

Federal funds and repurchase agreements Commercial paper U.S. Treasury bills Negotiable CDs Banker’s acceptances

18.1%

25.7% 26.5%

2.6%

35.6% 26.5%

14.4%

23.3%0.2%

0.0%

27.1%

45.8%

11.8%

23.4% 19.0%

2010 $6.5 trillion outstanding

0.0%

16.7%

25.6%

28.6%

29.1%

Final PDF to printer

8 Part 1 Introduction and Overview of Financial Markets

sau19714_ch01_001-025.indd 8 06/28/17 11:03 AM

Capital Markets. Capital markets are markets that trade equity (stocks) and debt (bonds) instruments with maturities of more than one year (see Figure 1–3). The major suppliers of capital market securities (or users of funds) are corporations and govern- ments. Households are the major suppliers of funds for these securities. Given their longer maturity, these instruments experience wider price fluctuations in the second- ary markets in which they trade than do money market instruments. For example, all else constant, long-term maturity debt instruments experience wider price fluctuations for a given change in interest rates than short-term maturity debt instruments (see Chapter 3).

Capital Market Instruments. Table 1–3 lists and defines the major capital market secu- rities. Figure 1–5 shows their outstanding amounts by dollar market value. Notice that in 2000, 2010, and 2016, corporate stocks or equities represent the largest capital market instrument, followed by mortgages and corporate bonds. The relative size of the market value of capital market instruments outstanding depends on two factors: the number of

capital markets Markets that trade debt (bonds) and equity (stocks) instruments with maturities of more than one year.

Figure 1–5 Capital Market Instruments Outstanding

1990 $14.93 trillion outstanding

2000 $40.6 trillion outstanding

20.9%

31.3%

16.8% 9.0%

11.4%

4.2%

6.4%

2010 $67.9 trillion outstanding

15.3%

49.6%

13.0%

15.1%

9.0%

4.1%

3.9%

2016 $90.2 trillion outstanding

Corporate stocks Mortgages Corporate bonds

State and local government bonds U.S. government agency bonds Consumer loans

Treasury securities

25.5% 23.6%

11.4%

11.1%

10.9% 9.6%

7.9%

3.7%

5.7%

16.8%

43.4%

12.1%

7.7%

10.6%

Sources: Federal Reserve Board, “Financial Accounts of the United States,” Statistical Releases, Washington, DC, various issues. www.federalreserve.gov

Final PDF to printer

Chapter 1 Introduction 9

sau19714_ch01_001-025.indd 9 06/28/17 11:03 AM

securities issued and their market prices.2 One reason for the sharp increase in the value of equities outstanding is the bull market in stock prices in the 1990s. Stock values fell in the early 2000s as the U.S. economy experienced a downturn—partly because of 9/11 and partly because interest rates began to rise—and stock prices fell. Stock prices in most sec- tors subsequently recovered and, by 2007, even surpassed their 1999 levels. Stock prices fell precipitously during the financial crisis of 2008–2009. As of mid-March 2009, the Dow Jones Industrial Average (DJIA) had fallen 53.8 percent in value in less than 1½ years, larger than the decline during the market crash of 1929 when it fell 49 percent. How- ever, stock prices recovered, along with the economy, in the last half of 2009, rising 71.1 percent between March 2009 and April 2010. Capital market instruments and their opera- tions are discussed in detail in Chapters 6, 7, and 8.

Foreign Exchange Markets

In addition to understanding the operations of domestic financial markets, a financial man- ager must also understand the operations of foreign exchange markets and foreign capi- tal markets. Today’s U.S.-based companies operate globally. It is therefore essential that financial managers understand how events and movements in financial markets in other countries affect the profitability and performance of their own companies. For example, in 2015 a strengthening dollar reduced profits for internationally active firms. IBM experi- enced a drop in its 2015 earnings per share of $1.10 due to foreign exchange trends. Coca- Cola, which gets the majority of its sales from outside the United States, saw 2015 revenues decrease by 5.1 percent as the U.S. dollar strengthened relative to foreign currencies.

Cash flows from the sale of securities (or other assets) denominated in a for- eign currency expose U.S. corporations and investors to risk regarding the value at which foreign currency cash flows can be converted into U.S. dollars. For example, the actual amount of U.S. dollars received on a foreign investment depends on the exchange rate between the U.S. dollar and the foreign currency when the nondollar cash flow is converted into U.S. dollars. If a foreign currency depreciates (declines in value) relative to the U.S. dollar over the investment period (i.e., the period between the time a foreign investment is made and the time it is terminated), the dollar value of cash flows received will fall. If the foreign currency appreciates, or rises in value, relative to the U.S. dollar, the dollar value of cash flows received on the foreign investment will increase.

While foreign currency exchange rates are often flexible—they vary day to day with demand for and supply of a foreign currency for dollars—central govern- ments sometimes intervene in foreign exchange markets directly or affect foreign exchange rates indirectly by altering interest rates. We discuss the motivation and effects of these interventions in Chapters 4 and 9. The sensitivity of the value of cash flows on foreign investments to changes in the foreign currency’s price in terms of dollars is referred to as foreign exchange risk and is discussed in more

detail in Chapter 9. Techniques for managing, or “hedging,” foreign exchange risk, such as using derivative securities like foreign exchange (FX) futures, options, and swaps, are discussed in Chapter 23.