COPYRIGHTED MATERIAL.

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1 Contents Preface CHAPTER 1 Introduction 1 What You Will Learn in This Chapter 1 Overview 1 Where We Are Going in This Book 2 Contributions Made by the Financial System 4 Transfers of Resources from Surplus to Deficit Units 4 Other Contributions 8 Recurring Themes in the Chapters Ahead 11 Resources 12 CHAPTER 2 Overview of the Financial System 17 What You Will Learn in This Chapter 17 Introduction 17 Features of an Effective Financial System 17 Direct Methods of Finance 18 Investment Banks 19 Debt versus Equity 20 Money versus Capital Markets 21 Asymmetric Information 21 Adverse Selection 21 Moral Hazard 22 Indirect Methods of Finance 22 Primary versus Secondary Markets 27 Primary-Market Transactions 27 Secondary-Market Transactions 28 Trading Platforms 29 Brokers 29 COPYRIGHTED MATERIAL CHAPTER 3 The Special Role of Commercial Banks 33 What You Will Learn in This Chapter 33 Background 33 Commercial Bank Balance Sheet 34 Assets 35 Liabilities 35 Net Worth (Capital) 36 xvii vii

2 viii CONTENTS Payment System and Money 36 Commercial Banks and the Payment System 36 Payment System Infrastructure 40 Credit and Stored Value Cards 40 Payments Media in the Money Stock 41 Velocity (Turnover of Money) 42 Liquidity Provision 44 Dealing with Asymmetric Information 46 Maturity Transformation 46 The Safety Net and Regulatory Policy 47 CHAPTER 4 The Pricing of Financial Assets 55 What You Will Learn in This Chapter 55 Background 55 Present Value 56 Value of a Single Future Payment 57 Value of a Coupon Security 58 Other Applications 59 Solving for Yield to Maturity 59 Solving for Fixed Payments 60 The Special Case of a Consol 61 Maturity and Price Sensitivity 61 Holding Periods versus Maturities 63 Return versus Yield 63 Duration 64 Nominal versus Real Yields 66 Appendix A: Variations of the Valuation Relationship 69 Appendix B: Solutions Using a Financial Calculator 70 Future Value 70 Future Value A Higher Interest Rate 70 Present Value of Single Cash Flow 71 Lottery Choice 71 Current Price of a Coupon Security 71 Price of an Aasset Providing Uneven Cash Flows 71 Yield to Maturity 72 CHAPTER 5 Factors Affecting Yields 75 What You Will Learn in This Chapter 75 Background 75 The Term Structure of Interest Rates 76 The Expectations Hypothesis 77 The Term Premium Hypothesis 81 Market Segmentation Hypothesis 83 Implicit Forward Rates 84 The Role of the Term Structure 85

3 Contents ix Credit Risk 85 Credit Rating Agencies 86 Investment-Grade versus Below-Investment-Grade Debt 87 Cyclical Behavior of Credit Risk and Spreads 88 Credit Default Swaps (CDSs) 89 Changing Investor Tolerance for Risk 90 Liquidity 90 Taxation 91 Embedded Options 91 Flights to Safety 92 CHAPTER 6 Principles of Portfolio Selection and Effi cient Markets 97 What You Will Learn in This Chapter 97 Overview 97 Uncertainty, Expected Return, and Risk 98 Selecting a Portfolio 99 Expected Return 99 Risk 99 Interpreting the Expression for Risk 100 An Illustration 101 These Principles in Practice 102 Efficient Portfolios and Risk-Return Trade-Offs 103 Efficient Markets Hypothesis 104 Implications for a Random Walk 106 Other Implications 106 Asset Bubbles 106 Evidence 107 CHAPTER 7 The Money Market 111 What You Will Learn in This Chapter 111 Background and Basic Features of the Money Market 111 Pricing 112 Treasury Bills 114 Auction Procedures 114 The Role of Primary Dealers 114 Purpose for Issuing Bills 115 Commercial Paper 115 Credit Quality 115 Maturities 116 Asset-Backed Commercial Paper (ABCP) 116 Retreat of the ABCP Market 116 Commercial Paper Placement 117 The Role of Commercial Banks in the Money Market 117 Letters of Credit and Bankers Acceptances 119 Monetary Policy Effects on the Money Market 120

4 x CONTENTS CHAPTER 8 The Bond Market 125 What You Will Learn in This Chapter 125 Background 125 Treasury Notes and Bonds 126 Maturities 126 Features of TIPS 127 Placement 127 When-Issued Trading 127 STRIPS 128 Secondary-Market Trading 128 Reopening 128 Purposes for Issuing Coupon Securities 129 Credit Quality 129 Corporate Bonds 129 Placements 130 Tension between Bond and Shareholders 130 Indentures and the Role of Covenants 131 Credit Default Swaps (CDSs) 132 Below-Investment-Grade Market 132 Private Placements 133 Secondary-Market Trading 133 Munis 133 Tax Considerations 134 Credit Risk and Liquidity Differences 134 General Obligation versus Revenue Bonds 134 Placement 135 Indentures 135 Ratings 135 Government-Sponsored Enterprises (GSEs) 135 Fannie Mae and Freddie Mac 136 Federal Home Loan Banks 136 Features of GSE Bonds 136 The Impact of Monetary Policy on the Bond Market 136 CHAPTER 9 Securitization 143 What You Will Learn in This Chapter 143 Background 143 Obstacles to Overcome 144 Asymmetric Information and Adverse Selection 144 Corrective Measures 145 Regulatory Capital on Ordinary Loans 145 Beginnings of Securitization MBSs 146 Ginnie Mae 146 Illustration of the Process 146 Fannie Mae and Freddie Mac 147 Secondary-Market Trading 148 Other Mortgage Pools 148

5 Contents xi Other Securitized Loans Consumer ABSs 148 Auto ABSs 148 Credit Card ABSs 149 Other Consumer ABSs 149 Common Features 149 The Effects of the Financial Crisis 150 ABSs Involving Business Credit CDOs and Structured Securities 150 Standard Types of Pools CLOs, CBOs, and CMBSs 150 Structured Securities 150 CMOs 151 Senior-Subordinated Securities 152 Effects of the Financial Crisis 152 Securitization and the Integration of Credit Markets 152 Monetary Policy and Securitization 152 CHAPTER 10 The Mortgage Market 155 What You Will Learn in This Chapter 155 Background 155 Home Mortgages 156 Homeowner Choices 156 Standard Features of Home Mortgages 159 Commercial Mortgages 163 The Mortgage Market and Monetary Policy 163 CHAPTER 11 The Equity Market 167 What You Will Learn in This Chapter 167 Background 167 Equities as a Source of Corporate Finance 168 Preferred versus Common Shares 168 Types of Preferred 169 Primary and Secondary Markets 169 Valuation of Individual Shares 170 Basic Model 170 Dividend Growth 170 Price-Earnings 171 Some Implications 172 Extending These Principles to the Stock Market 173 Monetary Policy and the Stock Market 178 Indexes of Stock Prices 178 CHAPTER 12 Central Banking and the Federal Reserve 183 What You Will Learn in This Chapter 183 Background 183 Origins of Central Banks 184

6 xii CONTENTS Constitutional Foundations 184 The Century and a Quarter without a Central Bank 185 Creation of the Federal Reserve 186 Early Years of the Federal Reserve 188 Reforms of the 1930s 189 Fed Independence 190 Central Bank Accountability and Transparency 191 Central Bank Responsibilities 193 Monetary Operations 196 The Demand for Reserves 196 The Supply of Reserves 196 Market Equilibrium 198 Setting the Federal Funds Rate through Open Market Operations 198 Permanent versus Temporary Transactions 200 Payment of Interest on Excess Reserves 201 The Effect of the Financial Crisis on the Reserves Market 201 Interaction of Policy Instruments in the Reserves Market 202 CHAPTER 13 Monetary Policy: The Basics 211 What You Will Learn in This Chapter 211 Background 211 Effects of Monetary Policy on Output and Prices 212 The Goal of Price Stability 212 The Dual Mandate in the United States 212 The Operational Counterparts to Maximum Employment and Price Stability 213 Maximum Employment 213 Price Stability 214 Aggregate Demand and Aggregate Supply 215 Aggregate Supply 215 Aggregate Demand 216 Monetary Policy and Aggregate Demand 218 The Model 219 Steady Inflation 219 Rising Inflation 220 Falling Inflation 220 The Important Role of Inflation Expectations 220 Actual and Potential Output in Practice 221 Addressing Inflation 221 Addressing a Shortfall in Output 223 Okun s Law 224

7 Contents xiii CHAPTER 14 Monetary Policy: Challenges Faced by Policymakers 231 What You Will Learn in This Chapter 231 Background 231 Other Forces Affecting Output and Inflation 232 Lags and Other Complications 234 Need to Be Forward Looking 234 Importance of the Expected Path of Short-Term Rates 235 Forward Guidance 236 Policy Rules 237 Money Stock Rule 237 Taylor Rule 237 Expectations and Central Bank Credibility 239 Inflation Targeting 240 The Zero-Bound Constraint and the Slow Recovery from the Great Recession 241 CHAPTER 15 Financial Crises 247 What You Will Learn in This Chapter 247 Background 247 Classic Banking Panics 248 The Nightmare of the Great Depression 250 Gold Standard Restraints 250 The Stock Market Crash 251 Bank Runs 251 Massive Damage 252 Broader Financial Crises 252 Big Drop in Asset Values 253 Runs on Suspected Institutions 253 Fire Sales 253 The Financial Crisis 254 Background Factors 255 Proliferation of Nonstandard Mortgages 255 Growing Exposures of Key Financial Institutions 256 The Unraveling 257 Shadow Banking Stress 257 Major Credit Crunch 258 Policy Responses 258 Dodd-Frank 259 Common Threads 259 CHAPTER 16 The Foreign Exchange Market and Exchange Rate Regimes 263 What You Will Learn in This Chapter 263 Background 263 Features of the Market 264 The Relation between Spot and Forward Exchange Rates 266

8 xiv CONTENTS Long-Run Exchange Rate Relationships 267 The Real Exchange Rate 269 Exchange Rate Determination in the Shorter Run 269 Demand Schedule 270 Supply Schedule 271 Equilibrium 272 Floating Exchange Rate Regime 273 Fixed Exchange Rate Regime 275 An Undervalued Exchange Rate 275 The Dynamics of an Undervalued Currency 276 An Overvalued Currency 278 Variations on Fixed Exchange Rate Regimes 280 CHAPTER 17 Depository Institutions 285 What You Will Learn in This Chapter 285 Background 285 Organization of Commercial Banks and Other Depository Institutions 286 Commercial Banks 287 Savings Institutions 291 Credit Unions 292 Economic Functions of Depository Institutions 293 Payment Services 293 Liquidity Provision 293 Providing Credit When There Is Asymmetric Information 293 Maturity Transformation 293 The Balance Sheet of the Commercial Banking System 294 The Balance Sheet of Savings Institutions 295 The Balance Sheet of Credit Unions 296 Deposit Insurance 296 Regulation and Supervision of Depository Institutions 297 The Regulators 297 The Focus of Regulation and Supervision 298 Capital Standards 298 Liquidity Standards 299 Depository Institutions and Monetary Policy 300 CHAPTER 18 Mutual Funds 305 What You Will Learn in This Chapter 305 Background 305 History 306 SEC Regulation 307 Role of Mutual Fund Complexes 307 Types of Funds 309 Open-End Funds 309 Exchange-Traded Funds 314 Closed-End Funds 314 Mutual Funds and Monetary Policy 315

9 Contents xv CHAPTER 19 Hedge, Venture Capital, and Private Equity Funds 319 What You Will Learn in This Chapter 319 Background 319 Commonalities in Structure 320 Hedge Funds 321 Role of the Prime Broker 322 Leverage 322 Entry and Redemption 322 Types of Hedge Funds 322 Economic Value and Hedge Fund Risk 323 Venture Capital Funds 324 Types of Firms Selected for Financing 324 Risks Involved 324 Size and Stages of Financing 325 Exit 326 Economic Value Provided by VC Funds 326 Private Equity Funds 326 Leverage 327 Exit 328 Economic Value Provided by Private Equity Firms 328 Alternative Investment Funds and Monetary Policy 328 CHAPTER 20 Large Institutional Investors 333 What You Will Learn in This Chapter 333 Background 333 Pension Funds 334 Defined Benefit (DB) Plans 335 Defined Contribution (DC) Plans 336 Social Security 338 State and Local Government Pension Funds 338 Federal Government Retirement Funds 339 Life Insurance Companies 339 Life Insurance 339 Annuities 340 LICO Assets 340 Reinsurance 341 Property and Casualty Insurance Companies 341 Large Institutional Investors and Monetary Policy 342 About the Author 347 Index 349

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