FINANCIAL INSTITUTIONS, MARKETS, AND MONEY
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1 E L E V E N T H E D I T I O N FINANCIAL INSTITUTIONS, MARKETS, AND MONEY International Student Version David S. Kidwell University of Minnesota David W. Blackwell Texas A&M University David A. Whidbee Washington State University Richard W. Sias University of Arizona WILEY John Wiley & Sons, Inc.
2 CONTENTS Chapter 1 An Overview of Financial Markets and Institutions 1 Chapter Preview 2 Learning Objectives The Financial System Financial Markets and Direct Financing Types of Financial Markets 8 PEOPLE & EVENTS: Wall Street Faces Global Competition The Money Markets The Capital Markets Financial Intermediaries and Indirect Financing Types of Financial Intermediaries The Risks Financial Institutions Manage Regulation of the Financial System 29 Summary of Learning Objectives 32 Key Terms 34 Questions and Problems 34 ; Chapter 2 The Federal Reserve and Its Powers 35 Chapter Preview 36 Learning Objectives' Origins of the Federal Reserve System The Current Structure of the Fed Monetary Powers of the Board of Governors The Fed's Regulatory Powers Independence of the Fed The Fed's Balance Sheet 51 Learning by Doing 2.1: Computing a Bank's Excess Reserve Position The Fed's Role In Check Clearing Federal Reserve Tools of Monetary Policy 58 PEOPLE & EVENTS: A Contrast in Style: Greenspan Versus Bernanke 59 Learning by Doing 2.2: Calculating a Bank's Reserve Position 64 Summary of Learning Objectives 67 Key Terms 68 Questions and Problems 68 XV
3 XVi Contents Chapter 3 The Fed and Interest Rates 70 Chapter Preview 71 Learning Objectives Federal Reserve Control of the Money Supply The Fed's Influence on Interest Rates The Treasury Department and Fiscal Policy Goals of Monetary Policy 82 PEOPLE & EVENTS: The Fed as Lender of Last Resort: Preventing a Financial Panic The Fed and the Economy Complications of Monetary Policy Anatomy of a Financial Crisis 94 Summary of Learning Objectives 102 Key Terms 103 Questions and Problems 103 Chapter 4 The Level of Interest Rates 105 Chapter Preview 106 Learning Objectives What Are Interest Rates? The Real Rate of Interest Loanable Funds Theory of Interest Price Expectations and Interest Rates 113 PEOPLEfirEVENTS: Irving Fisher ( ): Economist 115 PEOPLE & EVENTS: Can Interest Rates be Negative? Forecasting Interest Rates 121 Summary of Learning Objectives 123 Key Terms 124 Questions and Problems 124 Chapter 5 Bond Prices and Interest Rate Risk 125 Chapter Preview 126 Learning Objectives The Time Value of Money Bond Pricing 128 PEOPLE & EVENTS: Rogue Trader Incurs Huge Financial Losses for French Bank 130 Learning by Doing 5.1: Calculating the Price of a Bond Using a Financial Calculator Bond Yields 134 Learning by Doing 5.2: Calculating the Yield-to-Maturity on a Bond Important Bond Pricing Relationships Interest Rate Risk and Duration 143 Learning by Doing 5.3: Calculating the Duration of a Bond 144 Summary of Learning Objectives 153 Key Terms 154 Questions and Problems 154
4 Contents xvii Chapter 6 The Structure of Interest Rates 156 Chapter Preview 157 -; Learning Objectives The Term Structure of Interest Rates 157 Learning by Doing 6.1: Using the Term Structure Formula to Calculate Implied Forward Rates Default Risk 169 PEOPLEfirEVENTS: The Credit-Rating Club Tax Treatment Marketability Options of Debt Securities Behavior of Interest Rates over the Business Cycle 180 Summary of Learning Objectives 182 Key Terms 183 Questions and Problems 184 Chapter 7 Money Markets 186 Chapter Preview 187 Learning Objectives How the Money Markets Work Economic Role of the Money Markets Features of Money Market Instruments Treasury Bills 190 Learning by Doing 7.1: Calculating the Discount Yield 194 Learning by Doing 7.2: Calculating the Bond Equivalent Yield Federal Agency Securities Fed Funds Other Major Money Market Instruments 201 PEOPLEfirEVENTS: Lehman Brothers' "Creative" Accounting: Repos 105 and Money Market Participants The Impact of the Financial Crisis on the Money Markets 214 Summary of Learning Objectives 219 Key Terms 220 Questions and Problems 220 Chapter 8 Bond Markets 221 Chapter Preview 222 Learning Objectives Functions of the Capital Markets U.S. Government and Agency Securities 224 PEOPLEfirEVENTS: What Do Negative Yields on TIPS Tell Us? State and Local Government Bonds Corporate Bonds Financial Guarantees 240
5 xviii Contents 8.6 Securitized Credit Instruments Financial Market Regulators Bond Markets Around the World Are Increasingly Linked The Impact of the Financial Crisis on the Bond Markets 245 Summary of Learning Objectives 246 Key Terms 247 Questions and Problems 247 Chapter 9 Mortgage Markets 249 Chapter Preview 250 Learning Objectives The Unique Nature of Mortgage Markets Types of Mortgages Mortgage Qualifying 259 Learning by Doing 9.1: Determining How Much Home You Can Buy Mortgage-backed Securities Mortgage Prepayment Risk Participants in the Mortgage Markets 272 PEOPLE & EVENTS: The Rise and Fall of Fannie and Freddie Relationship Between Mortgage Markets and the Capital Markets 276 Summary of Learning Objectives 277 Key Terms 278 Questions and Problems 279 Chapter 10 Equity Markets 280 Chapter Preview 281. Learning Objectives 281 \ 10.1 What Are Equity Securities? Equity Markets Equity Trading Global Stock Markets Regulation of Equity Markets Equity Valuation Basics 295 Learning by Doing 10.1: Valuing a Stock Equity Risk Stock Market Indexes 304 PEOPLEfirEVENTS: Circuit Breakers, Black Monday, and the Flash Crash The Stock Market as a Predictor of Economic Activity 308 Summary of Learning Objectives 309 Key Terms 310 Questions and Problems 311
6 Contents xix Chapter 11 Derivatives Markets 312 Chapter Preview 313 : Learning Objectives 313 ; 11.1 The Nature of Derivative Securities Forward Markets Futures Markets Uses of the Financial Futures Markets 323 Learning by Doing 11.1: Hedging Risk in a Stock Portfolio Risks in the Futures Markets Options Markets 331 ' 11.7 Regulations of the Futures and Options Markets Swap Markets 339 PEOPLEfirEVENTS: Swap Market Regulation 342 Summary of Learning Objectives 343 Key Terms 344 : Questions and Problems 344 Chapter 12 International Markets 345 Chapter Preview 346 Learning Objectives Difficulties of International Trade Exchange Rates Balance of Payments Foreign Exchange Markets Spot and Forward Transactions 355 Learning by Doing 12.1: Using Forward Contracts to Hedge Exchange Rate Risks 356 PEOPLE & EVENTS: The Big Mac Test of Purchasing Power Parity Capital Flows and Exchange Rates Government Intervention in Foreign Exchange Markets 363 Learning by Doing 12.2: Using Purchasing Power Parity to Determine the Expected Exchange Rate Financing International Trade International Money and Capital Markets The Globalization of Financial Markets 373 Summary of Learning Objectives 375 Key Terms 375 Questions and Problems 375 Chapter 13 Commercial Bank Operations 378 Chapter Preview 379 Learning Objectives An Overview of the Banking Industry Balance Sheet for a Commercial Bank The Source of Bank Funds 384
7 XX Contents 13.4 Bank Uses of Funds: Bank Investments and Cash Assets Bank Uses of Funds: Loans and Leases Loan Pricing Analysis of Loan Credit Risk 3 98 PEOPLEfirEVENTS: What's Your Score? Fee-Based Services Off-Balance-Sheet Banking Bank Earnings Bank Performance Bank and Financial Holding Companies 411 Summary of Learning Objectives 413 Key Terms 414 Questions and Problems 414 Chapter 14 International Banking 416 Chapter Preview 417 Learning Objectives Development of International Banking Regulation of Overseas Banking Activities 420 PEOPLEfirEVENTS: Credit Risk, Subprime Mortgage Crisis of 2007, and Challenges to the Banking Sector Delivery of Overseas Banking Services International Lending Foreign Banks in the United States Future Directions of International Banking 440 Summary of Learning Objectives 441 ; Key Terms 441 Questions and Problems 441 Chapter 15 Regulation of Financial Institutions 443 Chapter Preview 444 Learning Objectives Reasons for Regulation Bank Failures and Regulation 448 PEOPLEfirEVENTS: WaMu and the Destructive "Power of Yes" Safety and Soundness Regulation: Deposit Insurance Deposit Insurance Issues Safety and Soundness Regulation: Capital Requirements Bank Examinations Structure and Competition Regulations Consumer Protection Regulations Bank Regulators 473 Summary of Learning Objectives 476 Key Terms 476 Questions and Problems 477
8 Contents xxi Chapter 16 Thrift Institutions and Finance Companies 478 Chapter Preview 479 ^ Learning Objectives Historical Development of Savings Institutions Operations of Savings Institutions Credit Unions 492 PEOPLEfirEVENTS: Demographic Change Brings Opportunity 493 PEOPLEfirEVENTS: Commercial Banks Versus Credit Unions Thrift Institutions Around the Globe Finance Companies 500 Summary of Learning Objectives ~" Key Terms 509 Questions and Problems 509 Chapter 17 Insurance Companies and Pension Funds 510 Chapter Preview 511 " Learning Objectives Insurance The Insurance Industry 515 PEOPLEfirEVENTS: The Rise, Fall, and Return of American International Group (AIG) Life and Health Insurance 523 \ Learning by Doing 17.1: Calculating Policyholders' Surplus Property and Liability Insurance 529 Learning by Doing 17.2: Measuring Insurance Company Profitability with the Combined Ratio Pensions 532 Summary of Learning Objectives 538 Key Terms 539 Questions and Problems 539 Chapter 18 Investment Banking 541 Chapter Preview 542 Learning Objectives The Relationship Between Commercial and Investment Banking 542 PEOPLEfirEVENTS: Where, Oh, Where Have All the Investment Banks Gone? Primary Services of an Investment Bank Private Equity 559 Learning by Doing 18.1: Evaluating a Venture Capital Investment 562 Summary of Learning Objectives 565 Key Terms 565 Questions and Problems 566 Chapter 19 Investment Companies 567 Chapter Preview 568 Learning Objectives Investment Companies 568
9 XXii Contents 79.2 Open-End Mutual Funds 569 Learning by Doing 19.1: Calculating Net Asset Value Closed-End Mutual Funds Exchange-Traded Funds Hedge Funds 587 PEOPLEfirEVENTS: Hedge Funds and the Dodd-Frank Wall Street Reform and Consumer Protection Act Real Estate Investment Trusts 591 Summary of Learning Objectives 595 Key Terms 595 Questions and Problems 595 Chapter 20 Risk Management in Financial Institutions 597 Chapter Preview 598 Learning Objectives 598 Glossary 628 Index The Dilemma: Profitability Versus Safety Liquidity Management 600 PEOPLEfirEVENTS: Operational Risk Managing Credit Risk 604 PEOPLEfirEVENTS: Counterparty Controversy: AIG and Its Risky Risk Management Measuring and Assessing Interest Rate Risk Hedging Interest Rate Risk 617 Learning by Doing 20.1: Measuring Interest Rate Risk 623 Summary of Learning Objectives 626 Key Terms 626 Questions and Problems 627
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