Financial Institutions and Markets 9TH EDITION

Financial Institutions and Markets 9TH EDITION JEFF MADURA Florida Atlantic University, SOUTH-WESTERN 1 CENGAGE Learning- Australia Brazil Japan Korea Mexico Singapore Spain United Kingdom United State

IIIIIII Brief Contents PART1: Overview of the Financial Environment 1 Role of Financial Markets and Institutions, 3 2 Determination of Interest Rates, 29 3 Structure of Interest Rates, 49 PART 2: The Fed and Monetary Policy 79 4 Functions of the Fed, 81 5 Monetary Policy, 99 PART 3: Debt Security Markets 123 6 Money Markets, 125 7 Bond Markets, 149 8 Bond Valuation and Risk, 173 9 Mortgage Markets, 205 PART 4: Equity Markets 227 10 Stock Offerings and Investor Monitoring, 229 11 Stock Valuation and Risk, 263 12 Market Microstructure and Strategies, 303 PART 5: Derivative Security Markets 323 13 Financial Futures Markets, 325 14 Options Markets, 353 15 Swap Markets, 391 16 Foreign Exchange Derivative Markets, 417 PART 6: Commercial Banking 459 17 Commercial Bank Operations, 461 18 Bank Regulation, 481 19 Bank Management, 499 20 Bank Performance, 527 PART 7: Nonbank Operations 543 21 Thrift Operations, 545 22 Finance Operations, 567 23 Mutual Fund Operations, 579 24 Securities Operations, 615 25 Insurance and Pension Fund Operations, 641 Appendix A: Comprehensive Project, 677 Appendix B: Using Excel to Conduct Analyses, 687 Glossary, 691 Index, 705

Contents Preface, xxxi About the Author, xxxvii PART1: Overview of the Financial Environment 1: ROLE OF FINANCIAL MARKETS AND INSTITUTIONS Role of Financial Markets, 3 Types of Financial Markets, 4 How Financial Markets Facilitate Corporate Finance, 5 Securities Traded in Financial Markets, 6 Money Market Securities, 6 Capital Market Securities, 6 Using the Wall Street Journal: Assessing Stock Performance, 8 Derivative Securities, 8 Valuation of Securities in Financial Markets, 9 Market Efficiency, 10 Financial Market Regulation, 11 Global Financial Markets, 12 International Corporate Governance, 12 Global Integration, 13 Role of the Foreign Exchange Market, 13 Role of Financial Institutions, 13 Role of Depository Institutions, 14 Role of Nondepository Financial Institutions, 15 Comparison of Roles among Financial Institutions, 16 Relative Importance of Financial Institutions, 18 Consolidation of Financial Institutions, 19 Impact of the Internet on Financial Institutions, 21 Global Expansion by Financial Institutions, 21 Impact of the Credit Crisis on Financial Institutions, 21 Summary, 22 Point Counter-Point: Will Computer Technology Cause Financial Intermediaries to Become Extinct? 23 Questions and Applications, 23 Advanced Questions, 24 Interpreting Financial News, 24 Managing in Financial Markets, 24 Flow of Funds Exercise: Roles of Financial Markets and Institutions, 25 Internet/Excel Exercises, 25 WSJ Exercise: Differentiating between Primary and Secondary Markets, 26 Term Paper on the Credit Crisis, 27

x Contents 2: DETERMINATION OF INTEREST RATES 29 Loanable Funds Theory, 29 Household Demand for Loanable Funds, 29 Business Demand for Loanable Funds, 30 Government Demand for Loanable Funds, 31 Foreign Demand for Loanable Funds, 32 Aggregate Demand for Loanable Funds, 32 Supply of Loanable Funds, 34 Equilibrium Interest Rate, 35 Factors That Affect Interest Rates, 36 Impact of Economic Growth on Interest Rates, 37 Impact of Inflation on Interest Rates, 38 Impact of Monetary Policy on Interest Rates, 39 Impact of the Budget Deficit on Interest Rates, 39 Impact of Foreign Flows of Funds on Interest Rates, 40 Summary of Forces That Affect Interest Rates, 41 Forecasting Interest Rates, 43 Summary, 45 Point Counter-Point: Does a Large Fiscal Budget Deficit Result in Higher Interest Rates? 45 Questions and Applications, 45 Advanced Questions, 46 Interpreting Financial News, 46 Managing in Financial Markets, 46 Problems, 47 Flow of Funds Exercise: How the Flow of Funds Affects Interest Rates, 47 Internet/Excel Exercises, 47 WSJ Exercise: Forecasting Interest Rates, 48 3: STRUCTURE OF INTEREST RATES " 49 Why Debt Security Yields Vary, 49 Credit (Default) Risk, 49 Liquidity, 51 Tax Status, 51 Term to Maturity, 52 Explaining Actual Yield Differentials, 53 Yield Differentials of Money Market Securities, 53 Yield Differentials of Capital Market Securities, 53 Estimating the Appropriate Yield, 54 Using the Wall Street Journal: Assessing the Yield Curve, 56 A Closer Look at the Term Structure, 56 Pure Expectations Theory, 56 Liquidity Premium Theory, 61 Segmented Markets Theory, 63 Research on Term Structure Theories, 64 Integrating the Theories of the Term Structure, 65 Uses of the Term Structure, 66 Why the Slope of the Yield Curve Changes, 67 How the Yield Curve Has Changed over Time, 68 International Structure of Interest Rates, 68 Summary, 70

Contents xi Point Counter-Point: Should a Yield Curve Influence a Borrower's Preferred Maturity of a Loan? 70 Questions and Applications, 71 Advanced Questions, 71 Interpreting Financial News, 72 Managing in Financial Markets, 72 Problems, 72 Flow of Funds Exercise: Influence of the Structure of Interest Rates, 73 Internet/Excel Exercises, 74 WSJ Exercise: Interpreting the Structure of Interest Rates, 74 Part 1 Integrative Problem: Interest Rate Forecasts and Investment Decisions, 76 Questions, 77 PART 2: The Fed and Monetary Policy 79 4: FUNCTIONS OF THE FED 81 Organizational Structure of the Fed, 81 Federal Reserve District Banks, 81 Member Banks, 83 Board of Governors, 83 Federal Open Market Committee (FOMC), 83 Advisory Committees, 83 Integration of Federal Reserve Components, 84 How the Fed Controls the Money Supply, 84 Open Market Operations, 84 Role of the Fed's Trading Desk, 86 How Fed Operations Affect All Interest Rates, 88 Using the Wall Street Journal: The Federal Funds Rate, 89 Adjusting the Reserve Requirement Ratio, 90 Adjusting the Fed's Loan Rate, 91 The Fed's Lending Role during the Credit Crisis, 92 Facilities Created by the Fed, 92 Global Monetary Policy, 93 A Single Eurozone Monetary Policy, 93 Global Central Bank Coordination, 95 Summary, 95 Point Counter-Point: Should There Be a Global Central Bank? 96 Questions and Applications, 96 Interpreting Financial News, 97 Managing in Financial Markets, 97 Flow of Funds Exercise: Monitoring the Fed, 97 Internet/Excel Exercise, 98 WSJ Exercise: Reviewing Fed Policies, 98 5: MONETARY POLICY 99 Mechanics of Monetary Policy, 99 Indicators oj Economic Growth, 99 Using the Wall Street Journal: The Consumer Price Index, 101 Indicators of Inflation, 101 How Monetary Policy Corrects the Economy, 102 Limitations of Monetary Policy, 103

xii Contents Tradeoff in Monetary Policy, 107 Impact of Other Forces on the Tradeoff, 107 Shifts in Monetary Policy 2001-2008, 109 How Monetary Policy Responds to Fiscal Policy, 110 Proposals to Focus on Inflation, 110 Impact of Monetary Policy, 111 Impact on Financial Markets, 112 Impact on Financial Institutions, 115 Global Monetary Policy, 115 Impact of the Dollar, 115 Impact of Global Economic Conditions, 116 Transmission of Interest Rates, 116 Summary, 117 Point Counter-Point: Can the Fed Prevent U.S. Recessions? 117 Questions and Applications, 117 Advanced Questions, 118 Interpreting Financial News, 119 Flow of Funds Exercise: Anticipating Fed Actions, 119 Internet/Excel Exercises, 119 WSJ Exercise: Market Assessment of Fed Policy, 120 Part 2 Integrative Problem: Fed Watching, 121 Questions, 122 PART 3: Debt Security Markets 123 6: MONEY MARKETS 125 Money Market Securities, 125 Treasury Bills, 126 Commercial Paper, 129 Negotiable Certificates of Deposit (NCDs), 131 Repurchase Agreements, 132 Federal Funds, 133 Banker's Acceptances, 133 Using the Wall Street Journal: Rates on Banker's Acceptances, 134 Institutional Use of Money Markets, 135 Valuation of Money Market Securities, 137 Impact of Changes in Credit Risk, 139 Interest Rale Risk, 139 Globalization of Money Markets, 141 Eurodollar Securities, 141 International Interbank Market, 143 Performance of Foreign Money Market Securities, 143 Summary, 145 Point Counter-Point: Should Firms Invest in Money Market Securities? 145 Questions and Applications, 145 Advanced Questions, 146 Interpreting Financial News, 146 Managing in Financial Markets, 146 Problems, 147

Contents xiii Flow of Funds Exercise: Financing in the Money Markets, 148 Internet/Excel Exercises, 148 WSJ Exercise: Assessing Yield Differentials of Money Market Securities, 148 7: BOND MARKETS 149 Background on Bonds, 149 Institutional Use of Bond Markets, 149 Bond Yields, 150 Treasury and Federal Agency Bonds, 151 Treasury Bond Auction, 152 Trading Treasury Bonds, 152 Treasury Bond Quotations, 153 Stripped Treasury Bonds, 153 Inflation-Indexed Treasury Bonds, 154 Savings Bonds, 154 Federal Agency Bonds, 155 Municipal Bonds, 155 Credit Risk, 155 Characteristics of Municipal Bonds, 156 Trading and Quotations, 156 Yields Offered on Municipal Bonds, 156 Corporate Bonds, 158 Corporate Bond Offerings, 158 Characteristics of Corporate Bonds, 159 Corporate Bond Yields and Risk, 161 Using the Wall Street Journal: Bond Yields, 162 Secondary Market for Corporate Bonds, 163 Junk Bonds, 164 How Corporate Bonds Finance Restructuring, 165 Globalization of Bond Markets, 166 Eurobond Market, 167 Other Types of Long-Term Debt Securities, 167 Structured Notes, 167 Exchange-Traded Notes, 168 Auction-Rate Securities, 168 Summary, 169 Point Counter-Point: Should Financial Institutions Invest in Junk Bonds? 169 Questions and Applications, 169 Advanced Questions, 170 Interpreting Financial News, 170 Managing in Financial Markets, 170 Problems, 171 Flow of Funds Exercise: Financing in the Bond Markets, 171 Internet/Excel Exercise, 172 WSJ Exercise: Impact of Treasury Financing on Bond Prices, 172 8: BOND VALUATION AND RISK 173 Bond Valuation Process, 173 Impact of the Discount Rate on Bond Valuation, 174 Impact of the Timing of Payments on Bond Valuation, 175 Valuation of Bonds with Semiannual Payments, 175 Relationships between Coupon Rate, Required Return, and Bond Price, 176

xiv Contents Explaining Bond Price Movements, 178 Factors That Affect the Risk-Free Rate, 178 Factors That Affect the Credit (Default) Risk Premium, 180 Summary of Factors Affecting Bond Prices, 181 Implications for Financial Institutions, 182 Using the Wall Street Journal: Bond Values, 183 Sensitivity of Bond Prices to Interest Rate Movements, 184 Bond Price Elasticity, 184 Duration, 185 Bond Investment Strategies, 189 Matching Strategy, 189 Laddered Strategy, 189 Barbell Strategy, 189 Interest Rate Strategy, 189 Valuation and Risk of International Bonds, 190 Influence of Foreign Interest Rate Movements, 190 Influence of Credit Risk, 190 Influence of Exchange Rate Fluctuations, 191 International Bond Diversification, 191 Summary, 192 Point Counter-Point: Does Governance of Firms Affect the Prices of Their Bonds? 193 Questions and Applications, 193 Advanced Questions, 194 Interpreting Financial News, 195 Managing in Financial Markets, 195 Problems, 195 Flow of Funds Exercise: Interest Rate Expectations, Economic Growth, and Bond Financing, 197 Internet/Excel Exercises, 198 Appendix 8: Forecasting Bond Prices and Yields 199-. ^ 9: MORTGAGE MARKETS 2O5 Background on Mortgages, 205 Flow Mortgage Markets Facilitate the Flow of Funds, 205 Criteria Used to Measure Creditworthiness, 207 Classification of Mortgages, 207 Types of Residential Mortgages, 208 Fixed-Rate Mortgages, 208 Adjustable-Rate Mortgages (ARMs), 209 Using the Wall Street Journal: Mortgage Rates, 210 Graduated-Payment Mortgages (GPMs), 210 Growing-Equity Mortgages, 211 Second Mortgages, 211 Shared-Appreciation Mortgages, 211 Balloon Payment Mortgages, 211 Valuation and Risk of Mortgages, 211 Risk from Investing in Mortgages, 212 Mortgage-Backed Securities, 213 The Securitization Process, 213 Mortgage-Backed Securities within CDOs, 214 Types of Mortgage-Backed Securities, 214 Risk of Mortgage-Backed Securities, 216

Contents xv Mortgage Credit Crisis, 217 Who Is to Blame? 217 Contagion Effects of the Credit Crisis, 219 Government Programs Implemented in Response to the Crisis, 219 Impact of the Credit Crisis on Fannie Mae and Freddie Mac, 219 Government Bailout of Financial Institutions, 221 Summary, 221 Point Counter-Point: Is the Trading of Mortgages Similar to the Trading of Corporate Bonds? 222 Questions and Applications, 222 Advanced Questions, 222 Interpreting Financial News, 223 Managing in Financial Markets, 223 Problem, 224 Flow of Funds Exercise: Mortgage Financing, 224 Internet/Excel Exercise, 224 WSJ Exercise: Explaining Mortgage Rate Premiums, 224 Part 3 Integrative Problem: Asset Allocation, 225 Questions, 225 PART 4: Equity Markets 227 1 O: STOCK OFFERINGS AND INVESTOR MONITORING 229 Private Equity, 229 Financing by Venture Capital Funds, 229 Financing by Private Equity Funds, 230 Public Equity, 230 Ownership and Voting Rights, 232 Preferred Stock, 232 Participation in Stock Markets, 232 Initial Public Offerings, 234 Process of Going Public, 234 Underwriter Efforts to Ensure Price Stability, 236 Timing of IPOs, 237 Initial Returns of IPOs, 237 Using the Wall Street Journal: Recent IPO Performance, 238 Google's IPO, 238 Abuses in the IPO Market, 240 Long-Term Performance Following IPOs, 240 Impact of the Sarbanes-Oxley Act on IPOs, 241 Secondary Stock Offerings, 241 Shelf-Registration, 242 Stock Repurchases, 242 Stock Exchanges, 242 Organized Exchanges, 242 Over-the-Counter Market, 244 Electronic Stock Exchanges, 245 Extended Trading Sessions, 245 Stock Quotations Provided by Exchanges, 245 Using the Wall Street Journal: Late Trading, 246 Stock Index Quotations, 248 Using the Wall Street Journal: Stock Market Review, 249

xviii Contents Internet/Excel Exercises, 321 Part 4 Integrative Problem: Stock Market Analysis, 322 Questions, 322 PART 5: Derivative Security Markets 323 1 3: FINANCIAL FUTURES MARKETS 325 Background on Financial Futures, 325 Purpose of Trading Financial Futures, 325 Structure of the Futures Market, 326 Trading Futures, 327 Interpreting Financial Futures Tables, 327 Valuation of Financial Futures, 328 Using the Wall Street Journal: Interest Rate Futures, 329 Impact of the Opportunity Cost, 329 Explaining Price Movements of Bond Futures Contracts, 330 Speculating with Interest Rate Futures, 331 Impact of Leverage, 332 Closing Out the Futures Position, 332 Hedging with Interest Rate Futures, 333 Using Interest Rate Futures to Create a Short Hedge, 333 Using Interest Rate Futures to Create a Long Hedge, 336 Hedging Net Exposure, 336 Bond Index Futures, 336 Stock Index Futures, 337 Valuing Stock Index Futures Contracts, 338 Speculating with Stock Index Futures, 339 Hedging with Stock Index Futures, 339 Using the Wall Street Journal: Stock Index Futures Contracts, 340 Dynamic Asset Allocation with Stock Index Futures, 341 Prices of Stock Index Futures versus Stocks, 342 Arbitrage with Stock Index Futures, 342 Circuit Breakers on Stock Index Futures, 343 Single Stock Futures, 343 Risk of Trading Futures Contracts, 344 Market Risk, 344 Basis Risk, 344 Liquidity Risk, 345 Credit Risk, 345 Prepayment Risk, 345 Operational Risk, 345 Regulation in the Futures Markets, 346 Institutional Use of Futures Markets, 346 Globalization of Futures Markets, 347 Non-U.S. Participation in U.S. Futures Contracts, 347 Foreign Stock Index Futures, 347 Currency Futures Contracts, 348 Summary, 349 Point Counter-Point: Has the Futures Market Created More Uncertainty for Stocks? 349

.Contents xix Questions and Applications, 349 Advanced Questions, 350 Interpreting Financial News, 350 Managing in Financial Markets, 351 Problems, 351 Flow of Funds Exercise: Hedging with Futures Contracts, 351 Internet/Excel Exercises, 352 1 4: OPTIONS MARKETS 353 Background on Options, 353 Markets Used to Trade Options, 354 How Option Trades Are Executed, 355 Types of Orders, 355 Stock Option Quotations, 355 Speculating with Stock Options, 356 Speculating with Call Options, 356 Speculating with, Put Options, 357 Excessive Risk from Speculation, 360 Determinants of Stock Option Premiums, 361 Determinants of Call Option Premiums, 361 Determinants of Put Option Premiums, 362 ' Explaining Changes in Option Premiums, 364 Indicators Monitored by Participants in the Options Market, 365 Hedging with Stock Options, 365 Hedging with Call Options, 365 Hedging with Put Options, 367 Using Options to Measure a Stock's Risk, 367 Options on ETFs and Stock Indexes, 368 Hedging with Stock Index Options, 368 Dynamic Asset Allocation with Stock Index Options, 369 Using Index Options to Measure the Market's Risk, 370 Options on Futures Contracts, 370 Speculating with Options on Futures, 371 Hedging with Options on Futures, 372 Hedging with Options on Interest Rate Futures, 372 Hedging with Options on Stock Index Futures, 373 Institutional Use of Options Markets, 375 Options as Compensation, 375 Globalization of Options Markets, 376 Currency Options Contracts, 377 Summary, 377 Point Counter-Point: If You Were a Major Shareholder of a Publicly Traded Firm, Would You Prefer That Stock Options Be Traded on That Stock? 378 Questions and Applications, 378 Advanced Questions, 378 Interpreting Financial News, 379 Managing in Financial Markets, 379 Problems, 380 Flow of Funds Exercise: Hedging with Options Contracts, 381 Internet/Excel Exercises, 382 WSJ Exercise: Assessing Stock Option Information, 382 Appendix 14: Option Valuation, 383

xx Contents 1 5: SWAP MARKETS 391 Background, 391 Use of Swaps for Hedging, 392 Use of Swaps for Speculating, 393 Participation by Financial Institutions, 393 Types of Interest Rate Swaps, 394 Plain Vanilla Swaps, 394 Forward Swaps, 396 Callable Swaps, 397 Putable Swaps, 397 Extendable Swaps, 398 Zero-Coupon-for-Floating Swaps, 398 Rate-Capped Swaps, 400 Equity Swaps, 400 Other Types of Swaps, 401 Risks of Interest Rate Swaps, 402 Basis Risk, 402 Credit Risk, 402 Sovereign Risk, 403 Pricing Interest Rate Swaps, 403 Prevailing Market Interest Rates, 403 Availability of Counterparties, 403 Credit and Sovereign Risk, 404 Factors Affecting the Performance of Interest Rate Swaps, 404 Interest Rate Caps, Floors, and Collars, 404 Interest Rate Caps, 405 Interest Rate Floors, 406 Interest Rate Collars, 407 Credit Default Swaps, 408 Development of the CDS Market, 409 Payments on a Credit Default Swap, 409 How CDSs Affect Debtor-Creditor Negotiations, 409 Impact of the Credit Crisis on the CDS Market, 409 Globalization of Swap Markets, 410 Currency Swaps, 411 Summary, 413 Point Counter-Point: Should Financial Institutions Engage in Interest Rate Swaps for Speculative Purposes? 414 Questions and Applications, 414 Advanced Questions, 415 Interpreting Financial News, 415 Managing in Financial Markets, 415 Problems, 415 Flow of Funds Exercise: Hedging with Interest Rate Derivatives, 416 Internet/Excel Exercises, 416 WSJ Exercise: Impact of Interest Rates on a Swap Arrangement, 416 1 6: FOREIGN EXCHANGE DERIVATIVE MARKETS 417 Foreign Exchange Markets, 417 Institutional Use of Foreign Exchange Markets, 417 Exchange Rate Quotations, 418 Types of Exchange Rate Systems, 419

Contents xxi Factors Affecting Exchange Rates, 420 Differential Inflation Rates, 420 Differential Interest Rates, 421 Central Bank Intervention, 421 Foreign Exchange Controls, 423 Forecasting Exchange Rates, 423 Technical Forecasting, 423 Fundamental Forecasting, 424 Market-Based Forecasting, 424 Mixed Forecasting, 424 Foreign Exchange Derivatives, 425 Forward Contracts, 425 Currency Futures Contracts, 426 Currency Swaps, 426 Currency Options Contracts, 426 Using the Wall Street Journal: Currency Futures Contracts. 427 Use of Foreign Exchange Derivatives for Speculating, 429 International Arbitrage, 431 Locational Arbitrage, 431 Triangular Arbitrage, 431 Covered Interest Arbitrage, 432 Summary, 433 Point Counter-Point: Do Financial Institutions Need to Consider Foreign Exchange Market Conditions When Making Domestic Security Market Decisions? 434 Questions and Applications, 434 Advanced Questions, 435 Interpreting Financial News, 435 Managing in Financial Markets, 435 Problems, 435 Flow of Funds Exercise: Hedging with Foreign Exchange Derivatives, 436 Internet/Excel Exercises, 436 WSJ Exercise: Assessing Exchange Rate Movements, 436 Appendix 16A: Impact of the Asian Crisis on Foreign Exchange Markets and Other Financial Markets, 437 Appendix 16B: Currency Option Pricing, 447 Part 5 Integrative Problem: Choosing among Derivative Securities, 451 Questions, 451 Midterm Self-Exam, 453 Midterm Review, 453 Midterm Self-Exam, 454 Answers to Midterm Self-Exam, 456 PART 6: Commercial Banking 459 1 7: COMMERCIAL BANK OPERATIONS 461 Background on Commercial Banks, 461 Bank Market Structure, 461 Bank Sources of Funds, 462 Transaction Deposits, 463 Savings Deposits, 463

xxii Contents Time Deposits, 463 Money Market Deposit Accounts, 464 Federal Funds Purchased, 464 Borrowing from the Federal Reserve Banks, 465 Repurchase Agreements, 465 Eurodollar Borrowings, 466 Bonds Issued by the Bank, 466 Bank Capital, 466 Distribution of Bank Sources of Funds, 467 Uses of Funds by Banks, 467 Cash, 468 Bank Loans, 468 Using the Wall Street Journal: Prime Rates, 470 Investment in Securities, 472 Federal Funds Sold, 473 Repurchase Agreements, 473 Eurodollar Loans, 473 Fixed Assets, 473 Summary of Bank Uses of Funds, 473 Off-Balance Sheet Activities, 475 Loan Commitments, 476 Standby Letters of Credit, 476 Forward Contracts on Currencies, 476 Interest Rate Swap Contracts, 477 Credit Default Swap Contracts, 477 International Banking, 477 Global Competition in Foreign Countries, 477 Impact of the Euro on Global Competition, 478 Summary, 478 Point Counter-Point: Should Banks Engage in Other Financial Services Besides Banking? 479 Questions and Applications, 479 Interpreting Financial News, 479 Managing in Financial Markets, 479 Flow of Funds Exercise: Services Provided by Financial Conglomerates, 480 Internet/Excel Exercise, 480 1 8: BANK REGULATION 481 Background, 481 Background Structure, 481 Regulators, 482 Regulation of Bank Ownership, 482 Regulation of Bank Operations, 482 Regulation of Deposit Insurance, 482 Regulation of Deposits, 484 Regulation of Bank Loans, 484 Regulation of Bank Investment in Securities, 485 Regulation of Securities Services, 485 Regulation of Insurance Services, 486 Regulation of Off-Balance Sheet Transactions, 486 Regulation of the Accounting Process, 487

Contents xxiii Regulation of Capital, 488 Basel I Accord, 488 Basel II Accord, 488 Use of the VAR Method to Determine Capital Requirements, 490 How Regulators Monitor Banks, 491 CAMELS Ratings, 491 Corrective Action by Regulators, 494 Funding the Closure of Failing Banks, 494 Global Bank Regulations, 496 Summary, 496 Point Counter-Point: Should Regulators Intervene to Take Over Weak Banks? 497 Questions and Applications, 497 Interpreting Financial News, 498 Managing in Financial Markets, 498 Flow of Funds Exercise: Impact of Regulation and Deregulation on Financial Services, 498 Internet/Excel Exercise, 498 WSJ Exercise: Impact of Bank Regulations, 498 1 9: BANK MANAGEMENT 499 Bank Management Goals and Structures, 499 Board of Directors, 499 Overview oj Bank Management, 500 Management of Operations, 500 Managing Liquidity, 500 Use of Securitization to Boost Liquidity, 501 Liquidity Problems, 501 Managing Interest Rate Risk, 501 Methods Used to Assess Interest Rate Risk, 502 Whether to Hedge Interest Rate Risk, 507 Methods Used to Reduce Interest Rate Risk, 507 International Interest Rate Risk, 511 Managing Credit Risk, 512 Measuring Credit Risk, 512 Tradeoff between Credit Risk and Return, 513 Reducing Credit Risk, 513 Managing Market Risk, 514 Measuring Market Risk, 515 Methods Used to Reduce Market Risk, 515 Integrated Bank Management, 516 Application, 516 Managing Risk of International Operations, 519 Exchange Rate Risk, 519 Settlement Risk, 520 Participation in Financial Markets, 520 Summary, 521 Point Counter-Point: Can Bank Failures Be Avoided? 521 Questions and Applications, 521 Advanced Questions, 522 Interpreting Financial News, 522 Managing in Financial Markets, 522

xxiv Contents Problems, 523 Flow of Funds Exercise: Managing Credit Risk, 525 Internet/Excel Exercises, 526 WSJ Exercise: Bank Management Strategies, 526 2 O: BANK PERFORMANCE 527 Valuation of a Commercial Bank, 527 Factors That Affect Cash Flows, 527 Factors That Affect the Required Rate of Return by Investors, 529 Performance of Banks, 530 Interest Income and Expenses, 530 Noninterest Income and Expenses, 531 Net Income, 533 How to Evaluate a Bank's Performance, 533 Examination of Return on Assets (ROA), 534 Application, 535 Summary, 537 Point Counter-Point: Does a Bank's Income Statement Clearly Indicate the Bank's Performance? 537 Questions and Applications, 537 Interpreting Financial News, 538 Managing in Financial Markets, 538 Problem, 538 Flow of Funds Exercise: How the Flow of Funds Affects Bank Performance, 539 Internet/Excel Exercises, 539 WSJ Exercise: Assessing Bank Performance, 539 Part 6 Integrative Problem: Forecasting Bank Performance, 540 Questions, 541 PART 7: Nonbank Operations 543 21: THRIFT OPERATIONS 545 Background on Savings Institutions, 545 Ownership of Savings Institutions, 545 Regulation of Savings Institutions, 546 Regulatory Assessment of Savings Institutions, 546 Deregulation of Services, 546 Sources and Uses of Funds, 546 Sources of Funds, 547 Uses of Funds, 548 Balance Sheet of Savings Institutions, 549 Exposure to Risk, 550 Liquidity Risk, 550 Credit Risk, 551 Interest Rate Risk, 552 Management of Interest Rate Risk, 553 Adjustable-Rate Mortgages (ARMs), 553 Interest Rate Futures Contracts, 554 Interest Rate Swaps, 554 Conclusions about Interest Rate Risk, 554

Contents xxv Interaction with Other Financial Institutions, 555 Participation in Financial Markets, 555 Valuation of a Savings Institution, 556 Factors That Affect Cash Flows, 556 Factors That Affect the Required Rate of Return, 557 Exposure of Savings Institutions to Crises, 557 Savings Institution Crisis in the Late 1980s, 557 The Credit Crisis, 559 Credit Unions, 560 Ownership of Credit Unions, 560 Advantages and Disadvantages of Credit Unions, 561 Credit Union Sources of Funds, 561 Credit Union Uses of Funds, 562 Regulation of Credit Unions, 562 Exposure of Credit Unions to Risk, 563 Summary, 563 Point Counter-Point: Can All Savings Institutions Avoid Failure? 564 Questions and Applications, 564 Interpreting Financial News, 565 Managing in Financial Markets, 565 Flow of Funds Exercise: Market Participation by Savings Institutions, 566 Internet/Excel Exercises, 566 WSJ Exercise: Assessing Performance of Savings Institutions, 566 2 2: FINANCE OPERATIONS 567 Types of Finance Companies, 567 Consumer Finance Companies, 567 Business Finance Companies, 567 Captive Finance Subsidiaries, 568 Sources and Uses of Funds, 568 Sources of Funds, 568 Uses of Finance Company Funds, 569 Risks Faced by Finance Companies, 571 Liquidity Risk, 571 Interest Rate Risk, 571 Credit Risk, 572 Valuation of a Finance Company, 572 Factors That Affect Cash Flows, 572 Factors That Affect the Required Rate of Return, 573 Interaction with Other Financial Institutions, 573 Participation in Financial Markets, 574 Multinational Finance Companies, 575 Summary, 575 Point Counter-Point: Will Finance Companies Be Replaced by Banks? 576 Questions and Applications, 576 Interpreting Financial News, 576 Managing in Financial Markets, 576 Flow of Funds Exercise: How Finance Companies Facilitate the Flow of Funds, 577 Internet/Excel Exercises, 577 WSJ Exercise: Finance Company Performance, 577

xxvi Contents 2 3: MUTUAL FUND OPERATIONS 579 Background on Mutual Funds, 579 Types of Funds, 579 Comparison to Depository Institutions, 581 Regulation, 581 Estimating the Net Asset Value, 582 Distributions to Shareholders, 582 Mutual Fund Classifications, 583 Management of Mutual Funds, 583 Expenses Incurred by Shareholders, 584 Sales Load, 585 12b-l Fees, 586 Governance of Mutual Funds, 586 Late Trading Scandal, 587 Corporate Control by Mutual Funds, 587 Mutual Fund Categories, 587 Stock Mutual Fund Categories, 588 Bond Mutual Fund Categories, 589 Asset Allocation Funds, 591 Growth and Size of Mutual Funds, 591 Performance of Mutual Funds, 593 Performance of Stock Mutual Funds, 593 Using the Wall Street Journal: Performance of Mutual Fund Indexes, 594 Performance from Diversifying among Mutual, 595 Performance of Closed-End Stock Funds, 595 Performance of Bond Mutual Funds, 595 Research on Mutual Fund Performance, 596 Money Market Funds, 596 Asset Composition of Money Market Funds, 598 Maturity of Money Market Funds, 598 Risk of Money Market Funds, 599 Management of Money Market Funds, 600 Regulation and Taxation of Money Market Funds, 600 Other Types of Funds, 600 Exchange-Traded Funds, 601 Venture Capital Funds, 602 Private Equity Funds, 602 Hedge Funds, 604 Real Estate Investment Trusts, 607 Interaction with Other Financial Institutions, 607 Use of Financial Markets, 608 Globalization through Mutual Funds, 609 Summary, 610 Point Counter-Point: Should Mutual Funds Be Subject to More Regulation? 610 Questions and Applications, 610 Advanced Questions, 611 Interpreting Financial News, 611 Managing in Financial Markets, 611 Flow of Funds Exercise: How Mutual Funds Facilitate the Flow of Funds, 612 Internet/Excel Exercises, 612 WSJ Exercise: Finance Company Performance, 613

Contents xxvii 2 4: SECURITIES OPERATIONS 615 Services Provided by Securities Firms, 615 Facilitating New Stock Offerings, 615 Facilitating New Bond Offerings, 617 Facilitating Leveraged Buyouts, 618 Facilitating Arbitrage, 619 Facilitating Corporate Restructuring, 620 Providing Brokerage Services, 621 Investing Their Own Funds, 623 Summary of Services Provided, 624 Interaction with Other Financial Institutions, 625 Participation in Financial Markets, 625 Regulation of Securities Firms, 625 Financial Services Modernization Act, 627 Regulation FD, 628 Analyst Compensation and Ratings, 628 Rules' Preventing Abuses in the IPO Market, 629 Repeal of the Trade-Through Rule, 629 Risks of Securities Firms, 629 Market Risk, 629 Interest Rate Risk, 629 Credit Risk, 630 Exchange Rate Risk, 630 Valuation of a Securities Firm, 630 Factors That Affect Cash Flows, 630 Factors That Affect the Required Rate of Return, 631 Impact of the Credit Crisis on Securities Firms, 631 Government Assistance to Bear Stearns, 631 Failure of Lehman Brothers, 634 Impact of the Crisis on Regulatory Reform, 635 Globalization of Securities Firms, 636 Growth in International Joint Ventures, 636 Growth in International Securities Transactions, 636 Summary, 637 Point Counter-Point: Should Analysts Be Separated from Securities Firms to Prevent Conflicts of Interest? 638 Questions and Applications, 638 Interpreting Financial News, 638 Managing in Financial Markets, 639 Flow of Funds Exercise: How Securities Firms Facilitate the Flow of Funds, 639 Internet/Excel Exercises, 639 WSJ Exercise: Performance of Securities Firms, 640 2 5: INSURANCE AND PENSION FUND OPERATIONS 641 Background, 641 Determinants of Insurance Premiums, 641 Investments by Insurance Companies, 643 Regulation of Insurance Companies, 643 Life Insurance Operations, 644 Ownership, 645 Types of Life Insurance, 645

xxviii Contents Sources of Funds, 645 Uses of Funds, 646 Asset Management of Life Insurance Companies, 648 Other Types of Insurance Operations, 649 Property and Casualty Insurance, 650 Health Care Insurance, 651 Business Insurance, 652 Bond Insurance, 652 Mortgage Insurance, 653 Interaction with Other Financial Institutions, 653 Participation in Financial Markets, 654 Exposure to Risk, 655 Interest Rate Risk, 655 Credit Risk, 655 Market Risk, 655 Liquidity Risk, 655 Valuation of an Insurance Company, 655 Factors That Affect Cash Flows, 656 Factors That Affect the Required Rate of Return by Investors, 656 Impact of the Credit Crisis, 657 Indicators of Value and Performance, 658 Multinational Insurance Companies, 659 Background on Pension Funds, 660 Public Pension Funds, 660 Private Pension Plans, 660 Pension Fund Participation in Financial Markets, 661 Pension Regulations, 662 Pension Fund Management, 664 Management of Insured versus Trust Portfolios, 664 Management of Portfolio Risk, 665 Corporate Control by Pension Funds, 665 Performance of Pension Funds, 665 Pension Fund's Stock Portfolio Performance, 666 Pension Fund's Bond Portfolio Performance, 666 Performance Evaluation, 667 Performance of Pension Portfolio Managers, 667 Performance during the Credit Crisis, 667 Summary, 668 Point Counter-Point: Should Pension Fund Managers Be More Involved with Corporate Governance? 668 Questions and Applications, 668 Interpreting Financial News, 669 Managing in Financial Markets, 669 Flow of Funds Exercise: How Insurance Companies Facilitate the Flow of Funds, 670 Internet/Excel Exercises, 670 WSJ Exercise: Insurance Company Performance, 670 Part 7 Integrative Problem: Assessing the Influence of Economic Conditions across a Financial Conglomerate's Units, 671 Questions, 671 Final Self-Exam, 672

Contents xxix Final Review, 672 Final Self-Exam, 673 Answers to Final Self-Exam, 674 Appendix A: Comprehensive Project 677 Appendix B: Using Excel to Conduct Analyses 687 Glossary 691 Index 705