SIXTH EDITION FREDERIC S. MISHKSN Graduate School of Business, Columbia University STANLEY G. EAKINS East Carolina University PEARSON Mr Boston San Francisco New York London Toronto Sydney Tokyo Singapore Madrid Mexico City Munich Paris Cape Town Hong Kong Montreal
PART ONE Chapter 1 Chapter 2 Contents on the Web Preface About the Authors INTRODUCTION Why Study Financial Markets and Institutions? Preview Why Study Financial Markets? Debt Markets and Interest Rates The Stock Market The Foreign Exchange Market Why Study Financial Institutions? Central Banks and the Conduct of Monetary Policy Structure of the Financial System Banks and Other Financial Institutions Financial Innovation Managing Risk in Financial Institutions Applied Managerial Perspective How We Will Study Financial Markets and Institutions Exploring the Web Collecting and Graphing Data Web Exercise Concluding Remarks Summary Key Terms Questions Quantitative Problems Web Exercises: Working with Financial Market Data Overview of the Financial System Preview Function of Financial Markets Structure of Financial Markets Debt and Equity Markets Primary and Secondary Markets s xxvn xxix xxxix 3 3 4 4 5 6 9 9 9 10 11 11 11 14 14 14 15 15 16 17 17 18 20 20 20 IX
Exchanges and Over-the-Counter Markets 21 Money and Capital Markets 22 Internationalization of Financial Markets 22 International Bond Market, Eurobonds, and Eurocurrencies 22 GLOBAL Are U.S. Capital Markets Losing Their Edge? 23 World Stock Markets 24 Function of Financial Intermediaries: Indirect Finance 24 FOLLOWING THE FINANCIAL NEWS Foreign Stock Market Indexes 25 Transaction Costs 25 GLOBAL The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison 26 Risk Sharing 27 Asymmetric Information: Adverse Selection and Moral Hazard 27 Types of Financial Intermediaries 29 Depository Institutions 29 Contractual Savings Institutions 30 Investment Intermediaries 32 Regulation of the Financial System 33 Increasing Information Available to Investors 33 Ensuring the Soundness of Financial Intermediaries 34 Financial Regulation Abroad 35 Summary 36 Key Terms 36 Questions 37 Web Exercises: The Financial System 37 PART TWO FUNDAMENTALS OF FINANCIAL MARKETS 39 Chapter 3 What Do Interest Rates Mean and What is Their Role in Valuation? 41 Preview 41 Measuring Interest Rates 42 Present Value 42 Four Types of Credit Market Instruments 44 Yield to Maturity 45 GLOBAL Negative T-Bill Rates? Japan Shows the Way 52 The Distinction Between Real and Nominal Interest Rates, 52 The Distinction Between Interest Rates and Returns ' 55 MINI-CASE With TIPS, Real Interest Rates Have Become Observable in the United States 56 Maturity and the Volatility of Bond Returns: Interest-Rate Risk 59 MINI-CASE Helping Investors Select Desired Interest-Rate Risk 59 Reinvestment Risk 60 Summary 60 THE PRACTICING MANAGER Calculating Duration to Measure Interest-Rate Risk 61 Calculating Duration 62 Duration and Interest-Rate Risk 66
xi Summary 67 Key Terms 68 Questions 68 Quantitative Problems 68 Web Exercises: Understanding Interest Rates 70 Chapter 4 Why Do Interest Rates Change? 71 Preview. 71 Determinants of Asset Demand 71 Wealth 72 Expected Returns 72 Risk 73 Liquidity 75 Summary 75 Supply and Demand in the Bond Market 75 Demand Curve 76 Supply Curve 77 Market Equilibrium 78 Supply and Demand Analysis 79 Changes in Equilibrium Interest Rates 79 Shifts in the Demand for Bonds 80 Shifts in the Supply of Bonds 83 CASE Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect 86 CASE Changes in the Interest Rate Due to a Business Cycle Expansion 87 CASE Explaining Low Japanese Interest Rates 89 CASE Reading the Wall Street Journal "Credit Markets" Column 90 FOLLOWING THE FINANCIAL NEWS The "Credit Markets" Column 91 THE PRACTICING MANAGER Profiting from Interest-Rate Forecasts 92 FOLLOWING THE FINANCIAL NEWS Forecasting Interest Rates 93 Summary 94 Key Terms 95 Questions 95 Quantitative Problems 96 Web Exercises: Interest Rates ond Inflation 97 Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 99 Preview 99 Risk Structure of Interest Rates 99 Default Risk 100 CASE The Enron Bankruptcy and the Baa-Aaa Spread 103 Liquidity 104 Income Tax Considerations 104 Summary 105 CASE Effects of the Bush Tax Cut on Bond Interest Rates 106 Term Structure of Interest Rates 107 FOLLOWING THE FINANCIAL NEWS Yield Curves 107
xii Contents in Detail Expectations Theory 109 Market Segmentation Theory 113 Liquidity Premium Theory 114 MINI-CASE The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle 118 Evidence on the Term Structure 118 Summary 119 CASE Interpreting Yield Curves, 1980-2008 119 THE PRACTICING MANAGER Using the Term Structure to Forecast Interest Rates 120 Summary 124 Key Terms 124 Questions 124 Quantitative Problems 125 Web Exercises: The Risk and Term Structures of interest Rotes 126 Chapter 6 Are Financial Markets Efficient? 127 Preview 127 The Efficient Market Hypothesis 128 Rationale Behind the Hypothesis 130 Stronger Version of the Efficient Market Hypothesis 131 Evidence on the Efficient Market Hypothesis 131 Evidence in Favor of Market Efficiency 131 MINI-CASE An Exception That Proves the Rule: Ivan Boesky 133 CASE Should Foreign Exchange Rates Follow a Random Walk? 135 Evidence Against Market Efficiency 135 Overview of the Evidence on the Efficient Market Hypothesis 137 THE PRACTICING MANAGER Practical Guide to Investing in the Stock Market 138 How Valuable Are Published Reports by Investment Advisers? 138 MINI-CASE Should You Hire an Ape as Your Investment Adviser? 138 Should You Be Skeptical of Hot Tips? 139 Do Stock Prices Always Rise When There Is Good News? 139 Efficient Markets Prescription for the Investor 140 CASE What Do the Black Monday Crash of 1987 and the Tech Crash of 2000 Tell Us About the Efficient Market Hypothesis? 141 Behavioral Finance 142 Summary 143 Key Terms 143 Questions ', 143 Quantitative Problems ' 144 Web Exercises: The Efficient Market Hypothesis 144 PART THREE CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY 145 Chapter 7 Structure of Central Banks and the Federal Reserve System 147 Preview 147 Origins of the Federal Reserve System 147 INSIDE THE FED The Political Genius of the Founders of the Federal Reserve System 148
xlil Structure of the Federal Reserve System 149 Federal Reserve Banks 150 INSIDE THE FED The Special Role of the Federal Reserve Bank of New York 151 Member Banks 152 Board of Governors of the Federal Reserve System 153 INSIDE THE FED The Role of the Research Staff 154 Federal Open Market Committee (FOMC) 155 The FOMC Meeting 155 INSIDE THE FED Green, Blue, and Beige: What Do These Colors Mean at the Fed? 156 Why the Chairman of the Board of Governors Really Runs the Show 156 How Independent Is the Fed? 157 Structure and Independence of the European Central Bank 158 Differences Between the European System of Central Banks and the Federal Reserve System 159 Governing Council 159 How Independent Is the ECB? 160 Structure and Independence of Other Foreign Central Banks 161 Bank of Canada 161 Bank of England 161 Bank of Japan 162 The Trend Toward Greater Independence 162 Explaining Central Bank Behavior 163 INSIDE THE FED Federal Reserve Transparency 163 Should the Fed Be Independent? 164 The Case for Independence 164 The Case Against Independence 165 Central Bank Independence and Macroeconomic Performance Throughout the World 166 Summary 166 Key Terms 167 Questions ani Problems 167 Web Exercises: The Structure of the Federal Reserve System 168 Chapter 8 Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics 169 Preview 169 The Federal Reserve's Balance Sheet 169 Liabilities 170 Assets - I 171 Open Market Operations 171 Discount Lending 172 The Market for Reserves and the Federal Funds Rate 173 Demand and Supply in the Market for Reserves 173 How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate 11A Tools of Monetary Policy 176 Open Market Operations 177 A Day at the Trading Desk 178
xiv Contents in Detail Discount Policy. 179 Operation of the Discount Window 179 Lender of Last Resort 180 INSIDE THE FED Using Discount Policy to Prevent a Financial Panic 182 Reserve Requirements 183 Monetary Policy Tools of the European Central Bank 183 Open Market Operations 184 Lending to Banks 184 Reserve Requirements 184 The Price Stability Goal and the Nominal Anchor 185 The Role of a Nominal Anchor 185 The Time-Inconsistency Problem 185 Other Goals of Monetary Policy 186 High Employment 186 Economic Growth 187 Stability of Financial Markets 187 Interest-Rate Stability 188 Stability in Foreign Exchange Markets 188 Should Price Stability Be the Primary Goal of Monetary Policy? 188 Hierarchical Versus Dual Mandates 189 Price Stability as the Primary, Long-Run Goal of Monetary Policy 189 Monetary Targeting 190 Monetary Targeting in the United States, Japan, and Germany 190 GLOBAL The European Central Bank's Monetary Policy Strategy 193 Advantages of Monetary Targeting 193 Disadvantages of Monetary Targeting 194 Inflation Targeting 194 Inflation Targeting in New Zealand, Canada, and the United Kingdom 194 Advantages of Inflation Targeting 196 Disadvantages of Inflation Targeting 197 INSIDE THE FED The New Fed Chairman and Inflation Targeting 199 Tactics: Choosing the Policy Instrument 199 Criteria for Choosing the Policy Instrument 202 THE PRACTICING MANAGER Using a Fed Watcher 203 Summary 204 Key Terms 205 Questions ; 205 Quantitative Problems 206 Web Exercises; Conduct of Monetary Poiicy 207 PART FOUR FINANCIAL MARKETS 209 Chapter 9 The Money Markets 211 Preview 211 The Money Markets Defined 211 Why Do We Need the Money Markets? 212 Money Market Cost Advantages 213
xv The Purpose of the Money Markets 214 Who Participates in the Money Markets? 215 U.S. Treasury Department 215 Federal Reserve System 215 Commercial Banks 215 Businesses 216 Investment and Securities Firms 216 Individuals 217 Money Market Instruments 217 Treasury Bills 218 CASE Discounting the Price of Treasury Securities to Pay the Interest 218 MINI-CASE Treasury Bill Auctions Go Haywire 220 Federal Funds 222 Repurchase Agreements 223 Negotiable Certificates of Deposit 224 Commercial Paper 224 Banker's Acceptances 227 Eurodollars 229 GLOBAL Ironic Birth of the Eurodollar Market 229 Comparing Money Market Securities 230 Interest Rates 230 Liquidity 231 FOLLOWING THE FINANCIAL NEWS Money Market Rates 232 How Money Market Securities Are Valued 233 Summary- 234 Key Terms 234 Questions 235 Quontitative Problems 235 Web Exercises: The Money Markets 236 Chapter 10 The Bond Market 237 Preview 237 Purpose of the Capital Market 237 Capital Market Participants - 238 Capital Market Trading 238 Types of Bonds 239 Treasury Notes and Bonds ; 240 Treasury Bond Interest Rates 240 Treasury Inflation Protected Securities (TIPS) 240 Treasury STRIPS 242 Agency Bonds 242 Municipal Bonds 243 Risk in the Municipal Bond Market 244 Corporate Bonds 244 Characteristics of Corporate Bonds 245 Types of Corporate Bonds 247
xvi Contents in Detail Financial Guarantees for Bonds 250 Current Yield Calculation.. 250 Current Yield 250 Finding the Value of Coupon Bonds 252 Finding the Price of Semiannual Bonds 252 Investing in Bonds 255 Summary 256 Key Terms 256 Questions 256 Quantitative Problems 257 Web Exercise: The Bond Market ' 258 Chapter 11 The Stock Market 259 Preview 259 Investing in Stocks 259 Common Stock Versus Preferred Stock 260 How Stocks Are Sold 261 Computing the Price of Common Stock 265 The One-Period Valuation Model 265 The Generalized Dividend Valuation Model 266 The Gordon Growth Model 267 Price Earnings Valuation Method 268 How the Market Sets Security Prices 269 Errors in Valuation 270 Problems with Estimating Growth 270 Problems with Estimating Risk 271 Problems with Forecasting Dividends 271 CASE The September 11 Terrorist Attack, the Enron Scandal, and the Stock Market 272 Stock Market Indexes 272 MINI-CASE History of the Dow Jones Industrial Average 273 Buying Foreign Stocks 275 Regulation of the Stock Market 275 The Securities and Exchange Commission 275 Summary 276 Key Terms 277 Questions 277 Quantitative Problems ' ; 277 Web Exercises: The Stock Market 279 Chapter 12 The Mortgage Markets 2si Preview 281 What Are Mortgages? 282 Characteristics of the Residential Mortgage 283 Mortgage Interest Rates 283 CASE The Discount Point Decision 284 Loan Terms 285
xvii Mortgage Loan Amortization. 287 CASE Computing the Payment on Mortgage Loans 288 Types of Mortgage Loans 289 Insured and Conventional Mortgages 289 Fixed- and Adjustable-Rate Mortgages 290 Other Types of Mortgages 290 Mortgage-Lending Institutions 293 Loan Servicing 294 E-FINANCE Borrowers Shop the Web for Mortgages 294 Secondary Mortgage Market 295 Securitization of Mortgages 295 What Is a Mortgage-Backed Security? 296 MINI-CASE Are Fannie Mae and Freddie Mac Getting Too Big for Their Britches? 296 Types of Pass-Through Securities 297 Mortgage-Backed Securities Clearing Corporation 298 The Impact of Securitized Mortgages on the Mortgage Market 299 Subprime Mortgages 299 Summary 300 Key Terms 301 Questions 301 Quantitative Problems 302 Web Exercises: The Mortgage Markets 303 Chapter 13 The Foreign Exchange Market 305 Preview 305 Foreign Exchange Market 306 What Are Foreign Exchange Rates? 307 Why Are Exchange Rates Important? 307 FOLLOWING THE FINANCIAL NEWS Foreign Exchange Rates 308 How Is Foreign Exchange Traded? 308 Exchange Rates in the Long Run 309 Law of One Price 309 Theory of Purchasing Power Parity 310 Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates 311 Factors That Affect Exchange Rates in the Long Run 311 Exchange Rates in the Short Run. 313 Comparing Expected Returns on Domestic and Foreign Assets 314 Interest Parity Condition 316 Demand Curve for Domestic Assets 317 Supply Curve for Domestic Assets 319 Equilibrium in the Foreign Exchange Market 319 Explaining Changes in Exchange Rates 319 Shifts in the Demand for Domestic Assets 319 CASE Changes in the Equilibrium Exchange Rate: Two Examples 324 Changes in Interest Rates 324
xviii Contents in Detail Changes in the Money Supply 325 Exchange Rate Overshooting 326 CASE Why Are Exchange Rates So Volatile? 327 CASE The Dollar and Interest Rates, 1973-2007 328 CASE The Euro's First Nine Years 329 CASE Reading the Wall Street Journal: The "Currency Trading" Column 330 FOLLOWING THE FINANCIAL NEWS The "Currency Trading" Column 331 THE PRACTICING MANAGER Profiting from Foreign Exchange Forecasts 332 Summory ' 333 Key Terms 333 Questions 333 Quantitative Problems 334 Web Exercises: The Foreign Exchange Market 335 Chapter 14 The International Financial System 337 Preview 337 Intervention in the Foreign Exchange Market 337 Foreign Exchange Intervention and the Money Supply 338 INSIDE THE FED A Day at the Federal Reserve Bank of New York's Foreign Exchange Desk 339 Unsterilized Intervention 340 Sterilized Intervention 341 Balance of Payments 342 Exchange Rate Regimes in the International Financial System 343 GLOBAL Why the Large U.S. Current Account Deficit Worries Economists 344 Fixed Exchange Rate Regimes 344 How a Fixed Exchange Rate Regime Works 345 GLOBAL The Euro's Challenge to the Dollar 345 GLOBAL Argentina's Currency Board 348 GLOBAL Dollarization 349 CASE The Foreign Exchange Crisis of September 1992 349 THE PRACTICING MANAGER Profiting from a Foreign Exchange Crisis 351 CASE Recent Foreign Exchange Crises in Emerging Market Countries: Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002 352 CASE How Did China Accumulate Over $1 Trillion of International Reserves? 353 Managed Float 354 Capital Controls 355 Controls on Capital Outflows. 355 Controls on Capital Inflows ' ' 355 The Role of the IMF 356, Should the IMF Be an International Lender of Last Resort? 356 How Should the IMF Operate? 358 Summary 359 Key Terms 359 Questions 360 Quoniitative Problems 361 Web Exercises: The International Financial System 361
xix PART FIVE FUNDAMENTALS OF FINANCIAL INSTITUTIONS 363 Chapter 15 Why Do Financial Institutions Exist? 365 Preview 365 Basic Facts About Financial Structure Throughout the World 365 Transaction Costs 369 How Transaction Costs Influence Financial Structure 369 How Financial Intermediaries Reduce Transaction Costs 369 Asymmetric Information: Adverse Selection and Moral Hazard 370 The Lemons Problem: How Adverse Selection Influences Financial Structure 371 Lemons in the Stock and Bond Markets 371 Tools to Help Solve Adverse Selection Problems 372 CONFLICTS OF INTEREST The Enron Implosion 374 How Moral Hazard Affects the Choice Between Debt and Equity Contracts 376 Moral Hazard in Equity Contracts: The Principal-Agent Problem 377 Tools to Help Solve the Principal-Agent Problem 378 How Moral Hazard Influences Financial Structure in Debt Markets 379 Tools to Help Solve Moral Hazard in Debt Contracts 380 Summary 382 CASE Financial Development and Economic Growth 383 CASE Is China a Counter-Example to the Importance of Financial Development? 385 Financial Crises and Aggregate Economic Activity 386 Factors Causing Financial Crises 386 CASE Financial Crises in the United States 389 MINI-CASE Case Study of a Financial Crisis: The Great Depression 391 CASE Financial Crises in Emerging Market Countries: Mexico, 1994 1995; East Asia, 1997-1998; and Argentina, 2001-2002 391 Summery 395 Key Terms 396 Questions 396 Quantitative Problems 397 Web Exercises: Why Do Financial Institutions Exist? 397 Chapter 16 What Should Be Done About Conflicts of Interest? A Central Issue in Business Ethics 399 Preview 399 What Are Conflicts of Interest and Why Are They Important? ; 400 Why Do We Care About Conflicts of Interest? 401 Ethics and Conflicts of Interest 401 Types of Conflicts of Interest 401 Underwriting and Research in Investment Banking 401 Auditing and Consulting in Accounting Firms 402 CONFLICTS OF INTEREST The King, Queen, and Jack of the Internet 403 CONFLiaS OF INTEREST Frank Quattrone and Spinning 404 Credit Assessment and Consulting in Credit-Rating Agencies 404
xx Contents in Detail CONFLICTS OF INTEREST The Collapse of Arthur Andersen 405 Universal Banking 405 MINI-CASE Why Do Issuers of Securities Pay to Have Their Securities Rated? 406 Can the Market Limit Exploitation of Conflicts of Interest? 406 CONFLICTS OF INTEREST Banksters 407 What Has Been Done to Remedy Conflicts of Interest? 410 Sarbanes-Oxley Act of 2002 410 Global Legal Settlement of 2002 410 A Framework for Evaluating Policies to Remedy Conflicts of Interest 411 Approaches to Remedying Conflicts of Interest 412 CASE Evaluating Sarbanes-Oxley and the Global Legal Settlement 414 Summary 417 Key Terms 417 Questions 417 Web Exercises: What Should Be Done About Conflicts of Interest? 418 PART SIX THE FINANCIAL INSTITUTIONS INDUSTRY im Chapter 17 Banking and the Management of Financial Institutions 421 Preview 421 The Bank Balance Sheet 421 Liabilities 422 Assets 424 Basic Banking 425 General Principles of Bank Management 428 Liquidity Management and the Role of Reserves 428 Asset Management 431 Liability Management 432 Capital Adequacy Management. 433 THE PRACTICING MANAGER Strategies for Managing Bank Capital 435 CASE Did the Capital Crunch Cause a Credit Crunch in the Early 1990s? 436 Off-Balance-Sheet Activities 437 Loan Sales 437 Generation of Fee Income 437 Trading Activities and Risk Management Techniques 438 CONFLICTS OF INTEREST Barings, Daiwa, Sumitomo, and Allied Irish: Rogue Traders and the Principal-Agent Problem 439 Measuring Bank Performance 440 Bank's Income Statement 440 Measures of Bank Performance 442 Recent Trends in Bank Performance Measures 443 Summary 444 Key Terms 445 Questions 445 Quantitative Problems 446 Web Exercises: Bonking and the Management of Financiai Institutions 447
xxi Chapter 18 Commercial Banking Industry: Structure and Competition 449 Preview 449 Historical Development of the Banking System 450 Multiple Regulatory Agencies 452 Financial Innovation and the Evolution of the Banking Industry 452 Responses to Changes in Demand Conditions: Interest Rate Volatility 453 Responses to Changes in Supply Conditions: Information Technology 454 E-FINANCE Will "Clicks" Dominate "Bricks" in the Banking Industry? 456 E-FINANCE Why Are Scandinavians So Far Ahead of Americans in Using Electronic Payments and Online Banking? 457 E-FINANCE Are We Headed for a Cashless Society? 458 Avoidance of Existing Regulations 460 THE PRACTICING MANAGER Profiting from a New Financial Product: A Case Study of Treasury Strips 462 Financial Innovation and the Decline of Traditional Banking 464 Structure of the U.S. Commercial Banking Industry 467 Restrictions on Branching 468 Response to Branching Restrictions 469 Bank Consolidation and Nationwide Banking 470 E-FINANCE Information Technology and Bank Consolidation 472 The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 472 What Will the Structure of the U.S. Banking Industry Look Like in the Future? 473 Are Bank Consolidation and Nationwide Banking Good Things? 473 Separation of Banking and Other Financial Service Industries 474 Erosion of Glass-Steagall 474 The Gramm-Leach-Bliley Financial Services Modernization Act of 1999: Repeal of Glass-Steagall 475 Implications for Financial Consolidation 475 Separation of the Banking and Other Financial Services Industries Throughout the World 475 International Banking 476 Eurodollar Market 477 Structure of U.S. Banking Overseas 477 Foreign Banks in the United States 478 Summary 479 Key Terms 480 Questions 480 Web Exercises: Commercial Banking Industry: Structure ond Competition / 481 Chapter 19 Savings Associations and Credit Unions 483 Preview 483 Mutual Savings Banks 484 Savings and Loan Associations 485 Mutual Savings Banks and Savings and Loans Compared 485 Savings and Loans in Trouble: The Thrift Crisis 486 Later Stages of the Crisis: Regulatory Forbearance 487 Competitive Equality in Banking Act of 1987 488
Political Economy of the Savings and Loan Crisis 489 Principal-Agent Problem for Regulators and Politicians 489 CASE Principal-Agent Problem in Action: Charles Keating and the Lincoln Savings and Loan Scandal 490 Savings and Loan Bailout: Financial Institutions Reform, Recovery, and Enforcement Act of 1989 491 The Savings and Loan Industry Today 492 Number of Institutions 493 S&L Size 493 S&L Assets 494 S&L Liabilities and Net Worth 496 Capital 496 Profitability and Health 496 The Future of the Savings and Loan Industry 497 Credit Unions 499 History and Organization 499 Sources of Funds 504 Uses of Funds 505 Advantages and Disadvantages of Credit Unions 505 The Future of Credit Unions 506 Summary 507 Key Terms 508 Questions 508 Web Exercises: Savings Associations and Credit Unions 509 Chapter 20 Banking Regulation 511 Preview 511 Asymmetric Information and Bank Regulation 511 Government Safety Net: Deposit Insurance and the FDIC 512 GLOBAL The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing? 514 Restrictions on Asset Holdings and Bank Capital Requirements 515 GLOBAL Basel 2: How Well Will It Work? 517 Bank Supervision: Chartering and Examination 518 Assessment of Risk Management 519 Disclosure Requirements 520 Consumer Protection 520 Restrictions on Competition 520 E-FINANCE Electronic Banking: New Challenges for Bank Regulation, 521 v International Banking Regulation ' 523 Problems in Regulating International Banking 523 Summary 524 The 1980s U.S. Banking Crisis 524 Federal Deposit Insurance Corporation Improvement Act of 1991 526 Banking Crises Throughout the World 527 Scandinavia 528 Latin America 529 Russia and Eastern Europe 530
xxili Japan 531 China 532 East Asia 532 "Dejd Vu All Over Again" 533 Summary 533 Key Terms 534 Questions 534 Quantitative Problems 534 Web Exercises: Banking Regulation 535 Chapter 21 The Mutual Fund Industry 537 Preview 537 The Growth of Mutual Funds 537 The First Mutual Funds 538 Benefits of Mutual Funds 538 Ownership of Mutual Funds 539 Mutual Fund Structure 542 Open- Versus Closed-End Funds 542 Organizational Structure 542 CASE Calculating a Mutual Fund's Net Asset Value 543 Investment Objective Classes 544 Equity Funds 544 Bond Funds 545 Hybrid Funds 546 Money Market Funds 546 Index Funds 548 Fee Structure of Investment Funds 549 Regulation of Mutual Funds 550 Hedge Funds 551 MINI-CASE The Long Term Capital Debacle 553 Conflicts of Interest in the Mutual Fund Industry 554 Sources of Conflicts of Interest 554 CONFLICTS OF INTEREST Many Mutual Funds Are Caught Ignoring Ethical Standards 555 Mutual Fund Abuses 555 CONFLICTS OF INTEREST SEC Survey Reports Mutual Fund Abuses Widespread 557 Government Response to Abuses 557 Summary, 558 x Key Terms ' 558 Questions 559 Quontitative Problems 559 Web Exercises: Investment Banks, Brokerage Firms, and Mutuol Funds 560 Chapter 22 Insurance Companies and Pension Funds 561 Preview 561 Insurance Companies 562 Fundamentals of Insurance 563
xxiv Contents in Detail Adverse Selection and Moral Hazard in Insurance 563 Selling Insurance 564 MINI-CASE Insurance Agent: The Customer's Ally 565 Growth and Organization of Insurance Companies 565 Types of Insurance 566 Life Insurance 567 Health Insurance 570 Property and Casualty Insurance 572 Insurance Regulation 574 CONFLICTS OF INTEREST Insurance Behemoth Charged with Conflicts of Interest Violations 574 THE PRACTICING MANAGER Insurance Management 575 Screening 575 Risk-Based Premium 576 Restrictive Provisions 576 Prevention of Fraud 577 Cancellation of Insurance 577 Deductibles 577 Coinsurance 577 Limits on the Amount of Insurance 577 Summary 578 Pensions 578 Types of Pensions 578 Defined-Benefit Pension Plans 579 Defined-Contribution Pension Plans 579 Private and Public Pension Plans 580 MINI-CASE Power to the Pensions 581 Regulation of Pension Plans 584 Employee Retirement Income Security Act 584 Individual Retirement Plans 587 The Future of Pension Funds 587 Summary 587 Key Terms 588 Questions 588 Quantitative Problems 589 Web Exercises: Insurance Companies and Pension Funds 589 Chapter 23 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms l 591 Preview 591 Investment Banks 592 Background 592 Underwriting Stocks and Bonds 593 FOLLOWING THE FINANCIAL NEWS New Securities Issues 596 Equity Sales 598 Mergers and Acquisitions 599 Securities Brokers and Dealers 600
xxv Brokerage Services 600 MINI-CASE Example of Using the Limit-Order Book 603 Securities Dealers 604 Regulation of Securities Firms 604 Relationship Between Securities Firms and Commercial Banks 605 Private Equity Investment 606 Venture Capital Firms 606 Private Equity Buyouts 610 E-FINANCE Venture Capitalists Lose Focus with Internet Companies 611 Advantages to Private Equity Buyouts 611 Life Cycle of the Private Equity Buyout 612 Implications of the Private Equity Ownership Structure 612 Summary 613. Key Terms 613 Questions 614 Quantitative Problems 614 Web Exercises: Investment Bonks, Security Brokers and Dealers, ond Venture Capital Firms 615 PART SEVEN THE MANAGEMENT OF FINANCIAL INSTITUTIONS 617 Chapter 24 Risk Management in Financial Institutions 619 Preview 619 Managing Credit Risk 619 Screening and Monitoring 620 Long-Term Customer Relationships 621 Loan Commitments 622 Collateral 622 Compensating Balances 622 Credit Rationing 623 Managing Interest-Rate Risk 624 Income Gap Analysis 625 Duration Gap Analysis 627 Example of a Nonbanking Financial Institution 631 Some Problems with Income Gap and Duration Gap Analyses 633 THE PRACTICING MANAGER Strategies for Managing Interest-Rate Risk 634 Summary 636 Key Terms 636 Questions. j 636 Quantitative Problems 637 Web Exercises: Risk Management in Financial Institutions 639 Chapter 25 Hedging with Financial Derivatives 641 Preview 641 Hedging 641 Forward Markets 642 Interest-Rate Forward Contracts 642
xxvi Contents in Detail THE PRACTICING MANAGER Hedging Interest-Rate Risk with Forward Contracts 642 Pros and Cons of Forward Contracts 643 Financial Futures Markets 644 Financial Futures Contracts 644 FOLLOWING THE FINANCIAL NEWS Financial Futures 645 THE PRACTICING MANAGER Hedging with Financial Futures 646 Organization of Trading in Financial Futures Markets 648 Globalization of Financial Futures Markets 648 Explaining the Success of Futures Markets 649 MINI-CASE The Hunt Brothers and the Silver Crash 651 THE PRACTICING MANAGER Hedging Foreign Exchange Risk with Forward and Futures Contracts 652 Hedging Foreign Exchange Risk with Forward Contracts 652 Hedging Foreign Exchange Risk with Futures Contracts 653 Stock Index Futures 654 Stock Index Futures Contracts 654 MINI-CASE Program Trading and Portfolio Insurance: Were They to Blame for the Stock Market Crash of 1987? 654 FOLLOWING THE FINANCIAL NEWS Stock Index Futures 655 THE PRACTICING MANAGER Hedging with Stock Index Futures 656 Options 657 Options Contracts 657 Profits and Losses on Option and Futures Contracts 658 Factors Affecting the Prices of Option Premiums 661 Summary 662 THE PRACTICING MANAGER Hedging with Futures Options 663 Interest-Rate Swaps 664 Interest-Rate Swap Contracts 664 THE PRACTICING MANAGER Hedging with Interest-Rate Swaps 665 Advantages of Interest-Rate Swaps 666 Disadvantages of Interest-Rate Swaps 666 Financial Intermediaries in Interest-Rate Swaps 667 Credit Derivatives 667 Credit Options 668 Credit Swaps 668 Credit-Linked Notes 669 CASE Are Financial Derivatives a Worldwide Time Bomb? 669 CONFLIQS OF INTEREST < The Orange County Bankruptcy 670 Summary - / 671 Key Terms 672 Questions 672 Quantitative Problems 673 Web Exercises: Hedging with financial Derivatives 675 Glossary Index 1-1 G-l