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part1 INTRODUCTION AND OVERVIEW OF FINANCIAL MARKETS1

1 Introduction2

Why Study Financial Markets and Institutions？：Chapter Overview2

Overview of Financial Markets4

Primary Markets versus Secondary Markets4

Money Markets versus Capital Markets8

Financial Market Regulation9

Foreign Exchange Markets10

Overview of Financial Institutions11

Unique Economic Functions Performed by Financial Institutions14

Additional Benefits FIs Provide to Suppliers of Funds17

Economic Functions FIs Provide to the Financial System as a Whole18

Regulation of Financial Institutions20

Globalization of Financial Markets and Institutions21

2 Determinants of Interest Rates26

Interest Rate Fundamentals：Chapter Overview26

Time Value of Money and Interest Rates27

Time Value of Money27

Present Values28

Future Values30

Interest Rates on Securities with a Maturity of Less than One Year33

Loanable Funds Theory36

Supply of Loanable Funds36

Demand for Loanable Funds38

Equilibrium Interest Rate40

Factors that Cause the Supply and Demand Curves for Loanable Funds to Shift40

Movement of Interest Rates Over Time45

Determinants of Interest Rates for Individual Securities45

Inflation45

Real Interest Rates47

Fisher Effect47

Default or Credit Risk48

Liquidity Risk48

Special Provisions or Covenants49

Term to Maturity50

Term Structure of Interest Rates52

Unbiased Expectations Theory52

Liquidity Premium Theory54

Market Segmentation Theory55

Forecasting Interest Rates56

3 Interest Rates and Security Valuation58

Interest Rates as a Determinant of Financial Security Values：Chapter Overview58

Various Interest Rate Measures59

Required Rate of Return60

Expected Rate of Return60

Required versus Expected Rates of Return：The Role of Efficient Markets61

Realized Rate of Return62

Coupon Rate62

Bond Valuation63

Bond Valuation Formula Used to Calculate Fair Present Values63

Bond Valuation Formula Used to Calculate Yield to Maturity65

Impact of Interest Rate Changes on Security Values66

Impact of Maturity on Security Values68

Maturity and Security Prices68

Maturity and Security Price Sensitivity to Changes in Interest Rates69

Impact of Coupon Rates on Security Values70

Coupon Rate and Security Prices70

Coupon Rate and Security Price Sensitivity to Changes in Interest Rates70

Duration71

A Simple Illustration of Duration73

A General Formula for Duration74

Features of Duration78

Economic Meaning of Duration78

Large Interest Rate Changes and Duration81

Appendix：Equity Valuation83

4 The Federal Reserve System，Monetary Policy，and Interest Rates89

Major Duties and Responsibilities of the Federal Reserve System：Chapter Overview89

Structure of the Federal Reserve System90

Federal Reserve Banks90

Board of Governors of the Federal Reserve System97

Federal Open Market Committee98

Balance Sheet of the Federal Reserve98

Monetary Policy Tools100

Open Market Operations102

The Discount Rate104

Reserve Requirements （Reserve Ratios）106

The Federal Reserve，the Money Supply，and Interest Rates109

Effects of Monetary Tools on Various Economic Variables109

Money Supply versus Interest Rate Targeting111

International Monetary Policies and Strategies115

Impact of U.S.Monetary Policy on Foreign Exchange Rates116

part2 SECURITIES MARKETS121

5 Money Markets122

Definition of Money Markets：Chapter Overview122

Money Markets123

Money Market Securities125

Treasury Bills126

Federal Funds132

Repurchase Agreements133

Commercial Paper136

Negotiable Certificates of Deposit139

Banker’s Acceptances141

Comparison of Money Market Securities142

Money Market Participants143

The U.S.Treasury143

The Federal Reserve144

Commercial Banks144

Brokers and Dealers144

Corporations145

Other Financial Institutions145

International Aspects of Money Markets145

Euro Money Markets145

Euro Money Market Securities149

6 Bond Markets153

Definition of Bond Markets：Chapter Overview153

Bond Market Securities154

Treasury Notes and Bonds154

Municipal Bonds164

Corporate Bonds171

Bond Ratings177

Bond Market Indexes178

Bond Market Participants179

Comparison of Bond Market Securities179

International Aspects of Bond Markets181

Eurobonds，Foreign Bonds，and Brady and Sovereign Bonds184

Eurobonds184

Foreign Bonds185

Brady Bonds and Sovereign Bonds185

7 Mortgage Markets189

Mortgages and Mortgage-Backed Securities：Chapter Overview189

Primary Mortgage Market191

Mortgage Characteristics191

Mortgage Amortization196

Other Types of Mortgages199

Secondary Mortgage Markets201

History and Background of Secondary Mortgage Markets201

Mortgage Sales202

Securitization of Mortgages203

Institutional Use of Mortgage Markets212

International Trends in Securitization213

Demand by International Investors for U.S.Mortgage-Backed Securities213

International Mortgage Securitization214

8 Stock Markets218

The Stock Markets：Chapter Overview218

Stock Market Securities219

Common Stock220

Preferred Stock225

Primary and Secondary Stock Markets226

Primary Markets226

Secondary Markets232

Stock Market Indexes240

Stock Market Participants244

Other Issues Pertaining to Stock Markets246

Economic Indicators246

Market Efficiency246

Stock Market Regulations249

International Aspects of Stock Markets250

Appendix：Event Study Tests254

9 Foreign Exchange Markets256

Foreign Exchange Markets and Risk：Chapter Overview256

Background and History of Foreign Exchange Markets258

Foreign Exchange Rates and Transactions258

Foreign Exchange Rates258

Foreign Exchange Transactions260

Return and Risk of Foreign Exchange Transactions262

Role of Financial Institutions in Foreign Exchange Transactions267

Interaction of Interest Rates，Inflation，and Exchange Rates273

Purchasing Power Parity273

Interest Rate Parity274

Balance of Payment Accounts275

CurrentAccount276

Capital Accounts277

10 Derivative Securities Markets280

Derivative Securities：Chapter Overview280

Forwards and Futures281

Spot Markets281

Forward Markets282

Futures Markets284

Options291

Call Options293

Put Options295

Option Values296

Option Markets298

Regulation of Futures and Options Markets304

Swaps304

Interest Rate Swaps305

Currency Swaps308

Swap Markets309

Caps，Floors，and Collars310

Appendix：Black-Scholes Option Pricing Model313

part3 DEPOSITORY INSTITUTIONS317

11 Commercial Banks318

Commercial Banks as a Sector of the Financial Institutions Industry：Chapter Overview318

Definition of a Commercial Bank320

Balance Sheets and Recent Trends320

Assets320

Liabilities322

Equity324

Off-Balance-Sheet Activities324

Other Fee-Generating Activities325

Size，Structure，and Composition of the Industry328

Economies of Scale and Scope329

Bank Size and Concentration335

Bank Size and Activities336

Industry Performance339

Regulators340

Federal Deposit Insurance Corporation340

Office of the Comptroller of the Currency340

Federal Reserve System340

State Authorities341

12 Thrift Institutions343

Three Categories of Thrift Institutions：Chapter Overview343

Savings Associations344

Size，Structure，and Composition of the Industry344

Balance Sheets and Recent Trends348

Savings Banks350

Size，Structure，and Composition of the Industry350

Balance Sheets and Recent Trends350

Regulators of Savings Institutions351

Savings Association and Savings Bank Recent Performance352

Credit Unions354

Size，Structure，and Composition of the Industry354

Balance Sheets and Recent Trends359

Regulators362

Industry Performance362

13 Depository Institutions’ Financial Statements and Analysis364

Why Evaluate the Performance of Depository Institutions：Chapter Overview364

Financial Statements of Commercial Banks366

Balance Sheet Structure366

Off-Balance-SheetAssets and Liabilities374

Income Statement380

Direct Relationship between the Income Statement and the Balance Sheet382

Financial Statement Analysis Using a Return on Equity Framework383

Return on Equity and Its Components384

Return on Assets and Its Components390

Other Ratios393

Impact of Market Niche and Bank Size on Financial Statement Analysis394

Impact of a Bank’s Market Niche394

Impact of Size on Financial Statement Analysis395

14 Regulation of Depository Institutions398

Specialness and Regulation：Chapter Overview398

Types of Regulations and the Regulators399

Safety and Soundness Regulation399

Monetary Policy Regulation401

Credit Allocation Regulation401

Consumer Protection Regulation401

Investor Protection Regulation402

Entry and Chartering Regulation402

Regulators402

Regulation of Product and Geographic Expansion403

Product Segmentation in the U.S.Depository Institutions Industry404

Geographic Expansion in the U.S.Depository Institutions Industry410

History of Bank and Savings Institution Guarantee Funds414

FDIC414

The Federal Savings and Loan Insurance Corporation and Its Demise415

Causes of the Depository Fund Insolvencies415

Non-U.S.Deposit Insurance Systems418

Balance Sheet Regulations418

Regulations on Depository Institution Liquidity418

Regulations on Capital Adequacy （Leverage）419

Off-Balance-Sheet Regulations422

Foreign versus Domestic Regulation of Depository Institutions424

Product Diversification Activities424

Global or International Expansion Activities424

Appendix A：Depository Institutions and Their Regulators429

Appendix B：Financial Services Modernization Act of 1999：Summary of Provisions430

Appendix C：Calculating Minimum Required Reserves at U.S.Depository Institutions434

Appendix D：Calculating Risk-Based Capital Ratios438

part4 OTHER FINANCIAL INSTITUTIONS445

15 Insurance Companies446

Two Categories of Insurance Companies：Chapter Overview446

Life Insurance Companies447

Size，Structure，and Composition of the Industry447

Balance Sheets and Recent Trends452

Regulation454

Property-Casualty Insurance Companies455

Size，Structure，and Composition of the Industry455

Balance Sheets and Recent Trends460

Regulation467

16 Securities Firms and Investment Banks470

Services Offered by Securities Firms versus Investment Banks：Chapter Overview470

Size，Structure，and Composition of the Industry471

Securities Firm and Investment Bank Activity Areas473

Investing474

Investment Banking474

Market Making478

Trading479

Cash Management482

Mergers and Acquisitions482

Other Service Functions482

Recent Trends and Balance Sheets483

Recent Trends483

Balance Sheet486

Regulation487

17 Finance Companies490

Finance Company Functions：Chapter Overview490

Size，Structure，and Composition of the Industry490

Balance Sheets and Recent Trends494

Assets494

Liabilities and Equity499

Regulation499

18 Mutual Funds502

Mutual Funds：Chapter Overview502

Size，Structure，and Composition of the Industry503

Historical Trends503

Different Types of Mutual Funds504

Mutual Fund Prospectuses and Objectives511

Size and Mutual Fund Performance：The Case of the Magellan Fund514

Investor Returns from Mutual Fund Ownership515

Mutual Fund Costs517

Mutual Fund Share Quotes520

Balance Sheets and Recent Trends521

Money Market Funds521

Long-Term Funds522

Regulation523

19 Pension Funds525

Pension Funds Defined：Chapter Overview525

Size，Structure，and Composition of the Industry526

Insured versus Noninsured Pension Funds526

Defined Benefit versus Defined Contribution Pension Funds528

Private Pension Funds529

Public Pension Funds537

Financial Asset Investments and Recent Trends538

Private Pension Funds538

Public Pension Funds539

Regulation of Pension Funds540

part5 RISK MANAGEMENT IN FINANCIAL INSTITUTIONS545

20Types of Risks Incurred by Financial Institutions546

Why Financial Institutions Need to ManageRisk：Chapter Overview546

Credit Risk547

Liquidity Risk550

Interest Rate Risk550

The Federal Reserve and Interest Rate Risk550

Maturity Mismatching and Interest Rate Risk551

Market Risk554

Off-Balance-Sheet Risk554

Foreign Exchange Risk555

Country or Sovereign Risk557

Technology and Operational Risk557

Insolvency Risk560

Interaction Among Risks560

21 Managing Risk on the BalanceSheet Ⅰ：Credit Risk564

Credit Risk Management：Chapter Overview564

Credit Analysis568

Real Estate Lending568

Consumer （Individual） and Small-Business Lending571

Mid-Market Commercial and Industrial Lending571

Large Commercial and Industrial Lending578

Calculating the Return on a Loan582

Return on Assets （ROA）584

RAROC Models586

Appendix：Loan Portfolio Risk and Management589

22 Managing Risk on the Balance SheetⅡ：Liquidity Risk593

Liquidity Risk Management：Chapter Overview593

Causes of Liquidity Risk594

Liquidity Risk and Depository Institutions595

Liability Side Liquidity Risk595

Asset Side Liquidity Risk599

Measuring a Bank’s Liquidity Exposure599

Liquidity Risk，Unexpected Deposit Drains，and Bank Runs603

Bank Runs，the Discount Window，and Deposit Insurance605

Liquidity Risk and Insurance Companies609

Life Insurance Companies609

Property-Casualty Insurance Companies609

Guarantee Programs for Life and Property-Casualty Insurance Companies610

Liquidity Risk and Mutual Funds611

23 Managing Risk on the Balance Sheet Ⅲ：Interest Rate and Insolvency Risk614

Interest Rate and Insolvency Risk Management：Chapter Overview614

Interest Rate Risk Measurement and Management616

Repricing Model616

Duration Model623

Insolvency Risk Management629

Capital and Insolvency Risk630

24 Managing Risk with Derivative Securities640

Derivative Securities Used to Manage Risk：Chapter Overview640

Forward and Futures Contracts641

Hedging with Forward Contracts642

Hedging with Futures Contracts643

Options648

Basic Features of Options648

Actual Interest Rate Options652

Hedging with Options654

Swaps654

Interest Rate Swaps655

Currency Swaps658

Credit Risk Concerns with Swaps660

Comparison of Hedging Methods661

Writing versus Buying Options661

Futures versus Options Hedging662

Swaps versus Forwards，Futures，and Options663

25 Loan Sales and Asset Securitization667

Why Financial Institutions Securitize Assets：Chapter Overview667

Loan Sales668

Types of Loan Sales Contracts669

Bank Loan Sale Market672

Secondary Market for Less Developed Country Debt675

Factors Encouraging Future Loan Sales Growth675

Factors Deterring Future Loan Sales Growth676

Loan Securitization677

Pass-Through Security677

Collateralized Mortgage Obligation683

Mortgage-Backed Bond686

Securitization of Other Assets688

Can All Assets Be Securitized？689

Glossary693

Appendix703

References711

Index713