cover & table of contents - financial markets and institutions (7th edition)

Financial Marketsand InstitutionsS E V E N T H E D I T I O N

The Prentice Hall Series in Finance

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Alexander/Sharpe/BaileyFundamentals of Investments

AndersenGlobal Derivatives: A Strategic Risk

Management Perspective

Bear/Moldonado-BearFree Markets, Finance, Ethics, and Law

Berk/DeMarzoCorporate Finance*

Corporate Finance: The Core*

Bierman/SmidtThe Capital Budgeting Decision:

Economic Analysis of Investment Projects

Bodie/Merton/CleetonFinancial Economics

Click/CovalThe Theory and Practice of International

Financial Management

Copeland/Weston/ShastriFinancial Theory and Corporate Policy

Cornwall/Vang/HartmanEntrepreneurial Financial Management

Cox/RubinsteinOptions Markets

DorfmanIntroduction to Risk Management and

Insurance

DietrichFinancial Services and Financial

Institutions: Value Creation in Theory

and Practice

Dufey/GiddyCases in International Finance

EakinsFinance in .learn

Eiteman/Stonehill/MoffettMultinational Business Finance

Emery/Finnerty/StoweCorporate Financial Management

FabozziBond Markets, Analysis and Strategies

Fabozzi/ModiglianiCapital Markets: Institutions and

Instruments

Fabozzi/Modigliani/Jones/FerriFoundations of Financial Markets and

Institutions

FinklerFinancial Management for Public, Health,

and Not-for-Profit Organizations

Francis/IbbotsonInvestments: A Global Perspective

Fraser/OrmistonUnderstanding Financial Statements

GeisstInvestment Banking in the Financial

System

GitmanPrinciples of Managerial Finance*

Principles of Managerial Finance––

Brief Edition*

Gitman/JoehnkFundamentals of Investing*

Gitman/MaduraIntroduction to Finance

Guthrie/LemonMathematics of Interest Rates and Finance

HaugenThe Inefficient Stock Market: What Pays

Off and Why

Modern Investment Theory

The New Finance: Overreaction,

Complexity, and Uniqueness

HoldenExcel Modeling and Estimation in the

Fundamentals of Corporate Finance

Excel Modeling and Estimation in the

Fundamentals of Investments

Excel Modeling and Estimation in

Investments

Excel Modeling and Estimation in

Corporate Finance

Hughes/MacDonaldInternational Banking: Text and Cases

HullFundamentals of Futures and Options

Markets

Options, Futures, and Other Derivatives

Risk Management and Financial

Institutions

KeownPersonal Finance: Turning Money into

Wealth

Keown/Martin/Petty/ScottFinancial Management: Principles and

Applications

Foundations of Finance: The Logic and

Practice of Financial Management

Kim/NofsingerCorporate Governance

Levy/PostInvestments

May/May/AndrewEffective Writing: A Handbook for Finance

People

MaduraPersonal Finance

MarthinsenRisk Takers: Uses and Abuses of Financial

Derivatives

McDonaldDerivatives Markets

Fundamentals of Derivatives Markets

MegginsonCorporate Finance Theory

MelvinInternational Money and Finance

Mishkin/EakinsFinancial Markets and Institutions

MoffettCases in International Finance

Moffett/Stonehill/EitemanFundamentals of Multinational Finance

NofsingerPsychology of Investing

Ogden/Jen/O’ConnorAdvanced Corporate Finance

PennacchiTheory of Asset Pricing

RejdaPrinciples of Risk Management and

Insurance

SchoenebeckInterpreting and Analyzing Financial

Statements

Scott/ Martin/ Petty/Keown/Thatcher Cases in Finance

SeilerPerforming Financial Studies: A

Methodological Cookbook

ShapiroCapital Budgeting and Investment

Analysis

Sharpe/Alexander/BaileyInvestments

Solnik/McLeaveyGlobal Investments

Stretcher/MichaelCases in Financial Management

Titman/MartinValuation: The Art and Science of

Corporate Investment Decisions

TrivoliPersonal Portfolio Management:

Fundamentals and Strategies

Van HorneFinancial Management and Policy

Financial Market Rates and Flows

Van Horne/WachowiczFundamentals of Financial Management

VaughnFinancial Planning for the Entrepreneur

Weston/Mitchel/MulherinTakeovers, Restructuring, and Corporate

Governance

Winger/FrascaPersonal Fikance

www.myfinancelab.com

Financial Marketsand InstitutionsS E V E N T H E D I T I O N

Frederic S. MishkinGraduate School of Business, Columbia University

Stanley G. EakinsEast Carolina University

Prentice HallBoston Columbus Indianapolis New York San Francisco Upper Saddle River

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ISBN 10: 0-13-213683-XISBN 13: 978-0-13-213683-9

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Library of Congress Cataloging-in-Publication Data

Mishkin, Frederic S.Financial markets and institutions / Frederic S. Mishkin, Stanley G.

Eakins. -- 7th ed.p. cm. -- (The Prentice Hall series in finance)

Includes index.ISBN 978-0-13-213683-9 (0-13-213683-x)

1. Financial institutions--United States. 2. Money--United States. 3.Money market--United States. 4. Banks and banking--United States. I.Eakins, Stanley G. II. Title. III. Series.

HG181.M558 2012332.10973--dc22

2010048490

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vii

Contents in Brief

Contents in Detail ixContents on the Web xxviiPreface xxixAbout the Authors xxxix

PART ONE INTRODUCTION 1

1 Why Study Financial Markets and Institutions? 12 Overview of the Financial System 15

PART TWO FUNDAMENTALS OF FINANCIAL MARKETS 36

3 What Do Interest Rates Mean and What Is Their Role in Valuation? 364 Why Do Interest Rates Change? 645 How Do Risk and Term Structure Affect Interest Rates? 896 Are Financial Markets Efficient? 116

PART THREE FUNDAMENTALS OF FINANCIAL INSTITUTIONS 134

7 Why Do Financial Institutions Exist? 1348 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy? 163

PART FOUR CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY 191

9 Central Banks and the Federal Reserve System 19110 Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics 214

PART FIVE FINANCIAL MARKETS 254

11 The Money Markets 25412 The Bond Market 27913 The Stock Market 30214 The Mortgage Markets 32315 The Foreign Exchange Market 34416 The International Financial System 374

PART SIX THE FINANCIAL INSTITUTIONS INDUSTRY 398

17 Banking and the Management of Financial Institutions 39818 Financial Regulation 42519 Banking Industry: Structure and Competition 45420 The Mutual Fund Industry 48921 Insurance Companies and Pension Funds 51322 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms 543

viii Contents in Brief

PART SEVEN THE MANAGEMENT OF FINANCIAL INSTITUTIONS 568

23 Risk Management in Financial Institutions 56824 Hedging with Financial Derivatives 590

Glossary G-1

Index I-1

CHAPTERS ON THE WEB

25 Savings Associations and Credit Unions26 Finance Companies

ix

Contents in Detail

Contents on the Web xxvii

Preface xxix

About the Authors xxxix

PART ONE INTRODUCTION

Chapter 1 Why Study Financial Markets and Institutions? 1

Preview 1

Why Study Financial Markets? 2

Debt Markets and Interest Rates 2

The Stock Market 3

The Foreign Exchange Market 4

Why Study Financial Institutions? 6

Structure of the Financial System 6

Financial Crises 6

Central Banks and the Conduct of Monetary Policy 6

The International Financial System 7

Banks and Other Financial Institutions 7

Financial Innovation 7

Managing Risk in Financial Institutions 7

Applied Managerial Perspective 8

How We Will Study Financial Markets and Institutions 8

Exploring the Web 9

Collecting and Graphing Data 9

Web Exercise 10

Concluding Remarks 12

Summary 12

Key Terms 13

Questions 13

Quantitative Problems 14

Web Exercises 14

Chapter 2 Overview of the Financial System 15

Preview 15

Function of Financial Markets 16

Structure of Financial Markets 18

Debt and Equity Markets 18

Primary and Secondary Markets 18

Exchanges and Over-the-Counter Markets 19

Money and Capital Markets 20

x Contents in Detail

Internationalization of Financial Markets 20

International Bond Market, Eurobonds, and Eurocurrencies 20

■ GLOBAL Are U.S. Capital Markets Losing Their Edge? 21

World Stock Markets 22

Function of Financial Intermediaries: Indirect Finance 22

Transaction Costs 22

■ FOLLOWING THE FINANCIAL NEWS Foreign Stock Market Indexes 23

■ GLOBAL The Importance of Financial Intermediaries Relative toSecurities Markets: An International Comparison 24

Risk Sharing 25

Asymmetric Information: Adverse Selection and Moral Hazard 25

Types of Financial Intermediaries 27

Depository Institutions 28

Contractual Savings Institutions 29

Investment Intermediaries 29

Regulation of the Financial System 30

Increasing Information Available to Investors 30

Ensuring the Soundness of Financial Intermediaries 32

Financial Regulation Abroad 33

Summary 33

Key Terms 34

Questions 34

Web Exercises 35

PART TWO FUNDAMENTALS OF FINANCIAL MARKETS

Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation? 36

Preview 36

Measuring Interest Rates 37

Present Value 37

Four Types of Credit Market Instruments 39

Yield to Maturity 40

■ GLOBAL Negative T-Bill Rates? It Can Happen 47

The Distinction Between Real and Nominal Interest Rates 48

The Distinction Between Interest Rates and Returns 50

■ MINI-CASE With TIPS, Real Interest Rates Have Become Observable in the United States 51

Maturity and the Volatility of Bond Returns: Interest-Rate Risk 53

Reinvestment Risk 54

■ MINI-CASE Helping Investors Select Desired Interest-Rate Risk 54

Summary 55

■ THE PRACTICING MANAGER Calculating Duration to Measure Interest-Rate Risk 55

Calculating Duration 56

Duration and Interest-Rate Risk 60

Summary 61

Key Terms 62

Questions 62

Contents in Detail xi


Web Exercises 63

Chapter 4 Why Do Interest Rates Change? 64

Preview 64

Determinants of Asset Demand 64

Wealth 65

Expected Returns 65

Risk 66

Liquidity 67

Summary 68

Supply and Demand in the Bond Market 68

Demand Curve 69

Supply Curve 69

Market Equilibrium 70

Supply-and-Demand Analysis 71

Changes in Equilibrium Interest Rates 72

Shifts in the Demand for Bonds 72

Shifts in the Supply of Bonds 75

■ CASE Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect 78

■ CASE Changes in the Interest Rate Due to a Business Cycle Expansion 79

■ CASE Explaining Low Japanese Interest Rates 81

■ CASE Reading the Wall Street Journal “Credit Markets” Column 82

■ FOLLOWING THE FINANCIAL NEWS The “Credit Markets” Column 83

■ THE PRACTICING MANAGER Profiting from Interest-Rate Forecasts 84

■ FOLLOWING THE FINANCIAL NEWS Forecasting Interest Rates 85

Summary 85

Key Terms 86

Questions 86


Web Exercises 87

Web Appendices 88

Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 89

Preview 89

Risk Structure of Interest Rates 89

Default Risk 90

■ CASE The Subprime Collapse and the Baa-Treasury Spread 93Liquidity 93

Income Tax Considerations 94

Summary 95

■ CASE Effects of the Bush Tax Cut and Its Possible Repeal on Bond Interest Rates 96

Term Structure of Interest Rates 96

■ FOLLOWING THE FINANCIAL NEWS Yield Curves 97

Expectations Theory 98

Market Segmentation Theory 102

Liquidity Premium Theory 103

xii Contents in Detail

Evidence on the Term Structure 106

Summary 107

■ MINI-CASE The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle 108

■ CASE Interpreting Yield Curves, 1980–2010 108

■ THE PRACTICING MANAGER Using the Term Structure to Forecast Interest Rates 110

Summary 112

Key Terms 113

Questions 113


Web Exercises 115

Chapter 6 Are Financial Markets Efficient? 116

Preview 116

The Efficient Market Hypothesis 117

Rationale Behind the Hypothesis 119

Stronger Version of the Efficient Market Hypothesis 120

Evidence on the Efficient Market Hypothesis 120

Evidence in Favor of Market Efficiency 120

■ MINI-CASE An Exception That Proves the Rule: Ivan Boesky 122

■ CASE Should Foreign Exchange Rates Follow a Random Walk? 124

Evidence Against Market Efficiency 124

Overview of the Evidence on the Efficient Market Hypothesis 126

■ THE PRACTICING MANAGER Practical Guide to Investing in the Stock Market 127

How Valuable Are Published Reports by Investment Advisers? 127

■ MINI-CASE Should You Hire an Ape as Your Investment Adviser? 127

Should You Be Skeptical of Hot Tips? 128

Do Stock Prices Always Rise When There Is Good News? 128

Efficient Markets Prescription for the Investor 129

■ CASE What Do the Black Monday Crash of 1987 and the Tech Crash of 2000 Tell Us About the Efficient Market Hypothesis? 130

Behavioral Finance 131

Summary 132

Key Terms 132

Questions 132


Web Exercises 133

PART THREE FUNDAMENTALS OF FINANCIAL INSTITUTIONS

Chapter 7 Why Do Financial Institutions Exist? 134

Preview 134

Basic Facts About Financial Structure Throughout the World 134

Transaction Costs 138

How Transaction Costs Influence Financial Structure 138

How Financial Intermediaries Reduce Transaction Costs 138

Asymmetric Information: Adverse Selection and Moral Hazard 139

Contents in Detail xiii

The Lemons Problem: How Adverse Selection Influences Financial Structure 140

Lemons in the Stock and Bond Markets 140

Tools to Help Solve Adverse Selection Problems 141

■ MINI-CASE The Enron Implosion 143

How Moral Hazard Affects the Choice Between Debt and Equity Contracts 145

Moral Hazard in Equity Contracts: The Principal–Agent Problem 145

Tools to Help Solve the Principal–Agent Problem 146

How Moral Hazard Influences Financial Structure in Debt Markets 148

Tools to Help Solve Moral Hazard in Debt Contracts 149

Summary 151

■ CASE Financial Development and Economic Growth 152

■ MINI-CASE Should We Kill All the Lawyers? 153

■ CASE Is China a Counter-Example to the Importance of Financial Development? 154

Conflicts of Interest 154

What Are Conflicts of Interest and Why Do We Care? 155

Why Do Conflicts of Interest Arise? 155

■ MINI-CASE The Demise of Arthur Andersen 157

■ MINI-CASE Credit Rating Agencies and the 2007–2009 Financial Crisis 158

What Has Been Done to Remedy Conflicts of Interest? 158

■ MINI-CASE Has Sarbanes-Oxley Led to a Decline in U.S. Capital Markets? 160

Summary 160

Key Terms 161

Questions 161


Web Exercises 162

Chapter 8 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy? 163

Preview 163

Asymmetric Information and Financial Crises 164

Agency Theory and the Definition of a Financial Crisis 164

Dynamics of Financial Crises in Advanced Economies 164

Stage One: Initiation of Financial Crisis 164

Stage Two: Banking Crisis 167

Stage Three: Debt Deflation 168

■ CASE The Mother of All Financial Crises: The Great Depression 169

■ CASE The 2007–2009 Financial Crisis 171

Causes of the 2007–2009 Financial Crisis 171

Effects of the 2007–2009 Financial Crisis 172

■ INSIDE THE FED Was the Fed to Blame for the Housing Price Bubble? 174

■ GLOBAL Ireland and the 2007–2009 Financial Crisis 177

Height of the 2007–2009 Financial Crisis and the Decline of

Aggregate Demand 178

Dynamics of Financial Crises in Emerging Market Economies 178

Stage One: Initiation of Financial Crisis 178

Stage Two: Currency Crisis 181

Stage Three: Full-Fledged Financial Crisis 182

xiv Contents in Detail

■ CASE Financial Crises in Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002 184

■ GLOBAL The Perversion of the Financial Liberalization/Globalization Process:Chaebols and the South Korean Crisis 185

Summary 188

Key Terms 189

Questions 189

Web Exercises 190

Web References 190

PART FOUR CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY

Chapter 9 Central Banks and the Federal Reserve System 191

Preview 191

Origins of the Federal Reserve System 192

■ INSIDE THE FED The Political Genius of the Founders of the Federal Reserve System 192

Structure of the Federal Reserve System 193

Federal Reserve Banks 194

■ INSIDE THE FED The Special Role of the Federal Reserve Bank of New York 195

Member Banks 196

Board of Governors of the Federal Reserve System 197

■ INSIDE THE FED The Role of the Research Staff 198

Federal Open Market Committee (FOMC) 198

The FOMC Meeting 199

■ INSIDE THE FED Green, Blue, Teal, and Beige: What Do These Colors Mean at the Fed? 200

Why the Chairman of the Board of Governors Really Runs the Show 200■ INSIDE THE FED How Bernanke’s Style Differs from Greenspan’s 201

How Independent Is the Fed? 202

Structure and Independence of the European Central Bank 203

Differences Between the European System of Central Banks and

the Federal Reserve System 204

Governing Council 204

How Independent Is the ECB? 205

Structure and Independence of Other Foreign Central Banks 206

Bank of Canada 206

Bank of England 206

Bank of Japan 207

The Trend Toward Greater Independence 207

Explaining Central Bank Behavior 207

Should the Fed Be Independent? 208

The Case for Independence 208

■ INSIDE THE FED The Evolution of the Fed’s Communication Strategy 209

The Case Against Independence 210

Central Bank Independence and Macroeconomic Performance

Throughout the World 211

Contents in Detail xv

Summary 212

Key Terms 212

Questions and Problems 212

Web Exercises 213

Chapter 10 Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics 214

Preview 214

The Federal Reserve’s Balance Sheet 214

Liabilities 215

Assets 216

Open Market Operations 216

Discount Lending 217

The Market for Reserves and the Federal Funds Rate 217

Demand and Supply in the Market for Reserves 218

How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate 219

■ INSIDE THE FED Why Does the Fed Need to Pay Interest on Reserves? 220

■ CASE How the Federal Reserve’s Operating Procedures Limit Fluctuationsin the Federal Funds Rate 223

Tools of Monetary Policy 224


A Day at the Trading Desk 225

Discount Policy 226

Operation of the Discount Window 226

Lender of Last Resort 227

Reserve Requirements 228

■ INSIDE THE FED Federal Reserve Lender-of-Last-Resort Facilities During the 2007–2009 Financial Crisis 229

Monetary Policy Tools of the European Central Bank 230


Lending to Banks 231

Reserve Requirements 231

The Price Stability Goal and the Nominal Anchor 232

The Role of a Nominal Anchor 232

The Time-Inconsistency Problem 232

Other Goals of Monetary Policy 233

High Employment 233

Economic Growth 234

Stability of Financial Markets 234

Interest-Rate Stability 234

Stability in Foreign Exchange Markets 235

Should Price Stability Be the Primary Goal of Monetary Policy? 235

Hierarchical vs. Dual Mandates 235

Price Stability as the Primary, Long-Run Goal of Monetary Policy 236

Inflation Targeting 237

Inflation Targeting in New Zealand, Canada, and the United Kingdom 237

Advantages of Inflation Targeting 238

xvi Contents in Detail

■ GLOBAL The European Central Bank’s Monetary Policy Strategy 240

Disadvantages of Inflation Targeting 240

■ INSIDE THE FED Chairman Bernanke and Inflation Targeting 242

Central Banks’ Response to Asset-Price Bubbles: Lessons from the 2007–2009 Financial Crisis 243

Two Types of Asset-Price Bubbles 243

Should Central Banks Respond to Bubbles? 244

Should Monetary Policy Try to Prick Asset-Price Bubbles? 244

Are Other Types of Policy Responses Appropriate? 245

Tactics: Choosing the Policy Instrument 246

Criteria for Choosing the Policy Instrument 248

■ THE PRACTICING MANAGER Using a Fed Watcher 249

Summary 250

Key Terms 251

Questions 251


Web Exercises 252

Web Appendices 253

PART FIVE FINANCIAL MARKETS

Chapter 11 The Money Markets 254

Preview 254

The Money Markets Defined 255

Why Do We Need the Money Markets? 255

Money Market Cost Advantages 256

The Purpose of the Money Markets 257

Who Participates in the Money Markets? 258

U.S. Treasury Department 258

Federal Reserve System 258

Commercial Banks 258

Businesses 259

Investment and Securities Firms 260

Individuals 260

Money Market Instruments 260

Treasury Bills 261

■ CASE Discounting the Price of Treasury Securities to Pay the Interest 261

■ MINI-CASE Treasury Bill Auctions Go Haywire 264

Federal Funds 264

Repurchase Agreements 266

Negotiable Certificates of Deposit 267

Commercial Paper 268

Banker’s Acceptances 271

Eurodollars 271

■ GLOBAL Ironic Birth of the Eurodollar Market 272

Comparing Money Market Securities 273

Interest Rates 273

Contents in Detail xvii

Liquidity 274

How Money Market Securities Are Valued 274

■ FOLLOWING THE FINANCIAL NEWS Money Market Rates 274

Summary 276

Key Terms 277

Questions 277


Web Exercises 278

Chapter 12 The Bond Market 279

Preview 279

Purpose of the Capital Market 279

Capital Market Participants 280

Capital Market Trading 280

Types of Bonds 281

Treasury Notes and Bonds 282

Treasury Bond Interest Rates 282

Treasury Inflation-Protected Securities (TIPS) 282

Treasury STRIPS 283

Agency Bonds 284

■ CASE The 2007–2009 Financial Crisis and the Bailout of Fannie Mae and Freddie Mac 284

Municipal Bonds 286

Risk in the Municipal Bond Market 288

Corporate Bonds 288

Characteristics of Corporate Bonds 289

Types of Corporate Bonds 290

Financial Guarantees for Bonds 293

Current Yield Calculation 294

Current Yield 294

Finding the Value of Coupon Bonds 295

Finding the Price of Semiannual Bonds 296

Investing in Bonds 298

Summary 299

Key Terms 300

Questions 300


Web Exercises 301

Chapter 13 The Stock Market 302

Preview 302

Investing in Stocks 302

Common Stock vs. Preferred Stock 303

How Stocks Are Sold 304

Computing the Price of Common Stock 307

The One-Period Valuation Model 308

The Generalized Dividend Valuation Model 309

xviii Contents in Detail

The Gordon Growth Model 309

Price Earnings Valuation Method 311

How the Market Sets Security Prices 311

Errors in Valuation 313

Problems with Estimating Growth 313

Problems with Estimating Risk 314

Problems with Forecasting Dividends 314

■ CASE The 2007–2009 Financial Crisis and the Stock Market 314

■ CASE The September 11 Terrorist Attack, the Enron Scandal, and the Stock Market 315

Stock Market Indexes 316

■ MINI-CASE History of the Dow Jones Industrial Average 318

Buying Foreign Stocks 318

Regulation of the Stock Market 319

The Securities and Exchange Commission 319

Summary 320

Key Terms 320

Questions 321


Web Exercises 322

Chapter 14 The Mortgage Markets 323

Preview 323

What Are Mortgages? 324

Characteristics of the Residential Mortgage 325

Mortgage Interest Rates 325

■ CASE The Discount Point Decision 326

Loan Terms 327

Mortgage Loan Amortization 329

Types of Mortgage Loans 330

Insured and Conventional Mortgages 330

Fixed- and Adjustable-Rate Mortgages 330

Other Types of Mortgages 331

Mortgage-Lending Institutions 333

Loan Servicing 334

■ E-FINANCE Borrowers Shop the Web for Mortgages 335

Secondary Mortgage Market 335

Securitization of Mortgages 336

What Is a Mortgage-Backed Security? 336

Types of Pass-Through Securities 337

Subprime Mortgages and CDOs 338

The Real Estate Bubble 339

Summary 340

Key Terms 340

Questions 341


Web Exercises 343

Contents in Detail xix

Chapter 15 The Foreign Exchange Market 344

Preview 344

Foreign Exchange Market 345

What Are Foreign Exchange Rates? 346

Why Are Exchange Rates Important? 346

■ FOLLOWING THE FINANCIAL NEWS Foreign Exchange Rates 347

How Is Foreign Exchange Traded? 348

Exchange Rates in the Long Run 348

Law of One Price 348

Theory of Purchasing Power Parity 349

Why the Theory of Purchasing Power Parity Cannot Fully Explain

Exchange Rates 350

Factors That Affect Exchange Rates in the Long Run 351

Exchange Rates in the Short Run: A Supply and Demand Analysis 352

Supply Curve for Domestic Assets 353

Demand Curve for Domestic Assets 353

Equilibrium in the Foreign Exchange Market 354

Explaining Changes in Exchange Rates 355

Shifts in the Demand for Domestic Assets 355

Recap: Factors That Change the Exchange Rate 358

■ CASE Changes in the Equilibrium Exchange Rate: An Example 360

■ CASE Why Are Exchange Rates So Volatile? 362

■ CASE The Dollar and Interest Rates 362

■ CASE The Subprime Crisis and the Dollar 364

■ CASE Reading the Wall Street Journal: The “Currency Trading” Column 365

■ FOLLOWING THE FINANCIAL NEWS The “Currency Trading” Column 366

■ THE PRACTICING MANAGER Profiting from Foreign Exchange Forecasts 366

Summary 367

Key Terms 368

Questions 368


Web Exercises 369

Chapter 15 Appendix The Interest Parity Condition 370

Comparing Expected Returns on Domestic and Foreign Assets 370

Interest Parity Condition 372

Chapter 16 The International Financial System 374

Preview 374

Intervention in the Foreign Exchange Market 374

Foreign Exchange Intervention and the Money Supply 374

■ INSIDE THE FED A Day at the Federal Reserve Bank of New York’s ForeignExchange Desk 376

Unsterilized Intervention 377

Sterilized Intervention 377

Balance of Payments 379

■ GLOBAL Why the Large U.S. Current Account Deficit Worries Economists 380

xx Contents in Detail

Exchange Rate Regimes in the International Financial System 380

Fixed Exchange Rate Regimes 381

How a Fixed Exchange Rate Regime Works 381

■ GLOBAL The Euro’s Challenge to the Dollar 383

■ GLOBAL Argentina’s Currency Board 384

■ GLOBAL Dollarization 385

■ CASE The Foreign Exchange Crisis of September 1992 386

■ THE PRACTICING MANAGER Profiting from a Foreign Exchange Crisis 387

■ CASE Recent Foreign Exchange Crises in Emerging Market Countries: Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002 388

■ CASE How Did China Accumulate Over $2 Trillion of International Reserves? 389

Managed Float 390

Capital Controls 391

Controls on Capital Outflows 391

Controls on Capital Inflows 391

The Role of the IMF 392

Should the IMF Be an International Lender of Last Resort? 392

How Should the IMF Operate? 393

Summary 395

Key Terms 395

Questions 396


Web Exercises 397

Web Appendices 397

PART SIX THE FINANCIAL INSTITUTIONS INDUSTRY

Chapter 17 Banking and the Management of Financial Institutions 398

Preview 398

The Bank Balance Sheet 399

Liabilities 399

Assets 401

Basic Banking 403

General Principles of Bank Management 405

Liquidity Management and the Role of Reserves 406

Asset Management 408

Liability Management 409

Capital Adequacy Management 410

■ THE PRACTICING MANAGER Strategies for Managing Bank Capital 412

■ CASE How a Capital Crunch Caused a Credit Crunch in 2008 413

Off-Balance-Sheet Activities 414

Loan Sales 414

Generation of Fee Income 414

Trading Activities and Risk Management Techniques 415

■ CONFLICTS OF INTEREST Barings, Daiwa, Sumitomo, and Societé Generale:Rogue Traders and the Principal–Agent Problem 416

Measuring Bank Performance 417

Bank’s Income Statement 417

Contents in Detail xxi

Measures of Bank Performance 419

Recent Trends in Bank Performance Measures 420

Summary 422

Key Terms 422

Questions 422


Web Exercises 424

Chapter 18 Financial Regulation 425

Preview 425

Asymmetric Information and Financial Regulation 425

Government Safety Net 425

■ GLOBAL The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing? 427

Restrictions on Asset Holdings 430

Capital Requirements 430

Prompt Corrective Action 431

■ GLOBAL Whither the Basel Accord? 432

Financial Supervision: Chartering and Examination 433

Assessment of Risk Management 434

Disclosure Requirements 435

Consumer Protection 436

Restrictions on Competition 436

■ MINI-CASE Mark-to-Market Accounting and the 2007–2009 Financial Crisis 437

■ MINI-CASE The 2007–2009 Financial Crisis and Consumer Protection Regulation 438

Summary 438

■ E-FINANCE Electronic Banking: New Challenges for Bank Regulation 439

■ GLOBAL International Financial Regulation 440

The 1980s Savings and Loan and Banking Crisis 443

Federal Deposit Insurance Corporation Improvement Act of 1991 444

Banking Crises Throughout the World in Recent Years 445

“Déjà Vu All Over Again” 447

The Dodd-Frank Bill and Future Regulation 448

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 448

Future Regulation 449

Summary 451

Key Terms 451

Questions 451


Web Exercises 453

Web Appendices 453

Chapter 19 Banking Industry: Structure and Competition 454

Preview 454

Historical Development of the Banking System 454

Multiple Regulatory Agencies 456

xxii Contents in Detail

Financial Innovation and the Growth of the Shadow Banking System 457

Responses to Changes in Demand Conditions: Interest Rate Volatility 458

Responses to Changes in Supply Conditions: Information Technology 459

■ E-FINANCE Will “Clicks” Dominate “Bricks” in the Banking Industry? 461

■ E-FINANCE Why Are Scandinavians So Far Ahead of Americans in Using Electronic Payments and Online Banking? 462

■ E-FINANCE Are We Headed for a Cashless Society? 463

Avoidance of Existing Regulations 465

■ MINI-CASE Bruce Bent and the Money Market Mutual Fund Panic of 2008 467

■ THE PRACTICING MANAGER Profiting from a New Financial Product:A Case Study of Treasury Strips 467

Financial Innovation and the Decline of Traditional Banking 469

Structure of the U.S. Commercial Banking Industry 473

Restrictions on Branching 474

Response to Branching Restrictions 474

Bank Consolidation and Nationwide Banking 475

■ E-FINANCE Information Technology and Bank Consolidation 477

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 477

What Will the Structure of the U.S. Banking Industry Look Like in the Future? 478

Are Bank Consolidation and Nationwide Banking Good Things? 478

Separation of the Banking and Other Financial Service Industries 479

Erosion of Glass-Steagall 480

The Gramm-Leach-Bliley Financial Services Modernization Act of 1999:

Repeal of Glass-Steagall 480

Implications for Financial Consolidation 480

Separation of Banking and Other Financial Services Industries

Throughout the World 481

■ MINI-CASE The 2007-2009 Financial Crisis and the Demise of Large, Free-Standing Investment Banks 481

Thrift Industry: Regulation and Structure 482

Savings and Loan Associations 482

Mutual Savings Banks 483

Credit Unions 483

International Banking 483

Eurodollar Market 484

Structure of U.S. Banking Overseas 485

Foreign Banks in the United States 485

Summary 486

Key Terms 487

Questions 487

Web Exercises 488

Chapter 20 The Mutual Fund Industry 489

Preview 489

The Growth of Mutual Funds 489

The First Mutual Funds 490

Benefits of Mutual Funds 490

Ownership of Mutual Funds 491

Contents in Detail xxiii

Mutual Fund Structure 494

Open- Versus Closed-End Funds 494

Organizational Structure 494

■ CASE Calculating a Mutual Fund’s Net Asset Value 495

Investment Objective Classes 497

Equity Funds 497

Bond Funds 498

Hybrid Funds 498

Money Market Funds 499

Index Funds 500

Fee Structure of Investment Funds 501

Regulation of Mutual Funds 502

Hedge Funds 503

■ MINI-CASE The Long Term Capital Debacle 505

Conflicts of Interest in the Mutual Fund Industry 506

■ CONFLICTS OF INTEREST Many Mutual Funds Are Caught Ignoring Ethical Standards 507

Sources of Conflicts of Interest 506

Mutual Fund Abuses 507

■ CONFLICTS OF INTEREST SEC Survey Reports Mutual Fund Abuses Widespread 509

Government Response to Abuses 509

Summary 510

Key Terms 510

Questions 511


Web Exercises 512

Chapter 21 Insurance Companies and Pension Funds 513

Preview 513

Insurance Companies 514

Fundamentals of Insurance 515

Adverse Selection and Moral Hazard in Insurance 515

Selling Insurance 516

■ MINI-CASE Insurance Agent: The Customer’s Ally 517

Growth and Organization of Insurance Companies 517

Types of Insurance 518

Life Insurance 518

Health Insurance 522

Property and Casualty Insurance 524

Insurance Regulation 525

■ CONFLICTS OF INTEREST Insurance Behemoth Charged with Conflicts of Interest Violations 526

■ THE PRACTICING MANAGER Insurance Management 526

Screening 527

Risk-Based Premium 527

Restrictive Provisions 528

Prevention of Fraud 528

xxiv Contents in Detail

Cancellation of Insurance 528

Deductibles 528

Coinsurance 529

Limits on the Amount of Insurance 529

Summary 529

Credit Default Swaps 529

■ CONFLICTS OF INTEREST The AIG Blowup 530

Pensions 531

■ CONFLICTS OF INTEREST The Subprime Financial Crisis and the Monoline Insurers 531

Types of Pensions 532

Defined-Benefit Pension Plans 532

Defined-Contribution Pension Plans 532

Private and Public Pension Plans 533

■ MINI-CASE Power to the Pensions 534

Regulation of Pension Plans 537

Employee Retirement Income Security Act 537

Individual Retirement Plans 539

The Future of Pension Funds 540

Summary 540

Key Terms 541

Questions 541


Web Exercises 542

Chapter 22 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms 543

Preview 543

Investment Banks 544

Background 544

Underwriting Stocks and Bonds 545

■ FOLLOWING THE FINANCIAL NEWS New Securities Issues 548

Equity Sales 550

Mergers and Acquisitions 551

Securities Brokers and Dealers 552

Brokerage Services 553

Securities Dealers 555

■ MINI-CASE Example of Using the Limit-Order Book 556

Regulation of Securities Firms 556

Relationship Between Securities Firms and Commercial Banks 558

Private Equity Investment 558

Venture Capital Firms 558

Private Equity Buyouts 562

Advantages to Private Equity Buyouts 563

■ E-FINANCE Venture Capitalists Lose Focus with Internet Companies 563

Life Cycle of the Private Equity Buyout 564

Contents in Detail xxv

Summary 564

Key Terms 565

Questions 565


Web Exercises 567

PART SEVEN THE MANAGEMENT OF FINANCIAL INSTITUTIONS

Chapter 23 Risk Management in Financial Institutions 568

Preview 568

Managing Credit Risk 569

Screening and Monitoring 569

Long-Term Customer Relationships 570

Loan Commitments 571

Collateral 571

Compensating Balances 572

Credit Rationing 572

Managing Interest-Rate Risk 573

Income Gap Analysis 574

Duration Gap Analysis 576

Example of a Nonbanking Financial Institution 581

Some Problems with Income Gap and Duration Gap Analyses 582

■ THE PRACTICING MANAGER Strategies for Managing Interest-Rate Risk 584

Summary 585

Key Terms 586

Questions 586


Web Exercises 589

Chapter 24 Hedging with Financial Derivatives 590

Preview 590

Hedging 590

Forward Markets 591

Interest-Rate Forward Contracts 591

■ THE PRACTICING MANAGER Hedging Interest-Rate Risk with Forward Contracts 591

Pros and Cons of Forward Contracts 592

Financial Futures Markets 593

Financial Futures Contracts 593

■ FOLLOWING THE FINANCIAL NEWS Financial Futures 594

■ THE PRACTICING MANAGER Hedging with Financial Futures 595

Organization of Trading in Financial Futures Markets 597

Globalization of Financial Futures Markets 597

Explaining the Success of Futures Markets 598

■ MINI-CASE The Hunt Brothers and the Silver Crash 600

■ THE PRACTICING MANAGER Hedging Foreign Exchange Risk with Forward and Futures Contracts 601

xxvi Contents in Detail

Hedging Foreign Exchange Risk with Forward Contracts 601

Hedging Foreign Exchange Risk with Futures Contracts 602

Stock Index Futures 603

Stock Index Futures Contracts 603

■ MINI-CASE Program Trading and Portfolio Insurance: Were They to Blame for the Stock Market Crash of 1987? 603

■ FOLLOWING THE FINANCIAL NEWS Stock Index Futures 604

■ THE PRACTICING MANAGER Hedging with Stock Index Futures 605

Options 606

Option Contracts 606

Profits and Losses on Option and Futures Contracts 607

Factors Affecting the Prices of Option Premiums 610

Summary 611

■ THE PRACTICING MANAGER Hedging with Futures Options 613

Interest-Rate Swaps 613

Interest-Rate Swap Contracts 613

■ THE PRACTICING MANAGER Hedging with Interest-Rate Swaps 613

Advantages of Interest-Rate Swaps 615

Disadvantages of Interest-Rate Swaps 615

Financial Intermediaries in Interest-Rate Swaps 616

Credit Derivatives 616

Credit Options 616

Credit Swaps 617

Credit-Linked Notes 617

■ CASE Lessons from the Subprime Financial Crisis: When Are Financial Derivatives Likely to Be a Worldwide Time Bomb? 618

Summary 619

Key Terms 620

Questions 620


Web Exercises 623

Web Appendices 623

Glossary G-1

Index I-1

xxvii

Contents on the Web

Chapter 25 Savings Associations and Credit UnionsPreview

Mutual Savings Banks

Savings and Loan Associations

Mutual Savings Banks and Savings and Loans Compared

Savings and Loans in Trouble: The Thrift Crisis

Later Stages of the Crisis: Regulatory Forbearance

Competitive Equality in Banking Act of 1987

Political Economy of the Savings and Loan Crisis

Principal–Agent Problem for Regulators and Politicians

■ CASE Principal–Agent Problem in Action: Charles Keating and the Lincoln Savings and Loan Scandal

Savings and Loan Bailout: Financial Institutions Reform, Recovery, and Enforcement Act of 1989

The Savings and Loan Industry Today

Number of Institutions

S&L Size

S&L Assets

S&L Liabilities and Net Worth

Capital

Profitability and Health

The Future of the Savings and Loan Industry

Credit Unions

History and Organization

Sources of Funds

Uses of Funds

Advantages and Disadvantages of Credit Unions

The Future of Credit Unions

SummaryKey TermsQuestionsWeb Exercises

Chapter 26 Finance CompaniesHistory of Finance Companies I

Purpose of Finance Companies

Risk in Finance Companies

The following updated chapters and appendices are available

on our Companion Website at www.pearsonhighered.com/mishkin_eakins.

www.pearsonhighered.com/mishkin_eakins

xxviii Contents on the Web

Types of Finance Companies

Business (Commercial) Finance Companies

Consumer Finance Companies

Sales Finance Companies

Regulation of Finance Companies

Finance Company Balance Sheet

Assets

Liabilities

Income

Finance Company Growth

SummaryKey TermsQuestionsWeb Exercises

CHAPTER APPENDICES

Chapter 4 Appendix 1: Models of Asset Pricing

Chapter 4 Appendix 2: Applying the Asset Market Approach to aCommodity Market: The Case of Gold

Chapter 4 Appendix 3: Loanable Funds Framework

Chapter 4 Appendix 4: Supply and Demand in the Market for Money: TheLiquidity Preference Framework

Chapter 10 Appendix: The Fed’s Balance Sheet and the Monetary Base

Chapter 16 Appendix: Balance of Payments

Chapter 18 Appendix 1: Evaluating FDICIA and Other Proposed Reforms ofthe Banking Regulatory System

Chapter 18 Appendix 2: Banking Crises Throughout the World

Chapter 24 Appendix: More on Hedging with Financial Derivatives

cover & table of contents - financial markets and institutions (7th edition)

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