SIXTH E D I T I O N

FREDERIC S. MISHKSNGraduate School of Business, Columbia University

STANLEY G. EAKINSEast Carolina University

PEARSON

•Mr

Boston San Francisco New YorkLondon Toronto Sydney Tokyo Singapore Madrid

Mexico City Munich Paris Cape Town Hong Kong Montreal

Contents on the WebPrefaceAbout the Authors

PART ONE INTRODUCTION

Chapter 1 Why Study Financial Markets and Institutions?PreviewWhy Study Financial Markets?

Debt Markets and Interest RatesThe Stock MarketThe Foreign Exchange Market

Why Study Financial Institutions?Central Banks and the Conduct of Monetary PolicyStructure of the Financial SystemBanks and Other Financial InstitutionsFinancial InnovationManaging Risk in Financial Institutions

Applied Managerial PerspectiveHow We Will Study Financial Markets and Institutions

Exploring the WebCollecting and Graphing Data

Web Exercise

Concluding Remarks

Summary

Key Terms

Questions

Quantitative Problems s

Web Exercises: Working with Financial Market Data

Chapter 2 Overview of the Financial SystemPreviewFunction of Financial MarketsStructure of Financial Markets

Debt and Equity MarketsPrimary and Secondary Markets

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IX

Contents in Detail

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? 23World Stock Markets 24

Function of Financial Intermediaries: Indirect Finance 24

• FOLLOWING THE FINANCIAL NEWS Foreign Stock Market Indexes 25Transaction Costs 25

• GLOBAL The Importance of Financial Intermediaries Relative to Securities Markets:An International Comparison 26Risk 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 36Key Terms 36Questions 37Web Exercises: The Financial System 37

PART TWO FUNDAMENTALS OF FINANCIAL MARKETS 39

Chapter 3 What Do Interest Rates Mean and What isTheir Role in Valuation? 41Preview 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 5 6Maturity and the Volatility of Bond Returns: Interest-Rate Risk 59

• MINI-CASE Helping Investors Select Desired Interest-Rate Risk 59Reinvestment Risk 60Summary 60

• THE PRACTICING MANAGER Calculating Duration to Measure Interest-Rate Risk 6 1Calculating Duration 62Duration and Interest-Rate Risk 66

Contents in Detail xi

Summary 6 7

Key Terms 6 8Questions 6 8

Quantitative Problems 6 8Web Exercises: Understanding Interest Rates 70

Chapter 4 Why Do Interest Rates Change? 71Preview . 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 8 6• CASE Changes in the Interest Rate Due to a Business Cycle Expansion 8 7• CASE Explaining Low Japanese Interest Rates 8 9• CASE Reading the Wall Street Journal "Credit Markets" Column 9 0• FOLLOWING THE FINANCIAL NEWS The "Credit Markets" Column 9 1• THE PRACTICING MANAGER Profiting from Interest-Rate Forecasts 9 2• FOLLOWING THE FINANCIAL NEWS Forecasting Interest Rates 93Summary 9 4Key Terms 9 5Questions 9 5Quantitative Problems 9 6Web Exercises: Interest Rates ond Inflation 9 7

Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 99Preview • 99

Risk Structure of Interest Rates 99

Default Risk 100

• CASE The Enron Bankruptcy and the Baa-Aaa Spread 103Liquidity 104Income Tax Considerations 104Summary 105

• CASE Effects of the Bush Tax Cut on Bond Interest Rates 106T e r m Structure of Interest Rates 107• FOLLOWING THE FINANCIAL NEWS Yield Curves 107

x i i Contents in Detail

Expectations Theory 109Market Segmentation Theory 113Liquidity Premium Theory 114

• MINI-CASE The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle 118Evidence on the Term Structure 118Summary 119

• CASE Interpreting Yield Curves, 1980-2008 119• THE PRACTICING MANAGER Using the Term Structure to Forecast Interest Rates 120Summary 124Key Terms 124Questions 124Quantitative Problems 125Web Exercises: The Risk and Term Structures of interest Rotes 126

Chapter 6 Are Financial Markets Efficient? 127Preview 127The Efficient Market Hypothesis 128

Rationale Behind the Hypothesis 130Stronger Version of the Efficient Market Hypothesis 131

Evidence on the Efficient Market Hypothesis 131Evidence 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? 1 3 5

Evidence Against Market Efficiency 135Overview of the Evidence on the Efficient Market Hypothesis 137

• THE PRACTICING MANAGER Practical Guide to Investing in the Stock Market 1 3 8How Valuable Are Published Reports by Investment Advisers? 138

• MINI-CASE Should You Hire an Ape as Your Investment Adviser? 138Should You Be Skeptical of Hot Tips? 139Do Stock Prices Always Rise When There Is Good News? 139Efficient Markets Prescription for the Investor 140

• CASE What Do the Black Monday Crash of 1987 and the Tech Crash of 2000Tell Us About the Efficient Market Hypothesis? 141

Behavioral Finance 142Summary 143Key Terms 1 4 3Questions ' , 1 4 3Quantitative Problems ' 144Web Exercises: The Efficient Market Hypothesis 1 4 4

PART THREE CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY 145

Chapter 7 Structure of Central Banks and the Federal Reserve System 147Preview 147Origins of the Federal Reserve System 147• INSIDE THE FED The Political Genius of the Founders of the Federal Reserve System 148

Contents in Detail x l i l

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 1 5 1

Member Banks 152

Board of Governors of the Federal Reserve System 153

• INSIDE THE FED The Role of the Research Staff 1 5 4

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? 1 5 6

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 166Key Terms 1 6 7Questions ani Problems 167Web Exercises: The Structure of the Federal Reserve System 168

Chapter 8 Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics 169Preview 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

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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 182Reserve 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 1 9 3

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 199Tactics: Choosing the Policy Instrument 199

Criteria for Choosing the Policy Instrument 202

• THE PRACTICING MANAGER Using a Fed Watcher 2 0 3Summary 2 0 4Key Terms 2 0 5Questions ; 2 0 5Quantitative Problems 2 0 6Web Exercises; Conduct of Monetary Poiicy 2 0 7

PART FOUR FINANCIAL MARKETS 209

Chapter 9 The Money Markets 211Preview 211

The Money Markets Defined 211

Why Do We Need the Money Markets? 212

Money Market Cost Advantages 213

Contents in Detail 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 2 1 8• MINI-CASE Treasury Bill Auctions Go Haywire 2 2 0

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 2 3 2

How Money Market Securities Are Valued 233

Summary- 234

Key Terms 2 3 4

Questions 2 3 5

Quontitative Problems 2 3 5

Web Exercises: The Money Markets 2 3 6

Chapter 10 The Bond Market 237Preview • 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 2 5 6

Key Terms 256

Questions 256

Quantitative Problems 257

Web Exercise: The Bond Market ' 258

Chapter 11 The Stock Market 259Preview 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 272Stock M a r k e t I ndexes 272

• MINI-CASE History of the Dow Jones Industrial Average 273Buying Foreign Stocks 275

Regulation of the Stock Market 275

The Securities and Exchange Commission 275Summary 2 7 6

Key Terms 2 7 7

Questions 2 7 7

Quantitative Problems ' ; 2 7 7

Web Exercises: The Stock Market 2 7 9

Chapter 12 The Mortgage Markets 2siPreview 281

What Are Mortgages? 282

Characteristics of the Residential Mortgage 283

Mortgage Interest Rates 283

• CASE The Discount Point Decision 284Loan Terms 285

Contents in Detail xv i i

Mortgage Loan Amortization . 287• CASE Computing the Payment on Mortgage Loans 288Types of Mortgage Loans 289

Insured and Conventional Mortgages 289Fixed- and Adjustable-Rate Mortgages 290Other Types of Mortgages 290

Mortgage-Lending Institutions 293Loan Servicing 294• E-FINANCE Borrowers Shop the Web for Mortgages 294Secondary Mortgage Market 295Securitization of Mortgages 295

What Is a Mortgage-Backed Security? 296• MINI-CASE Are Fannie Mae and Freddie Mac Getting Too Big for Their Britches? 2 9 6

Types of Pass-Through Securities 297Mortgage-Backed Securities Clearing Corporation 298The Impact of Securitized Mortgages on the Mortgage Market 299Subprime Mortgages 299

Summary 300Key Terms 3 0 1

Questions 3 0 1

Quantitative Problems 302Web Exercises: The Mortgage Markets 303

Chapter 13 The Foreign Exchange Market 305Preview 305Foreign Exchange Market 306

What Are Foreign Exchange Rates? 307Why Are Exchange Rates Important? 307

• FOLLOWING THE FINANCIAL NEWS Foreign Exchange Rates 308How Is Foreign Exchange Traded? 308

Exchange Rates in the Long Run 309Law of One Price 309Theory of Purchasing Power Parity 310Why the Theory of Purchasing Power Parity Cannot Fully Explain

Exchange Rates 311Factors That Affect Exchange Rates in the Long Run 311

Exchange Rates in the Short Run . 313Comparing Expected Returns on Domestic and Foreign Assets 314Interest Parity Condition 316Demand Curve for Domestic Assets 317Supply Curve for Domestic Assets 319Equilibrium in the Foreign Exchange Market 319

Explaining Changes in Exchange Rates 319Shifts in the Demand for Domestic Assets 319

• CASE Changes in the Equilibrium Exchange Rate: Two Examples 324Changes in Interest Rates 324

xvi i i 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 3 2 8• 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 3 3 1• THE PRACTICING MANAGER Profiting from Foreign Exchange Forecasts 332Summory ' 333Key Terms 333Questions 333Quantitative Problems 334Web Exercises: The Foreign Exchange Market 335

Chapter 14 The International Financial System 337Preview 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 339Unsterilized Intervention 340Sterilized 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 344Fixed Exchange Rate Regimes 344How 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 3 5 1• 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? 358Summary 359Key Terms 359Questions 360Quoniitative Problems 3 6 1Web Exercises: The International Financial System 3 6 1

Contents in Detail x ix

PART FIVE FUNDAMENTALS OF FINANCIAL INSTITUTIONS 363

Chapter 15 Why Do Financial Institutions Exist? 365Preview 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 3 8 3• 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 3 8 9• MINI-CASE Case Study of a Financial Crisis: The Great Depression 3 9 1• CASE Financial Crises in Emerging Market Countries: Mexico, 1994—1995;

East Asia, 1997-1998; and Argentina, 2001-2002 3 9 1Summery 3 9 5

Key Terms 3 9 6

Questions 3 9 6

Quantitative Problems 3 9 7

Web Exercises: Why Do Financial Institutions Exist? 3 9 7

Chapter 16 What Should Be Done About Conflicts of Interest?A Central Issue in Business Ethics 399Preview 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 4 0 3

• CONFLiaS OF INTEREST Frank Quattrone and Spinning 4 0 4

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? 406Can the Market Limit Exploitation of Conflicts of Interest? 406

• CONFLICTS OF INTEREST Banksters 407What 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 414Summary 417Key Terms 417Questions 417Web 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 421Preview 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? 436Off-Balance-Sheet Ac t i v i t ies 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 445Questions 445Quantitative Problems 446Web Exercises: Bonking and the Management of Financiai Institutions 447

Contents in Detail xx i

Chapter 18 Commercial Banking Industry: Structure and Competition 449Preview 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? 4 5 6• 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 462Financial 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 4 7 2

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 479Key Terms 480Questions 4 8 0Web Exercises: Commercial Banking Industry: Structure ond Competition / 4 8 1

Chapter 19 Savings Associations and Credit Unions 483Preview 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

Contents in Detail

Political Economy of the Savings and Loan Crisis 489Principal-Agent Problem for Regulators and Politicians 489

• CASE Principal-Agent Problem in Action: Charles Keating and the Lincoln Savings and Loan Scandal 4 9 0

Savings and Loan Bailout: Financial Institutions Reform, Recovery,and Enforcement Act of 1989 491

The Savings and Loan Industry Today 492Number of Institutions 493S&L Size 493S&L Assets 494S&L Liabilities and Net Worth 496Capital 496Profitability and Health 496The Future of the Savings and Loan Industry 497

Credit Unions 499History and Organization 499Sources of Funds 504Uses of Funds 505Advantages and Disadvantages of Credit Unions 505The Future of Credit Unions 506

Summary 5 0 7Key Terms 5 0 8Questions 5 0 8Web Exercises: Savings Associations and Credit Unions 5 0 9

Chapter 20 Banking Regulation 511Preview 511Asymmetric 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? 5 1 4

Restrictions on Asset Holdings and Bank Capital Requirements 515• GLOBAL Basel 2: How Well Will It Work? 5 1 7

Bank Supervision: Chartering and Examination 518Assessment of Risk Management 519Disclosure Requirements 520Consumer Protection 520Restrictions on Competition 520

• E-FINANCE Electronic Banking: New Challenges for Bank Regulation , 521

International Banking Regulation v ' 523

Problems in Regulating International Banking 523Summary 524

The 1980s U.S. Banking Crisis 524Federal Deposit Insurance Corporation Improvement Act of 1991 526Banking Crises Throughout the World 527

Scandinavia 528Latin America 529Russia and Eastern Europe 530

Contents in Detail xx i l i

Japan 531

China 532

East Asia 532

"Dejd Vu All Over Again" 533

Summary 533Key Terms 5 3 4

Questions 5 3 4Quantitative Problems 534Web Exercises: Banking Regulation 5 3 5

Chapter 21 The Mutual Fund Industry 537Preview 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 543Investment 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 555Mutual Fund Abuses 555

• CONFLICTS OF INTEREST SEC Survey Reports Mutual Fund Abuses Widespread 557Government Response to Abuses 557

Summary , 558

Key Terms x ' 558Questions 559Quontitative Problems 559Web Exercises: Investment Banks, Brokerage Firms, and Mutuol Funds 560

Chapter 22 Insurance Companies and Pension Funds 561Preview 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 5 7 4• THE PRACTICING MANAGER Insurance Management 5 7 5

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 5 8 7

Key Terms 5 8 8

Questions 5 8 8

Quantitative Problems 5 8 9

Web Exercises: Insurance Companies and Pension Funds 5 8 9

Chapter 23 Investment Banks, Security Brokers and Dealers,and Venture Capital Firms l 591Preview 591

Investment Banks 592

Background 592

Underwriting Stocks and Bonds 593

• FOLLOWING THE FINANCIAL NEWS New Securities Issues 5 9 6

Equity Sales 598

Mergers and Acquisitions 599

Securities Brokers and Dealers 600

Contents in Detail xxv

Brokerage Services 600

• MINI-CASE Example of Using the Limit-Order Book 6 0 3Securities 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 6 1 1

Advantages to Private Equity Buyouts 611

Life Cycle of the Private Equity Buyout 612

Implications of the Private Equity Ownership Structure 612

Summary 6 1 3. Key Terms 6 1 3

Questions 6 1 4Quantitative Problems 6 1 4Web 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 619Preview 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 6 3 4Summary 6 3 6Key Terms 6 3 6Questions . j 6 3 6Quantitative Problems 6 3 7Web Exercises: Risk Management in Financial Institutions 6 3 9

Chapter 25 Hedging with Financial Derivatives 641Preview 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 643Financial Futures Markets 644

Financial Futures Contracts 644• FOLLOWING THE FINANCIAL NEWS Financial Futures 645• THE PRACTICING MANAGER Hedging with Financial Futures 6 4 6

Organization of Trading in Financial Futures Markets 648Globalization of Financial Futures Markets 648Explaining the Success of Futures Markets 649

• MINI-CASE The Hunt Brothers and the Silver Crash 6 5 1

• THE PRACTICING MANAGER Hedging Foreign Exchange Risk with Forward and Futures Contracts 6 5 2Hedging Foreign Exchange Risk with Forward Contracts 652Hedging Foreign Exchange Risk with Futures Contracts 653

Stock Index Futures 654Stock Index Futures Contracts 654

• MINI-CASE Program Trading and Portfolio Insurance: Were They to Blamefor the Stock Market Crash of 1987? 654

• FOLLOWING THE FINANCIAL NEWS Stock Index Futures 655• THE PRACTICING MANAGER Hedging with Stock Index Futures 656Options 657

Options Contracts 657Profits and Losses on Option and Futures Contracts 658Factors Affecting the Prices of Option Premiums 661Summary 662

• THE PRACTICING MANAGER Hedging with Futures Options 663Interest-Rate Swaps 664

Interest-Rate Swap Contracts 664• THE PRACTICING MANAGER Hedging with Interest-Rate Swaps 6 6 5

Advantages of Interest-Rate Swaps 666Disadvantages of Interest-Rate Swaps 666Financial Intermediaries in Interest-Rate Swaps 667

Credit Derivatives 667Credit Options 668Credit Swaps 668Credit-Linked Notes 669

• CASE Are Financial Derivatives a Worldwide Time Bomb? 669• CONFLIQS OF INTEREST < The Orange County Bankruptcy 670Summary - / 6 7 1Key Terms 672Questions 672Quantitative Problems 673Web Exercises: Hedging with financial Derivatives 675

Glossary G-l

Index 1-1