Financial Markets and Institutions (7th Edition). - eBooks

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Financial Economics. Click/Coval. The Theory and Practice of International. Financial Management. Copeland/Weston/Shastri. Financial Theory and Corporate ...

Financial Markets and Institutions SEVENTH EDITION

The Prentice Hall Series in Finance Alexander/Sharpe/Bailey

Geisst

Fundamentals of Investments

Megginson

Investment Banking in the Financial System

Andersen

Corporate Finance Theory

Melvin

Global Derivatives: A Strategic Risk Management Perspective

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Gitman

International Money and Finance

Principles of Managerial Finance* Principles of Managerial Finance–– Brief Edition*

Mishkin/Eakins Financial Markets and Institutions

Free Markets, Finance, Ethics, and Law

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Cases in International Finance

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Eakins

Advanced Corporate Finance

Pennacchi Theory of Asset Pricing

Rejda Principles of Risk Management and Insurance

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

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Personal Finance: Turning Money into Wealth

Finance in .learn

Psychology of Investing

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Keown/Martin/Petty/Scott Financial Management: Principles and Applications Foundations of Finance: The Logic and Practice of Financial Management

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May/May/Andrew Effective Writing: A Handbook for Finance People

Financial Management and Policy Financial Market Rates and Flows

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Finkler Financial Management for Public, Health, and Not-for-Profit Organizations

Francis/Ibbotson Investments: A Global Perspective

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Marthinsen Risk Takers: Uses and Abuses of Financial Derivatives

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Financial Markets and Institutions SEVENTH EDITION

Frederic S. Mishkin Graduate School of Business, Columbia University

Stanley G. Eakins East Carolina University

Prentice Hall Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montréal Toronto Delhi Mexico City São Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo

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Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate page within text. Microsoft® and Windows® are registered trademarks of the Microsoft Corporation in the U.S.A. and other countries. Screen shots and icons reprinted with permission from the Microsoft Corporation. This book is not sponsored or endorsed by or affiliated with the Microsoft Corporation. Copyright © 2012, 2009, 2006 Pearson Education, Inc. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Rights and Contracts Department, 501 Boylston Street, Suite 900, Boston, MA 02116, fax your request to 617 671-3447, or e-mail at http://www. pearsoned.com/legal/permission.htm Many of the designations by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps. 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 2012 332.10973--dc22 2010048490 10 9 8 7 6 5 4 3 2 1

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

To My Dad —F. S. M. To My Wife, Laurie —S. G. E.

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Contents in Brief

PART ONE 1 2

PART TWO 3 4 5 6

PART THREE 7 8

PART FOUR 9 10

PART FIVE 11 12 13 14 15 16

PART SIX 17 18 19 20 21 22

Contents in Detail Contents on the Web Preface About the Authors

ix xxvii xxix xxxix

INTRODUCTION

1

Why Study Financial Markets and Institutions? Overview of the Financial System

1 15

FUNDAMENTALS OF FINANCIAL MARKETS

36

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

36 64 89 116

FUNDAMENTALS OF FINANCIAL INSTITUTIONS Why Do Financial Institutions Exist? Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?

134 134 163

CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY 191 Central Banks and the Federal Reserve System Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics

FINANCIAL MARKETS The Money Markets The Bond Market The Stock Market The Mortgage Markets The Foreign Exchange Market The International Financial System

THE FINANCIAL INSTITUTIONS INDUSTRY Banking and the Management of Financial Institutions Financial Regulation Banking Industry: Structure and Competition The Mutual Fund Industry Insurance Companies and Pension Funds Investment Banks, Security Brokers and Dealers, and Venture Capital Firms

191 214

254 254 279 302 323 344 374

398 398 425 454 489 513 543

vii

viii

Contents in Brief

PART SEVEN 23 24

THE MANAGEMENT OF FINANCIAL INSTITUTIONS Risk Management in Financial Institutions Hedging with Financial Derivatives

568 590

Glossary

G-1

Index

CHAPTERS ON THE WEB 25 26

568

Savings Associations and Credit Unions Finance Companies

I-1

Contents in Detail Contents on the Web Preface About the Authors

PART ONE

xxvii xxix xxxix

INTRODUCTION

Chapter 1 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? Structure of the Financial System Financial Crises Central Banks and the Conduct of Monetary Policy The International 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

Chapter 2 Overview of the Financial System Preview Function of Financial Markets Structure of Financial Markets Debt and Equity Markets Primary and Secondary Markets Exchanges and Over-the-Counter Markets Money and Capital Markets

1 1 2 2 3 4 6 6 6 6 7 7 7 7 8 8 9 9 10 12 12 13 13 14 14 15 15 16 18 18 18 19 20

ix

x

Contents in Detail Internationalization of Financial Markets International Bond Market, Eurobonds, and Eurocurrencies ■ GLOBAL Are U.S. Capital Markets Losing Their Edge? World Stock Markets Function of Financial Intermediaries: Indirect Finance Transaction Costs ■ FOLLOWING THE FINANCIAL NEWS Foreign Stock Market Indexes ■ GLOBAL The Importance of Financial Intermediaries Relative to Securities Markets: An International Comparison Risk Sharing Asymmetric Information: Adverse Selection and Moral Hazard Types of Financial Intermediaries Depository Institutions Contractual Savings Institutions Investment Intermediaries Regulation of the Financial System Increasing Information Available to Investors Ensuring the Soundness of Financial Intermediaries Financial Regulation Abroad Summary Key Terms Questions Web Exercises

PART TWO

20 20 21 22 22 22 23 24 25 25 27 28 29 29 30 30 32 33 33 34 34 35

FUNDAMENTALS OF FINANCIAL MARKETS

Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation? Preview Measuring Interest Rates Present Value Four Types of Credit Market Instruments Yield to Maturity ■ GLOBAL Negative T-Bill Rates? It Can Happen The Distinction Between Real and Nominal Interest Rates The Distinction Between Interest Rates and Returns ■ MINI-CASE With TIPS, Real Interest Rates Have Become Observable in the United States Maturity and the Volatility of Bond Returns: Interest-Rate Risk Reinvestment Risk ■ MINI-CASE Helping Investors Select Desired Interest-Rate Risk Summary ■ THE PRACTICING MANAGER Calculating Duration to Measure Interest-Rate Risk Calculating Duration Duration and Interest-Rate Risk Summary Key Terms Questions

36 36 37 37 39 40 47 48 50 51 53 54 54 55 55 56 60 61 62 62

Contents in Detail

Chapter 4

xi

Quantitative Problems Web Exercises

62 63

Why Do Interest Rates Change?

64

Preview Determinants of Asset Demand Wealth Expected Returns Risk Liquidity Summary Supply and Demand in the Bond Market Demand Curve Supply Curve Market Equilibrium Supply-and-Demand Analysis Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds Shifts in the Supply of Bonds ■ CASE Changes in the Interest Rate Due to Expected Inflation: The Fisher Effect ■ CASE Changes in the Interest Rate Due to a Business Cycle Expansion ■ CASE Explaining Low Japanese Interest Rates ■ CASE Reading the Wall Street Journal “Credit Markets” Column ■ FOLLOWING THE FINANCIAL NEWS The “Credit Markets” Column ■ THE PRACTICING MANAGER Profiting from Interest-Rate Forecasts ■ FOLLOWING THE FINANCIAL NEWS Forecasting Interest Rates Summary Key Terms Questions Quantitative Problems Web Exercises Web Appendices

64 64 65 65 66 67 68 68 69 69 70 71 72 72 75 78 79 81 82 83 84 85 85 86 86 87 87 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 93 Liquidity 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 Summary ■ MINI-CASE The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle ■ CASE Interpreting Yield Curves, 1980–2010 ■ THE PRACTICING MANAGER Using the Term Structure to Forecast Interest Rates Summary Key Terms Questions Quantitative Problems Web Exercises

Chapter 6 Are Financial Markets Efficient?

106 107 108 108 110 112 113 113 114 115 116

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 Quantitative Problems 133 Web Exercises 133

PART THREE Chapter 7

FUNDAMENTALS OF FINANCIAL INSTITUTIONS Why Do Financial Institutions Exist?

134

Preview Basic Facts About Financial Structure Throughout the World Transaction Costs How Transaction Costs Influence Financial Structure How Financial Intermediaries Reduce Transaction Costs Asymmetric Information: Adverse Selection and Moral Hazard

134 134 138 138 138 139

Contents in Detail

Chapter 8

xiii

The Lemons Problem: How Adverse Selection Influences Financial Structure Lemons in the Stock and Bond Markets Tools to Help Solve Adverse Selection Problems ■ MINI-CASE The Enron Implosion How Moral Hazard Affects the Choice Between Debt and Equity Contracts Moral Hazard in Equity Contracts: The Principal–Agent Problem Tools to Help Solve the Principal–Agent Problem How Moral Hazard Influences Financial Structure in Debt Markets Tools to Help Solve Moral Hazard in Debt Contracts Summary ■ CASE Financial Development and Economic Growth ■ MINI-CASE Should We Kill All the Lawyers? ■ CASE Is China a Counter-Example to the Importance of Financial Development? Conflicts of Interest What Are Conflicts of Interest and Why Do We Care? Why Do Conflicts of Interest Arise? ■ MINI-CASE The Demise of Arthur Andersen ■ MINI-CASE Credit Rating Agencies and the 2007–2009 Financial Crisis What Has Been Done to Remedy Conflicts of Interest? ■ MINI-CASE Has Sarbanes-Oxley Led to a Decline in U.S. Capital Markets? Summary Key Terms Questions Quantitative Problems Web Exercises

154 154 155 155 157 158 158 160 160 161 161 162 162

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

163

Preview Asymmetric Information and Financial Crises Agency Theory and the Definition of a Financial Crisis Dynamics of Financial Crises in Advanced Economies Stage One: Initiation of Financial Crisis Stage Two: Banking Crisis Stage Three: Debt Deflation ■ CASE The Mother of All Financial Crises: The Great Depression ■ CASE The 2007–2009 Financial Crisis Causes of the 2007–2009 Financial Crisis Effects of the 2007–2009 Financial Crisis ■ INSIDE THE FED Was the Fed to Blame for the Housing Price Bubble? ■ GLOBAL Ireland and the 2007–2009 Financial Crisis Height of the 2007–2009 Financial Crisis and the Decline of Aggregate Demand Dynamics of Financial Crises in Emerging Market Economies Stage One: Initiation of Financial Crisis Stage Two: Currency Crisis Stage Three: Full-Fledged Financial Crisis

140 140 141 143 145 145 146 148 149 151 152 153

163 164 164 164 164 167 168 169 171 171 172 174 177 178 178 178 181 182

xiv

Contents in Detail ■ CASE Financial Crises in Mexico, 1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002 ■ GLOBAL The Perversion of the Financial Liberalization/Globalization Process: Chaebols and the South Korean Crisis Summary Key Terms Questions Web Exercises Web References

184 185 188 189 189 190 190

PART FOUR CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY Chapter 9 Central Banks and the Federal Reserve System Preview Origins of the Federal Reserve System ■ INSIDE THE FED The Political Genius of the Founders of the Federal Reserve System Structure of the Federal Reserve System Federal Reserve Banks ■ INSIDE THE FED The Special Role of the Federal Reserve Bank of New York Member Banks Board of Governors of the Federal Reserve System ■ INSIDE THE FED The Role of the Research Staff Federal Open Market Committee (FOMC) The FOMC Meeting ■ INSIDE THE FED Green, Blue, Teal, and Beige: What Do These Colors Mean at the Fed? Why the Chairman of the Board of Governors Really Runs the Show ■ INSIDE THE FED How Bernanke’s Style Differs from Greenspan’s How Independent Is the Fed? Structure and Independence of the European Central Bank Differences Between the European System of Central Banks and the Federal Reserve System Governing Council How Independent Is the ECB? Structure and Independence of Other Foreign Central Banks Bank of Canada Bank of England Bank of Japan The Trend Toward Greater Independence Explaining Central Bank Behavior Should the Fed Be Independent? The Case for Independence ■ INSIDE THE FED The Evolution of the Fed’s Communication Strategy The Case Against Independence Central Bank Independence and Macroeconomic Performance Throughout the World

191 191 192 192 193 194 195 196 197 198 198 199 200 200 201 202 203 204 204 205 206 206 206 207 207 207 208 208 209 210 211

Contents in Detail

Chapter 10

xv

Summary Key Terms Questions and Problems Web Exercises

212 212 212 213

Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics

214

Preview The Federal Reserve’s Balance Sheet Liabilities Assets Open Market Operations Discount Lending The Market for Reserves and the Federal Funds Rate Demand and Supply in the Market for Reserves How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate ■ INSIDE THE FED Why Does the Fed Need to Pay Interest on Reserves? ■ CASE How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate Tools of Monetary Policy Open Market Operations A Day at the Trading Desk Discount Policy Operation of the Discount Window Lender of Last Resort Reserve Requirements ■ INSIDE THE FED Federal Reserve Lender-of-Last-Resort Facilities During the 2007–2009 Financial Crisis Monetary Policy Tools of the European Central Bank Open Market Operations Lending to Banks Reserve Requirements The Price Stability Goal and the Nominal Anchor The Role of a Nominal Anchor The Time-Inconsistency Problem Other Goals of Monetary Policy High Employment Economic Growth Stability of Financial Markets Interest-Rate Stability Stability in Foreign Exchange Markets Should Price Stability Be the Primary Goal of Monetary Policy? Hierarchical vs. Dual Mandates Price Stability as the Primary, Long-Run Goal of Monetary Policy Inflation Targeting Inflation Targeting in New Zealand, Canada, and the United Kingdom Advantages of Inflation Targeting

214 214 215 216 216 217 217 218 219 220 223 224 224 225 226 226 227 228 229 230 231 231 231 232 232 232 233 233 234 234 234 235 235 235 236 237 237 238

xvi

Contents in Detail ■ GLOBAL The European Central Bank’s Monetary Policy Strategy Disadvantages of Inflation Targeting ■ INSIDE THE FED Chairman Bernanke and Inflation Targeting Central Banks’ Response to Asset-Price Bubbles: Lessons from the 2007–2009 Financial Crisis Two Types of Asset-Price Bubbles Should Central Banks Respond to Bubbles? Should Monetary Policy Try to Prick Asset-Price Bubbles? Are Other Types of Policy Responses Appropriate? Tactics: Choosing the Policy Instrument Criteria for Choosing the Policy Instrument ■ THE PRACTICING MANAGER Using a Fed Watcher Summary Key Terms Questions Quantitative Problems Web Exercises Web Appendices

PART FIVE Chapter 11

240 240 242 243 243 244 244 245 246 248 249 250 251 251 252 252 253

FINANCIAL MARKETS The Money Markets

254

Preview The Money Markets Defined Why Do We Need the Money Markets? Money Market Cost Advantages The Purpose of the Money Markets Who Participates in the Money Markets? U.S. Treasury Department Federal Reserve System Commercial Banks Businesses Investment and Securities Firms Individuals Money Market Instruments Treasury Bills ■ CASE Discounting the Price of Treasury Securities to Pay the Interest ■ MINI-CASE Treasury Bill Auctions Go Haywire Federal Funds Repurchase Agreements Negotiable Certificates of Deposit Commercial Paper Banker’s Acceptances Eurodollars ■ GLOBAL Ironic Birth of the Eurodollar Market Comparing Money Market Securities Interest Rates

254 255 255 256 257 258 258 258 258 259 260 260 260 261 261 264 264 266 267 268 271 271 272 273 273

Contents in Detail

Chapter 12

Chapter 13

xvii

Liquidity How Money Market Securities Are Valued ■ FOLLOWING THE FINANCIAL NEWS Money Market Rates Summary Key Terms Questions Quantitative Problems Web Exercises

274 274 274 276 277 277 277 278

The Bond Market

279

Preview Purpose of the Capital Market Capital Market Participants Capital Market Trading Types of Bonds Treasury Notes and Bonds Treasury Bond Interest Rates Treasury Inflation-Protected Securities (TIPS) Treasury STRIPS Agency Bonds ■ CASE The 2007–2009 Financial Crisis and the Bailout of Fannie Mae and Freddie Mac Municipal Bonds Risk in the Municipal Bond Market Corporate Bonds Characteristics of Corporate Bonds Types of Corporate Bonds Financial Guarantees for Bonds Current Yield Calculation Current Yield Finding the Value of Coupon Bonds Finding the Price of Semiannual Bonds Investing in Bonds Summary Key Terms Questions Quantitative Problems Web Exercises

279 279 280 280 281 282 282 282 283 284 284 286 288 288 289 290 293 294 294 295 296 298 299 300 300 300 301

The Stock Market

302

Preview Investing in Stocks Common Stock vs. Preferred Stock How Stocks Are Sold Computing the Price of Common Stock The One-Period Valuation Model The Generalized Dividend Valuation Model

302 302 303 304 307 308 309

xviii

Contents in Detail

Chapter 14

The Gordon Growth Model Price Earnings Valuation Method How the Market Sets Security Prices Errors in Valuation Problems with Estimating Growth Problems with Estimating Risk Problems with Forecasting Dividends ■ CASE The 2007–2009 Financial Crisis and the Stock Market ■ CASE The September 11 Terrorist Attack, the Enron Scandal, and the Stock Market Stock Market Indexes ■ MINI-CASE History of the Dow Jones Industrial Average Buying Foreign Stocks Regulation of the Stock Market The Securities and Exchange Commission Summary Key Terms Questions Quantitative Problems Web Exercises

309 311 311 313 313 314 314 314

The Mortgage Markets

323

Preview What Are Mortgages? Characteristics of the Residential Mortgage Mortgage Interest Rates ■ CASE The Discount Point Decision Loan Terms Mortgage Loan Amortization Types of Mortgage Loans Insured and Conventional Mortgages Fixed- and Adjustable-Rate Mortgages Other Types of Mortgages Mortgage-Lending Institutions Loan Servicing ■ E-FINANCE Borrowers Shop the Web for Mortgages Secondary Mortgage Market Securitization of Mortgages What Is a Mortgage-Backed Security? Types of Pass-Through Securities Subprime Mortgages and CDOs The Real Estate Bubble Summary Key Terms Questions Quantitative Problems Web Exercises

323 324 325 325 326 327 329 330 330 330 331 333 334 335 335 336 336 337 338 339 340 340 341 341 343

315 316 318 318 319 319 320 320 321 321 322

Contents in Detail

Chapter 15

The Foreign Exchange Market

344

Preview Foreign Exchange Market What Are Foreign Exchange Rates? Why Are Exchange Rates Important? ■ FOLLOWING THE FINANCIAL NEWS Foreign Exchange Rates How Is Foreign Exchange Traded? Exchange Rates in the Long Run Law of One Price Theory of Purchasing Power Parity Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates Factors That Affect Exchange Rates in the Long Run Exchange Rates in the Short Run: A Supply and Demand Analysis Supply Curve for Domestic Assets Demand Curve for Domestic Assets Equilibrium in the Foreign Exchange Market Explaining Changes in Exchange Rates Shifts in the Demand for Domestic Assets Recap: Factors That Change the Exchange Rate ■ CASE Changes in the Equilibrium Exchange Rate: An Example ■ CASE Why Are Exchange Rates So Volatile? ■ CASE The Dollar and Interest Rates ■ CASE The Subprime Crisis and the Dollar ■ CASE Reading the Wall Street Journal: The “Currency Trading” Column ■ FOLLOWING THE FINANCIAL NEWS The “Currency Trading” Column ■ THE PRACTICING MANAGER Profiting from Foreign Exchange Forecasts Summary Key Terms Questions Quantitative Problems Web Exercises

344 345 346 346 347 348 348 348 349

Chapter 15 Appendix The Interest Parity Condition

Chapter 16

xix

350 351 352 353 353 354 355 355 358 360 362 362 364 365 366 366 367 368 368 368 369 370

Comparing Expected Returns on Domestic and Foreign Assets Interest Parity Condition

370 372

The International Financial System

374

Preview Intervention in the Foreign Exchange Market Foreign Exchange Intervention and the Money Supply ■ INSIDE THE FED A Day at the Federal Reserve Bank of New York’s Foreign Exchange Desk Unsterilized Intervention Sterilized Intervention Balance of Payments ■ GLOBAL Why the Large U.S. Current Account Deficit Worries Economists

374 374 374 376 377 377 379 380

xx

Contents in Detail Exchange Rate Regimes in the International Financial System Fixed Exchange Rate Regimes How a Fixed Exchange Rate Regime Works ■ GLOBAL The Euro’s Challenge to the Dollar ■ GLOBAL Argentina’s Currency Board ■ GLOBAL Dollarization ■ CASE The Foreign Exchange Crisis of September 1992 ■ THE PRACTICING MANAGER Profiting from a Foreign Exchange Crisis ■ CASE Recent Foreign Exchange Crises in Emerging Market Countries: Mexico 1994, East Asia 1997, Brazil 1999, and Argentina 2002 ■ CASE How Did China Accumulate Over $2 Trillion of International Reserves? Managed Float Capital Controls Controls on Capital Outflows Controls on Capital Inflows The Role of the IMF Should the IMF Be an International Lender of Last Resort? How Should the IMF Operate? Summary Key Terms Questions Quantitative Problems Web Exercises Web Appendices

PART SIX Chapter 17

380 381 381 383 384 385 386 387 388 389 390 391 391 391 392 392 393 395 395 396 396 397 397

THE FINANCIAL INSTITUTIONS INDUSTRY Banking and the Management of Financial Institutions

398

Preview The Bank Balance Sheet Liabilities Assets Basic Banking General Principles of Bank Management Liquidity Management and the Role of Reserves Asset Management Liability Management Capital Adequacy Management ■ THE PRACTICING MANAGER Strategies for Managing Bank Capital ■ CASE How a Capital Crunch Caused a Credit Crunch in 2008 Off-Balance-Sheet Activities Loan Sales Generation of Fee Income Trading Activities and Risk Management Techniques ■ CONFLICTS OF INTEREST Barings, Daiwa, Sumitomo, and Societé Generale: Rogue Traders and the Principal–Agent Problem Measuring Bank Performance Bank’s Income Statement

398 399 399 401 403 405 406 408 409 410 412 413 414 414 414 415 416 417 417

Contents in Detail

Chapter 18

Chapter 19

xxi

Measures of Bank Performance Recent Trends in Bank Performance Measures Summary Key Terms Questions Quantitative Problems Web Exercises

419 420 422 422 422 423 424

Financial Regulation

425

Preview Asymmetric Information and Financial Regulation Government Safety Net ■ GLOBAL The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing? Restrictions on Asset Holdings Capital Requirements Prompt Corrective Action ■ GLOBAL Whither the Basel Accord? Financial Supervision: Chartering and Examination Assessment of Risk Management Disclosure Requirements Consumer Protection Restrictions on Competition ■ MINI-CASE Mark-to-Market Accounting and the 2007–2009 Financial Crisis ■ MINI-CASE The 2007–2009 Financial Crisis and Consumer Protection Regulation Summary ■ E-FINANCE Electronic Banking: New Challenges for Bank Regulation ■ GLOBAL International Financial Regulation The 1980s Savings and Loan and Banking Crisis Federal Deposit Insurance Corporation Improvement Act of 1991 Banking Crises Throughout the World in Recent Years “Déjà Vu All Over Again” The Dodd-Frank Bill and Future Regulation Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 Future Regulation Summary Key Terms Questions Quantitative Problems Web Exercises Web Appendices

425 425 425

438 438 439 440 443 444 445 447 448 448 449 451 451 451 452 453 453

Banking Industry: Structure and Competition

454

Preview Historical Development of the Banking System Multiple Regulatory Agencies

454 454 456

427 430 430 431 432 433 434 435 436 436 437

xxii

Contents in Detail

Chapter 20

Financial Innovation and the Growth of the Shadow Banking System Responses to Changes in Demand Conditions: Interest Rate Volatility Responses to Changes in Supply Conditions: Information Technology ■ E-FINANCE Will “Clicks” Dominate “Bricks” in the Banking Industry? ■ E-FINANCE Why Are Scandinavians So Far Ahead of Americans in Using Electronic Payments and Online Banking? ■ E-FINANCE Are We Headed for a Cashless Society? Avoidance of Existing Regulations ■ MINI-CASE Bruce Bent and the Money Market Mutual Fund Panic of 2008 ■ THE PRACTICING MANAGER Profiting from a New Financial Product: A Case Study of Treasury Strips Financial Innovation and the Decline of Traditional Banking Structure of the U.S. Commercial Banking Industry Restrictions on Branching Response to Branching Restrictions Bank Consolidation and Nationwide Banking ■ E-FINANCE Information Technology and Bank Consolidation The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 What Will the Structure of the U.S. Banking Industry Look Like in the Future? Are Bank Consolidation and Nationwide Banking Good Things? Separation of the Banking and Other Financial Service Industries Erosion of Glass-Steagall The Gramm-Leach-Bliley Financial Services Modernization Act of 1999: Repeal of Glass-Steagall Implications for Financial Consolidation Separation of Banking and Other Financial Services Industries Throughout the World ■ MINI-CASE The 2007-2009 Financial Crisis and the Demise of Large, Free-Standing Investment Banks Thrift Industry: Regulation and Structure Savings and Loan Associations Mutual Savings Banks Credit Unions International Banking Eurodollar Market Structure of U.S. Banking Overseas Foreign Banks in the United States Summary Key Terms Questions Web Exercises

457 458 459 461

481 482 482 483 483 483 484 485 485 486 487 487 488

The Mutual Fund Industry

489

Preview The Growth of Mutual Funds The First Mutual Funds Benefits of Mutual Funds Ownership of Mutual Funds

489 489 490 490 491

462 463 465 467 467 469 473 474 474 475 477 477 478 478 479 480 480 480 481

Contents in Detail

Chapter 21

xxiii

Mutual Fund Structure Open- Versus Closed-End Funds Organizational Structure ■ CASE Calculating a Mutual Fund’s Net Asset Value Investment Objective Classes Equity Funds Bond Funds Hybrid Funds Money Market Funds Index Funds Fee Structure of Investment Funds Regulation of Mutual Funds Hedge Funds ■ MINI-CASE The Long Term Capital Debacle Conflicts of Interest in the Mutual Fund Industry ■ CONFLICTS OF INTEREST Many Mutual Funds Are Caught Ignoring Ethical Standards Sources of Conflicts of Interest Mutual Fund Abuses ■ CONFLICTS OF INTEREST SEC Survey Reports Mutual Fund Abuses Widespread Government Response to Abuses Summary Key Terms Questions Quantitative Problems Web Exercises

494 494 494 495 497 497 498 498 499 500 501 502 503 505 506

509 509 510 510 511 511 512

Insurance Companies and Pension Funds

513

Preview Insurance Companies Fundamentals of Insurance Adverse Selection and Moral Hazard in Insurance Selling Insurance ■ MINI-CASE Insurance Agent: The Customer’s Ally Growth and Organization of Insurance Companies Types of Insurance Life Insurance Health Insurance Property and Casualty Insurance Insurance Regulation ■ CONFLICTS OF INTEREST Insurance Behemoth Charged with Conflicts of Interest Violations ■ THE PRACTICING MANAGER Insurance Management Screening Risk-Based Premium Restrictive Provisions Prevention of Fraud

513 514 515 515 516 517 517 518 518 522 524 525

507 506 507

526 526 527 527 528 528

xxiv

Contents in Detail

Chapter 22

528 528 529 529 529 529 530 531

Cancellation of Insurance Deductibles Coinsurance Limits on the Amount of Insurance Summary Credit Default Swaps ■ CONFLICTS OF INTEREST The AIG Blowup Pensions ■ CONFLICTS OF INTEREST The Subprime Financial Crisis and the Monoline Insurers Types of Pensions Defined-Benefit Pension Plans Defined-Contribution Pension Plans Private and Public Pension Plans ■ MINI-CASE Power to the Pensions Regulation of Pension Plans Employee Retirement Income Security Act Individual Retirement Plans The Future of Pension Funds Summary Key Terms Questions Quantitative Problems Web Exercises

531 532 532 532 533 534 537 537 539 540 540 541 541 541 542

Investment Banks, Security Brokers and Dealers, and Venture Capital Firms

543

Preview Investment Banks Background Underwriting Stocks and Bonds ■ FOLLOWING THE FINANCIAL NEWS New Securities Issues Equity Sales Mergers and Acquisitions Securities Brokers and Dealers Brokerage Services Securities Dealers ■ MINI-CASE Example of Using the Limit-Order Book Regulation of Securities Firms Relationship Between Securities Firms and Commercial Banks Private Equity Investment Venture Capital Firms Private Equity Buyouts Advantages to Private Equity Buyouts ■ E-FINANCE Venture Capitalists Lose Focus with Internet Companies Life Cycle of the Private Equity Buyout

543 544 544 545 548 550 551 552 553 555 556 556 558 558 558 562 563 563 564

Contents in Detail Summary Key Terms Questions Quantitative Problems Web Exercises

PART SEVEN Chapter 23

Chapter 24

xxv 564 565 565 566 567

THE MANAGEMENT OF FINANCIAL INSTITUTIONS Risk Management in Financial Institutions

568

Preview Managing Credit Risk Screening and Monitoring Long-Term Customer Relationships Loan Commitments Collateral Compensating Balances Credit Rationing Managing Interest-Rate Risk Income Gap Analysis Duration Gap Analysis Example of a Nonbanking Financial Institution Some Problems with Income Gap and Duration Gap Analyses ■ THE PRACTICING MANAGER Strategies for Managing Interest-Rate Risk Summary Key Terms Questions Quantitative Problems Web Exercises

568 569 569 570 571 571 572 572 573 574 576 581 582 584 585 586 586 586 589

Hedging with Financial Derivatives

590

Preview Hedging Forward Markets Interest-Rate Forward Contracts ■ THE PRACTICING MANAGER Hedging Interest-Rate Risk with Forward Contracts Pros and Cons of Forward Contracts Financial Futures Markets Financial Futures Contracts ■ FOLLOWING THE FINANCIAL NEWS Financial Futures ■ THE PRACTICING MANAGER Hedging with Financial Futures Organization of Trading in Financial Futures Markets Globalization of Financial Futures Markets Explaining the Success of Futures Markets ■ MINI-CASE The Hunt Brothers and the Silver Crash ■ THE PRACTICING MANAGER Hedging Foreign Exchange Risk with Forward and Futures Contracts

590 590 591 591 591 592 593 593 594 595 597 597 598 600 601

xxvi

Contents in Detail Hedging Foreign Exchange Risk with Forward Contracts Hedging Foreign Exchange Risk with Futures Contracts Stock Index Futures Stock Index Futures Contracts ■ MINI-CASE Program Trading and Portfolio Insurance: Were They to Blame for the Stock Market Crash of 1987? ■ FOLLOWING THE FINANCIAL NEWS Stock Index Futures ■ THE PRACTICING MANAGER Hedging with Stock Index Futures Options Option Contracts Profits and Losses on Option and Futures Contracts Factors Affecting the Prices of Option Premiums Summary ■ THE PRACTICING MANAGER Hedging with Futures Options Interest-Rate Swaps Interest-Rate Swap Contracts ■ THE PRACTICING MANAGER Hedging with Interest-Rate Swaps Advantages of Interest-Rate Swaps Disadvantages of Interest-Rate Swaps Financial Intermediaries in Interest-Rate Swaps Credit Derivatives Credit Options Credit Swaps Credit-Linked Notes ■ CASE Lessons from the Subprime Financial Crisis: When Are Financial Derivatives Likely to Be a Worldwide Time Bomb? Summary Key Terms Questions Quantitative Problems Web Exercises Web Appendices

618 619 620 620 620 623 623

Glossary

G-1

Index

601 602 603 603 603 604 605 606 606 607 610 611 613 613 613 613 615 615 616 616 616 617 617

I-1

Contents on the Web The following updated chapters and appendices are available on our Companion Website at www.pearsonhighered.com/mishkin_eakins.

Chapter 25

Savings Associations and Credit Unions Preview 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 Summary Key Terms Questions Web Exercises

Chapter 26

Finance Companies History of Finance Companies I Purpose of Finance Companies Risk in Finance Companies

xxvii

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 Summary Key Terms Questions Web Exercises

CHAPTER APPENDICES Chapter 4

Appendix 1: Models of Asset Pricing

Chapter 4 Appendix 2: Applying the Asset Market Approach to a Commodity Market: The Case of Gold Chapter 4 Appendix 3: Loanable Funds Framework Chapter 4 Appendix 4: Supply and Demand in the Market for Money: The Liquidity 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 of the Banking Regulatory System

Chapter 18

Appendix 2: Banking Crises Throughout the World

Chapter 24

Appendix: More on Hedging with Financial Derivatives

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