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Financial
Markets and
Institutions
A Modern Perspective
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The McGraw-Hill/Irwin Series in Finance, Insurance and Real Estate

Stephen A. Ross Nunnally and Plath Rose

Franco Modigliani Professor of Finance Cases in Finance Money and Capital Markets:
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sau48925_FM.qxd 8/9/00 9:25 AM Page v

Financial
Markets and
Institutions
A Modern Perspective

Anthony Saunders
Stern School of Business
New York University

Marcia Millon Cornett

Southern Illinois University

Boston Burr Ridge, IL Dubuque, IA Madison, WI

New York San Francisco St. Louis
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McGraw-Hill Higher Education

A Division of The McGraw-Hill Companies
FINANCIAL MARKETS AND INSTITUTIONS
Published by McGraw-Hill/Irwin, an imprint of The McGraw-Hill Companies, Inc. 1221
Avenue of the Americas, New York, NY, 10020. Copyright © 2001 by The McGraw-
Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced
or distributed in any form or by any means, or stored in a database or retrieval system,
without the prior written consent of The McGraw-Hill Companies, Inc., including, but
not limited to, in any network or other electronic storage or transmission, or broadcast for
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Some ancillaries, including electronic and print components, may not be available to
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This book is printed on acid-free paper.
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www.mhhe.com
sau48925_FM.qxd 8/9/00 9:25 AM Page vii

To my father, Myer Saunders (1919–1998).

TONY SAUNDERS

To Galen
MARCIA MILLON CORNETT
sau48925_FM.qxd 8/9/00 9:25 AM Page viii
About the Authors
ANTHONY SAUNDERS
Anthony Saunders is the John M. Schiff Professor of Finance
and Chair of the Department of Finance at the Stern School
of Business at New York University. Professor Saunders re-
ceived his Ph.D. from the London
School of Economics and has
taught both undergraduate
and graduate level courses at
NYU since 1978. Through-
out his academic career, his
teaching and research have
specialized in financial institu-
tions and international banking.
He has served as a visiting professor
all over the world, including INSEAD, the Stockholm School
of Economics, and the University of Melbourne. He is cur-
rently on the Executive Committee of the Salomon Center for
the Study of Financial Institutions, NYU.
Professor Saunders holds positions on the Board of Aca-
demic Consultants of the Federal Reserve Board of Gover-
nors as well as the Council of Research Advisors for the
Federal National Mortgage Association. In addition, Dr.
Saunders has acted as a visiting scholar at the comptroller of
the Currency and at the Federal Monetary Fund. He is the ed-
itor of the Journal of Banking and Finance and the Journal of
Financial Markets, Instruments and Institutions, as well as
the associate editor of eight other journals, including Finan-
cial Management and the Journal of Money, Credit and
Banking. His research has been published in all of the major
money and banking journals and in several books. He has just
published a book on Financial Institutions Management: A
Modern Perspective with McGraw-Hill/Irwin.
viii
MARCIA MILLON CORNETT
Marcia Millon Cornett is a Professor of Finance at Southern
Illinois University at Carbondale. She received her B.S. de-
gree in Economics from Knox College in Galesburg, Illinois,
and her M.B.A. and Ph.D. degrees in Finance from Indiana
University in Bloomington, Indiana. Dr. Cornett has written
and published several articles in the areas of bank perfor-
mance, bank regulation, corporate finance, and investments.
Articles authored by Dr. Cornett have appeared in such aca-
demic journals as the Journal of Finance, the Journal of
Money, Credit, and Banking, the Journal of Financial Eco-
nomics, Financial Management, and the Journal of Banking
and Finance. She served as an Associate Editor of Financial
Management and is currently an Associ-
ate Editor for the Multinational Fi-
nance Journal. Dr. Cornett is
currently a member of the
Board of Directors and the
Finance Committee of the
Southern Illinois University
Credit Union. Dr. Cornett has
also taught at the University of
Colorado, Boston College, and
Southern Methodist University. She is
a member of the Financial Management Association, the
American Finance Association, and the Western Finance
Association.
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Preface

T
he 1990s was characterized as a period in which financial markets in the United
States boomed. The Dow Jones Industrial Average rose from a level of 2,800 in
January 1990 to more than 11,000 by the end of the decade; this compared to a
move from 100 at its inception in 1906 to 2,800 thirty-four years later. While
security values in U.S. financial markets rose dramatically, financial markets in South-
east Asia, South America, and Russia plummeted. For example, on July 2, 1997, the
Thai baht fell nearly 50 percent in value relative to the U.S. dollar. Countries such
as Russia, Thailand, and South Korea required an international bailout by the Inter-
national Monetary Fund to prevent a complete collapse of their financial markets
and their economies. Nevertheless, Indonesia had to declare a moratorium on some
of its debt repayments, while Russia defaulted on payments on its short-term govern-
ment bonds.
Meanwhile, the financial services industry is approaching a full historical cycle.
Originally the banking industry operated as a full-service industry, performing directly
or indirectly all financial services (commercial banking, investment banking, stock in-
vesting, insurance provision, etc.). In the early 1930s, the economic and industrial col-
lapse resulted in the separation of some of these activities. In the 1970s and 1980s,
new, relatively unregulated financial services industries sprang up (e.g., mutual funds,
brokerage funds, etc.) that separated the financial service functions even further. Now,
at the turn of the century, regulatory barriers, via the Financial Services Modernization
Act of 1999, technological innovation, and financial innovation has resulted in changes
such that a full set of financial services may again be offered by a single financial
institution (FI) such as Citigroup. Not only are the boundaries between traditional
industry sectors weakening but competition is becoming global in nature as the
Germans, French, and other Europeans enter into U.S. financial service markets, and
vice versa.
As the economic and competitive environments change, attention to profit and,
more than ever, risk becomes increasingly important. This book offers a unique analy-
sis of the risks faced by investors and savers interacting through both financial institu-
tions and financial markets, as well as strategies that can be adopted for controlling and
managing these risks. Special emphasis is also put on new areas of operations in
financial markets and institutions, such as asset securitization, off-balance-sheet activ-
ities, and globalization of financial services.
While maintaining a risk measurement and management framework, Financial
Markets and Institutions: A Modern Perspective provides a broader application of
this important perspective. This book recognizes that domestic and foreign financial
ix
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x Preface

markets are increasingly connected and that financial intermediaries are evolving
towards a single financial services industry. The analytical rigor is mathematically ac-
cessible to all levels of students, undergraduate and graduate, and is balanced by a
comprehensive discussion of the unique environment within which financial markets
and institutions operate. Important practical tools such as how to issue and trade fi-
nancial securities or how to analyze financial statements and loan applications will arm
students with skills necessary to understand and manage financial market and institu-
tion risks in this dynamic environment. While descriptive concepts, so important to fi-
nancial management (financial market securities, regulation, industry trends, industry
characteristics, etc.) are included in the book, ample analytical techniques are also in-
cluded as practical tools to help students to understand the operation of modern finan-
cial markets and institutions.

Intended Audience
Financial Markets and Institutions: A Modern Perspective is aimed at the first course
in financial markets and institutions at both the undergraduate and MBA levels. While
topics covered in this book are found in more advanced textbooks on financial markets
and institutions, the explanations and illustrations are aimed at those with little or no
practical or academic experience beyond the introductory level in financial courses. In
most chapters, the main relationships are presented using figures, graphs, and simple
examples. The more complicated details and technical problems related to in-chapter
discussion are provided in appendixes to the chapters.

Organization
Since our focus is on return and risk and the sources of that return and risk in domes-
tic and foreign financial markets and institutions, this book relates ways in which a
modern financial manager, saver, and investor can expand return with a managed level
of risk to achieve the best, or most favorable, return-risk outcome.
The book is divided into five major sections. Part One provides an introduction to
the text and an overview of financial markets and institutions. Chapter 1 defines and
introduces the various domestic and foreign financial markets and describes the special
functions of FIs. This chapter also takes an analytical look at how financial markets
and institutions benefit today’s economy. In Chapter 2, we provide an in-depth look
at interest rates. We first review the concept of time value of money. We then look
at factors that determine interest rate levels, as well as their past, present, and expected
future movements. Chapter 3 then applies these interest rates to security valuation.
In Chapter 4, we describe the Federal Reserve System and how monetary policy im-
plemented by the Federal Reserve affects interest rates and, ultimately, the overall
economy.
Part Two of the text presents an overview of the domestic securities markets. We
describe each securities market, its participants, the securities traded in each, the trad-
ing process, and how changes in interest rates, inflation, and foreign exchange rates
impact the FI managers’ decisions to hedge risk. These chapters cover the money mar-
kets (Chapter 5), bond markets (Chapter 6), mortgage markets (Chapter 7), stock mar-
kets (Chapter 8), foreign exchange markets (Chapter 9), and derivative securities
markets (Chapter 10).
Part Three of the text summarizes the operations of depository institutions. Chap-
ter 11 describes the key characteristics and recent trends in the commercial banking
sector. Chapter 12 does the same for the thrift institution sector. Chapter 13 describes
the financial statements of a typical depository institution and the ratios used to ana-
lyze those statements. This chapter also analyzes actual financial statements for repre-
sentative financial institutions. Chapter 14 provides a comprehensive look at the
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Preface xi

regulations under which these financial institutions operate and, particularly, at the ef-
fect of recent changes in regulation.
Part Four of the text provides an overview describing the key characteristics and
regulatory features of the other major sectors of the U.S. financial services industry.
We discuss insurance institutions in Chapter 15, securities firms and investment banks
in Chapter 16, finance companies in Chapter 17, mutual fund firms in Chapter 18, and
pension funds in Chapter 19.
Part Five concludes the text by examining the risks facing a modern FI and FI
managers, and the various strategies for managing these risks. In Chapter 20, we pre-
view the risk measurement and management chapters that follow with an overview of
the risks facing a modern FI. We divide the chapters on risk measurement and man-
agement along two lines: measuring and managing risks on the balance sheet, and
managing risks off the balance sheet. In Chapter 21, we begin the on-balance-sheet risk
measurement and management section by looking at credit risk on individual loans and
bonds and how these risks adversely impact an FI’s profits and value. The chapter also
discusses the lending process, including loans made to small households and small,
medium-sized, and large corporations. Chapter 22 covers liquidity risk in financial in-
stitutions. This chapter includes a detailed analysis of ways in which FIs can insulate
themselves from liquidity risk, and the key role deposit insurance and other guarantee
schemes play in reducing liquidity risk.
In Chapter 23, we investigate the net interest margin as a source of profitability
and risk, with a focus on the effects of interest rate risk and the mismatching of asset
and liability maturities on FI risk exposure. At the core of FI risk insulation is the size
and adequacy of the owner’s capital stake, which is also a focus of this chapter.
The management of risk off the balance sheet is examined in Chapter 24. The
chapter highlights various new markets and instruments that have emerged to allow FIs
to better manage three important types of risk: interest rate risk, foreign exchange risk,
and credit risk. These markets and instruments and their strategic use by FIs include
forwards and futures, options, and swaps.
Finally, Chapter 25 explores ways of removing credit risk from the loan portfolio
through asset sales and securitization.

Walk-Through
Main Features
The following special features have been integrated throughout the text to encourage
student interaction and to aid them in absorbing the material.
• Chapter-opening outlines offer students a snapshot view of what they can expect
to learn from each chapter’s discussion.

Reserve System, Major Duties and

Responsibilities of the
Federal Reserve System:
Chapter Overview

Monetary Policy, Structure of the Federal

Reserve System

and Interest Rates Federal Reserve

Banks
Board of Governors of
the Federal Reserve
System
Federal Open Market
Committee
Chapter Navigator Balance Sheet of the
1. What are the major functions of the Federal Reserve System? Federal Reserve
Monetary Policy Tools
2. What is the structure of the Federal Reserve System? Open Market
Operations
3. What are the monetary policy tools used by the Federal Reserve? The Discount Rate
Reserve
4. How do monetary policy changes affect key economic variables? Requirements
(Reserve Ratios)
5. How do U.S. monetary policy initiatives affect foreign exchange rates? The Federal Reserve, the
Money Supply, and
Interest Rates
Effects of Monetary
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xii Preface

• Chapter Navigators list the chapter topics in order, providing numbers that cor-
respond with the section in which they can be found in the chapter.

Monetary Policy Tools

3 In the previous section of this chapter, we referred briefly to tools or instru-
ments that the Federal Reserve uses to implement its monetary policy. These in-
cluded open market operations, the discount rate, and reserve requirements.
Regardless of the tool the Federal Reserve uses to implement monetary policy, the ma-
jor link by which monetary policy impacts the macroeconomy occurs through the Fed-
eral Reserve influencing the market for bank reserves (required and excess reserves
held as depository institution reserves balances in accounts at Federal Reserve Banks
plus vault cash on hand of commercial banks). Specifically, the Federal Reserve’s

7. The minimum daily average reserves that a bank must maintain are computed as a percentage of
the daily average net transaction accounts held by the bank over the two-week computation period, called
the reserve computation period. Transaction accounts include all deposits on which an account holder may
make withdrawals (for example, demand deposits, NOW accounts, and share draft accounts—offered by

• Bold key terms and a marginal glossary emphasize the main terms and concepts
throughout the chapter.
• Pertinent website addresses are also referenced in the margins throughout each
chapter providing additional resources to aid in the learning process.

www.ny.frb.org/ Open Market Operations

Federal Reserve Board
Trading Desk
Unit of the Federal Reserve
Bank of New York through
which open market operations
are conducted.
policy directive
Statement sent to the Federal
Reserve Board Trading Desk
from the FOMC that specifies
the money supply target.
When a targeted monetary aggregate (M1, M2, etc.—see definition below) or interest
rate level is determined by the FOMC, it is forwarded to the Federal Reserve Board
Trading Desk at the Federal Reserve Bank of New York (FRBNY) through a state-
ment called the policy directive. The manager of the Trading Desk uses the policy di-
rective to instruct traders on the amount of open market purchases or sales to transact.
Open market operations are the Federal Reserves’ purchases or sales of securities in
the U.S. Treasury securities market. This is an over-the-counter market in which
traders are linked to each other electronically (see Chapter 5).
Open market operations are particularly important because they are the primary
determinant of changes in bank excess reserves in the banking system and thus directly
impact the size of the money supply and/or the level of interest rates (e.g., the fed
funds rate). When the Federal Reserve purchases securities, it pays for the securities by
either writing a check on itself or directly transferring funds (by wire transfer) into the
seller’s account. Either way, the Fed credits the reserve deposit account of the bank
that sells it (the Fed) the securities. This transaction increases the bank’s excess reserve
levels. When the Fed sells securities, it either collects checks received as payment or
receives wire transfers of funds from these agents (such as banks) using funds from

• “Do You Understand?” boxes allow students to test themselves on the main con-
cepts within each major chapter section.
banks (reserve account) deposits at the Fed.

Example 4–1 Purchases of Securities by the Federal Reserve

Suppose the FOMC instructs the FRBNY Trading Desk to purchase $500 million of
Treasury securities. Traders at the FRBNY call primary government securities dealers
of major commercial and investment banks (such as Goldman Sachs and Chase)9 who
provide a list of securities they have available for sale, including the denomination,
maturity, and the price on each security. FRBNY traders then seek to purchase the tar-
get number of securities (at the desired maturities and lowest possible price) until they
have purchased the $500 million. The FRBNY then notifies its government bond de-
partment to receive and pay the sellers for the securities it has purchased. The securi-
ties dealer sellers (such as banks) in turn deposit these payments in their accounts held
at their local Federal Reserve Bank. As a result of these purchases, the Treasury secu-
rities account balance of the Federal Reserve System is increased by $500 million and
the total reserve accounts maintained by these banks and dealers at the Fed is increased
by $500 million. We illustrate these changes to the Federal Reserve’s balance sheet in
Table 4–6. In addition, there is also an impact on commercial bank balance sheets. To-
tal reserves (assets) of commercial banks will increase by $500 million due to the pur-
chase of securities by the Fed, and demand deposits (liabilities) of the securities dealers
(those who sold the securities) at their banks will increase by $500 million.10 We also
show the changes to commercial banks’ balance sheets in Table 4–6.

Note the Federal Reserve’s purchase of Treasury securities has increased the total
supply of bank reserves in the financial system. This in turn increases the ability of

• In-chapter examples provide numerical demonstrations of the analytical material

described in many chapters.
money supply.

Gold and Foreign Exchange and Treasury Currency. The Federal Reserve holds
Treasury gold certificates that are redeemable at the U.S. Treasury for gold. The Fed
also holds small amounts of Treasury-issued coinage and foreign-denominated assets
to assist in foreign currency transactions or currency swap agreements
with the central banks of other nations.
Do You Understand?
Loans to Domestic Banks. As mentioned earlier, in a liquidity emer-
1. What the main functions of Federal
gency, depository institutions in need of additional funds can borrow at
Reserve Banks are?
the Federal Reserve’s discount window (discussed in detail below). The
2. What the main responsibilities of
interest rate or discount rate charged on these loans is often lower than
the Federal Reserve Board are?
other interest rates in the short-term money markets (see Chapter 5). To
3. How the FOMC implements
prevent excessive borrowing from the discount window, the Fed dis-
monetary policy?
courages borrowing unless a bank is in serious liquidity need (see
4. What the main assets and liabilities
Chapters 14 and 22). As a result, (discount) loans to domestic banks are
in the Federal Reserve System are?
normally a relatively small portion of the Fed’s total assets.8
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Preface xiii

• “In the News . . .” boxes demonstrate the application of chapter material to real,
current events.

In the News
N
4–1

A
lan Greenspan,
U.S. Federal Re-
serve Chairman,
said yesterday he
expected “a lot of prob-
lems” to emerge in the
global financial payments
system because of the Year
2000 computer problem.
The Fed had already or-
dered the printing of extra
banknotes for the next year
U.S. Prints Cash
to Cope with
Demands of
Millennium
Bomb
is we are going to run into a
lot of problems. And as a
consequence we are doing
a great deal of planning on
for banknotes between July
and the end of 1999. In
July, the Fed estimated it
had $460 billion in bank-
notes in circulation with an
additional $153 billion in its
vaults, a total of $613 bil-
lion. As part of the Fed’s
contingency planning, it had
ordered increased printing
of currency for the fiscal
year starting in October

• End-of-chapter problems. At least 20 problems per chapter are written for varied
levels of difficulty.

Summary
This chapter described the Federal Reserve System in the United States. The Federal
Reserve is the central bank charged with conducting monetary policy, supervising and
regulating depository institutions, maintaining the stability of the financial system, and
providing specific financial services to the U.S. government, the public, and financial
institutions. We reviewed the structure under which the Fed provides these functions,
the monetary policy tools it uses, and the impact of monetary policy changes on credit
availability, interest rates, money supply, security prices, and foreign exchange rates.

Questions
1. Describe the functions performed by Federal Reserve
Banks.
2. Define the discount window and the discount rate.
3. Describe the structure of the Board of Governors of the
Federal Reserve System.
4. What are the primary responsibilities of the Federal
Reserve Board?
5. What are the primary responsibilities of the Federal
Open Market Committee?
6. What are the major liabilities of the Federal Reserve
System? Describe each.
7. What are the major assets of the Federal Reserve Sys-
tem? Describe each.
8. What are the tools used by the Federal Reserve to im-
plement monetary policy?
9. Suppose the Federal Reserve instructs the Trading Desk
to purchase $1 billion of securities. Show the result of
this transaction on the balance sheets of the Federal Re-
serve System and commercial banks.
10. Suppose the Federal Reserve instructs the Trading Desk
to sell $850 million of securities. Show the result of this
transaction on the balance sheets of the Federal Reserve
System and commercial banks.
11. Explain how a decrease in the discount rate affects
credit availability and the money supply.
12. Why does the Federal Reserve rarely use the discount
rate to implement its monetary policy?
13. What is the difference between an adjustment credit, a
seasonal credit, and an extended credit discount win-
dow loan?
14. Bank Three currently has $600 million in transaction
deposits on its balance sheet. The Federal Reserve has
currently set the reserve requirement at 10 percent of
transaction deposits.
a. If the Federal Reserve decreases the reserve re-
quirement to 8 percent, show the balance sheet of
Bank Three and the Federal Reserve System just
before and after the full effect of the reserve re-
quirement change. Assume Bank Three withdraws
all excess reserves and gives out loans, and that
borrowers eventually return all of these funds to
Bank Three in the form of transaction deposits.
b. Redo part (a) using a 12 percent reserve requirement.
15. National Bank currently has $500 million in transaction
deposits on its balance sheet. The current reserve re-
quirement is 10 percent, but the Federal Reserve is de-
creasing this requirement to 8 percent.
a. Show the balance sheet of the Federal Reserve and
National Bank if National Bank converts all excess
reserves to loans, but borrowers return only 50 per-
cent of these funds to National Bank as transaction
deposits.
b. Show the balance sheet of the Federal Reserve and
National Bank if National Bank converts 75 percent
of its excess reserves to loans and borrowers return
60 percent of these funds to National Bank as trans-
action deposits.
16. Which of the monetary tools available to the Federal
Reserve is most often used? Why?
17. Describe how expansionary activities conducted by the
Federal Reserve impact credit availability, the money
supply, interest rates, and security prices. Do the same
for contractionary activities.

Supplements
• The Wall Street Journal Edition. Through a unique arrangement with Dow Jones,
McGraw-Hill/Irwin is able to offer your students a 10-week subscription to The
Wall Street Journal as part of the purchase price of the WSJ Edition text. The WSJ
will keep students up to date on the world of finance. (ISBN 007239708X)
• The Instructor’s Manual, prepared by Tim Manuel of the University of Montana,
includes detailed chapter contents, additional examples for use in the classroom,
sau48925_FM.qxd 8/9/00 9:27 AM Page xiv

xiv Preface

and complete solutions to end-of-chapter question and problem materials. (ISBN

0072397047)
• Also prepared by Tim Manuel, the Test Bank includes nearly 1,000 additional
problems to be used for test material. (ISBN 0072397055)
• Our Brownstone Diploma Testing System offers the test items for Financial
Markets and Institutions on computer disk. This program makes it possible to cre-
ate tests based on chapter, type of questions, and difficulty level. It allows instruc-
tors to combine their own questions with test items created by the Test Bank
author. This system can be used to edit existing questions and create several dif-
ferent versions of each test. The program accepts graphics, allows password
protection of saved tests, and may be used on a computer network. (ISBN
0072397063)
• William Lepley, University of Wisconsin–Green Bay, has written a Study Guide
that speaks directly to the student. It provides a conceptual outline and applica-
tions that include definitional and quantitative problems for each chapter. Detailed
solutions explain how answers were derived. (ISBN 0072397039)
• The PowerPoint Presentation, prepared by Joseph Ogden of the State University
of New York–Buffalo, includes full-color slides featuring lecture notes, figures,
and tables. Found only on the book’s website, the slides can be easily downloaded
and edited for a specific course.
• The Instructor’s CD-ROM provides the instructor with one resource for all sup-
plementary material, including the Instructor’s Manual, Test Bank, and Power-
point. (ISBN 0072397071)
• The Saunders/Cornett Custom Crafted Website is found at www.mhhe.com/
sc1e. In addition to information on the book and its features, the site also includes
downloadable Powerpoint slides and Excel Spreadsheet examples and a sampler
chapter from both the text and the Study Guide.
• PAGEOUT: THE COURSE WEBSITE DEVELOPMENT CENTER AND
PAGEOUT LITE
www.pageout.net
This Web page generation software, free to adopters, is designed to help professors
just beginning to explore website options. In just a few minutes, even a novice
computer user can have a course website.
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Anthony Saunders
Marcia Millon Cornett
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Contents in Brief
Preface ix
part 4 OTHER FINANCIAL
INSTITUTIONS 000
part 1 INTRODUCTION AND OVERVIEW
OF FINANCIAL MARKETS 1 15 Insurance Companies 000
1 Introduction 2 16 Securities Firms and Investment Banks 000

2 Determinants of Interest Rates 00 17 Finance Companies 000

3 Interest Rates and Security Valuation 00 18 Mutual Funds 000

4 The Federal Reserve System, Monetary 19 Pension Funds 000

Policy, and Interest Rates 00
part 5 RISK MANAGEMENT IN
part 2 SECURITIES MARKETS 121 FINANCIAL INSTITUTIONS 000

5 Money Markets 122

20 Types of Risks Incurred by Financial
Institutions 000
6 Bond Markets 153
21 Managing Risk on the Balance Sheet I:
7 Mortgage Markets 000 Credit Risk 000

8 Stock Markets 000 22 Managing Risk on the Balance Sheet II:

Liquidity Risk 000
9 Foreign Exchange Markets 000
23 Managing Risk on the Balance Sheet III:
10 Derivative Securities Markets 000 Interest Rate and Insolvency Risk 000
24 Managing Risk with Derivative
part 3 DEPOSITORY INSTITUTIONS 000 Securities 000
11 Commercial Banks 000 25 Loan Sales and Asset Securitization 000
12 Thrift Institutions 000
Glossary 000
13 Depository Institutions’ Financial Appendix 000
Statements and Analysis 000 References 000
14 Regulation of Depository Institutions 000 Index 000

xv
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Contents
part 1 INTRODUCTION AND OVERVIEW
OF FINANCIAL MARKETS 1
1 Introduction 2
Why Study Financial Markets and
Institutions?: Chapter Overview 0
Overview of Financial Markets 0 Real Interest Rates 00
Primary Markets versus Secondary
Markets 0
Money Markets versus Capital Markets
Financial Market Regulation 0
Foreign Exchange Markets 0
Overview of Financial Institutions 0 Term Structure of Interest Rates 00
Unique Economic Functions Performed by
Financial Institutions 0
Additional Benefits FIs Provide to
Suppliers of Funds 0
Economic Functions FIs Provide to the
Financial System as a Whole 0
Regulation of Financial Institutions 0
Globalization of Financial Markets and
Institutions 0
2 Determinants of Interest Rates 00
Interest Rate Fundamentals:
Chapter Overview 00
Time Value of Money and Interest Rates 00
Time Value of Money 00
Present Values 00
Future Values 00
Interest Rates on Securities with a Maturity
of Less than One Year 00
Loanable Funds Theory 00
Supply of Loanable Funds 00
Demand for Loanable Funds 00
Equilibrium Interest Rate 00
Factors that Cause the Supply and Demand
Curves for Loanable Funds to Shift 00
Movement of Interest Rates Over Time 00
Determinants of Interest Rates for Individual
Securities 00
Inflation 00
Fisher Effect 00
Default or Credit Risk 00
0 Liquidity Risk 00
Special Provisions or Covenants 00
Term to Maturity 00
Unbiased Expectations Theory 00
Liquidity Premium Theory 00
Market Segmentation Theory 00
Forecasting Interest Rates 00
3 Interest Rates and Security
Valuation 00
Interest Rates as a Determinant of Financial
Security Values: Chapter Overview 00
Various Interest Rate Measures 00
Required Rate of Return 00
Expected Rate of Return 00
Required versus Expected Rates of Return:
The Role of Efficient Markets 00
Realized Rate of Return 00
Coupon Rate 00
Bond Valuation 00
Bond Valuation Formula Used to Calculate
Fair Present Values 00
Bond Valuation Formula Used to Calculate
Yield to Maturity 00
Impact of Interest Rate Changes on Security
Values 00
xvii
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xviii Contents
Impact of Maturity on Security Values 00
Maturity and Security Price 00
Maturity and Security Price Sensitivity to
Changes in Interest Rates 00
Impact of Coupon Rates on Security
Values 00
Coupon Rate and Security Prices 00
Coupon Rate and Security Price Sensitivity
to Changes in Interest Rates 00
Duration 00
A Simple Illustration of Duration 00
A General Formula for Duration 00
Features of Duration 00
Economic Meaning of Duration 00
Large Interest Rate Changes and
Duration 00
Appendix: Equity Valuation 00
4 The Federal Reserve System,
Monetary Policy, and
Interest Rates 000
Major Duties and Responsibilities of
the Federal Reserve System:
Chapter Overview 000
Structure of the Federal Reserve
System 000
Federal Reserve Banks 000
Board of Governors of the Federal Reserve
System 000
Federal Open Market Committee 000
Balance Sheet of the Federal Reserve 000
Monetary Policy Tools 000
Tools of Monetary Policy 000
The Federal Reserve, the Money Supply,
and Interest Rates 000
Effects of Monetary Tools on Various
Economic Variables 000
Money Supply versus Interest Rate
Targeting 000
International Monetary Policies and
Strategies 000
Impact of U.S. Monetary Policy on Foreign
Exchange Rates 000
part 2 SECURITIES MARKETS 121
5 Money Markets 122
Definition of Money Markets:
Chapter Overview 122
Money Markets 123
Money Market Securities 125
Treasury Bills 126
Federal Funds 132
Repurchase Agreements 133
Commercial Paper 136
Negotiable Certificates of Deposit 139
Banker’s Acceptances 141
Comparison of Money Market
Securities 142
Money Market Participants 143
The U.S. Treasury 143
The Federal Reserve 144
Commercial Banks 144
Brokers and Dealers 144
Corporations 145
Other Financial Institutions 145
International Aspects of Money
Markets 145
Euro Money Markets 145
Euro Money Market Securities 149
6 Bond Markets 153
Definition of Bond Markets:
Chapter Overview 153
Bond Market Securities 154
Treasury Notes and Bonds 154
Municipal Bonds 164
Corporate Bonds 171
Bond Ratings 177
Bond Market Indexes 178
Bond Market Participants 179
Comparison of Bond Market
Securities 179
International Aspects of Bond Markets 181
Eurobonds, Foreign Bonds, and Brady and
Sovereign Bonds 184
Eurobonds 184
Foreign Bonds 185
Brady Bonds and Sovereign Bonds 185
7 Mortgage Markets 000
Mortgages and Mortgage-Backed Securities:
Chapter Overview 000
Primary Mortgage Market 000
Mortgage Characteristics 000
Mortgage Amortization 000
Other Types of Mortgages 000
Secondary Mortgage Markets 000
History and Background of Secondary
Mortgage Markets 000
Mortgage Sales 000
Securitization of Mortgages 000
Institutional Use of Mortgage Markets 000
International Trends in Securitization 000
Demand by International Investors for U.S.
Mortgage-Backed Securities 000
International Mortgage Securities 000
8 Stock Markets 000
The Stock Markets: Chapter Overview 000
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Contents xix

Stock Market Securities 000 Currency Swaps 000

Common Stock 000 Swap Markets 000
Preferred Stock 000 Caps, Floors, and Collars 000
Primary and Secondary Stock Markets 000 Appendix: Black-Scholes Option Pricing
Primary Markets 000
Model 000
Secondary Markets 000
Stock Market Indexes 000
Stock Market Participants 000 part 3 DEPOSITORY INSTITUTIONS 000
Other Issues Pertaining to Stock 11 Commercial Banks 000
Markets 000
Commercial Banks as a Sector of
Economic Indicators 000
the Financial Institutions Industry:
Market Efficiency 000
Stock Market Regulations 000 Chapter Overview 000
International Aspects of Stock Definition of a Commercial Bank 000
Markets 000 Balance Sheets and Recent Trends 000
Assets 000
Appendix: Event Study Tests 000
Liabilities 000
9 Foreign Exchange Markets 000 Equity 000
Off-Balance-Sheet Activities 000
Foreign Exchange Markets and Risk: Other Fee-Generating Activities 000
Chapter Overview 000
Size, Structure, and Composition of
Background and History of Foreign the Industry 000
Exchange Markets 000 Economies of Scale and Scope 000
Foreign Exchange Rates and Bank Size and Concentration 000
Transactions 000 Bank Size and Activities 000
Foreign Exchange Rates 000 Industry Performance 000
Foreign Exchange Transactions 000
Regulators 000
Return and Risk of Foreign Exchange
Federal Deposit Insurance
Transactions 000
Corporation 000
Role of Financial Institutions in Foreign
Office of the Comptroller of the
Exchange Transactions 000
Currency 000
Interaction of Interest Rates, Inflation, and Federal Reserve System 000
Foreign Exchange Rates 000 State Authorities 000
Purchasing Power Parity 000
Interest Rate Parity 000 12 Thrift Institutions 000
Balance of Payment Accounts 000 Three Categories of Thrift Institutions:
Current Account 000 Chapter Overview 000
Capital Accounts 000 Savings Associations 000
Size, Structure, and Composition of the
10 Derivative Securities Markets 000 Industry 000
Derivative Securities: Balance Sheets and Recent Trends 000
Chapter Overview 000 Savings Banks 000
Forwards and Futures 000 Size, Structure, and Composition of the
Spot Markets 000 Industry 000
Forward Markets 000 Balance Sheets and Recent Trends 000
Futures Markets 000 Regulators of Savings
Options 000 Institutions 000
Call Options 000
Savings Association and Savings Bank
Put Options 000
Recent Performance 000
Option Values 000
Option Markets 000 Credit Unions 000
Size, Structure, and Composition of the
Regulation of Futures and Options
Industry 000
Markets 000 Balance Sheets and Recent Trends 000
Swaps 000 Regulators 000
Interest Rate Swaps 000 Industry Performance 000
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xx Contents
13 Depository Institutions’ Financial
Statements and Analysis 000
Why Evaluate Performance of Depository
Institutions: Chapter Overview 000
Financial Statements of Commercial
Banks 000
Balance Sheet Structure 000
Off-Balance-Sheet Assets and
Liabilities 000
Income Statement 000
Direct Relationship between the Income
Statement and the Balance Sheet 000
Financial Statement Analysis Using a Return
on Equity Framework 000
Return on Equity and Its Components 000
Return on Assets and Its Components 000
Other Ratios 000
Impact of Market Niche and Bank Size on
Financial Statement Analysis 000
Impact of a Bank’s Market Niche 000
Impact of Size on Financial Statement
Analysis 000
14 Regulation of Depository
Institutions 000
Specialness and Regulation:
Chapter Overview 000
Types of Regulations and the
Regulators 000
Safety and Soundness Regulation 000
Monetary Policy Regulation 000
Credit Allocation Regulation 000
Consumer Protection Regulation 000
Investor Protection Regulation 000
Entry and Chartering Regulation 000
Regulators 000
Regulation of Product and Geographic
Expansion 000
Product Segmentation in the U.S.
Depository Institutions Industry
Geographic Expansion in the U.S.
Depository Institutions Industry
History of Bank and Savings Institution
Guarantee Funds 000
FDIC 000
The Federal Savings and Loan Insurance
Corporation and Its Demise 000
Causes of the Depository Fund
Insolvencies 000
Non U.S. Deposit Insurance
Systems 000
Balance Sheet Regulations 000
Regulations on Depository Institution
Liquidity 000
Regulations on Capital Adequacy
(Leverage) 000
Off-Balance-Sheet Regulations 000
Foreign versus Domestic Regulation of
Depository Institutions 000
Product Diversification Activities 000
Global or International Expansion
Activities 000
Appendix A: Depository Institutions and
Their Regulators 000
Appendix B: Financial Services
Modernization Act of 1999: Summary of
Provisions 000
Appendix C: Calculating Minimum
Required Reserves at U.S. Depository
Institutions 000
Appendix D: Calculating Risk-Based
Capital Ratios 000
part 4 OTHER FINANCIAL
INSTITUTIONS 000
15 Insurance Companies 000
Two Categories of Insurance Companies:
Chapter Overview 000
Life Insurance Companies 000
Size, Structure, and Composition of the
Industry 000
Balance Sheets and Recent Trends 000
Regulation 000
Property-Casualty Insurance
Companies 000
Size, Structure, and Composition of the
Industry 000
Balance Sheets and Recent Trends 000
Regulation 000
16 Securities Firms and Investment
Banks 000
Services Offered by Securities Firms versus
000 Investment Banks: Chapter Overview 000
Size, Structure, and Composition of the
000
Industry 000
Securities Firm and Investment Bank
Activity Areas 000
Investing 000
Investment Banking 000
Market Making 000
Trading 000
Cash Management 000
Mergers and Acquisitions 000
Other Service Functions 000
Recent Trends and Balance Sheets 000
Recent Trends 000
Balance Sheet 000
Regulation 000
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Contents xxi

17 Finance Companies 000 Liquidity Risk 000

Finance Company Functions: Interest Rate Risk 000
Chapter Overview 000 The Federal Reserve and Interest
Rate Risk 000
Size, Structure, and Composition of the Maturity Mismatching and Interest
Industry 000 Rate Risk 000
Balance Sheets and Recent Trends 000 Market Risk 000
Assets 000
Liabilities and Equity 000 Off-Balance-Sheet Risk 000

Regulation 000 Foreign Exchange Risk 000

18 Mutual Funds 000
Mutual Funds: Chapter Overview 000
Size, Structure, and Composition of the
Industry 000
Historical Trends 000
Different Types of Mutual Funds 000
Mutual Fund Prospectuses and
Objectives 000
Size and Mutual Fund Performance:
The Case of the Magellan Fund 000
Investor Returns from Mutual Fund
Ownership 000
Mutual Fund Costs 000
Mutual Fund Share Quotes 000
Balance Sheets and Recent Trends 000
Money Market Funds 000
Long-Term Funds 000
Regulation 000
19 Pension Funds 000
Pension Funds Defined:
Chapter Overview 000
Size, Structure, and Composition of the
Industry 000
Insured versus Noninsured Pension
Funds 000
Defined Benefit versus Defined
Contribution Pension Funds 000
Private Pension Funds 000
Public Pension Funds 000
Financial Asset Investments and Recent
Trends 000
Private Pension Funds 000
Public Pension Funds 000
Regulation of Pension Funds 000
part 5 RISK MANAGEMENT IN
FINANCIAL INSTITUTIONS 000
20 Types of Risks Incurred by Financial
Institutions 000
Why Financial Institutions Need to Manage
Risk: Chapter Overview 000
Credit Risk 000
Country or Sovereign Risk 000
Technology and Operational Risk 000
Insolvency Risk 000
Interaction Among Risks 000
21 Managing Risk on the Balance
Sheet I: Credit Risk 000
Credit Risk Management:
Chapter Overview 000
Credit Analysis 000
Real Estate Lending 000
Consumer (Individual) and Small-Business
Lending 000
Mid-Market Commercial and Industrial
Lending 000
Large Commercial and Industrial
Lending 000
Calculating the Return on a Loan 000
Return on Assets (ROA) 000
RAROC Models 000
Appendix: Loan Portfolio Risk and
Management 000
22 Managing Risk on the Balance
Sheet II: Liquidity Risk 000
Liquidity Risk Management:
Chapter Overview 000
Causes of Liquidity Risk 000
Liquidity Risk and Depository
Institutions 000
Liability Side Liquidity Risk 000
Asset Side Liquidity Risk 000
Measuring a Bank’s Liquidity
Exposure 000
Liquidity Risk, Unexpected Deposit Drains,
and Bank Runs 000
Bank Runs, the Discount Window, and
Deposit Insurance 000
Liquidity Risk and Insurance
Companies 000
Life Insurance Companies 000
Property-Casualty Insurance
Companies 000
Guarantee Programs for Life and Property-
Casualty Insurance Companies 000
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xxii Contents

Liquidity Risk and Mutual Funds 000 Futures versus Options Hedging 000
Swaps versus Forwards, Futures, and
23 Managing Risk on the Balance Options 000
Sheet III: Interest Rate and
Insolvency Risk 000 25 Loan Sales and Asset
Interest Rate and Insolvency Risk
Securitization 000
Management: Chapter Overview 000 Why Financial Institutions Securitize Assets:
Chapter Overview 000
Interest Rate Risk Measurement and
Management 000 Loan Sales 000
Repricing Model 000 Types of Loan Sales Contracts 000
Duration Model 000 Bank Loan Sale Market 000
Secondary Market for Less Developed
Insolvency Risk Management 000 Country Debt 000
Capital and Insolvency Risk 000
Factors Encouraging Future Loan Sales
24 Managing Risk with Derivative Growth 000
Securities 000 Factors Deterring Future Loan Sales
Growth 000
Derivative Securities Used to Manage Risk:
Chapter Overview 000 Loan Securitization 000
Pass-Through Security 000
Forward and Futures Contracts 000 Collateralized Mortgage Obligation 000
Hedging with Forward Contracts 000 Mortgage-Backed Bond 000
Hedging with Futures Contracts 000
Securitization of Other Assets 000
Options 000
Basic Features of Options 000
Can All Assets Be Securitized? 000
Actual Interest Rate Options 000
Hedging with Options 000 Glossary 000
Swaps 000 Appendix 000
Interest Rate Swaps 000 References 000
Currency Swaps 000
Index 000
Credit Risk Concerns with Swaps 000
Comparison of Hedging Methods 000
Writing versus Buying Options 000