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ROLE OF FINANCIAL MARKETS AND INSTITUTIONS 3 1-1 Role of Financial Markets, 3
3-5b Why the slope of the yield curve changes, 68 3-5c How the yield curve has changed over time, 69 3-5d International Structure of Interest Rate, 69. 4-3c How Fed operations affect all interest rates, 90 4-3d Adjustment of the reserve requirement ratio, 91 4-3e Adjustment of the Fed's lending rate, 92.
STOCK OFFERINGS AND INVESTOR MONITORING 249 10-1 Private Equity, 249
8-5 Valuation and Risk of International Bonds, 206 8-5a Influence of Foreign Interest Rate Movements, 207 8-5b Influence of Credit Risk, 207. Using the Wall Street Journal: Biggest Stock Gains and Losses, 290 11-3e Integration of Faktorer, der påvirker aktiekurserne, 290.
MARKET MICROSTRUCTURE AND STRATEGIES 319 12-1 Stock Market Transactions, 319
FOREIGN EXCHANGE DERIVATIVE MARKETS 439 16-1 Foreign Exchange Markets, 439
18-4e Use of the VaR Method to Determine Capital Levels, 506 18-4f Stress Tests Imposed to Determine Capital Levels, 507 18-4g Government Capital Infusion During the Credit Crisis, 507 .
BANK PERFORMANCE 551 20-1 Valuation of a Commercial Bank, 551
FINANCE COMPANY OPERATIONS 597 22-1 Types of Finance Companies, 597
24-4e The Impact of Leverage on Risk Exposure, 657 24-5 The Impact of the Credit Crisis on Securities Firms, 658.
INSURANCE AND PENSION FUND OPERATIONS 667 25-1 Background, 667
Each type of financial market is described with a focus on the securities that are traded and the participation of the financial institutions. Therefore, this text pays particular attention to the impact of financial reforms on each type of financial market and financial institution.
I NTENDED M ARKET
Today, many financial institutions offer all kinds of financial services, such as banking, securities services, mutual fund services and insurance services. Therefore, the discussion of financial services in this book is organized by type of financial service that may be offered by financial institutions.
O RGANIZATION OF THE T EXT
Alternatively, if an investment course provides a thorough background on the types of securities, Parts 3 and 4 may be given less attention. However, the crisis has had an impact on every type of market and financial institution, so it is covered in each chapter as it applies to the content of that chapter.
C OVERAGE OF M AJOR C ONCEPTS AND E VENTS
If, for example, a course on derivatives is commonly offered, Part 5 of this text may be ignored. Regardless of the order in which the chapters are studied, it is highly recommended that some questions and exercises from each chapter be assigned.
F EATURES OF THE T EXT
An integrative problem at the end of each section integrates the key concepts of the chapters within that section. At the end of Chapter 25, a final self-exam is provided to test students' knowledge of financial institutions.
S UPPLEMENTS TO THE T EXT
In addition, the Internet/Excel exercises on financial institutions give students practice in assessing the activities and performance of financial institutions.
A DDITIONAL C OURSE T OOLS
A CKNOWLEDGMENTS
Payne, University of Tennessee – Chattanooga Sarah Peck, University of Iowa Chien-Chih Peng, Morehead State. Charles Walwyn, SUNY–Maritime Fang Wang, West Virginia University Bruce Watson, Wellesley College Jennifer Westbrook, University of.
1-1 R OLE OF F INANCIAL M ARKETS
The financial markets serve as the mechanism by which corporations (acting as deficit units) can obtain funds from investors (acting as surplus units). Another key role of financial markets is to accommodate surplus units that want to invest in either debt or equity securities.
1-2 S ECURITIES T RADED IN F INANCIAL M ARKETS
Thus, investors who buy these securities in the primary market may not be able to sell them easily in the secondary market. This results in a lower supply of this security for sale (by investors who previously bought it) in the secondary market.
1-3 R OLE OF F INANCIAL I NSTITUTIONS
The role of financial institutions in facilitating the flow of funds from individual surplus units (investors) to deficit units is illustrated in Exhibit 1.3. Many of the transactions between the financial institutions and Exhibit 1.3 Comparison of roles between financial institutions.
1-4 C REDIT C RISIS FOR F INANCIAL I NSTITUTIONS
On July 21, 2010, President Obama signed the Financial Reform Act (also called the Wall Street Reform Act or Consumer Protection Act), which was intended to prevent some of the problems that caused the credit crisis. In general, the government's response to the credit crisis was intended to increase the safety of financial institutions.
S UMMARY
This agency can establish rules to ensure that information about recommendations of specific financial products is accurate and to prevent misleading practices. Because financial institutions act as intermediaries for the financial markets, increased regulation of financial institutions can stabilize financial markets and encourage greater participation of surplus and deficit units in these markets.
P OINT C OUNTER -P OINT
In addition, the act established the Consumer Financial Protection Bureau (housed in the Federal Reserve) to regulate specific consumer financial services, including online banking, checking accounts, credit cards, and student loans. Surplus units will continue to provide funds to financial intermediaries, rather than making direct loans, because they are not capable of credit analysis, even if more information is available about prospective borrowers.
Q UESTIONS A ND A PPLICATIONS
It is often said that all types of financial institutions have come to offer services that were previously offered only by certain types. Assuming that you decide to issue debt securities, describe the types of financial institutions that can purchase these securities.
F LOW OF F UNDS E XERCISE
How do individuals indirectly finance your business when they hold deposits with depository institutions, invest in mutual funds, buy insurance policies or invest in pensions?
I NTERNET /E XCEL E XERCISES
5y" just below the stock price chart to see IBM's stock price movements over the past five years. Explain how the market capitalization and trading volume for PLCE differs from that for IBM.
WSJ E XERCISE
O NLINE A RTICLES WITH R EAL -W ORLD E XAMPLES
Transparency of financial institutions during the credit crunch Select a financial institution that has had serious financial problems due to the credit crunch. Causes of Financial Institutions' Problems During the Credit Crisis Choose a financial institution that has had serious financial problems due to the credit crisis.
2-1 L OANABLE F UNDS T HEORY
Df ¼tual demand for loanable funds The total supply of funds (SA) can also be written as At the equilibrium interest rate i, the supply of loanable funds equals the demand for loanable funds.
2-2 F ACTORS T HAT A FFECT I NTEREST R ATES
When the Fed increases the money supply, it increases the supply of loanable funds, putting downward pressure on interest rates. As the demand for loanable funds fell during this period (as explained earlier), the downward pressure on interest rates was even more pronounced.
2-3 F ORECASTING I NTEREST R ATES
So, the factors that influence the supply of money and the demand for money must be predicted in order to predict interest rates. In some years (such as 2008), the budget deficit was large, but interest rates were very low.
Q UESTIONS AND A PPLICATIONS
Impact of Government SpendingJayhawk forecasting services analyzed several factors that could affect interest rates in the future. Political influence on interest rates Provide an argument for why a political regime that favors big government will cause interest rates to be higher.
P ROBLEMS
You plan to borrow money and can use the interest rate forecast to determine whether you should take out a fixed-rate or variable-rate loan. Identify the factors that require attention because they can influence future interest rate movements.
If the investor's tax rate is 20 percent, the return after tax will be 20 percent. To match this after-tax return, taxable securities must have a pre-tax return on them.
3-2 E XPLAINING A CTUAL Y IELD D IFFERENTIALS
Because the yield curve in Exhibit 3.3 is based on Treasuries, the curve is unaffected by credit risk. The yield curve for AA-rated corporate bonds would typically have a slope similar to the Treasury yield curve, but the yield on a corporate issue at any given time to maturity would be higher to reflect the risk premium.
3-3 E STIMATING THE A PPROPRIATE Y IELD
The appropriate commercial paper rate will change over time, possibly due to changes in the risk-free rate and/or default price, liquidity premium and tax adjustment factors. EXAMPLE If the default risk premium decreases from 0.7 percent to 0.5 percent, but Rf increases from 8 percent to 8.7 percent, that would be the appropriate yield to be offered on commercial paper (assuming no change in premiums of previously assumed liquidity and tax adjustment). .
3-4 A C LOSER L OOK AT THE T ERM S TRUCTURE
The yield curve can also be used to predict annual interest rates for periods other than one year. For example, the information from the last example could be used to determine the two-year forward rate that begins a year from now.
3-5 I NTEGRATING THE T HEORIES OF T ERM S TRUCTURE
However, it is generally believed that interest rate expectations are a major contributing factor to the shape of the yield curve. Interpret what the shift in the yield curve suggests about changing market expectations about future interest rates.
4-1 O VERVIEW
4-2 O RGANIZATIONAL S TRUCTURE OF THE F ED
Commercial banks can choose to become member banks if they meet specific requirements from the board. Each district member is elected each year by the board of directors of the respective district bank.
4-3 H OW THE F ED C ONTROLS M ONEY S UPPLY
Thus, the Fed affects the federal interest rate by revising the amount of funds in the banking system. Because of these limitations, the Fed typically relies on open market operations rather than adjustments to the reserve requirement ratio to control the money supply.
However, during the 2008 credit crisis, some depository institutions that were unable to obtain credit in the federal funds market were allowed to obtain funding from the Fed's discount window. The Fed's willingness to buy commercial paper and other debt securities has restored trading and liquidity in some debt markets.
4-5 G LOBAL M ONETARY P OLICY
The Fed's impact on unemployment Explain how the Fed's monetary policy affects the unemployment level. The Fed's future monetary policy will depend on the economic indicators that will be reported this week." b.
I NTERNET /E XCEL E XERCISE
Most recently, it received an alert from the service suggesting that the Fed had sold large holdings of Treasuries in the secondary Treasuries market. It is equally important for participants to know how changes in the money supply affect the economy, which is the subject of this chapter.
5-1 M ECHANICS OF M ONETARY P OLICY
Producer and Consumer Price Index The producer price index represents prices at the wholesale level and the consumer price index represents prices paid by consumers (retail level). Nevertheless, financial markets monitor price indices closely because they can be used to predict inflation, which affects nominal interest rates and the prices of some securities.
5-2 I MPLEMENTING M ONETARY P OLICY
The point is that all companies (regardless of risk level) will be able to borrow funds at lower interest rates thanks to the Fed's stimulative monetary policy. Similarly, the Fed's accommodative monetary policy can lower borrowing costs for households as well.
5-3 T RADE - OFF IN M ONETARY P OLICY
Here, the Fed can use a very stimulative (loose money) policy that is expected to lead to point A (9 percent inflation and 4 percent unemployment), or it can use a highly restrictive (tight money) policy that is expected. to result in point B (3 percent inflation and 8 percent unemployment). The trade-offs involved in monetary policy can be understood by considering the Fed's decisions over time.
5-4 M ONITORING THE I MPACT OF M ONETARY P OLICY
When higher oil prices raise concerns about inflation, the Fed is pressured to implement restrictive monetary policy. Financial institutions such as commercial banks, bond funds, insurance companies and pension funds maintain large portfolios of bonds, meaning their portfolios will be negatively affected if the Fed raises interest rates.
5-5 G LOBAL M ONETARY P OLICY
Monetary Policy During the Credit Crisis Describe the Fed's monetary policy response to the credit crisis. Assume that the Fed's philosophy regarding monetary policy is to maintain economic growth and low inflation.
6-1 M ONEY M ARKET S ECURITIES
EXAMPLE If an investor buys 30-day commercial paper with a par value of for a price of. When companies sell their commercial paper at a lower (higher) price than projected, their cost of raising funds will be higher (lower) than they initially expected.
At this point, a Banker's Acceptance (B/A) is created, which obligates the importer's bank to make a payment to the holder of the Banker's Acceptance at a specified future date. For this reason, the credit risk at banker's acceptance is somewhat similar to that of NCDs issued by commercial banks.
Insurance companies • May maintain part of their investment portfolio as money market securities for liquidity. Financial institutions that purchase money market securities act as creditors of the original issuer of the securities.
6-3 V ALUATION OF M ONEY M ARKET S ECURITIES
Credit risk after Lehman's default The credit crisis of 2008 had a major impact on the perceived risk of money market bonds. Months later, rates on most money market bonds fell as credit risk declined, leading to a reduction in the credit risk premium.
6-4 G LOBALIZATION OF M ONEY M ARKETS
However, the pricing of money market bonds changes in response to a shift in the required rate of return by investors. Investments in foreign money market securities are subject to exchange rate risk because the foreign currency denominating the securities may depreciate over time.
F LOW OF F UNDS E XERCISE Financing in the Money Markets
If your course is live, your professor may ask you to summarize your use of the article in class. 2. commercial note AND offer 3. commercial note AND credit rating 4. repurchase agreement AND financing 5. money market AND yield.
7-1 B ACKGROUND ON B ONDS
The yield to maturity is the annualized discount rate that equates the future coupon and principal payments to the initial yield received from the bond offering. The yield to maturity does not include the transaction costs associated with issuing the bonds.
7-2 T REASURY AND F EDERAL A GENCY B ONDS
In this example and in most cases, the largest component of the yield to maturity is the series of coupon payments. When these transaction costs are taken into account, the issuer's actual borrowing costs are slightly higher than the yield to maturity.
