Financial Markets and Institutions, Eighth Edition
By Anthony Saunders, Marcia Millon Cornett and Otgontsetseg (Otgo) Erhemjamts
Contents:
Preface viii
Co part 1 INTRODUCTION AND OVERVIEW OF FINANCIAL MARKETS 1
1 Introduction 1
Why Study Financial Markets and Institutions?
Chapter Overview 1
Overview of Financial Markets 3
Primary Markets versus Secondary Markets 4
Money Markets versus Capital Markets 6
Foreign Exchange Markets 9
Derivative Security Markets 9
Financial Market Regulation 10
Overview of Financial Institutions 11
Unique Economic Functions Performed by Financial Institutions 12
Additional Benefits FIs Provide to Suppliers of Funds 15
Economic Functions FIs Provide to the Financial System as a Whole 15
Risks Incurred by Financial Institutions 16
Regulation of Financial Institutions 17
Trends in the United States 17
Globalization of Financial Markets and Institutions 22
Appendix 1A: The Financial Crisis: The Failure of Financial Institutions’ Specialness 26
2 Determinants of Interest Rates 27
Interest Rate Fundamentals: Chapter Overview 27
Loanable Funds Theory 28
Supply of Loanable Funds 30
Demand for Loanable Funds 31
Equilibrium Interest Rate 32
Factors That Cause the Supply and Demand Curves for Loanable Funds to Shift 33
Movement of Interest Rates over Time 37
Determinants of Interest Rates for Individual Securities 37
Inflation 38
Real Risk-Free Rates 38
Default or Credit Risk 39
Liquidity Risk 41
Special Provisions or Covenants 42
Term to Maturity 42
Term Structure of Interest Rates 44
Unbiased Expectations Theory 44
Liquidity Premium Theory 46
Market Segmentation Theory 48
Forecasting Interest Rates 50
Time Value of Money and Interest Rates 51
Time Value of Money 51
Lump Sum Valuation 52
Annuity Valuation 54
3 Interest Rates and Security Valuation 60
Interest Rates as a Determinant of Financial Security Values: Chapter Overview 60
Various Interest Rate Measures 61
Coupon Rate 61
Required Rate of Return 61
Expected Rate of Return 62
Required versus Expected Rates of Return: The Role of Efficient Markets 63
Realized Rate of Return 64
Bond Valuation 65
Bond Valuation Formula Used to Calculate Fair Present Values 65
Bond Valuation Formula Used to Calculate Yield to Maturity 67
Equity Valuation 68
Zero Growth in Dividends 70
Constant Growth in Dividends 71
Supernormal (or Nonconstant) Growth in Dividends 72
Impact of Interest Rate Changes on Security Values 73
Impact of Maturity on Security Values 74
Maturity and Security Prices 75
Maturity and Security Price Sensitivity to
Changes in Interest Rates 75
Impact of Coupon Rates on Security Values 76
Coupon Rate and Security Price 77
Coupon Rate and Security Price Sensitivity to
Changes in Interest Rates 77
Duration 78
A Simple Illustration of Duration 78
A General Formula for Duration 80
Features of Duration 84
Economic Meaning of Duration 86
Large Interest Rate Changes and Duration 87
Appendix 3A: Duration and Immunization 94
Appendix 3B: More on Convexity 94
4 The Federal Reserve System, Monetary Policy, and Interest Rates 95
Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview 95
Structure of the Federal Reserve System 96
Organization of the Federal Reserve System 96
Board of Governors of the Federal Reserve
System 98
Federal Open Market Committee 99
Functions Performed by Federal Reserve Banks 99
Balance Sheet of the Federal Reserve 104
Monetary Policy Tools 107
Open Market Operations 110
The Discount Rate 114
Reserve Requirements (Reserve Ratios) 116
The Federal Reserve, the Money Supply, and Interest Rates 120
Effects of Monetary Tools on Various Economic Variables 121
Money Supply versus Interest Rate Targeting 122
International Monetary Policies and Strategies 126
Systemwide Rescue Programs Employed during the Financial Crisis 126
Challenges Remain after the Crisis 131
Part 2 SECURITIES MARKETS 135
5 Money Markets 135
Definition of Money Markets: Chapter Overview 135
Money Markets 136
Yields on Money Market Securities 136
Bond Equivalent Yields 137
Effective Annual Return 137
Discount Yields 137
Single-Payment Yields 138
Money Market Securities 139
Treasury Bills 141
Federal Funds 147
Repurchase Agreements 148
Commercial Paper 151
Negotiable Certificates of Deposit 156
Banker’s Acceptances 157
Comparison of Money Market Securities 158
Money Market Participants 158
The U.S. Treasury 159
The Federal Reserve 159
Commercial Banks 159
Money Market Mutual Funds 160
Brokers and Dealers 160
Corporations 161
Other Financial Institutions 161
Individuals 161
International Aspects of Money Markets 161
Euro Money Markets 162
Appendix 5A: Single versus Discriminating
Price Treasury Auctions 170
Appendix 5B: Creation of a Banker’s Acceptance 170
6 Bond Markets 171
Definition of Bond Markets: Chapter
Overview 171
Bond Market Securities 172
Treasury Notes and Bonds 172
Municipal Bonds 183
Corporate Bonds 189
Bond Ratings and Interest Rate Spreads 195
Bond Market Indexes 198
Bond Market Participants 199
Comparison of Bond Market Securities 200
International Aspects of Bond Markets 201
Eurobonds, Foreign Bonds, and Sovereign Bonds 201
7 Mortgage Markets 209
Mortgages and Mortgage-Backed Securities:
Chapter Overview 209
Primary Mortgage Market 211
Mortgage Characteristics 212
Mortgage Amortization 217
Other Types of Mortgages 222
Secondary Mortgage Markets 224
History and Background of Secondary Mortgage Markets 225
Mortgage Sales 226
Mortgage-Backed Securities 226
Participants in the Mortgage Markets 235
International Trends in Securitization 236
Appendix 7A: Amortization Schedules
for 30-Year Mortgage in Example 7–2 and
No-Points versus Points Mortgages in Example 7–4 241
8 Stock Markets 242
The Stock Markets: Chapter Overview 242
Stock Market Securities 244
Common Stock 244
Preferred Stock 247
Primary and Secondary Stock Markets 249
Primary Stock Markets 249
Secondary Stock Markets 254
Stock Market Indexes 263
Stock Market Participants 268
Other Issues Pertaining to Stock Markets 270
Market Efficiency 270
Stock Market Regulations 274
International Aspects of Stock Markets 276
Appendix 8A: The Capital Asset Pricing
Model 283
Appendix 8B: Event Study Tests 283
9 Foreign Exchange Markets 284
Foreign Exchange Markets and Risk: Chapter Overview 284
Background and History of Foreign Exchange Markets 285
Foreign Exchange Rates and Transactions 290
Foreign Exchange Rates 290
Foreign Exchange Transactions 290
Return and Risk of Foreign Exchange Transactions 295
Role of Financial Institutions in Foreign Exchange Transactions 301
Interaction of Interest Rates, Inflation, and Exchange Rates 304
Purchasing Power Parity 305
Interest Rate Parity 307
Appendix 9A: Balance of Payment Accounts 312
10 Derivative Securities Markets 313
Derivative Securities: Chapter Overview 313
Forwards and Futures 315
Spot Markets 315
Forward Markets 316
Futures Markets 318
Options 325
Call Options 325
Put Options 327
Option Values 329
Option Markets 331
Regulation of Futures and Options Markets 337
Swaps 338
Interest Rate Swaps 339
Currency Swaps 343
Credit Swaps 344
Swap Markets 345
Caps, Floors, and Collars 347
International Aspects of Derivative Securities Markets 349
Appendix 10A: Black–Scholes Option Pricing Model 354
Part 3 COMMERCIAL BANKS 355
11 Commercial Banks 355
Commercial Banks as a Sector of the Financial Institutions Industry: Chapter Overview 355
Definition of a Commercial Bank 357
Balance Sheets and Recent Trends 357
Assets 357
Liabilities 360
Equity 361
Off-Balance-Sheet Activities 363
Other Fee-Generating Activities 366
Size, Structure, and Composition of the Industry 366
Bank Size and Concentration 368
Bank Size and Activities 369
Industry Performance 370
Regulators 373
Federal Deposit Insurance Corporation 373
Office of the Comptroller of the Currency 373
Federal Reserve System 374
State Authorities 375
Global Issues 375
Advantages and Disadvantages of International Expansion 376
Global Banking Performance 377
12 Commercial Banks’ Financial
Statements and Analysis 382
Why Evaluate the Performance of Commercial Banks? Chapter Overview 382
Financial Statements of Commercial Banks 384
Balance Sheet Structure 385
Off-Balance-Sheet Assets and Liabilities 391
Other Fee-Generating Activities 394
Income Statement 395
Direct Relationship between the Income Statement and the Balance Sheet 399
Financial Statement Analysis Using a Return on Equity Framework 400
Return on Equity and Its Components 401
Return on Assets and Its Components 403
Other Ratios 408
Impact of Market Niche and Bank Size on Financial Statement Analysis 409
Impact of a Bank’s Market Niche 409
Impact of Size on Financial Statement Analysis 409
13 Regulation of Commercial Banks 415
Specialness and Regulation: Chapter Overview 415
Types of Regulations and the Regulators 416
Safety and Soundness Regulation 416
Monetary Policy Regulation 419
Credit Allocation Regulation 419
Consumer Protection Regulation 419
Investor Protection Regulation 420
Entry and Chartering Regulation 420
Regulators 421
Regulation of Product and Geographic Expansion 421
Product Segmentation in the U.S. Commercial Banking Industry 421
Geographic Expansion in the U.S. Commercial Banking Industry 428
Bank and Savings Institution Guarantee Funds 429
The Federal Deposit Insurance Corporation (FDIC) 430
The Demise of the Federal Savings and Loan Insurance Corporation (FSLIC) 431
Reform of Deposit Insurance 432
Non–U.S. Deposit Insurance Systems 433
Balance Sheet Regulations 433
Regulations on Commercial Bank Liquidity 433
Regulations on Capital Adequacy (Leverage) 434
Foreign Versus Domestic Regulation of Commercial Banks 439
Product Diversification Activities 439
Global or International Expansion Activities 440
Appendix 13A: Calculation of Deposit Insurance Premiums 447
Appendix 13B: Calculating Minimum Required Reserves at U.S. Depository Institutions 456
Appendix 13C: Primary Regulators of
Depository Institutions 459
Appendix 13D: Deposit Insurance Coverage for
Commercial Banks in Various Countries 459
Appendix 13E: Calculating Risk-Based Capital
Ratios 459
Part 4 OTHER FINANCIAL INSTITUTIONS 460
14 Other Lending Institutions 460
Other Lending Institutions: Chapter Overview 460
Savings Institutions 461
Size, Structure, and Composition of the Industry 461
Balance Sheets and Recent Trends 463
Regulators 465
Savings Institution Recent Performance 465
Credit Unions 466
Size, Structure, and Composition of the Industry 468
Balance Sheets and Recent Trends 470
Regulators 471
Industry Performance 471
Finance Companies 473
Size, Structure, and Composition of the Industry 473
Balance Sheets and Recent Trends 474
Industry Performance 479
Regulation 480
Global Issues 482
15 Insurance Companies 485
Two Categories of Insurance Companies: Chapter Overview 485
Life Insurance Companies 486
Size, Structure, and Composition of the Industry 486
Balance Sheets and Recent Trends 491
Regulation 494
Property–Casualty Insurance Companies 495
Size, Structure, and Composition of the Industry 495
Balance Sheets and Recent Trends 497
Regulation 505
Global Issues 506
16 Securities Firms and Investment Banks 511
Services Offered by Securities Firms Versus Investment Banks: Chapter Overview 511
Size, Structure, and Composition of the Industry 513
Securities Firm and Investment Bank Activity Areas 515
Investment Banking 515
Venture Capital 517
Market Making 519
Trading 519
Investing 520
Cash Management 520
Mergers and Acquisitions 521
Other Service Functions 522
Recent Trends and Balance Sheets 522
Recent Trends 522
Balance Sheets 525
Regulation 527
Global Issues 530
17 Investment Companies 536
Investment Companies: Chapter Overview 536
Size, Structure, and Composition of the Mutual Fund Industry 537
Historical Trends 537
Different Types of Mutual Funds 538
Other Types of Investment Company Funds 543
Mutual Fund Returns and Costs 544
Mutual Fund Prospectuses and Objectives 544
Investor Returns from Mutual Fund Ownership 548
Mutual Fund Costs 550
Mutual Fund Balance Sheets and Recent Trends 553
Long-Term Funds 553
Money Market Funds 555
Mutual Fund Regulation 556
Mutual Fund Global Issues 560
Hedge Funds 562
Types of Hedge Funds 563
Fees on Hedge Funds 567
Offshore Hedge Funds 568
Regulation of Hedge Funds 569
18 Pension Funds 573
Pension Funds Defined: Chapter Overview 573
Size, Structure, and Composition of the Industry 574
Defined Benefit versus Defined Contribution Pension Funds 574
Insured versus Noninsured Pension Funds 576
Private Pension Funds 577
Public Pension Funds 583
Financial Asset Investments and Recent Trends 585
Private Pension Funds 585
Public Pension Funds 586
Regulation 588
Global Issues 590
Appendix 18A: Calculation of Growth in IRA Value during an Individual’s Working Years 594
19 Fintech Companies 595
Introduction 595
The Evolution of Fintech 596
Changing Relationship Between Banks and Fintechs 600
Banking-as-a-Service 602
The Types of Fintech Innovations 603
Payments, Clearing, and Settlement Services 603
Market Support Services 609
Credit, Deposit, and Capital-Raising Services 615
Investment Management Services 615
Regulatory Approaches to Fintech 616
Fintech Charters and Other Licenses 616
International Regulations 617
Part 5 RISK MANAGEMENT IN FINANCIAL INSTITUTIONS 620
20 Types of Risks Incurred by Financial Institutions 620
Why Financial Institutions Need to Manage Risk: Chapter Overview 620
Credit Risk 621
Liquidity Risk 624
Interest Rate Risk 625
Market Risk 628
Off-Balance-Sheet Risk 629
Foreign Exchange Risk 631
Country Or Sovereign Risk 633
Technology and Operational Risk 633
Fintech Risk 635
Insolvency Risk 636
Other Risks and Interaction Among Risks 636
21 Managing Credit Risk on the Balance Sheet 641
Credit Risk Management: Chapter Overview 641
Credit Quality Problems 643
Credit Analysis 644
Real Estate Lending 645
Consumer (Individual) and Small-Business Lending 648
Mid-Market Commercial and Industrial Lending 649
Large Commercial and Industrial Lending 657
Calculating the Return on a Loan 661
Return on Assets (ROA) 661
RAROC Models 663
Appendix 21A: Loan Portfolio Risk and Management 668
22 Managing Liquidity Risk on the Balance Sheet 669
Liquidity Risk Management: Chapter Overview 669
Causes of Liquidity Risk 670
Liquidity Risk and Depository Institutions 671
Liability-Side Liquidity Risk 671
Asset-Side Liquidity Risk 674
Measuring a DI’s Liquidity Exposure 675
Liquidity Risk, Unexpected Deposit Drains, and Bank Runs 680
Bank Runs, the Discount Window, and Deposit Insurance 681
Liquidity Risk and Insurance Companies 684
Life Insurance Companies 684
Property–Casualty Insurance Companies 685
Guarantee Programs for Life and Property– Casualty Insurance Companies 686
Liquidity Risk and Investment Funds 686
Appendix 22A: Statements of Cash Flows, JPMorgan Chase, 2017–2019 692
Appendix 22B: New Liquidity Risk Measures Implemented by the Bank for International Settlements 692
23 Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet 693
Interest Rate and Insolvency Risk Management: Chapter Overview 693
Interest Rate Risk Measurement and Management 694
Repricing Gap Model 694
Duration Gap Model 703
Insolvency Risk Management 711
Capital and Insolvency Risk 712
24 Managing Risk off the Balance Sheet with Derivative Securities 722
Derivative Securities Used to Manage Risk: Chapter Overview 722
Forward and Futures Contracts 723
Hedging with Forward Contracts 724
Hedging with Futures Contracts 725
Options 728
Basic Features of Options 728
Actual Interest Rate Options 731
Hedging with Options 731
Caps, Floors, and Collars 732
Risks Associated with Futures, Forwards, and Options 733
Swaps 734
Hedging with Interest Rate Swaps 734
Hedging with Currency Swaps 737
Credit Swaps 738
Credit Risk Concerns with Swaps 741
Comparison of Hedging Methods 742
Writing versus Buying Options 742
Futures versus Options Hedging 744
Swaps versus Forwards, Futures, and
Options 745
Appendix 24A: Hedging with Futures Contracts 750
Appendix 24B: Hedging with Options 750
Appendix 24C: Hedging with Caps, Floors, and Collars 750
25 Managing Risk off the Balance Sheet with Loan Sales and Securitization 751
Why Financial Institutions Sell and Securitize Loans: Chapter Overview 751
Loan Sales 752
Types of Loan Sales Contracts 754
The Loan Sales Market 754
Secondary Market for Less Developed Country Debt 757
Factors Encouraging Future Loan Sales Growth 758
Factors Deterring Future Loan Sales Growth 759
Loan Securitization 760
Pass-Through Security 760
Collateralized Mortgage Obligation 767
Mortgage-Backed Bond 771
Securitization of Other Assets 773
Can All Assets Be Securitized? 774
References 779
Index 781