Financial Markets and Institutions, 8th Edition PDF by Anthony Saunders, Marcia Millon Cornett and Otgontsetseg (Otgo) Erhemjamts


Financial Markets and Institutions, Eighth Edition

By Anthony Saunders, Marcia Millon Cornett and Otgontsetseg (Otgo) Erhemjamts

Financial Markets and Institutions, 8th Edition


Preface viii


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


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

Economic Indicators 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


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


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


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

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