An introduction to financial markets and institutions burton, maureen SRG

An Introduction to

Financial Markets
and Institutions
Second Edition

Maureen Burton U Reynold Nesiba U Bruce Brown

ROUTLEDGE

Routledge
Taylor & Francis Group

LONDON AND NEW YORK


With much love to my grandchildren, Luke and Lucy Paddock, Madison Zehntner, and any
grandchildren still to come!
—Maureen Burton
To Nina, Byron, and Yuka—a lot to be thankful for.
—Bruce Brown
First published 2010 by M.E. Sharpe
Published 2015 by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
711 Third Avenue, New York, NY 10017, USA
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Notices
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Practitioners and researchers must always rely on their own experience and
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Library of Congress Cataloging-in-Publication Data
Proudly sourced and uploaded by [StormRG]

Burton, Maureen.
Kickass Torrents | TPB | ET | h33t
An introduction to fi nancial markets and institutions / Maureen Burton,
Reynold Nesiba, Bruce Brown—2nd ed.
p. cm.
ISBN 978- 0-7656-2276-1 (pbk. : alk. paper)
1. Finance. 2. Financial institutions. 3. Capital market. I. Nesiba, Reynold F.
(Reynold Frank), 1966– II. Brown, Bruce, 1960– III. Title.
HG173.B873 2009
332—dc22

ISBN 13: 9780765622761 (pbk)

2009021361

Brief Contents

Part 1 Introduction

1

10 Monetary Policy

209

Part 4 Financial
Markets

237

1 Introduction and Overview 3
2 Money: A Unique
Financial Instrument
3 Financial Markets,
Instruments, and
Market Makers
4 An Introduction to
Financial Intermediaries
and Risk

Part 2 Financial Prices

23

45

67

11 The Money Markets

239

12 The Corporate and
Government Bond
Markets

267

13 The Stock Market

297

14 The Mortgage Market

329

89

5 Interest Rates and
Bond Prices

91

6 The Structure of
Interest Rates

113

Part 5 Financial
Institutions

353

15 Commercial Banking

355

16 Savings Associations
and Credit Unions

379

7 Market Efficiency and
the Flow of Funds
Among Sectors

137

8 How Exchange Rates
Are Determined

17 Regulation of the
Financial System

403

157

18 Insurance Companies

431

19 Pension Plans and
Finance Companies

453

Part 3 The International
Financial System 185
9 The Overseer: The Federal
Reserve System
187

20 Securities Firms,
Mutual Funds, and
Financial Conglomerates 477


Part 6 Managing
Financial Risk

505

21 Financial Instability and
Strains on the Financial
System

507

22 Risk Assessment and
Management

531

23 Forward, Futures, and
Options Agreements

561

24 Asset-Backed Securities,
Interest Rate Agreements,
and Currency Swaps
589

iv

Brief Contents

Part 7 The International
Financial System 613
25 The International
Financial System

615

26 Monetary Policy in
a Globalized Financial
System

637


Detailed Contents

Preface xix

Part 1 Introduction
Chapter 1

Introduction and Overview

3

What This Book Is About 4
Economic and Financial Analysis of an Ever-Changing System 4
Finance in Our Daily Lives 6
Introducing the Financial System 8
More on Financial Intermediaries 9
Depository Institutions and Other Types of Intermediaries 11
The Federal Reserve System 12
The Role of Policy: Changing Views 14

Chapter 2

Money: A Unique Financial Instrument

23

Conceptualization: A Key Building Block 24
Defining Money 24
A Closer Look: Money, Exchange, and Economic Development 25
The Monetary Aggregates and Domestic Nonfinancial Debt 26
The Economy and the Aggregates 29
A Closer Look: The Ongoing Evolution of the Payments System 30
Looking Back: Staying Ahead of the Counterfeiter 33
The Demand for and Supply of Money 33
The Demand for Money 33
The Supply of Money 36
Money, Interest Rates, and the Economy 37

Chapter 3

Financial Markets, Instruments,
and Market Makers 45

Game Talk 46
Introducing Financial Markets 46
Major Financial Market Instruments 48
Money Market Instruments 48
A Closer Look: Money and Other Financial Claims 49
U.S. Treasury Bills 50
Negotiable Certificates of Deposit (CDs) 51

v


Commercial Paper 51
Bankers’ Acceptances 51
Repurchase Agreements 53
Federal (Fed) Funds 53
Eurodollars 53
Capital Market Instruments 54
Stocks 55
Mortgages 55
Corporate Bonds 56
U.S. Government Securities 56
U.S. Government Agency Securities 56
State and Local Government Bonds (Municipals) 57
The Role of Market Makers 57
Why Market Makers Make Markets 59
Market Making and Liquidity 59
Substitutability, Market Making, and Market Integration 61

Chapter 4

An Introduction to Financial
Intermediaries and Risk 67

Are All Financial Intermediaries More or Less Alike? 68
Common Characteristics 68
A Closer Look: FIs as Firms 69
Types of Risks Faced by All FIs 71
Credit or Default Risk 71

Interest Rate Risk 72
Liquidity Risk 73
Exchange Rate Risk 73
A Guide to FIs 74
Deposit-Type FIs 74
Commercial Banks 74
Savings Associations 76
Credit Unions 77
Contractual-Type FIs 78
Investment-Type FIs 79
Finance Company-Type FIs 80
Pulling Things Together 80

vi

Detailed Contents


Part 2 Financial Prices
Chapter 5

Interest Rates and Bond Prices

91

The Present versus the Future 92
The Time Value of Money 92
Compounding and Discounting 92
Compounding: Future Values 92
Discounting: Present Values 94

Interest Rates, Bond Prices, and Present Values 95
Fluctuations in Interest Rates and Managing a Bond Portfolio 97
The Determinants of Interest Rates 97
Changes in the Demand for Loanable Funds 99
Changes in the Supply of Funds 99
Inflation and Interest Rates 102
A Closer Look: Interest Rates: Which Theory Is Correct?
Reconciling Stocks and Flows 103
Cracking the Code: Calculating the Inflation Rate 106
The Cyclical Movement of Interest Rates 107

Chapter 6

The Structure of Interest Rates

113

From One Interest Rate to Many 114
The Role of Term to Maturity in Interest Rate Differentials 114
The Yield Curve 114
The Expectations Theory 116
Determining Interest Rate Expectations 121
Tying the Determinants of Expectations to the Changing Shape
and Level of Yield Curves 122
Some Necessary Modifications to the Expectations Theory 124
A Closer Look: The Segmented Market Hypothesis 126
The Role of Credit Risk and Taxes in Interest Rate Differentials 127
Credit Risk 127
Taxability 128

Chapter 7

Market Efficiency and the Flow
of Funds Among Sectors 137

“Stock Prices Rise over 28 Percent While Bond Prices Rise over
9 Percent” 138
How Expected Rates of Return Affect the Prices of Stocks and Bonds 138
A Closer Look: The Benefits of Diversification 139
Stocks 141
Bonds 141

Detailed Contents

vii


The Formation of Price Expectations 144
The Efficient Markets Hypothesis: Rational Expectations Applied
to Financial Markets 146
A Closer Look: Implications of the Efficient Markets Hypothesis 148
The Flow of Funds Among Sectors 150
Looking Back: The Historical Pattern of Surplus and Deficit Centers 152
Pulling It All Together 152

Chapter 8

How Exchange Rates Are Determined

157

The More Things Change, the More Things Stay the Same 158
Defining Exchange Rates 158
Cracking the Code: How Movements in the Exchange Rate Affect the
Dollar Price of Foreign Goods 159
Cracking the Code: Finding the Yen / Euro Exchange Rate 161
Determining Exchange Rates 161
The Demand for Dollars in the Foreign Exchange Market 161
Cracking the Code: The Cost of a Bushel of U.S. Wheat in Japan 163
The Supply of Dollars in the Foreign Exchange Market 163
Cracking the Code: The Foreign Exchange Market 165
Changes in Supply and Demand and How They Affect the Exchange
Rate 165
Exchange Rates in the Long Run: The Theory of Purchasing Power
Parity 168
A Closer Look: The Big Mac Index and Purchasing Power Parity 170
Choosing Among Domestic and Foreign Financial Instruments: The
Theory of Interest Rate Parity 172
Looking Back: The Causes and Consequences of Dollar Exchange Rate
Movements Since 1980 174
Defining the Balance of Payments and Its Influence on the Exchange Rate,
the Financial System, and the U.S. Economy 176
The Current Account 176
The Capital Account 177
The Balance of Payments and the Exchange Rate 178

Part 3 The International Financial System
Chapter 9

The Overseer: The Federal

Reserve System 187

Unraveling the Fed’s Mystique 188
Organizational Structure of the System 188
A Closer Look: The Board of Governors 189
Federal Reserve Banks 190

viii

Detailed Contents


Federal Open Market Committee (FOMC) 191
The Fed’s Functions 193
Formulation and Implementation of Monetary Policy 193
Supervision and Regulation of the Financial System 194
Facilitation of the Payments Mechanism 195
Operation as Fiscal Agent for the Government 196
Looking Out: The Eurosystem: Europe’s Central Bank 197
The Fed’s Major Policy Tools 198
Open Market Operations 198
The Discount Rate and Discount Rate Policy 198
Reserve Requirements 200
Looking Back: Early Attempts at Establishing a Central Bank 201
The Federal Reserve System and the Question of Central Bank
Autonomy 201

Chapter 10

Monetary Policy

209

Can the Business Cycle Be Mitigated? 210
The Goals of Monetary Policy 210
A Closer Look: The Fed’s New Tool Kit 211
Sustainable Economic Growth 214
Stabilization of Unemployment and Inflation 215
The Policy Process 217
Assessing the Economic Situation 219
From Assessment to Action 219
From Action to Effect 219
A Closer Look: Why The Fed Has Become More Open 220
Pitfalls in Policy Making 222
Uncertainty and Lags 222
Federal Open Market Committee Decisions 224
A Closer Look: Monetary Rules Versus Discretionary Risk
Management 226
The FOMC Policy Directive and Fed Communication 228
Looking Back: The Fed’s Response To The 9/11 Terrorist Attack 230
How the New York Fed implements the Policy Directive 231
Looking Forward: Will the Fed Have More or Less Power to Affect
the Economy in the Future? 232

Part 4 Financial Markets
Chapter 11

The Money Markets

239

Financial Markets 240
Money Market Characteristics, Benefits, and Participants 240

Detailed Contents

ix


Benefits 241
Participants 242
Commercial Banks and Savings Associations 242
Government and Government-Sponsored Enterprises 243
The Federal Reserve 243
Corporations and Finance Companies 244
Pension Funds and Insurance Companies 244
Brokers and Dealers 244
Money Market Mutual Funds and Individuals 245
Money Market Instruments 245
Commercial Paper 245
Federal ( Fed) Funds 248
A Closer Look: The Broker’s Role In The Federal Funds Market 249
Repurchase and Reverse Repurchase Agreements 250
Looking Back: Disruptions in the RP Market: Drysdale and ESM 252
Negotiable Certificates of Deposit (CDs) 253
U.S. Treasury Bills 255
Eurodollars 256
Cracking The Code: Treasury Bill Auction Results 257
A Closer Look: The Anatomy of Eurodollar Borrowing 258
Bankers Acceptances 259

Money Market Mutual Funds 260

Chapter 12

The Corporate and Government
Bond Markets 267

History in the Making 268
The Bond Market 268
The Corporate Bond Market 270
Looking Back: The Junk Bond Market 272
Cracking The Code: Corporate Bonds 273
The Treasury Bond Market 275
A Closer Look: The Treasury Auction Schedule 276
Cracking The Code: Treasury Bonds 284
Looking Out: The International Bond Markets 285
Municipal and Government Agency Securities 286
A Closer Look: Recent Trends In The Bond Market 288
The Determinants of Bond Prices 289

Chapter 13

The Stock Market

297

Speculative Bubbles and Their Effects on the Economy 298
A Closer Look: How Volatile Asset Prices Affect the Economy 299
The Anatomy of Stocks 301
Cracking the Code: The Stock Market 302

x

Detailed Contents


Stock Offerings 303
Looking Back: Famous Financial Quotations 304
The Stock Markets 305
A Closer Look: Private Equity Funds 308
The New York Stock Exchange 308
NASDAQ ( National Association of Securities Dealers Automated
Quotation System) 311
Other Exchanges 312
Stock Market Indexes 313
The Stock Market and Mutual Funds 316
The Valuation of Stocks 317
Looking Back: Could U.S. Stock Prices Be Justified? 319
Appendix: The Choice Between Stocks and Bonds 325

Chapter 14

The Mortgage Market

329

From Boom to Bust 330
The Anatomy of Mortgages 330
Mortgage Amortization 332
Insured and Uninsured Mortgages 333

Closing Costs 334
Looking Back: The Evolution of the Mortgage Market 335
Fixed and Variable Interest Rate Mortgages 336
Secondary Markets in Mortgages 338
A Closer Look: Innovative Types of Mortgages 339
Ginnie Mae 340
A Closer Look: The Mortgage Bailout Plan 341
Fannie Mae and Freddie Mac 342
A Closer Look: The Implicit Guarantee of Fannie Mae
and Freddie Mac 344
Private Mortgage-Backed Securities and Collateralized Mortgage
Obligations 345
The Determinants of the Price of Mortgages in Secondary Markets 346

Part 5 Financial Institutions
Chapter 15

Commercial Banking Structure,
Regulation, and Performance 355

The Biggest Intermediary in Town 356
The Banking Regulatory Structure 357
Looking Back: The Origins of the Dual Banking System 359
The Structure of the Commercial Banking System 362
Bank Holding Companies and Financial Holding Companies 364

Detailed Contents

xi

Ongoing Changes in the Structure of the Banking Industry 368
The Evolution of International Banking 369
A Closer Look: Mega-mergers of the Past Decade 370
Bank Management: Managing Risk and Profits 372
Bank Performance 374

Chapter 16

Savings Associations and Credit
Unions 379

Savings, Mortgages, and the American Dream 380
Savings Associations 381
History and Regulation 381
Savings Banks 382
Savings and Loan Associations (S&Ls) 382
Savings and Loans versus Savings Banks 383
Distribution of Insured Saving Institutions 383
Recent Trends 384
Looking Out: Savings Institutions in Other Countries 385
Savings Association Management of Risk 386
The S&L Crisis of the Late 1980s 388
Looking Back: The Lincoln Savings Scandal 390
Credit Unions 391
History and Regulation 391
Distribution of Credit Unions 394
Recent Trends 394
A Closer Look: Credit Unions, Corporate Taxes, and the Community
Reinvestment Act 395

Credit Union Management of Risk 396
The Evolution of Thrifts 397

Chapter 17

Regulation of the Banking System
and the Financial Services Industry

403

The Role of Regulation 404
The How and Why of Financial Services Regulation 405
A Closer Look: Regulators in the Financial Services Industry 407
Looking Forward: A Proposal to Overhaul the Financial Regulatory
Structure 409
Depository Institutions Deregulation and Monetary Control Act
of 1980 and the Garn-St. Germain Act of 1982: Deregulation
in the Early 1980s 410
Basel Accord—The Introduction of International Capital Standards 411
Looking Out: Basel Committee Announces 25 Core Principles for
Effective Bank Supervision 412

xii

Detailed Contents


A Closer Look: Bank Capital Standards Under the Basel Accord
(Basel I ) 413
Financial Institutions Reform, Recovery, and Enforcement Act

of 1989—Reregulation in Response to Financial Crisis
( Bailout of the Thrifts) 415
Federal Deposit Insurance Corporation Improvement Act of 1991—
Tightening Up Deposit Insurance 416
Federal Deposit Insurance Reform Act of 2005—Merging Deposit
Insurance Funds 417
Community Reinvestment Act—Outlawing Discriminatory Lending
Practices 418
Interstate Banking and Branching Efficiency Act of 1994 —The Dawn
of Nationwide Branching? 419
The Gramm-Leach-Bliley Act (GLBA) of 1999—The Final Demise
of Glass-Steagall 419
Major Provisions of the Gramm-Leach-Biley Act 420
Looking Back: A Time Line of Banking Legislation 421
The Emergency Economic Stabilization Act of 2008 422
A Closer Look: The Ongoing Bailout of the Banking System:
Nationalization or Not? 423
Other Possible Areas of Reform 425

Chapter 18

Insurance Companies

431

Life Is Uncertain 432
Insurance Companies 432
Overview 432
Adverse Selection and Moral Hazard 433
Employment 434

Life Insurance Companies 434
Overview 434
Looking Back: The Intellectual Roots and Philosophical Applications
of Risk Assessment 435
Types of Coverage 436
Term Life Insurance 436
Permanent Life Insurance 437
Annuities 439
Disability Insurance 439
Long-Term Care Insurance 439
Recent Trends and Balance Sheet Composition 439
Health Insurance Companies 440
Property and Casualty Companies 441
A Closer Look: Alleged Racial Bias in Property and Casualty Insurance
and Life Insurance 443

Detailed Contents

xiii


Managing Adverse Selection and Moral Hazard in the Insurance
Industry 444
Looking Back: 2001 Terrorist Attacks and 2005 Natural Disaster Cause
Record Insurance Losses 446
Regulation 447
A Closer Look: The American International Group (AIG) Bailout 448
Evolution and Globalization 449

Chapter 19

Pension Plans and Finance
Companies 453

Retirement Planning and Liquidity Management 454
Pension Plans 454
Overview 454
Types of Pension Plans 455
Public Pension Plans 455
Private Pension Plans 456
Individually Sponsored and Self-Employed Private
Pension Plans 456
Defined-Benefit and Defined-Contribution Plans 457
Recent Trends in Private Pensions 459
Pension Plan Regulation and Insurance 461
Social Security 462
A Closer Look: Social Security: Insurance Policy or Pension Plan? 463
Social Security: Plans for Reform 465
Looking Out 19.01: Chile’s Second Revolution: A Privatized Social
Security System 466
Finance Companies 467
Overview 467
Types of Finance Companies 468
Consumer Finance Companies 468
Business Finance Companies 469
Real Estate Loan Companies 470
Finance Companies and the 2008 Credit Crisis 471
Did Financial Modernization Contribute to the Credit Crisis? 472

Chapter 20

Securities Firms, Mutual Funds,
and Financial Conglomerates 477

The Boiler Room 478
Securities Firms 479
Investment Banks: The Primary Market 479
A Closer Look: Google’s Unusual Initial Public Offering 480
Responsibilities for New Offerings 480
Timing 481

xiv

Detailed Contents


The Role of the Securities and Exchange Commission 481
Credit Rating 481
Underwriting and Marketing 481
Investment Banks and the Functioning of the Primary Market 482
Private Placement 483
Private Equity 483
Brokers and Dealers: The Secondary Market 483
Types of Orders 484
Margin Loans 484
Brokerage Fees 484
A Closer Look: Online Trading 485
Investment Companies 487
Open-End and Closed-End Companies 487
Load and No-Load Companies 487

Growth of Investment Funds 487
Cracking The Code: Investment Companies/Open-End Mutual Funds/
Closed-End Funds 490
Hedge Funds 491
Real Estate Investment Trusts 492
Government-Sponsored Enterprises 494
The GSE Housing Market 495
The GSE Farm Loan Market 496
Other GSEs 496
The Student Loan Market 496
The Growth of Financial Conglomerates 497
A Closer Look: Citigroup 498

Part 6 Managing Financial Risk
Chapter 21

Financial Instability and Strains
on the Financial System 507

Memory Is the Thing You Forget With 508
Financial Intermediation, Risk, and Financial Crises 509
The Problem of Moral Hazard in Financial Intermediation 513
A Closer Look: The Great Financial Meltdown of 2008 514
A Closer Look: A Theory of Financial Instability 518
Other Areas of Concern 521
A Closer Look: The Savings and Loan Debacle 522

Chapter 22

Risk Assessment and Management

531

Managing Balance Sheet Risk and Return 532
The Five Cs of Credit 533

Detailed Contents

xv


Capacity 534
Character 534
Capital 535
Collateral 536
Conditions 537
Default Risk Assessment and Management Techniques 537
Accurate Discernment and Pricing 537
A Closer Look: Obtaining and Correcting a Credit Report 539
Looking Forward: Credit Scoring and Fair Lending 540
Careful Observation 541
Long-Term Banking Relationships 541
Active Management of Asset Portfolios 541
Assessing Interest-Rate Risk 542
Income Gap Analysis 543
Managing Interest Rate Risk in Response to Income Gap 545
Assessing Liquidity Risk 546
Managing Liquidity Risk 547
Additional Risks 548
A Closer Look: Bernard Madoff and his Modern Ponzi Scheme 549

A Closer Look: Black Swans 550

Chapter 23

Forward, Futures, and
Options Agreements 561

A Single Solution 562
Forward Transactions 562
Cracking The Code: Foreign Exchange Spot and Forward Rate
Quotations 565
Limitations of Forward Agreements 566
Financial Futures 567
A Closer Look: Futures, Exchanges That Trade Financial Futures,
and Minimum Amounts 569
Cracking The Code: Futures Prices 570
A Closer Look: LHT Inc. Enters the Futures Market 572
Determining the Futures Price 573
A Closer Look: Stock Index Futures and the ’87 Crash 574
Options 575
Put Options 576
A Closer Look: More About Options 577
Call Options 577
The Option Premium 578
Determining the Option Premium 579
A Closer Look: The Collapse of a California County and
a British Bank 580
Appendix: The Foreign Exchange Futures Market 584

xvi

Detailed Contents


Chapter 24

Asset-Backed Securities, Interest Rate
Agreements, and Currency Swaps 589

South Dakota, Scholarships, and Securitization 590
The Anatomy of a Securitization 591
Securitization Benefits to Borrowers, Issuers, and Investors 593
The Origins of Securitization 595
Trends in Common Types of Asset-Backed Securities 596
A Closer Look: Securitization of Small Business Loans 597
Interest-Rate Swaps 598
Interest-Rate Caps, Floors, and Collars 600
Interest Rate Caps 601
Interest-Rate Floors 602
Interest-Rate Collars 603
Currency Swaps 604
Trends in Interest-Rate Agreements and Currency Swaps 606
Conclusion 607

Part 7 The International Financial System
Chapter 25

The International Financial System

615

A Dramatic Metamorphosis 616
The International Financial System from 1944 to 1973 617
Looking Out: The Gold Standard 618
The Managed Float Exchange Rate System Since 1973 620
A Closer Look: The Foreign Exchange Market 622
Managing Exchange Rate Risk Under the Managed Float 623
Looking Out: The Path to a Single European Currency 625
The Role of the Dollar Under the Managed Float 626
Major International Financial Organizations 627
The International Monetary Fund ( IMF) 627
The World Bank 629
A Closer Look: The Role of the IMF in the Asian Crisis 630
The Bank for International Settlements (BIS) 631
A Framework for International Financial Stability 632

Chapter 26

Monetary Policy in a Globalized
Financial System 637

Monetary Policy and the Globalization of Finance 638
Monetary Policy Under Fixed Exchange Rates from 1944 to 1973 638
Monetary Policy Under Flexible Exchange Rates Since 1974 641
Looking Forward: Dollarization and Currency Boards 642

Detailed Contents

xvii

Looking Out: Capital Flows and the Mexican Peso Crisis 646
The Globalization of Monetary Policy 647
Looking Out: The Eurosystem 648
A Closer Look: A New Kind of Monetary Policy Coordination 651

Glossary 657
Index 000
About the Authors 000

xviii

Detailed Contents


Preface
INTRODUCTION TO THE TEXT
In late 2009, the economy continues to be embroiled in a fi nancial crisis that is unprecedented since the Great Depression. What started in the housing market spread throughout the entire financial system and wreaked havoc in the broader economy. The stock
market experienced the deepest bear market since the Great Depression, even surpassing the bursting of the stock market bubble in the early 2000s. The unemployment rate
hit a 25-year high. As a result, rapid and revolutionary changes are occurring within financial markets and institutions and will continue to occur for some time.
Even before the current crisis, fi nancial markets and institutions had been undergoing significant changes. Changes in information and computer technologies fostered
the growth of new financial instruments and products. Many of the new products were
thought to be creative ways to manage risk in a globalized environment. Technological
changes also allowed for the unbundling of risks among financial market participants.
Increased competition and globalization spurred on the changes. Regulations put in place
during the Great Depression were removed. Financial institutions entered nontraditional
venues. Laws forbidding the mergers of banks, securities firms and insurance companies
were overturned. Mega-mergers occurred that changed the scope, size, and activities of
fi nancial institutions and created mega-firms that were “too big to fail.”
Many of these changes have contributed to or facilitated the current crisis that financial markets are caught in. Managers of fi nancial institutions must now make decisions in a new environment where caution can no longer be thrown to the wind. In 2010,

fi nancial market participants, policy makers, and regulators face new challenges as they
continue to adapt to the changing environment in order to help the fi nancial system and
the economy recover. No doubt the regulatory structure of the financial system will see
a total overhaul as a result.
Given the economic climate, the motivation in developing this text is threefold.
• First, to give students an understanding of how fi nancial markets and institutions
work and their role in the broader economy.
• Second, to capture the recent changes in financial markets and institutions, some of
which have contributed to the ongoing financial crisis, and some of which result from
the crisis.
• Third, and most importantly, to present an analytical framework that enables students to understand and anticipate changes in financial markets and institutions as the
fi nancial system continues to evolve.

INTENDED AUDIENCE
The text is intended for an introductory undergraduate course in fi nancial markets and
institutions taught in either a fi nance or an economics department. It may also be suitable for use in a fi nancial markets and institutions course in an MBA Program.

CONTENTS OF THE TEXT
An Introduction to Financial Markets and Institutions, Second Edition covers the traditional
material found in a financial markets and institutions text and incorporates many of the
recent changes and controversies within the financial ser vices industry.

xix


In addition, there are several unique features in this edition:
With regard to the ongoing financial crisis, we cover the origins and causes of the
crisis including the development of subprime and Alt-A mortgages, the erosion of lending standards, the securitization of mortgages, and the development of credit derivatives. We look at financial bubbles and how they affect markets and lead to fi nancial
crises. We focus on what policy makers have done to mitigate the crisis. We have expanded our coverage of fi nancial instability including Hyman Minsky’s long-term theory of financial instability. With regard to specific actions taken as a result of the crisis,
we have in-depth coverage of the following topics:

• In Chapter 17 on regulation, we cover the Emergency Economic Stabilization Act
of September 2008. We look at not only the uses of the first half of the bailout funds
with regard to injecting capital into the largest fi nancial institutions but also the plan
on how to use the second half of the funds. We look at the Trea sury’s proposal to
overhaul the regulatory system.
• In Chapter 14 on the mortgage market, we look at the Mortgage Bailout Plan that
is part of the Financial Stability Plan.
• In Chapter 21 on financial instability, we cover the American Recovery and
Reinvestment Act of 2009—the $787 billion fiscal stimulus package that includes
both increases in government spending and tax cuts and is designed to mitigate the
economic downturn of 2009.
• In Chapter 10 on monetary policy, we look at the new special lending facilities
created by the Fed in response to the crisis. We explore in detail the Fed’s new tool
kit and how the new lending has caused a doubling of the Fed’s assets. We believe
that this is something totally under the radar screen for many Americans.

ORGANIZATION OF THE TEXT
An Introduction to Financial Markets and Institutions, Second Edition is organized in seven
parts:
Part One consists of a four-chapter introduction. The student is introduced
to the economy, money and credit, financial markets and products, and fi nancial
intermediaries.
Part Two consists of four chapters on fi nancial prices, including interest rate determination, the term structure of interest rates, the efficient market hypothesis, and
exchange rate determination. An alternative model of equilibrium based on the flow of
funds among sectors and market efficiency is also presented.
Part Three consists of two chapters on the Fed and monetary policy.
Part Four consists of four chapters on fi nancial markets including the money
market, the corporate and government bond markets, the stock market, and the mortgage market.
Part Five has six chapters on financial institutions including commercial banking,
savings associations and credit unions, regulation, insurance companies, pensions plans,

securities fi rms, mutual funds, and fi nancial conglomerates.
Part Six has four chapters on managing fi nancial risk that look at financial instability including Hyman Minsky’s financial instability hypothesis, risk assessment and
management, forward futures, options and asset-backed securities, and interest rate and
currency swaps.
Part Seven has two chapters on the international fi nancial system and monetary
policy in an increasingly globalized environment.

xx

Preface


An Introduction to Financial Markets and Institutions, Second Edition is designed to be
flexible. After completing Part One, the instructor can emphasize the relevant parts of
the text depending on the focus of the class. In parts that are not being emphasized,
chapters may be skipped.

PEDAGOGICAL FEATURES OF THE TEXT
In addition to presenting the material in a clear and concise manner, we have incorporated the following pedagogical tools to enhance the student’s understanding.
• Learning objectives at the beginning of each chapter tell the student where the
chapter is heading and what questions will be answered by studying the chapter.
• Recap sections are dispersed throughout each chapter to summarize analytical
material the student should know before moving forward, and also to check that the
student has mastered the preceding material.
• Highlighted features include:
• A Closer Look feature that delves more deeply into the topic being discussed and
provides enhancement material.
• Looking Out boxes that add relevant international material that show the interrelationships of global financial systems.
• Looking Back features that provide historical background of the foundations of
current economic circumstances.

• Looking Forward boxes that make projections about possible future situations
within the arena of the fi nancial system and economies.
• Cracking the Code feature that shows students how to interpret the financial
pages of daily newspapers, including stock, bond, Treasury bill, mutual fund,
foreign exchange quotes, and futures and options prices.
• Key Terms are bold-faced in the text where they are first defined, listed at the end
of each chapter, and also appear in the margins with defi nitions.
• Summary of Major Points that are chapter summaries intended to reinforce the
chapter content and to aid in study for exams and quizzes, as well as to provide
another check for students to make sure they have not missed an important
concept of the chapter.
• End-of-Chapter materials include:
• Review Questions and Analytical Questions that appear at the end of each
chapter. Questions marked with a check can be answered with a short answer or
a single number. Instructors may choose to use these objective questions for
homework in larger sections.
• Annotated Suggested Readings that direct the student to related material and
include relevant information available on the Internet.

SUPPLEMENTS TO THE TEXT
An Introduction to Financial Markets and Institutions, Second Edition offers a comprehensive and well-crafted supplemental package for the instructor.
• The test bank was carefully prepared by the authors and questions have been
thoroughly tested on students.

Preface

xxi


• Microsoft PowerPoint slides have also been prepared by the authors and can be used

to enhance lectures. The slides contain all of the exhibits in the text and additional
lecture slides that follow the material covered in the text.

ACKNOWLEDGMENTS
Many people have made important contributions to this text. Special thanks go to Lynn
Taylor, our Executive Editor at M.E. Sharpe, who was always supportive, enthusiastic,
and helpful. She is a first-rate editor. We also owe a debt of gratitude to Stacey Victor
who did a great job handling the production aspects of the text. Both are delightful to
work with.
Other people also deserve special recognition. As always, Professor Emeritus
George Galbreath gave invaluable comments and insights, answered every question
with thought and detail, and provided overall support and encouragement. Dr. Bryan
Taylor, President of Global Financial Data in Los Angeles, California, provided much of
the data and answered innumerable questions. Professor James Sutton also gave invaluable criticisms and suggestions. We are also grateful to our families and friends for their
comfort, support, and understanding of our obsessive compulsive desires to create this
text. We are also indebted to many current and former students who have assisted us in a
myriad of ways and enriched our lives. Roberto Ayala, Adam DeAvilan, Benton Wolverton, Naomi Rose Beezy, Ryanne Spady, Junyan Wang, Michael Medrano, and Duane A.
Dohrman II.

xxii

Preface


1

PA R T

n
o

i
t
c
u
d
o
r
t
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I

1 Introduction and Overview
al Instrument

2 Money: A Unique Financi

struments, and
ancial Markets, In

3 Fin

4 Financial Intermediaries and

Risk

Market Makers


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